How to make and manage a multi-asset fund

Yet is it really that simple? And if it is, why have so many people got this so wrong, creating ever-more complex multi-asset funds, with ill-defined risk parameters? 

One need only remember the Financial Conduct Authority's (FCA's) recent warnings on portfolios that hold illiquid assets - for example, multi-asset portfolios with exposure to property - or its 2015 thematic review, which found a significant disparity between the composition of portfolios and the risk tolerance and investment needs of clients.

Although the 2015 review, Wealth management firms and private banks - Suitability of investment portfolios, was not focused on multi-asset funds per se, the City watchdog did highlight problems with discretionary managed funds that purported to be multi-asset in composition. 

This hadn't been anything new to the regulator; as early as 2011 it had sent out a sternly-worded 'Dear CEO' letter, following an earlier review.

The letter warned wealth managers that their supposedly risk-rated portfolio ranges were not being managed appropriately enough and with due regard to the individual client's needs. 

The 2011 letter stated: 

So, what does make for a good multi-asset portfolio?

Flexibility

According to Andrew Harman, portfolio manager of the First State Diversified Growth fund, it is important to build "truly flexible, dynamic and well-diversified portfolios, without hidden risks".

To do this, he says, investment managers must look to develop "forward-looking estimates for expected returns, volatilities, and the correlations (co-variance between assets)."

He explains that such variables are not static: "The appeal of individual investment opportunities varies over time as valuations change according to prevailing market, economic and political conditions."

He also values the full flexibility and discretion given to managers regarding what to invest in, and what not to, at any point in time. Mr Harman adds: "By dynamically shifting exposures, we can take advantage of investment opportunities as and when they arise."

Diversification

Diversification seems like a given: after all, it's multi-asset, not single-asset. But as Chris Leyland, deputy chief investment officer for national advisory firm True Potential comments, there's no point having diversification just for the sake of it; it has to be tailored to the end client.

He says: "The client and target market is always the starting point. We look to provide solutions that are suitable for a broad range of clients, their different attitude to investment and, importantly their goals.

"From there, the key is to provide a diversified mix of assets that will work in changing market conditions."

So how to create the appropriate level of diversification?

Robeco’s paper ‘Bonds are from Venus, equities are from Venus too, actually’, shows traditional multi-asset portfolios may look well-diversified, but in fact the assets within may be exposed to the same underlying macro factor.

Robeco identifies six macro factors affecting the variability of returns as:

• Real Rates – changes in interest rates, the compensation for lending money for a longer period.
• Inflation – changes in prices. Fixed coupon nominal bond investors are particularly vulnerable to the risk of unexpected inflation surprises.
• Growth – unexpected changes in economic growth.
• Credit – associated with bond spreads and default risks.
• Equity – associated with equity-specific risks, the ‘animal spirits’ risk, from company defaults to “periods of exuberant expectations”.
• Emerging markets – associated with taking specific, political risks linked to investing in less developed and therefore less stable markets.

According to the paper, between 75 per cent and 90 per cent of the variability of returns of most liquid asset classes can be explained by using these six factors.

Should a portfolio be so constructed that the underlying holdings have high concentration to one or more of these risks, then it does not matter how ‘diversified’ by asset class or geography it looks at first glance; there will still be deeper-level correlation involved.

In the graph below, it shows a traditional ‘balanced’ portfolio of 40 per cent bonds and 60 per cent equities compared with a portfolio that aims for true diversification.

The first portfolio has a much higher exposure to equity risk and the ‘animal spirits’ that can ride high on sheer exuberance but can turn on a dime.

The second aims to smooth this out, reducing the overall risk.

“Nobody will deny bonds and equities have different risk/reward characteristics”, the paper says, but by analysing the underlying macro factors, for example the blurred line between emerging market equities and emerging market bonds,"a more effective risk-reward trade-off can be made between the two asset classes”, the report states.

Yet there is a case for avoiding too much diversification, with the two main considerations being the additional trading and management costs, and the potential dilution of returns by diversifying so much that the portfolio becomes meaningless as a dynamic multi-asset fund.

Risk management

For Mr Harman, risk management is a "continual process". Indeed, risk has been at the crux of the FCA's various investigations into the way in which portfolios are built and monitored with the end user in mind.

Mr Harman says: "In the finance industry, jargon like 'standard deviation', 'tracking error' and 'volatility' is often used a shorthand to describe and measure portfolio risk.

"But let's be clear: to many of us, 'risk' is the chance of losing money. Pure and simple. 

"There is a strong desire to protect our capital."

Using statistical models - stochastic modelling or various different economic measures such as the Sharpe Ratio - to analyse risks can be helpful for those creating and maintaining multi-asset portfolios.

A.D. Wilkie is credited with creating a stochastic model to chart the behaviour of various economic factors back in 1986.

The risks and rewards of hedging or not must be considered and implemented. Peter Sleep

This was building on the work of economists and economic theorists such as Tobin and Markowitz in the 1950s who were looking into the risk and return metrics of investment portfolios, using simulations such as the Monte Carlo method of analysis to evaluate the risks that could affect the outcome of different investment decisions.

While models building on these early simulations can be helpful for managers in creating a robust portfolio, to some managers, these are not the definitive solution to getting the balance of risk right for clients.

For example, Mr Harman says he uses statistical risk measures as aides to guide asset allocation decisions and risk controls, but adds: "While we believe these measures are helpful, they are imperfect and so need to be supplemented with market experience."

This experience can come in the form of implementing an investment process that helps the management teams to "allocate capital to an array of investment classes and adjusting this allocation given changes in the investment environment".

This is the view of Jonathan Webster-Smith, head of the multi-asset team at Brooks Macdonald, who continues: "For example, the process we use combines strategic and tactical approaches to asset allocation with vigorous individual security selection.

"It also involves the integration of qualitative and quantitative risk controls designed to reduce overall portfolio risk through diversification and other methods."

Make-up

So once the basic diversification and risk parameters are put in place, how should it be managed? According to Lukas Daalder, chief investment officer for Robeco, this “all depends on the risk appetite of the investor”.

Most multi-asset offerings sit in a range between these bands:

1) Pretty defensive – 80 per cent bonds, 20 per cent equities.

2) Pretty aggressive – 20 per cent bonds and 80 per cent equities.

Beyond that, Mr Daalder says you are into the leverage and all sorts of exciting investments.

“Once you have determined your risk profile, you basically match the right combination of assets, taking correlation and volatility into account.

“This can be as simple as sticking to pre-determined benchmarks or as elaborate as you want, using tactical asset allocation strategies such as hedging, overlays, pair trading and leverage, and so forth.”

Whatever risk band and style of management is all determined, he concludes, by the risk appetite of the investor.

Adapting the make-up of the fund to best fit the lifestyle of the end investor is therefore fundamental, as James Dowey, chief economist and chief investment officer for Neptune, comments.

“The biggest real-life risk inherent to investment portfolios is they fail to grow over the years.”

This means the funds need to be there to provide for people funding their retirement or other long-term goals.

Mr Dowey gives three main elements on which to focus:

1)      Asset classes which have long and reliable track records over history of producing strong inflation-adjusted returns over extended periods of 10 or 20 years; global equities, for example.

2)      Active stock selection, which is “highly potent”, he says, over the long term, as the economy changes and some companies thrive and fall.

3)      Capital protection during severe market sell-offs, by judiciously dedicating a minority of the portfolio to assets that will appreciate during a sell-off, including simple index put options.

Viability

As mentioned before, there are more than 1,000 multi-asset portfolios domiciled in the UK. Many of these might be bespoke creations for just one high net-worth client, or so small these are not marketed or even listed within the various Investment Association sectors.

Simply being able to construct a risk-robust portfolio with a good management team round it is not enough for the purposes of longevity, which is why many advisers choose to outsource rather than have discretionary investment permissions and create their own in-house portfolios.

Ben Willis, senior investment manager for Whitechurch Securities, explains making and managing a multi-asset fund is “not straightforward”. For a start, he says, getting the assets in to make it commercially viable is “just one hard part”.

He says: “The actual setting up of a fund is not cheap – anywhere between £50,000 to £150,000 in the first year alone.

“An authorised corporate director (ACD) has to be appointed, and these usually take care of all the administration, trading and regulatory requirements.”

Once this has been agreed, Mr Willis says the next hurdle is actually marketing the fund and attracting more assets – which can be hard when there is no track record to rely on.

“In addition”, he says, “charges on small funds are much higher due to the fixed costs of an ACD. This is a catch-22 situation in this cost-conscious world, as to lower the fund costs, the fund has to attract assets, but investors won’t invest in a fund with high charges.”

He believes a fund should get to around the £50m stage to start being truly profitable for the fund managers, and the costs need to be roughly on par with the peer group.”

Other considerations

For Peter Sleep, senior investment manager for Seven Investment Management, currency hedging, tax and choosing whether to go active or passive are important considerations.

He says: “Hedging can be an expensive process but can reduce volatility arising from sterling moving around but, similarly, having some openness to holding safe-haven currencies like the US dollar, Swiss frank or Japanese yen. 

"The risks and rewards of hedging or not must be considered and implemented."

Mr Sleep also advocates selecting multi-asset portfolios by type: active, passive or a blend of the two. 

Moreover, he cites the age-old issue of taxation.

"A UK taxpayer will want to ensure all the funds she selects have UK tax reporting status, or she could end up paying too much to Philip Hammond," he suggests.

simoney.kyriakou@ft.com