Chris Ralph, UK equity multi-manager analyst at Fidelity International, explains his company's diversified approach to third-party funds
From humble beginnings in the 1980s, when fund of funds just meant in-house managed funds, the market has now evolved to include a variety of different products including in-house and third party funds of funds, manager of manager mandates and, more recently, funds of hedge funds. They have all been given the generic title of multi-manager. I would like to concentrate on the third party (or unfettered) segment.
The unfettered market has grown significantly in the past few years. According to data from Financial & Economic Research International (FERI), there are now nearly 150 third party or unfettered funds of funds available in the market. Over the three-year period from December 2001 to April 2005, assets under management in these funds increased by 120% to nearly £10bn*.
Although many advisers believe that their business model is well-placed to provide fund selection and asset allocation recommendations, others are finding that outsourcing fund selection and ongoing portfolio management is an increasingly attractive option.
With nearly 2,000 individual funds managed by 120 investment companies in the UK and a reported 412 fund manager moves in 2004**, fund research has become increasingly time-consuming. At the same time, academic research continues to suggest that adding value through asset allocation is difficult and it often has a negative impact. Many advisers prefer to spend this time talking to their clients, managing their relationships and providing ongoing service. These are also the activities that clients often value the most.
When multi-manager first came onto the scene, it was seen as a product that could be sold direct to investors. Now, advisers are looking at it more as adopting a multi-manager solution for their business. They have moved from recommending funds to using multi-manager as a core part of their business model.
It could also be argued that as regulatory and compliance obligations have increased and become more formalised for the adviser, their ability to perform monitoring and oversight to the extent they would like is easier when restricted to a group of multi-manager providers. It is less onerous in terms of both time and efficiency as well as to the cost of their business. By using multi-manager, advisers have more time to run their business and to spend with clients, ensuring financial planning is up to date and in line with their clients' objectives.
As multi-manager offerings have developed, so have the investment processes that support them. The number of funds available to investors and indeed the type of fund has grown tremendously over the past few years, and so the management of multi-manager products has had to evolve accordingly.
Owing to the diverse nature of funds available to third-party managers not only in the UK but also globally, in-depth fund research and selection, asset allocation, portfolio construction and optimisation, ongoing implementation and rebalancing are now crucial to the successful management of such multi-manager portfolios.
Different multi-manager product providers will have different investment processes. The core of Fidelity's investment process is the belief that fund management skill, style and biases can be identified and exploited. We believe that the majority of consistent portfolio outperformance will come from fund selection decisions, with asset allocation providing a secondary source of returns.
Furthermore there is an increasing demand for products that offer a spread of exposure to different asset classes. Fidelity has recently launched a product through a Japanese distributor that invests in a number of different asset classes***. Within the fixed income portion of the assets, alongside global bond funds, the portfolio has exposure to high yield and emerging market debt products. These funds regularly use complicated instruments and complex strategies as they strive for outperformance. It is the job of the fund analyst to both understand these products, and to determine their potential positive (or even negative) impact on portfolio performance. This is no easy task.
In addition, the fund also holds positions in property funds investing in different regions, commodity funds and a market neutral product. The diversification provided by these different assets is attractive, but the research that is required to support it is specialised and time consuming.
Moreover, in an environment of declining stock market volatility, the traditional approach to managing funds of funds adopting a core and satellite approach is no longer working and it has been critical to respond to this challenge by adapting the way in which the portfolios are managed.
In the past it has been possible to run a portfolio with a mixture of lower risk core funds, which generally adopt index-like characteristics and these have reflected the longer term view of investment. At the same time, fund of funds portfolios have also held funds that offer a more tactical way to boost performance through exploiting current investment themes. These have been held in a series of small positions that add incremental performance to the overall portfolio without disrupting the core holdings.
However this approach no longer works because the return assumptions for our core funds have declined as market volatility has contracted (as shown by the adjacent graph). Critically we have found that a number of funds that offer low outperformance targets have simply been unable to deliver a return that exceeds the fees that they levy - not a very palatable situation.
We have therefore adopted an approach where we hold a number of different funds where tracking errors are higher but where the correlations between the funds are lower. This means that we can maintain our ambition of achieving a target of attractive outperformance with lower volatility without exposing the portfolio to any particular market biases. Diversification without dilution.
The multi-manager landscape is rapidly changing. It is important as managers in this area that we evolve to take advantage of these challenges and opportunities.
*Source: FERI Fund File to 30/04/05. Total net assets of funds classified as fund of funds (ex house).
**Based on Standard & Poor's report covering period from November 2003 to November 2004.
***These funds are not available to UK investors. The current asset allocation of the fund in high yield, emerging market debt and commodities is smaller than the asset allocation of the other asset classes.
****Source: Fidelity as at 30.06.05
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