No easy alternative

If many asset allocation calls are becoming more difficult, others have long been tough to work out - as we mentioned last week, government bond allocations are a case in point. Absolute return and hedge funds represent the converse of that puzzle - they've replaced fixed income exposure in many cases, but there's equally little consensus on how much of a typical portfolio should be given over to the asset class. 

Our chart below underlines that. It shows absolute return and hedge fund weightings for a selection of DFM Balanced portfolios, according to our database. The spread is significant, ranging from zero to in excess of 20 per cent - and these all in models which have the same risk rating.

Alternative funds have had their own problems of late, but plenty still have faith in their diversification benefits. Nearly half of the names in the chart still have double-digit allocations.

Tilney, which comes out top with a weighting of nearly 22 per cent, has loaded up on absolute return exposure because of concerns about traditional assets.

Here’s Ben Seager-Scott, Tilney’s chief investment strategist:

While equities are generally going to be the strongest long-term growth drivers in most portfolios, they also carry the highest risk so we look for assets with a lower risk/return profile and, importantly, lower correlation while making sure those assets can pull their own weight. From that point of view, fixed income looks unattractively valued, with negative real yields on many core sovereign bond markets and tensions in a lot of the credit market.

Others are less convinced, most likely due to the aforementioned torrid performance of many names in both the absolute return and hedge fund space: even Tilney stresses it has made a call on specific absolute return names rather than the sector as a whole. And several wealth managers have less than 5 per cent allocated in total to these areas. In most cases, these firms are relying on fixed income to fulfil a similar function.

One, Parmenion, has nothing in its equivalent of a Balanced portfolio. The investment team looks for several  years or even decades' worth of comparison data for funds in its Conviction portfolios, and says there just isn't the required information on absolute return.

That said, such funds are included in other types of MPS run by the firm. That divergence is arguably a microcosm of attitudes to alternatives across the industry as a whole.

A new model

The pressures of the present day mean wealth managers have little time to devote to considering the future of model portfolio construction. Help may be at hand in the shape of a report on platform MPS from the lang cat released earlier this week. And among its many theories are several that would have direct implications for asset allocation.

The good news: the consultancy thinks that the holy grail of investment management - combining scale with individualisation - will soon become more plausible courtesy of tech improvements. That might have the added bonus of dampening regulators' shoehorning concerns.

The firm says: We think the sector will move towards a commonly understood framework that governs how an adviser creates an individualised client proposition. This will be the plumbing that links risk assessment to goal setting to tax optimisation to reporting to rebalancing and so on.

Less promisingly, it notes that model portfolios, being a relatively recent development, have not yet borne the brunt of a full market cycle. A serious downturn, if and when it comes, could have equally significant consequences, in part because of the kind of dynamics we discussed at the start of this newsletter.

As absolute return allocations show, no two firms' balanced portfolios are the same - despite most of these portfolios having the same risk rating. And these things always tend to attract more attention when returns are deeply in the red.

The result? "Serious thinking about where to go next with investment proposition construction", per the report. One notable change it floats is the possibility of incorporating investment time horizons into risk profiles.

Getting this right is important, because DFMs in particular are still facing a battle with multi-asset funds for adviser money. The Lang Cat is among those that thinks this year's Mifid II disclosure demands will help restart the separation of investment and financial planning functions at most average-sized firms. But it's far from guaranteed discretionary fund managers will be the prime beneficiaries of this switch.

Passing of a pioneer

It would be remiss not to conclude by commenting on Vanguard founder John Bogle, who died last night aged 89.

Mr Bogle’s insistence that investors should “stay the course” and look to the long-term also applied to his own personal and professional life, as he overcame six heart attacks and widespread scepticism about tracker funds to oversee the rise of the $10trn index investing industry.

It seems strange now to recall how, just a few years ago, tracker funds were still a minority pursuit among UK professional investors. Nowadays, almost every wealth manager finds a place for them in their portfolios in some shape or form. 

That’s underlined by our MPS tracker database of discretionaries’ fund selections - judged by the total number of times a company’s funds are used in DFM model portfolios, Vanguard is now the wealth management industry’s single most popular asset manager. 

Nowadays, that pre-eminence extends to ETFs as well as trackers, despite Mr Bogle's continued criticism of the products as encouraging short-termism. But his legacy is not confined to a corner of the passives world. The entire funds industry, or more accurately its end investors, have benefited from his focus on excessive costs and charges. There are few who have done as much to change the course of retail investment history.