How flexible is flexible?
Andrew Harman explores the pitfalls to avoid in order to stay true to your investment process.
Staying true to your investment process: how flexible is flexible?
One of the key advantages of a multi-asset or diversified growth fund is that it has the potential to perform in all weather. Investors are, to some extent, more insulated from the highs and lows of individual asset markets, and can therefore achieve their financial outcomes with greater consistency and predictability.
However, in order for this to be a reality, flexible multi-asset funds really have to be flexible.
This has come into the spotlight because a number of multi‑asset and diversified growth funds have not performed as they said they would. They have proved neither as active, flexible or consistent as they claimed. It is clear from their positioning that when they say they are ‘go anywhere’, they are instead managed to relatively tight parameters.
To our mind, multi-asset doesn’t mean having a little bit more in bonds, or a little bit less in equities. If there is no value in government bonds, for example, they shouldn’t form part of a multi-asset portfolio. At the same time, if there is a compelling opportunity, an investor should be free to back it with conviction, rather than doing so half-heartedly because of a necessity to hold a certain percentage in another (less attractive) asset class. Flexibility needs to mean flexibility.
In achieving this, starting with a blank sheet of paper rather than a pre-populated asset allocation template is important in creating consistent long-term returns. Assets may display quite different risk characteristics over the course of a market cycle. As such, to say that an investment will always have 55-65% equities and 35-45% bonds is to ignore changing market and economic conditions. It suggests, erroneously, that an investment’s risk characteristics and correlation are static.
There are other problems with a static asset allocation. It can encourage behavioural biases. It can mean that a fund manager keeps adding to a weakening asset class as they rebalance a portfolio to meet their allocation model. As we see it, the appeal of individual investment types varies over time as valuations change and according to prevailing market, economic and political conditions. An asset class may be appropriate to meet an investor’s objectives at one point in the cycle, but will not serve the same purpose once the price has risen.
Achieving real diversity takes a more nuanced approach. There is an argument that investors can allocate within the equity market and achieve sufficient diversity. We would take issue with that premise. Yes, cyclical companies will behave differently to defensive companies. However, it is all equity risk and it doesn’t provide a lot of real diversification. When markets fall, both types will fall and the fact that one type of company falls less than another is irrelevant for an investors that needs to achieve CPI + 4% to achieve their goals.
Nowhere is this misperception of risk more acute than in the fixed income market. Investors tend to think of fixed income as very defensive because that has been the case historically. However, today, parts of the fixed income market have a zero return and don’t seem very defensive at all, particularly in a climate of rising inflation. Instead, by dynamically shifting exposures, it is possible to take advantage of investment opportunities as and when they arise.
Flexibility/matching with objectives
As we see it, each investment must be in the portfolio on its own merits. The only investments that need to be there are those where we are sufficiently compensated for taking investment risk and increase our chance of achieving our investors’ objectives. You need to understand that objective and have the tools to do it. We have a team-based approach. This means more pairs of eyes and that has a real benefit for our clients. At the same time, disciplined active management steers us away from behavioural biases.
Transparency is also important for multi-asset funds of all kinds. Investors should be able to interrogate their investment manager on how they have generated their returns, what worked and didn’t work, and how their allocation has changed over time. Only then can they see if a fund manager is truly ‘walking the walking’ on flexible asset allocation.
It is important for advisers’ relationship with their clients – if something goes wrong (or right), they can explain it. They can be reassured that the fund manager is sticking to the process and it is easy to maintain a good relationship. We know every asset allocation decisions we’ve made since the start of the fund almost three years ago and share this with our clients through a web based tool. This is proper transparency and gives real insight into how the fund is run and whether it is true to its investment process.
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