Fund managers under constant pressure to produce results would do well to put into action a Nobel Prize-winning theory that diversifies investment over seven non-correlated asset classes
When fund management houses talk about diversification, it begs the question as to how varied their share choices are. Is having a basket of UK, US, European and Far East shares real diversification? After all, they are all one asset class - equities. So if the world's markets suffer, so does the investor, admittedly to a greater or lesser degree depending on the market.
True diversification is actually having investments in different asset classes - not some misplaced marketing speak.
The fund management industry could be compared to the star culture the British public enjoys today. Whether it is sport, music or films, there is a constant stream of news on celebrities and what they are doing on a daily basis. The fund management industry works in just the same way. Fund managers are awarded the same star status, and there is an endless pipeline of news about them.
But what about those we do not hear about? How are they performing? Industry statistics show over the past 10 years 75% of fund managers globally failed to match the returns of their recognised indices and benchmarks.
Not only that, in searching for better performance, fund managers now have to find more than 7% additional return to match the performance of passive or tracker funds, such as the FTSE 100, the cost of trading and the effect of the bid/offer spread.
In addition, having just been through a severe bear market and with shares climbing rapidly over the past few years, the job has not become any easier.
So it is worth reminding fund managers that investors do not want to hear that despite their investments outperforming the relevant peer group ranking or benchmark, they have lost money or are at best recouping some of the losses of previous years. From an adviser's point of view, this will reflect negatively and not help build client relations.
With constant pressure to provide returns, the market has seen the rise of hedge funds, which are supposed to give absolute returns in any given market conditions. However, there is a nervousness surrounding these products and their recent poor performance, so, to date, all but the more wealthy investors have tended to avoid them and it lies in the 'four pillars of investment wisdom' discovered 40 years ago. Although the four pillars are known to the fund management industry, the principles behind this are forgotten.
There is a solution to this problem, Markowitz's Modern Portfolio Theory - which was recently acknowledged by the receipt of a Nobel Prize - asset allocation, index investing and alternative investments. Markowitz's theory claims that by combining non-correlated assets risk-adjusted return will increase. This compares to the well-held view that higher returns mean higher risk.
There have been a number of product launches that go some way to embracing this investment philosophy but, in each case, by watering down the products they fail to make the best of the theory.
One fund only has three asset classes and the other, while having five, involves active management, which is costly and dilutes the overall return. It is now possible to invest in seven asset classes through passive low-cost funds. These principles are: global equities, global bonds, emerging equities, emerging bonds, managed futures, commercial real estate and commodities.
The ability to combine these seven non-correlated asset classes means the overall risk is considerably lower than having even five asset classes and the passive element ensures the cost of running a fund is kept to a minimum. However, the more asset classes, the more difficult asset allocation becomes. Asset allocation alone can generate up to 90% of the likely return a fund is likely to achieve.
There are questions as to how the base asset allocation is decided on a flagship fund. A good guide is to analyse the major global pension funds, educational endowments, and private banks. This creates a consensus asset allocation based on the best investment brains in the world. At the end of a 12-month cycle, the portfolio should be rebalanced to the original weightings. This is to some extent a contrarian approach as it means selling part of winning asset classes and buying the losers, but it recognises that winners can become losers and vice versa.
All of the above theory has been known for more than 40 years but with the rise of the star fund managers, it has been put to one side. While indexation has seen tremendous growth - over a trillion dollars is now invested passively - and of course the large institutions can in effect replicate the investment methodology outlined, nevertheless they reduce the potential return by investing actively, such as buying property rather than a property index.
A different class
Over the past 12 years a global ungeared multi-asset fund run on the four pillars of investment wisdom would have produced an annual risk-adjusted return net of costs of just over 7.75% pa. This exceeds the performance of 90% of hedge funds last year and it is worth noting that failed hedge funds are not included in the statistics.
The returns of this fund can be calculated exactly, because they are based on measurable benchmarks and existing indices, whereas a newly launched active fund, if back-tested, is subject to doubts as to what the active fund manager could do.
Diversification is the most attractive element of a global multi-asset passive fund. It provides a low-cost wealth preservation platform investors can use as the core to their investment portfolio, providing capital preservation allied to high stable returns through all economic cycles.
Satellite funds can also be added around the stable diversified core, which may shoot the lights out if one or more of the star fund managers get their sums right.
From the adviser's point of view, they do not have to spend much time on asset allocation, worrying about their personal indemnity cover; they will have time to advise more clients and should not face the prospect of having to tell clients capital has been lost. This embraces both spirit and the observance of the new Treating Customers Fairly regime and the Financial Services Authority's new risk framework.
It must not be forgotten that in 2003 the FTSE 100 was almost half its peak at the end of 1999. So any fund based on the Nobel Prize-winning principles offers advisers a sustainable investment process and a sales message with greater integrity, and also delivers their clients a flagship portfolio at all times throughout the investment cycle.
So here is a solution that would seem to make a good core investment holding. It allows a client's existing portfolio to be partly 'swapped' or overlaid with the fund, ensuring greater risk-adjusted returns, less time required to manage the portfolio and lower costs. This will result in the classic core/satellite strategy being implemented.
Alternatively, the seven asset classes can be bought individually, allowing an adviser to gradually create a 'core' by adding investment classes where appropriate. For example, an equity and bond portfolio could have non-correlated asset classes like commodities or even global property added until a fully diversified portfolio is achieved.
Whichever route is taken, advisers are ensuring their clients will achieve overall lower portfolio riskiness and deliver greater risk-adjusted returns whatever the investment market conditions. This is what investors want - capital preservation and consistent returns.
Some investment advisers will be able to create their own Markowitz-based solution, but whether they can bring institutional investment instruments to the retail market is questionable and therefore the risk return will not be so attractive.
This is why the fund management industry should now grasp the benefits of cost-effective multi-asset class-based investing while still allowing their stars to attempt to weave their magic with satellite investment offers.
The solution outlined above has been described as the new generation with-profits, before fund managers forgot what with-profits were all about, but with more transparency. It is questionable whether this is a good comparison, but there is no doubt the Markowitz theory is something fund managers would benefit from putting into practice. In fact, the whole sector would benefit, but especially investors.
Investors would benefit from putting Markowitz's Nobel Prize winning theory into practice
Diversification is the most attractive element of a global multi-asset passive fund
Industry statistics show over the past 10 years 75% of fund managers globally have failed to match the returns of their recognised indices and benchmarks
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