Investors want their financial aims met

Since the start of the global financial crisis many things have changed. Central banks around the world have lowered their key interest rates and engaged in unconventional easing measures. This has led to an unprecedented decline in government bond yields in developed market economies. While this decline has been going on for more than 30 years now, delivering very attractive returns for fixed income investors, yields have recently fallen to such extremely low levels that little upside remains.

At the same time historically high levels of volatility in bond markets have been observed – yields on fixed income portfolios at or close to their lowest levels ever, together with increased risks present a major challenge for investors and their advisers. On one hand, the search for yield and return theme continues to unfold, while on the other hand the demand for lower-risk strategies only increases given demographic changes, stricter regulations and the collective memory of the 2008 financial crisis which has reduced investors’ ability and/or willingness to take risk.

As a result, investors are turning to professional investment managers who are able to provide the right balance of risk and return. Many managers of multi-asset funds are well-positioned to serve this need for several reasons, which we explore next.

Firstly, in a world where yield and returns are scarce and come at a price of high risk, flexibility is a big advantage. By definition, portfolio managers overseeing multi-asset funds have a broader set of opportunities to act upon than those overseeing single asset class funds. This is a big advantage in the eyes of clients and their advisers. Multiple academic studies have provided support for the hypothesis that mutual fund returns can to a large extent be explained by top-down asset allocation decisions among major asset classes. Skilled multi-asset managers who can make the right allocation calls can therefore provide a very appealing proposition for their investors.

However, many multi-asset funds are flexible enough to enable their managers to enhance the returns even beyond what can be achieved by the first top-down asset allocation decision. Portfolio theory tells us that given an asset manager’s skill, as measured by her information coefficient – a numerical expression of how often the investor makes the right calls – performance should improve as breadth (a higher number of independent views) increases. It is therefore desirable for any asset manager to have more granular views in a portfolio, next to the traditional top-down asset allocation between equities and fixed income, assuming a fund manager is be able to generate correct investment views. For example, the ability to form and act upon an accurate opinion on the outlook of sectors and regions next to asset classes can provide additional sources of return. Implementing a broad set of independent investment views in a portfolio also helps to manage (active) risk. This improves the risk-return trade-off and helps to increase the attractiveness to investors. To summarize, the key to success is the ability to use a wide set of opportunities and tap into a diversity of return sources.

Another reason for multi-asset funds’ popularity is the recent increased interest in so-called outcome-oriented funds. As opposed to their benchmarked counterparts, outcome-oriented funds – often referred to as growth, flexible or total return funds – are not tied to a benchmark and rather aim to achieve a “cash plus” or an “inflation plus” return with a certain long-term target level of risk. In the short term, their overall risk budget is often flexible, allowing the fund to take on more risk if market opportunities arise and to stay conservatively positioned to mitigate losses if risks surface. This also implies that outcome-oriented multi-asset funds are often less restrictive than traditional benchmarked mixed funds in terms of asset allocation, allowing their portfolio managers to take larger positions in their preferred asset classes. Mutual funds whose investment managers are able to make good use of this flexible fund design by accurately assessing the relative attractiveness of asset classes are clearly a strong value proposition for a broad base of clients.

Also, an increasingly prominent feature of many outcome-oriented multi-asset funds is their ability to manage their duration position more flexibly. By doing so, these funds can limit, eliminate or even benefit from potential interest rate increases, addressing a major concern of many clients.

A last point why multi-asset funds are gaining traction relates to the more risk-aware nature of clients. By allowing for more flexibility, well-managed flexible multi-asset strategies can provide attractive returns while running a risk level comparable to that of a diversified bond fund. Thus, many would-be fixed income investors are ever more turning to these investment strategies to satisfy their desire for safe returns at their desired level of overall risk. At the same time, potential equity investors can benefit from lower ex-ante risk of these funds, while still being able to participate to a big extent in an equity rally.

With respect to risk, it is important to mention another impact of the global financial crisis which influences the way multi-asset managers must approach asset allocation in today’s environment. Markets now appear to be gripped by even more herd-like behavior and more frequent disruptions. Emotions can have such an impact that markets can fail to function rationally much more often. Economic cycles have become shorter. Therefore, investors need to be quick to respond to opportunities and risks that arise in a market. Due to the greater sensitivity of the real economy to markets, opportunities can quickly disappear and risks can quickly increase. While in the long term, markets are driven by fundamental factors, investor behaviour can influence their direction significantly. Multi-asset managers who are able to correctly measure, interpret and translate their assessment of behavioral factors at play in a particular market might offer a big advantage in this environment.

Our environment is changing. Government bond yields are at record lows and the global financial crisis has altered the dynamics of markets. Investors are searching for yield and have become more risk-aware. As always, the backbone of a strong strategy is a good investment team with a proven process, demonstrated skill and prudent risk management. Next to this however, new innovative alpha sources and flexibility in fund design are becoming more important than ever. Multi-asset managers with the right investment approach might currently be best positioned to meet clients’ objectives in this environment.

Jan Kvapil is portfolio specialist, multi-asset and Valentijn van Nieuwenhuijzen is head of multi-asset boutique

Key points

Many multi-asset funds are flexible enough to enable their managers to enhance the returns even beyond what can be achieved by the first top-down asset allocation decision.

Well-managed flexible multi-asset strategies can provide attractive returns while running a risk level comparable to that of a diversified bond fund.

Markets now appear to be gripped by even more herd-like behavior and more frequent disruptions.