PensionsJul 23 2015

Risky business

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Risky business

The story in June was all about Greece and China. European politicians dallied and dithered, and the Greeks said no, then maybe, while the banks remained tightly shut in the now long-running drama of its debt crisis. In China, a sustained bull market fuelled by cheap credit finally ran out of steam, leading to panicky mom-and-pop investors selling up, and trading intermittently being halted on the mainland exchanges.

The net result of all this for UK investors was that equities and bonds fell in line with each other for most of the month, and while some equities did worse than others (in particular China) nowhere was safe, with the exception of cash or cash-like investments.

Smoothing out the bumps

It is months such as this that can tempt long-term pension investors to consider the merits of ‘clever’ multi-asset funds that are designed to smooth out bumps in the road not just through diversification, but also by assiduous portfolio management.

It has become fashionable for auto-enrolment default funds, Sipp investors and even large institutional investors to use multi-asset funds (also known as absolute return and diversified growth funds) in an attempt to capture long-term growth for less risk than can be achieved through a static asset allocation. But is this the right approach, or would long-term investors be better off simply riding out June-like squalls?

Be careful what you wish for

Many multi-asset funds have been marketed with the suggestion that they are designed to achieve the same growth levels as equities (or near to them) over the long term, but for significantly less risk.

The way they do this is by moving in and out of different assets classes, capturing the momentum of each asset class as it gains favour. Some also use derivatives extensively to reduce risk, a bit like a hedge fund.

It was really after the 2008 Lehmans-inspired sell off that these funds made their name, with many demonstrating the successful ability to navigate choppy waters and preserve value while all else was falling around them.

As a result, achieving returns with low volatility has been the goal of many of these funds which have been running annualised volatility of around 5 per cent ever since, while equities have offered more than twice this level of volatility.

This has become, then, a very low risk investment approach. And while it did well in the down markets of 2008, it has significantly underperformed stock markets in the bull markets that followed.

The argument proposed was that clever portfolio management would allow the funds to deliver equity-like returns for a fraction of the risk. They have kept their promise to keep volatility low, but the returns have been low as well.

This story does mean that the concept of managed multi-asset funds is faulty for long-term investors. It just reiterates the old adage that risk and return are related; if you take more risk you should expect to receive more in return. If you take less risk, as many of these multi-asset funds have, you should expect less in return.

Pension fund investors that need long-term equity-like returns to achieve their retirement objectives should not expect to receive this from multi-asset funds running at 5 per cent annualised volatility.

They receive no benefit from this low-risk approach in the long term; they are simply more likely to miss their retirement target.

By contrast, multi-asset funds that have taken more risk – using fewer or no derivatives and relying more on broad diversification and gradual asset allocation shifts rather than drastic lurches – have performed much better in the past few years. Over the long term there is good reason to believe that these higher-risk funds should deliver higher returns and deliver value for pension fund investors.

The second reason why the right sort of multi-asset funds still have a role to play for long-term investors is diversification itself. Diversification is not simply mixing bonds and equities.

The mix between bonds and equities is a good way of achieving a certain level of risk, but diversification is much more than this, involving more arcane equity markets (such as China and other emerging markets) and alternatives too.

This is something that investors and advisers can do themselves, using single asset class funds to create a static but diversified portfolio. But with hundreds of markets available to invest in, this is a complex task. As any multi-asset fund manager will tell you, researching and monitoring all these markets is a time-consuming task often carried out by large teams of specialists.

Getting the right blend of markets, without over-concentrating or filling the portfolio with highly correlated positions, is a detailed task.

Tried and tested

Any changes to the portfolio need to be modelled and tested. Risk levels and market movements need to be monitored daily. How much do you or your clients know about the Asian property market, the main Chinese A-shares indices or which is the best commodity index to follow?

The chances are, not a great deal, which makes choosing the right components to build a properly diversified multi-asset portfolio rather tricky, even if you are not planning to change it much or monitor each of the moving parts.

A very good level of diversification can be achieved by building a portfolio made up of a carefully selected basket of passive index-tracking funds – but that still involves a portfolio of 15 or more funds covering almost 100 capital markets.

As we all learn at investment school, investing is primarily about getting your asset allocation right. It is asset allocation that determines your client’s risk level and will be the main driver of their returns.

This vital job is all too often left with the client themselves or with advisers that do not have the time and resources to properly construct and monitor the portfolio.

Investing in a multi-asset fund with a very low risk level is likely to give you a lower return. But choosing a multi-asset fund running the right level of risk for your client makes sense.

With access to large investment teams and the time and expertise to research all global markets, many multi-asset funds are well placed to properly diversify your clients holdings and tilt it in the right direction with more diligence than you or your client are able to provide. Just do not expect them to be prophets gifted with second sight.

Managing expectations

In months such as June, you should expect the fund to fall in value. You should not expect your managers to have gone to cash on the 28 May and so whisk your client away from the impending Hellenic storm, deus ex machina. They will do their best to reduce risk and provide what protection they can much quicker than an adviser would be able to.

But they are not seers blessed with the ability to prophesise the whims of the market gods with perfect clarity.

Use multi-asset funds wisely for pension investors, but beware low risk multi-asset funds promising to boost returns with supernatural market foresight.

Bob Campion is head of institutional business at Charles Stanley Pan Asset Capital Management