As benchmark-driven funds will not significantly outperform the stock market, so advisers need to stress the importance of active portfolios for investors able to accept greater risk
With inflation seemingly content to stay at historically low levels, it is natural to assume absolute returns from all financial assets will be lower going forward.
And while we believe equities should continue to compensate investors with additional reward for the extra risk, a realistic long-run risk premium could be in the order of 2%-3% per year over bonds.
At the same time, consumer influence over investment product development has never been greater. Perhaps one of the most fundamental challenges this brings is our industry's need to champion the concept of active fund management over the passive approach.
Analysis from the likes of Sandler has pointed to the fact the industry has plenty of work to do on the design, marketing communication and differentiation of investment products. In our view, we must see innovation in these areas if the active investment industry is to clarify its proposition in customers' minds.
We believe the arguments for active management are compelling and the industry should clarify performance targets so clients can understand what magnitude of returns to expect. In addition, these quoted targets should be commensurate with the risk profile explicit in the underlying product design/portfolio construction.
While there are good reasons for the core benchmark-driven approach, a heavily constrained fund will not realistically deliver meaningful outperformance of the stock market for investors.
The constraints of overly conservative portfolio construction rules simply serve to dilute the impact of the core competence (stock selection) marketing materials might suggest is being exploited.
However, losing sight of portfolio construction rules and benchmark-aware risk control completely is unnecessary. What is needed is an appropriate blend of benchmark-aware risk control and the desire to translate the skills and investment expertise into performance.
In this way, investors can be given a clear choice from a range of funds that provide varying degrees of exposure to market returns, in particular the expertise of the investment firm's team of stockpickers.
Active managers must concentrate on products designed to deliver returns based on manager expertise rather than simply give clients exposure to financial markets as passive funds do this perfectly adequately. Among active managers, consumers should be given the chance to differentiate between providers on the basis of the core competencies of different firms.
For this to happen, providers must deliver products that distil any potential marketing advantage of the firm concerned and convert it into returns for the client. This requires innovation in both product design and marketing communications.
If marketing focuses on stock selection as a core competence, this stockpicking prowess must be evidenced. Similarly, portfolio construction rules should provide adequate latitude for these stock ideas to drive returns.
This rationale affects various aspects of product design. For example, to market a team-based approach, a product provider should demonstrate a high commonality between the holdings in the fund concerned and a model portfolio of the team's ideas. Even in general terms, conservative, balanced and aggressive approaches to an asset class should be backed up with appropriate risk profiles, portfolio construction rules and explicit performance targets.
If the link between the structure of the fund and the core competence of the investment business is not easily identifiable, then any investment strategy is less likely to deliver on its promises. Our investment process encourages a balanced and pragmatic approach to stockpicking, with no innate growth or value bias.
In addition, all funds are managed according to our team-based approach, with research shared among our regional investment teams through a system known as the Global Equity Research Portal (GERP). We target resources at generating superior insights and investment intelligence by analysing cashflow returns and comparing these with published earnings.
We reflect this through portfolio construction in a range of funds offering different blends of exposure to financial markets and investment expertise that differentiates us from other investment businesses. For clients who want the greatest access to the latter, we offer funds with demanding performance targets and portfolio construction rules that reflect the overriding desire for our manager to dictate the path of returns.
We differentiate our UK equity funds with both capital growth and income objectives through careful mandating and differentiated portfolio construction into three categories:
l Core/Blend ' large-cap market exposure & access to team/manager ideas.
l Flexible ' mixed exposure to market and managers ideas.
l Aggressive ' best of our best company ideas.
We believe a core UK equity product should concentrate on large companies and exhibit the highest commonality with the team's model portfolio.
In keeping with this approach, the Core/Blend team take the least risk relative to the benchmark when reflecting views on shares and targets are established relative to the market ' to outperform equities as an asset class by a few per cent per year over the long term, for example.
This traditional style of product offers clients exposure to the performance of the UK stock market, augmented with a degree of access to our team's company ideas within the large-cap arena.
The Flexible product also offers returns correlated with the market but provides the investor with greater exposure to the investment team's company research and the individual manager's ideas.
In our flexible funds, portfolio construction rules give the manager more latitude to deviate the profile from that of the market and, in keeping with this, commonality with the model portfolio is lower. Because the fund is benchmark-driven, we measure its outperformance relative to shares as an asset class.
However, because the manager has greater flexibility to change style, capitalisation bias, the number of holdings and the degree of risk taken, the targets are set at a higher level than they would be for the core approach. This is intended to ensure risk-adjusted returns remain positive.
In funds such as this, where exposure to the manager's company ideas is higher, we naturally deploy a manager with a long and distinguished stockpicking record and proven ability to add value across the stock market. Preferably, the fund manager will also be highly regarded by third-party rating agencies.
Because inflation is at such low levels, the future returns from all financial assets are likely to be lower. As a result, we expect clients to demand a more aggressive approach from active fund managers in future.
Our Aggressive products provide access to our company ideas over and above reference to the path of the stock market in general. In this context, managing money relative to the market may prove to be an unnecessary constraint on absolute performance. This is why we offer mandates that deliberately restrict a manager's tendency to replicate the index.
For retail investors, we achieve this through portfolio construction that dictates a specific number of equally weighted holdings. These funds are concentrated in nature, which means they are typically more volatile in the short term.
However, a concentrated and equally weighted approach also encourages maximum conviction in every share held and gives the manager the latitude to quickly change investment style as market conditions change, as well as representing a strong buy/sell discipline.
How do we control risk within this best of our best ideas portfolio? First, we encourage correlation with the performance of our other strategies through establishing significant commonality between the ideas in the fund and those within the relevant team-based model portfolio.
Second, we seek to control the manager's total exposure at the sector level, to ensure it is the individual companies that drive returns and not a style bias that could make the fund vulnerable to swings in sentiment. Our experience shows managers can add value through superior stockpicking, while we have no empirical evidence to suggest they can accurately pick sectors.
In this type of fund, company ideas dominate performance and the path of returns should be expected to be the least correlated with shares as an asset class.
Low inflation means lower absolute returns from traditional asset classes.
Product manufacturers must convert their core competence into performance.
A combination of new products and better communication is required.
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