The sheer time, effort and energy required to select, purchase, rebalance, monitor and review a series of investment vehicles or funds for each individual customer would be massively time consuming and not cost-effective for the investor or the adviser.
Multi-asset approaches – fund of funds, manager of managers or model portfolios – are compelling solutions as the offer many benefits, including:
•Diversified asset mix
•Rebalancing
•Economies of scale
•Range of investment styles
•Range of managers (potentially)
The initial products available in the market were fairly simple fund of fund solutions, either offered by one manager into their own underlying funds (fettered) or by selecting managers from the wider marketplace. Typically they held equities, bonds and sometimes property. The old Investment Management Association sectors of cautions, balanced and active grew in popularity and were complemented by new ideas such as single-sector fund of funds, niche managers and distribution products.
Most of these early funds were active managers putting together portfolios of active funds – this created one potential weakness of the fund of fund structure – namely cost. With two sets of managers (with their annual management charges) and two sets of dealing costs, this apparently simple product could be quite expensive with total expense ratios upwards of 2.5 per cent a year.
With the growth of passive funds, and exchange-traded funds particularly, we have seen these costs come down as managers are able to allocate to asset classes on a more cost-effective basis – running what are, in essence, core and satellite approaches. We have also seen the arrival of the first completely passive fund of funds with aggregate TERs below 1 per cent a year.
Manager of managers products have not been as popular as fund of funds. Perhaps this is due to their perceived ‘institutional’ nature, though RDR and new innovations may see this approach grow in popularity.
The introduction of Ucits IV legislation has allowed managers to use derivatives for the first time. This adds a layer of sophistication to the simple product idea. Combine this with the inclusion of synthetic ETFs inside fund of funds and you can see that this once-simple multi-asset solution has become a more complex animal.
There are many approaches that fund of fund and other multi-asset products can adopt. Some managers adopt long-term strategic asset allocation positions and only make occasional tilts away for this benchmark. Others are more aggressive at the tactical level and may take substantial positions away for the fund benchmark asset allocation.
A growing number of managers are using some external source of asset allocation for their benchmark – either from a risk tool or using some form of volatility measure to construct dynamic asset allocation. Understanding how these benchmarks are constructed, particularly the underlying assumptions, is an important part of any due diligence process for the adviser.
Many funds now have a risk rating of one form or another – again it is important to understand this. Is it, for example, a snapshot risk profile taken on some historic date, or is it a risk rating that is adhered to over time, that is, risk managed?
Post-RDR there has been a growing focus on costs – both of advice but also of the wider value chain. We have already seen a number of platforms trimming their fees. Bigger distributors have also been demanding greater discounts from their preferred managers. The debate over clean share classes has only just started, but many expect to see fund costs (well AMCs at least) fall.
The traditional fund of fund structures look a little out of place in an environment where inflation and asset class returns have fallen over the last few decades. Trying to charge a TER of 2.5 per cent a year with additional trading costs of perhaps 1.5 per cent a year on top is hard to justify in a low-return environment. The bar chart below shows how returns for a clean (zero cost) portfolio of 60 per cent UK Equity and 40 per cent UK Gilts have fallen over the last five decades. Charging 4 per cent a year when returns on the portfolio are only 3.7 per cent is unsustainable.
Advisers also need to be careful to compare apples with apples. Some TERs for fund of fund products appear low because of direct asset holdings – for example, bonds or derivatives, which have no apparent cost. While these might drive TERs down, the risk of holding single instruments or complex products may be substantially increased.
The general understanding of risk and complexity – value at risk, counterparty risks, swaps – has grown substantially among advisers in the past few years. But I would argue it is still some way behind that of the product manufacturers (the asset manager and investment banks). Even apparently simple fund of fund structures using low cost ETFs may not be simple once unpacked.
Consider a fund of fund investing in:
- A bond fund that invests in currency derivatives for hedging;
- A commodities fund that tracks a basket of commodities futures (and thus exposes investors to risk from futures prices being in contango or backwardation; and
- An absolute return fund that uses a range of arbitrage strategies.
Assume the adviser had sufficient knowledge to ask the right questions – how long would due diligence take on this structure, and what happens when the manager invests in a new vehicle?
Can, or should, an adviser be expected to understand all the underyling techniques and risks associated with investment products when they are intermediated by fund managers investing in investment bank products? It is surely impossible to achieve.
We have seen an example recently of when the asset allocation reported for a fund appears to be a long way from the benchmark. Investigation reveals that derivative exposure is being reported as cash while the economic (asset class) exposure is to a different asset. So even simple reporting is complex.
The growing use of derivative products either inside swap or synthetic ETFs, or for tactical exposures adds a layer of complexity that most advisers will be unfamiliar with. The collateral and pricing arrangements for some of these instruments are not particularly transparent either. Some funds hold physical assets only for strategic positions but use derivatives for all tactical views – does the adviser need to know the counter parties and embedded costs in these contracts?
The chart from the Bank of England Financial Stability Report June 2010 shows the cash flows in a swap-based ETF. Some would question whether this is a suitable or understandable product for retail investors – yet I suspect almost all multi-asset funds now hold some synthetic ETF products.
This is creating a real quandary for advisers, many of whom will happily acknowledge that their level of knowledge of some of these products is not at ‘expert’ level. What are they to do? Can they really be expected to understand every underlying investment and product structure inside every fund of fund they recommend? This, I would argue, is impossible.
Due diligence has never been required as much as it is now.
The benefits of multi-asset investing are clear, and perhaps we are starting to see a return to simpler, more cost-effective solutions that are easy for advisers to explain and use with confidence. This will allow them to focus more effort on perhaps the most important part of the value chain – the financial planning.
David Norman is chief executive of TCF Investment
Key points
- Multi-asset funds have remained an investment favourite with advisers for many decades.
- Some managers adopt long-term strategic asset allocation positions and only make occasional tilts away for this benchmark, while others are more aggressive at the tactical level.
- Advisers with even small scale can turn to a discretionary manager and ask for bespoke portfolios.
