Multi-assetMay 1 2019

Using multi-asset solutions

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Using multi-asset solutions

While many of the arguments of this debate are well-rehearsed and known by investors, they typically relate to using passive funds as a single asset class exposure within a portfolio.

Less understood are the implications of using passive multi-asset solutions.

While multi-asset strategies are quickly gaining traction among advisers and share many attractive features with their single asset class counterparts, they also pose challenges for investors.

This is due, in part, to the fact that the debate is focused on the future, which is inherently unknowable and consequently subject to conjecture.

It may also reflect a resistance to change – in part biased by longstanding conflicts of interest – with a perceived threat to business models and even the self-worth of active managers.

However, before sounding the bell to signal the death of active management, it is worth investigating the source of the performance that has driven the growth of passive funds to the top of the league tables.

As we do this, it is important to note that some of the logic that underpins the advantage of passive funds in the single asset space no longer applies.

For example, while it is a truism that the returns of a well-structured index must reflect the total returns of all participants (plus costs) in a single asset class context, the same is not true when operating across asset classes.

This is because the primary differentiators of a multi-asset fund – especially the split between equities, bonds and cash – typically reflect a risk preference set by the fund manager rather than the relative market capitalisation of those assets.

The rise and rise of passives

Before focusing on quality of the passive ‘basket’, it is worth reminding ourselves why passive investing has become so popular over the past few years.

While much research has been written about the historic relative returns of active vs passive, the more important debate is which strategy is likely to deliver better returns in the future.

In this context, passive funds have several key advantages, most notably the fact that they typically offer lower-cost exposure to an asset class, reducing the drag that fees exert on returns.

In addition, passive funds avoid the investment mistakes that frequently occur when active managers run portfolios.

For the fund selector, passive funds also help reduce the behavioural biases associated with picking managers, especially our natural inclination to buy funds that have performed well and sell those that have not.

In this guise, passive funds have delivered excellent returns for investors, with several passive strategies placed near the top of their relevant Morningstar category over the past five years.

This combination of low cost and strong performance is undoubtedly attractive and is fast becoming the default investment choice of many advisers keen to focus on financial planning rather than fund selection.

Acknowledging risk and the multi-asset dilemma

On the other side, one must acknowledge the role of uncertainty, especially given future returns are probabilistic.

For example, while a passive strategy may have a higher probability of success – if for no other reason than the fee advantage – it is not certain that the most likely outcome will occur.

Somewhat awkwardly, in this way investing can be likened to a horse race – while the favourite has the best chance of winning, they often do not, which is what makes the sport exciting.

Furthermore, while we must all appreciate the advantages for the passive investor, it is by no means certain that passive funds will perform better than active funds over the planned investment period.

It may be probable, but it is a mistake to think it is a deterministic inevitability.

This is further complicated when we add a multi-asset context.

In this world, the key driver of returns is decoupled from the price discovery mechanism that characterises single asset class funds.

While the impact of portfolio design is most obvious at a broad asset class level, it is also true within asset classes, as passive multi-asset funds will often exhibit a ‘home bias’ in their underlying exposures – we see this regularly across equity, bond and currency exposures, reflecting the liabilities and preferences of the local investor.

This again distorts the price discovery that is exhibited in single asset class funds and as a result, the features of a passive multi-asset funds differ significantly from their single asset class brethren.

It is important to highlight these differences because it can alter the risk profile of the portfolio through the impact of valuation and correlation.

This can be seen in the performance of passive multi-asset class funds over the past few years.

These funds have typically benefited from higher relative exposure to the largest capital markets – such as US equities or UK gilts – despite the fact that many investors consider these assets expensive. 

As both returns and risk are linked with starting valuations, this raises a dilemma.

That is, the high price of these assets reduces the prospective returns and increase the prospective risk.

While this is true of any passive fund, it is less relevant for a single asset fund as these are judged by their ability to deliver returns compared to the benchmark. The overall risk and return characteristics of this benchmark are therefore of little importance.  

However, the situation is different for multi-asset funds as these are primarily designed to deliver returns within a given risk boundary, which may include many different assets and portfolio constructions.

In this context, the success of the portfolio is judged primarily on its risk/return profile.

Periods of lower expected returns and higher expected risk, coupled with a static asset mix, can impact the suitability and lead to disappointment that is not experienced by investors in passive single asset class funds.

Key Points

  • Some of the logic that underpins the advantage of passive funds in the single asset space does not apply to multi-asset
  • It is by no means certain that passive funds will perform better than active funds over the planned investment period
  • Multi-asset funds have typically benefited from higher relative exposure to the largest capital markets – such as US equities or UK gilts

Dan Kemp is chief investment office of Morningstar Investment Management EMEA