Investors should be wary of believing using more than one multi-asset funds offers greater diversification. Careful blending of funds is need to ensure unintended strategic correlation is not introduced into a portfolio, says Wayne Nutland, head of Managed Index Solutions, Premier-Miton.
Multi-asset investment funds are often regarded as one stop shops, offering a holistic investment solution for clients suited to their risk profile. However multi-asset solutions will often embed longer-term structural design features and it can make sense to diversify these strategic approaches, particularly for clients with larger portfolios. Although we could consider diversifying multi-asset solutions with different risk profiles, for example by combining low and high risk funds to deliver a medium risk fund, for the purpose of this article we’ll focus on blending funds with similar risk profiles.
The same risk profile can deliver very different outcomes
Let’s look at a typical risk profile, say balanced, or a volatility target of 8%. There are numerous ways of building an asset allocation which fits a risk target. An 8% volatility target could be achieved via a 40:40:20 allocation to short-dated gilts, UK equities and commodities or alternatively via a 40:40:20 allocation to global government bonds (GBP hedged), North American equities and emerging market local currency bonds.
Over the 10 years to end March 2022 these two portfolios would have performed very differently despite having similar volatility profiles, with almost a 70 percentage point difference in cumulative total return. Whilst these are extreme examples, they demonstrate that portfolios with similar volatility targets can deliver very different return profiles at different times. These examples focus solely on how asset class level returns, stock or fund selection could narrow the gap or widen it further.
What drives differences in asset allocation and fund selection?
Multi-asset funds could be built to the same risk profile but deliver very different positioning and performance outcomes for many reasons. Both of the simple portfolios above use correlation and volatility assumptions, but the assumptions used may turn out to be broadly correct for one portfolio but incorrect for the other. Another way of thinking about this concept is in terms of macro-economic regimes. With debates over inflation and interest rates raging at present, it could be the case that different solutions are built with different big picture macroeconomic regimes in mind. For example, one fund may assume that the existing macro-economic regime is broadly persistent, whilst another may be positioned for a significant change in the macro regime.
Whilst big picture considerations like these tend to capture attention, often it’s the more mundane aspects of portfolio construction which drive important differences in portfolio positioning. These may be embedded in a firm’s investment philosophy via strategic asset allocation, or approach to fund selection, or may reflect other aspects of the portfolio construction process such as the size of tactical positions taken. For example, are there criteria to include or exclude asset classes, are alternatives included, does global equity exposure reflect market cap weightings, are currency exposures typically hedged or unhedged, is bond duration managed independently of asset allocation, is there a persistent style bias within equity, does equity selection include thematic or ESG approaches which may reflect client interests? Often these longer term structural features can have a major impact on the performance profile of the multi-asset solution, even where tactical position are taken.
Diversify across strategic approaches
Deciding which macro-economic regime is likely to dominate the next investment cycle or which approach to strategic portfolio construction will be most successful in future is very difficult. Whilst multi-asset funds are usually highly diversified at the security level, different approaches taken to strategic questions can lead to more focused exposures at the factor level. By understanding the approaches taken advisors may be able to ascertain which economic and market conditions may be relatively more or less favourable to different multi-asset solutions.
It makes sense when looking at a client’s holistic portfolio to select funds which offer multiple sources of return and offer some diversification across the types of strategic questions posed above. Different solutions will have different answers to these questions and the answers are not right or wrong; approaches differ and what is correct for one solution may not be suitable for another. But as we have seen the different approaches can lead to very different performance profiles even where similar levels of risk are taken.
Consequently, diversifying across multi-asset solutions which take different approaches to these strategic questions can make sense, especially for clients with large portfolios or without complete certainly over investment horizon. For example, if a client needs to make an unforeseen withdrawal in 5 years, holding complementary multi-asset solutions could prevent selling one approach when out of favour.
More broadly, holding complementary multi-asset solutions which take different approaches to strategic portfolio construction may lead to a smoother performance journey for clients, whilst differing approaches may also cover a greater number of issues on which advisers can engage clients to deepen their understanding of client needs and increase clients’ familiarity with their investments.
