Making flexibility your friend

The key investment conundrum of today is how to generate returns without taking on too much risk

Flexibility has become a popular mantra in the world of multi-asset investment yet it has also proved an elastic concept. Too often, ‘flexible’ can mean ‘within the limits of volatility targeting’ or ‘as long as our fund can remain in a certain IA sector’. The First State Diversified Growth Fund takes a different approach, however, targeting the UK’s Retail Prices Index plus 4% and having few constraints on how that outcome is achieved.

This necessitates adopting an alternative view of investment risk. Lead manager of the fund Andrew Harman believes volatility gives a one-dimensional view of investment risk. The ultimate hazard to an investor, he points out, is that they do not have enough savings to meet their current and future liabilities – and it is this view that underpins the fund’s investment process.

Harman and his team focus on the preservation and long-term growth of investors’ capital and to that end, rather than starting with a standard asset allocation mix and moving underweight or overweight, depending on market conditions, will concentrate on particular themes – for example, inflation and its implications for individual equity sectors, say, or commodities. “There are multiple avenues to gain exposure to different assets,” adds Harman. “We aim to target a specific outcome.”

There are two elements to the fund’s investment process. “We describe it as both flexible and dynamic,” says Harman. “We have our longer-term asset allocation framework and then we have a shorter-term allocation, which helps us look across the asset classes – whether that is equities, bonds, commodities or currencies – or within them. Is Europe more attractive than the US, for example? Should we be exposed particular segments of an asset class?”

Unlike more conventional multi-asset portfolios, there is no requirement for the fund to invest in any particular types of investment. Instead, the management team blend a combination of investments they believe have the highest likelihood of delivering the return objective.

To view an infographic on the First State Diversified Growth Fund investment process click here

In a similar vein, the fund is not obliged to track any benchmark or maintain static exposures – such as a 60% allocation to shares, say – or a certain volatility target. It is not a fund of funds either but takes direct exposure in individual asset classes. For this reason, says Harman, it as a more targeted solution for investors.

“The appeal of individual investment types varies over time as valuations change and according to prevailing market, economic and political conditions,” he explains. “Rather than be guided by the historic performance, correlation and volatility of asset classes, we can be more objective in our approach to investing.”

This can clearly be seen in the current portfolio positioning where, despite the apparently strong growth in the global economy, the portfolio holds just 10% in equities. “Growth in certain areas, such as Europe and emerging markets, is strong but that needs to be set against valuations,” says Harman. For him, the question is whether he is sufficiently compensated for risk and, through this lens, equities do not necessarily look so attractive in the current environment.

Where the fund is invested in equities, it is specific and targeted – focusing on areas that still appear to offer scope for genuine growth. “In 2017, investors saw high equity returns but also very low volatility of those returns,” Harman adds. “This can be seen in both realised and implied volatility, as markets are currently pricing in a continuation of this low-volatility environment. Without a commensurate increase in earnings, we see less incentive to hold equities.”

Two areas Harman does see pockets of value, though, are Europe and the emerging markets, particularly Asia – for example, China, Korea and Taiwan – and Latin America, where the focus is on Brazil and Mexico. For its part, European growth has been broad based, says Harman, “with consumption growth coming from higher wages and employment, and capital expenditures rising again”.

The fund also holds a number of short positions. While one constraint it does have is that it cannot be overall negative on equities, its managers are allowed to adopt some short exposures within equities to exploit the differences between certain markets.

A similarly targeted picture emerges with the group’s fixed income exposure, where Harman is avoiding developed market sovereign bonds but taking some duration risk elsewhere. “We believe nominal rates will move higher in the US, Europe and Japan,” he explains.

“We do have duration within the fund but it is in places such as emerging market debt – both in local and hard currency. Around 15% of the fund is now in emerging market debt, where we are positive on the economic cycle and reforms. Our other area of fixed income exposure is to inflation-linked bonds in the US and the UK, where higher inflation expectations are being priced in.”

Harman points out credit has seen impressive performance over the last few years, with US high yield spreads compressing from above 800 basis points (bps) in February 2016 to below 400bps at the end of 2017. From here, he says, valuations look high and he does not see many catalysts to drive spreads significantly tighter. As such, he has concluded US and European credit is not offering sufficient rewards for the risks and he exited the fund’s allocations in November.

Dynamic asset allocation

Still, if both bonds and equities offer only limited and selective value, where else can the fund turn for its returns? “Relying solely on equity and bonds in a constrained, long-only, unlevered environment is unlikely to be sufficient to meet investors’ return objectives going forward,” says Harman. “This is where our dynamic asset allocation process comes into its own, taking into account shorter-term market dynamics to deliver additional returns and abate portfolio risks.”

The fund will also invest in commodities and currencies, with the latter used for return enhancement and as a diversifier. “Some emerging market fixed income assets have a price and a currency component,” says Harman. “If you buy a foreign government short-term bond, the majority of your fluctuation is due to currency. In contrast, with emerging market equities, the fluctuation is in the price of the share.”

To see transparent, interactive view of our asset allocation decisions (and reasons why) since the inception of the First State Diversified Growth Fund click here

At present, the fund also has exposure to the euro and to emerging market currencies. Harman’s reasons for liking emerging market currencies are similar to those that see emerging market debt and equities well-represented elsewhere in the portfolio – the improving prospects for developing economies and the more attractive valuations on offer. The long exposure to the euro, meanwhile, is partly due to fundamentals, but also provides diversification in the event Brexit negotiations take longer than expected or break down.

Beating UK inflation can, Harman admits, be a challenge in the current circumstances. That said, he believes most of the UK’s inflation is imported. “Sterling has taken a significant hit, falling 15% to 20% on a trade-weighted basis, creating inflation of around 4%,” he says. “The Brexit negotiations will continue to influence this.”

Overall, the environment remains a challenging one for investors. “Valuations are looking increasingly expensive,” says Harman. “There has been a drive to capture return and yield, which has meant default spreads have been driven extremely low. Equity markets continue to rally to prices that are – if not at bubble levels - certainly full, even stretched. “We are now hitting a point where it is difficult to justify valuations on certain assets so we would rather avoid that risk altogether. The key investment conundrum of today is how to generate returns without taking on too much risk.” Fortunately, he adds, a significant benefit of a truly flexible multi-asset fund is its managers are in a position to look across the asset classes to find value, while remaining comfortable with the associated risks.

To see the top ten questions we get asked about the First State Diversified Growth Fund click here

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