Pick ’n’ mix funds find favour in tough climate

The multi-asset fund space is very broad, ranging from funds in the old balanced fund model that hold 60/40 equities and bonds, to absolute return style funds with the freedom to invest across a range of disparate assets.  The sector is growing fast, both with outcome-oriented launches focusing on income generation, and with funds that claim to be able to blend together different sources of risk and return to smooth volatility in difficult investment climates. 

The current economic backdrop is a conducive setting for multi-asset funds, as easy value opportunities have all but disappeared and return generation requires more dynamic and flexible thinking.

“Interest rates are very low, spreads are very tight, the valuation of equities is above historical standards, real estate is not cheap anymore, commodities are facing a hard time, insurance linked bonds are rather expensive…in short, almost all asset classes are fairly expensive,” says Beat Gerber, head of mixed assets at Swisscanto. 

“This makes it hard to generate performance. Multi-asset funds have the possibility of generating performance from tactical asset allocation. We also expect markets to be more volatile in the future which offers opportunities through market timing, shifting between asset classes and cash. This additional contribution from tactical asset allocation to the performance is very welcome in the current environment.”

The unusual degree of divergence between central bank policies and differential growth rates across the globe also point up the attractions of multi-asset investing. 

“There is a lot of dislocation in almost every asset class in the market, without clear trends,” says  Filippo Casagrande, head of investment at Generali Investments Europe. This is due to divergent macro pictures, to monetary policies’ uncertainties and geopolitical tensions, he says. 

“The low yield environment is a further element, a legacy from the Great Financial Crisis. In this complexity, flexibility is the key word and a multi-asset fund offers the possibility of looking for good investment ideas everywhere.”

Asset managers pushing into the multi-asset market include Threadneedle, BlackRock, Invesco Perpetual and Hermes which all aim to create products around investors’ specific needs rather than beating benchmarks, while in  September Pictet hired Barings’ multi-asset group head, Percival Stanion, and his team. 

The biggest growth has been in funds investing in a wide range of clever strategies, including the use of derivatives to try to extract better – or at least better defined – sources of return. However, most managers use only the most liquid market derivatives, such as futures, and shy away from complicated instruments such as structured products. 

Invesco Perpetual’s Global Targeted Returns fund, a best ideas absolute return fund launched in September 2013, targeting Libor + 5 per cent with half the volatility of equities, is run by David Millar and his team who previously worked on GARS (Global Absolute Return Strategies fund) at Standard Life Investments.

“Newcomers have been trying to launch these funds,” says Ian Trevers, Invesco’s head of retail and distribution.  “While some managers have propositions that are straightforward, others are finding ideas that require the use of sophisticated techniques, and our view is that the return profiles that investors seek cannot be satisfied from simple long only asset classes.” 

But there are high barriers to entry if you want to do it properly, he adds. Firstly, managers need to be sophisticated users of these techniques; another is the under-acknowledged challenge of the practical tasks of trading the instruments, settling those trades and valuing the holdings; and thirdly to have the capacity and desire to explain the strategy to clients and advisers. 

“There can be huge complexity in these funds but it cannot be shut away in a black box,” says Mr Trevers.

Ten year US Treasury yields are still under 2 per cent and German five year bund yields are at zero, says Mr Millar. “A year ago, who out there could have expected bond yields to be this low still. Interest rates had been expected to rise. If you have a portfolio where the ideas are long only, but you thought bond yields would rise, then how can you protect against scenarios like we had, with bond yields falling even further? We had a big debate about how to keep bonds in a portfolio. We have been buying 30-year bond futures and selling 10-year bond futures so we are only exposed to the long end of the bond curve.”

Using derivatives to pinpoint the exposure more precisely also means managers can limit exposure if the market goes the other way.

“At times we take a position in alpha but remove the market risk,” explains Mr Millar.  “That includes buying Invesco funds (such as income and growth funds), getting the stock selection benefit of the manager,  or making an allocation to a manager in European equities where we want to extract the manager’s alpha generating capabilities but hedge out the market exposure  by selling the future on the relevant stock index.”

One pitfall of these funds is that it is easy to put too great an emphasis on one economic viewpoint, skewing everything to one investment outlook,  particularly if that view is held by a prominent individual. 

At Nordea, the Stable Return fund, ranked third in our table by size, is centred on a risk balancing strategy with the aim of making optimal diversification calls.  “Too many multi-asset funds tend to focus too much on a particular forecast, which could risk their diversification, because they may load on a particular environment and then if they are wrong, they will be left holding all the wrong asset classes,” says Asbjørn Trolle Hansen, Nordea’s head of multi-assets. 

“Too high a conviction about one macro outlook could jeopardise your diversification.”

The Nordea tactic is to try to have as many bull approaches as bear approaches and to find asset classes that work in those markets. “A lot of asset managers talk about diversification but very few spend sufficient time on it,” he says. “We expect returns are coming down on the bond side so there is a need to work harder to get the right mix.”

Certainly, while some multi-asset managers are primarily looking at bonds from a diversification perspective, others espouse diversification but are actually more mindful of returns and invest in more aggressive subsectors such as emerging market bonds. 

“We are positioned in US Treasuries as a diversifier, because if there is a bear market, five to 10 year forward rates look decent enough at 3 per cent,” says Mr Trolle Hansen. “In our approach, emerging market debt is more like equities. Emerging market bonds offer the best return in bonds but in terms of Sharpe ratio and risk/return, equities still look better, so we are not in emerging markets owing to their different risk profile from other bonds.”

Arguably there is also a contradiction in fund managers’ attitudes to alpha and beta.

AXA IM’s Diversified Growth Fund launched in April 2014 and is, the company says, the only diversified growth fund that uses smart beta credit and smart beta equity strategies. The global smart beta strategy follows a ‘buy and maintain’ approach instead of a market-cap credit index which will necessarily be  most heavily invested in the most geared companies.

“In other multi-asset funds, strategies based on derivatives are mainly focused only on alpha, removing all beta, but if you are a long-term investor then you will want exposure to long-term beta and it should boost your performance,” says Yoram Lustig, head of multi-asset investments UK, AXA IM. “You have to be smart and dynamic about it.”

Income funds in the multi-asset space face particular problems in the current climate. Mediolanum AM decided to construct an income-oriented  fund of funds after finding very little diversification among high income managers in terms of style of holding and risk-return characteristics. Its Coupon Strategy Fund, the fifth largest fund in our table, is a traditional mix of 60 per cent equities/40 per cent bonds, mainly sold in Italy and other parts of continental Europe, as an alternative to traditional bond funds. 

“Within the equity income universe we found very little diversification among high income managers in terms of styles, regions, holdings and risk return characteristics,” says Michelle McGrade, consultant at Mediolanum AM. “Income is where managers tend to have similar styles and regional biases so we have been diversifying away using  unconstrained funds such as the Legg Mason Clearbridge fund, which has given the fund exposure to tech and healthcare stocks in the US.” 

Mediolanum has been overweight high yield  and credit but is now looking for managers who are flexible and can allocate across asset classes, and manage duration and interest rate risk in what it suspects will be a more challenging environment going forward when interest rates start to rise, adds Connor Owen, senior product manager at Mediolanum International Funds. 

“The best managers were early movers in the hedge fund space (such as Blue Bay, Muzinich, Western Asset Management)  – now there are more mainstream players. We recently purchased the Western multi strategy fund which has a track record back to the 1970s.”   

Best left to the big boys?

Both of the two big growth areas in multi-asset investing – income funds and low volatility funds – depend on quite complicated strategies. Arguably, such strategies are best suited to large players with capacity and experience. Small boutiques cannot necessarily deal with the complexity – both investment and operational.

 “Increasingly clients are looking for specific outcome-oriented products with certain income levels, typically instead of high yield bond funds, solutions that have stable incomes, because it is difficult to find that anywhere else in the market,” says  Stefan Lecher, global head strategist, UBS. “These allocate across a range of income-bearing assets.” 

The second trend is demand for a fund that will ride out the volatility in the markets, often using sophisticated tools such as futures and derivatives to hedge strategies.

“It is challenging for the asset manager to have expertise and experience across all these asset classes, and it puts more demands on the manager to have risk management tools in place,” he says. “Having the expertise in all of the asset classes combined with risk management capability is important.”

The low volatility  strategies rely on diversification and although this theory was challenged in 2008, it is still largely a principle that most would endorse. “Diversification still works and did work in the market crisis but managers must be careful in  how they apply it,” says Coutts’ chief investment officer Alan Higgins. 

Just bundling different asset classes together does not necessarily provide diversification. He gives the example of high yield bonds which will behave more like equities with a potential additional negative skew, as experienced in 2008. 

In stress scenarios, there are only a few asset classes, for example high quality bonds and currencies, that do provide diversification, ie negative correlation versus equities, says Mr Higgins. “If only safe haven assets can help with diversification, then you should have these in a portfolio even when the market background for equities is rosy.” 

Yields in high quality corporate and government bonds are not currently attractive outright but provide valuable diversifying effects, he adds. “This was overlooked by many before the 2008 crisis, now risk managers understand they have to look beyond standard deviation and test against stress scenarios.”

With pundits predicting 2015 as a year of volatility, these funds will be popular. Wealth managers report that investors are keen to avoid volatility, with a greater emphasis on preserving the gains made in the last few years. “A dynamic process will be crucial to adding/protecting  value and navigating what looks to be the start of a return of a more normal volatility regime,” says David Vickers, senior multi-asset portfolio manager at Russell Investments. 

VIEW FROM MORNINGSTAR: Great in theory, harder in practice

Multi-asset funds allow investors to gain access to allocate assets across different asset classes. In practice, however, dynamic asset allocation is a notoriously difficult task for active managers, and few manage to outperform a relevant composite benchmark over the long term. 

The year 2014 was no exception, as the sudden return of volatility in the second half took many managers by surprise, and the majority failed to adapt clients’ portfolios to a less risk-tolerant environment. 

Funds categorised to the Morningstar EUR Cautious Allocation Global category returned 5.3 per cent in euro on average, far behind the 13.1 per cent return of a composite index made of 75 per cent Barclays Eur Agg TR and 25 per cent FTSE Wld TR.

The ETHNA-AKTIV fund failed to beat the benchmark but continued to outperform peers. Its relative outperformance was partly triggered by a higher-than-peers equity exposure, particularly to US equities and the appreciating US dollar. Despite those good results, Morningstar analysts have rated the fund neutral as they are not convinced by the parent stewardship and consider its fee structure unfriendly to investors.

In contrast, they maintain a positive conviction on Silver-rated DNCA Invest Eurose. After outperforming its category for six consecutive years, the fund’s returns were in line with the average in 2014. Performance benefited from a move to re-allocate part of the portfolio to euro sovereign debt as well as a long-dated bet on French telecom operator Orange. However, it was dented in the second half of the year by exposure to high yield issuers.

Thomas Lancereau, director of Manager Research, Morningstar France