Tom Poulter: Cost or flexibility in the multi-manager arena?

How much we pay for something has always been a talking point in life, from millennials spending too much on avocado on toast to spiralling house prices in the UK. Our industry is not immune from this, and the introduction of MiFID II and the requirements for asset managers to provide value for money assessments has meant that costs have become a greater talking point across the industry.

The first thing we need to remember is that everybody will determine value for money differently: one person's bargain is another's rip off. For instance, many people will find it staggering that experts believe paying "only" £80m for a football player is an absolute steal. Therefore, the focus on value for money should not solely be on what an investor pays but consideration needs to be made for what they get in return.

When looking at how much an investor pays for a multi-manager fund there are multiple factors to consider. We break the universe out into four types of funds. 

There are those multi-asset funds that follow a pure passive approach, such as the Vanguard LifeStrategy range, which only invests in passive funds and has a static long-term asset allocation. Then there are funds that  use passive building blocks but where the asset allocation and underlying investments change over time. The L&G Multi Index range is a good example of this. 

Another approach is what is often described as a fettered fund of funds. Put simply, they are funds of internal active funds, where managers will only invest in funds managed by their own group and where the strategies are usually active.

The final option is the fully active approach, where the multi-manager has the ability to invest in any fund he or she wants. This provides the manager with the greatest available alpha opportunities, but it is also the most expensive option for investors. 

The below graph outlines the differences in costs between the four options. Please note we have picked examples of each type of fund range and alternative options in each type may be more or less expensive than the costs quoted. 

Passive funds can actually provide investors with the highest return for every basis point spent. For example, if a passive fund with an OCF of 0.1% returned 10.0%, then the investor would have received 1.0% for every basis point spent. An active fund with an OCF of 1.0% would have to return 100% to provide the same profit margin.

However, a passive fund's return is limited to what its benchmark has returned. Active funds may be more expensive but they have the ability to generate higher or lower returns than a benchmark.

Pure passive 

(Lowest cost approach priced at approximately 0.20%)

This is generally the simplest and lowest cost multi-asset fund available to investors.
The Vanguard LifeStrategy range adopts this approach and each fund will invest in passive funds in line with its static long-term asset allocation. For example, the Vanguard LifeStrategy 60% Equity fund will always have an allocation towards 60% equities and 40% bonds. 

The problem with this approach is that by investing in passive funds with a market cap benchmark, you could potentially have a higher allocation to overvalued large cap stocks and a lower allocation to undervalued small cap stocks. The static asset allocation also poses problems for investors because during market extremes the fund managers have no ability to change the asset allocation and have to just sit tight and ride out the storm. 

The approach may be simple, but it is not immune from the risks that impact any other multi-asset fund. This approach is suited for long-term investors who want to obtain access to the markets at the lowest cost possible, as well as for investors who do not believe that active managers can add value above their costs. 

Passive with active asset allocation 

(Priced between 0.20% - 0.60%)

This type of strategy will predominantly invest in passive funds, but the fund manager does not have to adhere to a static asset allocation. Investors are still exposed to the same risks associated with purely passive implementation; however, the fund manager has the ability to tilt the asset allocation based on their market views.  

If they believe that a certain asset class or region is over or undervalued, they can allocate accordingly. They also have the ability to allocate to cash if they think all markets are overvalued. Even though the fund manager has the ability to provide protection during market downturns, they may also get caught out going into downturns and actually lose investors more than a pure passive approach. Investors are effectively paying slightly more to provide the manager with the ability to overlay their long-term market views on the fund. It is up to the investor to decide if they believe the manager can add alpha above the extra cost paid. 

Internal active funds

(Normally priced between 0.7% - 0.9%)

As investors are provided with a greater opportunity set to add alpha, they ultimately have to pay more for the potential benefits. Funds that invest primarily in an investment group's own active funds are formally known as fettered funds of funds. 

For example, Bambos Hambi, fund manager of the ASI MyFolio Managed range, will predominately invest in Aberdeen Standard Investments funds within this range. This therefore provides Hambi with the ability to add value above a passive fund through fund selection. However, the fund manager is beholden to the quality and breadth of funds available to him which means this approach is more suited to large asset managers, as opposed to asset class specialists. This approach is cheaper than the fully active approach because the fund manager will pay a lower fee, or will not be charged at all, for investing in group funds. 

Fully active 

(Most expensive priced between 1.0% - 1.7%)

This approach provides fund managers with the greatest opportunity set to add alpha; however, it does come at a much higher cost. The higher cost comes because investors are not just paying for the fund manager's ability to add alpha through fund selection and asset allocation, but they are also paying a higher fee for perceived best in class managers. While this type of fund has the highest level of flexibility, the higher cost means that it has to produce much higher returns simply to overcome the fee drag. 

Conclusion  

With all four approaches, as you pay more, you provide the fund managers with greater flexibility and a larger opportunity set to add value, but it comes with higher fees. Ultimately, it is up to the end investor to decide whether the multi-manager can provide enough value to justify the extra costs.

Tom Poulter, head of quantitative research, Square Mile Investment Consulting and Research

This article appeared in the April issue of Professional Adviser's bi-monthly sister title Multi-Asset Review. To make sure you receive your own copy of the next issue, please register your interest here

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• Multi-manager
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• Investment