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