Flexible solutions in asset allocation

The old adage “do not put all your eggs in one basket”, inviting investors to keep portfolios well diversified, maintains its validity in modern times, but the way it is implemented is increasingly differing from past practices.

Traditional, balanced funds, which often represent the core of clients’ portfolios, are being replaced by more flexible solutions investing in a variety of asset classes. “Asset allocation funds have been around for many years, but they were mainly relative return products, which did not deliver the results clients expected,” says Stefan Angele, head of investment management at Swiss & Global.

“The focus is now more on goal oriented investment multi-asset solutions, which have a total return approach,” he says.

Fund houses managing these solutions do not follow a benchmark, but are given a “risk budget” to spend in the most efficient way, within the asset allocation framework, and have a more opportunistic, dynamic and flexible approach to asset allocation.

Futures, derivatives or exchange traded funds (ETFs) can be employed for short-term opportunistic views, while actively managed funds are used to invest in more secular trends, in fund of funds solutions, he explains. Good skills in risk management are also needed.

At Wegelin, Switzerland’s oldest bank, the concept of multi-asset investing is combined with a risk-weighted, as opposed to a capital-weighted approach. It is the bank’s belief that traditional balanced portfolios fail to achieve risk diversification, because riskier asset classes can dominate the total portfolio risk, says Dr Magne Orgland, managing partner and head of asset management research & portfolio management at Wegelin & Co.

In November 2009, the bank launched its Global Diversification Fund, which employs a quantitative approach aimed at ensuring each of the four asset classes used in the fund – equities, bonds, commodities and short-term government bonds – contribute equally, on a daily basis, to the total portfolio risk.

Indeed, optimum portfolio weightings are calculated on the basis of various risk indicators and adjusted daily. The bank claims this frequent rebalancing does not increase costs, as the fund invests in passive indices, ie in futures contracts on liquid indices, to ensure low transaction costs.

“The future of multi-asset investing is this equalised risk approach. The target is to provide an attractive return with much lower volatility,” insists Dr Orgland.

Particularly in bear markets, when equities are volatile, the fund is much more stable than a classical balanced fund, he claims.

The tail risk management engine in the fund identifies high risk in the market and systematically reduces exposure to it. Year to date, the fund has reduced exposure to equities down to zero twice and it has returned 8.5 per cent, he says.

“In uncertain times, it may be even more important that you have consistent decision making and don’t deviate from the rules you have set in the process,” says Dr Orgland. “What has become more important is transparency, because investors do not want to invest in black-boxes. That is why the quantitative approach should not be overly complicated and always explainable,” he says.

However, in a bull market, when equities are strong, the fund will perform less well than an equity portfolio, where the risk comes only from equities. As it is a long-only investment, it does not take short positions and could potentially produce negative returns.

Wegelin’s private bank selects third-party single funds for clients, using many indexed funds and ETFs, but does not buy multi-asset funds from external providers.

BATTLE FOR PRODUCT TERRITORY

Although asset managers claim multi-asset funds are a valuable building block for the core part of high net worth individuals’ portfolios, private banks tend to see asset allocation as their core competence and are reluctant for their clients to invest in this kind of strategy. “We run multi-asset portfolios, that’s our core skill set, and we don’t buy multi-asset funds,” confirms Robin Hubbard, head of investment management at UBS Wealth Management in London. “We construct the asset allocation and populate it with different instruments, primarily funds, but these are almost without exception single asset funds.”

Private bankers are often criticised for their way of managing investors’ portfolios, often seen as too static to adapt asset allocations to changing market conditions in a timely manner.

“The key issue is that implementation systems are needed to be able to execute across multiple clients’ portfolios simultaneously,” explains Mr Hubbard. Because of its size and scale UBS has invested significantly in technology, to be able to adjust to market conditions quickly.

However, there are a number of constraints. Clients do not necessarily like to see a high level of activity in their portfolios, he says, and as activity becomes very transparent when managing portfolios in that way, clients’ preferences have to be taken into account.

“Clients want to see what is under the lid,” says Mr Hubbard. “As a fund manager, if you run a multi-asset fund, you have more flexibility, but less transparency for the client. Clients don’t necessarily like that.”

Secondly, all asset allocations are mapped to a specific risk profile and it is not appropriate for private bankers to take the clients out of their selected profile, even when market conditions are changing rapidly. “For example, if a client has selected a growth risk profile, and the market is going down aggressively, ex post you think you should have done it, but if you had been wrong, they would have probably have the right to complain, if they see underperformance,” he says.

“You have got to make it clear what level of aggression you are using and how much divergence from your asset allocation you will take.”

UBS runs portfolios diversified across three to five asset classes. These include cash, bonds, equities, real estate and hedge funds of funds, which are preferred to single manager hedge fund, due to liquidity. Commodities will also be added in larger portfolios, which are typically more customised, says Mr Hubbard.

Adding all sorts of sub-asset classes may work for a pension fund but not for a relatively small client. “I am sceptical about the benefits of running much beyond five asset classes, because the sheer complexity of running that portfolio for a relatively small size private client probably starts to outweigh any benefit or optimisation gains you get from any additional diversification.

“Also, investors have really reacted against black-box type of products. That was a lesson of 2008, they want transparency and simplicity and there is bigger demand for single securities,” he says.

Customised portfolios

Multi-asset funds are not the focus of the selection team at Julius Baer private bank, either. A multi-asset fund is a more suitable product for retail investors, believes Lorenz Altwegg, head of fund solutions and open architecture specialist at Bank Julius Baer. “High net worth individuals demand their own strategic asset allocation and a customised portfolio,” he says.

Moreover, when an actively managed fund, which has a dynamic approach to asset allocation is added to a client’s portfolio, it makes it difficult to maintain a clear view of the exposure of the total portfolio to any class, sector or geographical area, as this information is hidden in the fund. This can generate cluster risks the investor or the adviser may not be aware of, he says.

Nevertheless, asset management companies continue to launch new multi-asset funds. “We see a big interest in multi-asset products from all client segments,” says Moritz Wendt, head of sales Western Europe at SEB Wealth Management. “Retail investors seek a bit more of an insurance policy and investing in these multi-asset products keeps down portfolio volatility. Private banking clients use them in their portfolios and unit linked holders in the insurance wrap products; even institutional clients have a great interest in this asset class.”

Investors are attracted by multi-asset funds for different reasons, according to Mr Wendt. Some are more interested in how these products fit within their total portfolio, while for others, performance is the key driver. Big inflows, for example, went into SEB’s Ucits III hedge fund, a multi-currency managed fund, which was the first multi-asset product launched by the firm, in 2006. The fund has grown to €1.5bn, mainly on the back of returns in 2008.

A second total return long-only multi-asset strategy was launched during the same year. Both strategies can be daily traded, as they use collateralised derivatives or ETFs.

This year, the Nordic firm added a new multi-manager product using overlays to constantly reallocate between managers. “I think the easiest way to construct multi-asset products is probably through passive investments, because there you don’t have an obligation toward the fund manager,” explains Ralf Ferner, head of international equities, tactical asset allocation and multi-management at the firm.

“However, in our active product, in order to maintain our trusted relationship with our selected managers and still keep the possibility of reallocating between asset classes, we have introduced an overlay allocation, and we have been very open about the drivers of our investment to our managers. It is a bit more complicated but we expect additional alpha from the selection of active managers,” he says. This last product is also a daily traded fund and its underlying investments are equally liquid, he explains.

SEB plans to upgrade some of its more traditional, balanced products, into multi-asset solutions. “We believe this move would add value, as the opportunity set is bigger, the benefits of diversification are greater, and we have very strong processes that have proven themselves during the crisis,” says Mr Ferner.

Barclays Wealth in the UK offers clients five asset allocation profiles, each of which is a portfolio of multi-manager funds, managed by 30 different asset managers, although other instruments such as structured products or hedge funds can be added.

“Multi-asset is the core of our offering to clients,” says Jaime Arguello, head of multi-manager and third party funds. “And multi-asset, actively managed funds means multi-manager for us,” he says.

The bank also offers five different portfolios profiles made exclusively of ETFs. These passive portfolios were launched in 2008, when people were more worried about active management, says Mr Arguello, and have been successful since.

Although they have grown to £600m (€733m) in assets, they are still small compared to the £7.4bn of assets held in the active, multi-manager portfolios.

The lion’s share of ETF assets remains in BGI’s iShares products, due to “historical reasons” going back to when the global asset management firm BGI was part of Barclays, but some other ETF providers have recently been added to the range.

Dr Magne Orgland, Wegelin & Co