A Perspective on Multi-Asset Strategies
In recent years, the concept of multi-asset strategies (often marketed under the banner of ‘diversified growth funds’) has risen to prominence within the UK pension fund community, and is predicted by its most vehement proponents to continue growing at a remarkable rate. Many investors, perhaps feeling chastened by the experiences of their equity investments during the 2008-09 financial crisis, are evidently drawn by the allure of equity-like returns with lower volatility, which many diversified growth funds purport to be able to deliver. In this piece, we look under the bonnet of these strategies and proffer our own observations.
We note that there appears to be no single definition of what constitutes a multi-asset strategy – the plethora of offerings that have flooded the marketplace in recent years comprises an extensive array of slightly different strategies and underlying assets classes. These range from the ‘balanced managed fund’ structures that, twenty to thirty years ago, were the staple diet of pension fund and retail investors alike (but have since been largely discarded as their results failed to live up to expectations) to those that more closely resemble many hedge fund offerings encompassing relative value strategies, complex derivatives and material leverage, to name just a few common features. Such a heterogeneous array of solutions inevitably renders comparisons a considerable challenge. However, most purport to provide investors with a single portfolio solution that aims to generate absolute positive returns in all market environments by mitigating material drawdown risk and/or the risk of capital impairment through diversification and asset allocation positioning. Target return expectations vary, although they typically aim to generate returns in excess of cash or inflation.
While conceptually appealing, we believe that such strategies are susceptible to a range of vulnerabilities that may undermine the ultimate achievement of the investment objective and even adversely affect the expected risk profile. We would highlight the following issues as deserving particular scrutiny by any investor assessing the viability of such strategies.
Many multi-asset strategies place a heavy reliance on adroit market timing skills to dictate asset allocation positioning in an attempt to exploit expected short-term asset class price movements (known as ‘tactical asset allocation’). These perceived skills rely on the practitioner’s ability to correctly forecast a wide range of future outcomes such as GDP growth, interest rate policy, market volatility and a slew of other top-down macro-economic factors, and successfully translate them into an investment strategy. There is a considerable weight of academic evidence demonstrating the fallibility of these endeavours and the difficulty of accurately predicting such outcomes consistently over time, given the multitude of uncertainties. Indeed, favourable track records can be rapidly tarnished by investment strategies missing key inflection points, incorrect forecasts, market shocks and “Black Swan” events. Furthermore, losses arising from a reliance on market timing are likely to be abandoned and capital impairments crystallised if events run contrary to expectations. Contrast this with bottom-up and value-led strategies where the investor can often recoup mark-to-market drawdowns by having the patience for fundamentals to reassert themselves.
A stable statistical relationship between historic asset class correlations is an important pillar of multi-asset strategies, in an attempt to insulate portfolios against unexpected drawdowns. However, there is no certainty that past relationships will persist into the future, as investors were reminded during 2013 when comments relating to the tapering of the US quantitative easing programme led to an abrupt sell-off in both equities and government bonds. A relationship that had existed for a prolonged period – that these two asset classes were negatively correlated – broke down, immediately invalidating the presumed diversification benefits.
Borrowing against portfolio assets and/or the use of margin on derivative positions often constitutes an implicit feature of many multi-asset strategies in an attempt to amplify returns, particularly during periods of low interest rates / return expectations. However, even relatively low leverage during periods of market turbulence can render a portfolio vulnerable, as managers may be forced to exit positions at inopportune junctures to manage its deleterious effect. It is worth remembering that the use of leverage cannot improve an investment decision; it merely accentuates its impact in either direction and dramatically foreshortens a manager’s intended time horizon. The collapse of LTCM, Amaranth Advisers, Bailey Coates and the widespread failure of a whole host of financial institutions during the credit crisis stand testament to the perils of levered portfolios. Leverage may also introduce investors to additional counterparty risk, which requires careful management.
In our experience, the ability to observe and understand the typically highly complex underlying investment process and inherent risks associated with multi-asset strategies can often be obscured by an unwillingness on the part of the investment manager to provide unadulterated disclosure, including the major drivers of modelling tools, nature of holdings / transactions and portfolio turnover. It can also be very difficult for outsiders to assess the frictional costs embedded in such portfolios and hence one is unable to gauge the gross added value that is required to meet the stated investment objective over time. Furthermore, many portfolios invest in other commingled vehicles (including exchange traded funds) and complex derivative positions, both of which present challenges in assessing the quality of the investment proposition, historic results, repeatability of favourable investment decisions, overt and covert risks, and the implications of leverage and illiquidity in different market environments.
Without sufficient clarity on how portfolios are structured and managed, including unequivocal evidence of how managers have handled risk and generated returns over time, the focus of investors will be drawn to headline results and other inadequate statistics highlighting only those providers that appear to have performed well over the short-term. Such a naïve method of strategy/manager selection is sharply vulnerable to outcome bias, a circumstance whereby favourable results imply the process employed to generate them is robust and repeatable. In reality, a positive experience, particularly through a propitious market environment, can easily mask frailties in an investment process and lead to ignorance of the underlying risks assumed. To have confidence in a multi-asset strategy and its ability to deliver expected returns in the future without unintended consequences, it is imperative to have full transparency on the historic activities embedded in the portfolio and to be able to monitor them on an ongoing basis.
For various reasons we remain sceptical about the supposed investment merits of the vast majority of multi-asset strategies that embrace tactical asset allocation, rely on the persistence of historical correlations, employ excessive leverage and lack transparency. While we embrace the concept that strategic asset allocation is critically important to manage risk and target returns over longer time horizons, we believe this is far more likely to be achieved through a carefully crafted investment structure that is subject to a disciplined and mechanistic rebalancing regime. The chance of ultimate investment success is further improved through the selection of high conviction portfolios comprising fundamentally driven investment strategies, managed by seasoned investment professionals who have a focus on valuation and stock selection.