Alex Farlow: The dangers of blending multi-asset funds

Multi-asset funds offer investors the opportunity to outsource asset allocation decisions, which can be very advantageous for those that do not have the time or resources to make those decisions themselves. Given that the majority of a portfolio's return and volatility on an absolute basis are likely to be driven by their asset allocation, these decisions are crucial to meeting a client's investment objectives.

A common reason advisers will hold multiple multi-asset funds within a client portfolio is for diversification purposes, however cost and a reduction in manager specific risk are also likely to be considerations. Analysing a manager's live portfolio and its key risks requires significant resources and transparency of portfolio positioning to avoid potentially compromising the diversification benefits.

The rudimentary due diligence method, which involves merely looking at fund factsheets, can be susceptible to problems when blending multi-asset funds. Factsheets will provide broad brush positioning data, which typically lags by one month or longer, as well as very little detail around the manager's investment approach and true objectives.

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It can be difficult to keep up to date on how the fund is positioned across different asset classes, regions and sectors and what the manager sets out to achieve under different market conditions.

Therefore, blending two or more funds complicates the mix and can make it difficult to get an accurate picture of how risk is spread across the fund's being blended and, hence, how one should expect the funds to complement each other.  

Moreover, risk itself is a blanket term for all the factors that come underneath it, such as interest rate risk, market risk, country risk and liquidity risk. These are factors that need to be considered independently when combining funds, especially for multi-asset funds, which have many more avenues of risk through which they can diversify.

Funds of the same ‘risk profile' may express risk in different ways, and therefore when investors combine a number of multi-asset funds they may not achieve their diversification expectations.

Moreover, while risk-targeted funds are designed to maintain a specified client risk profile, more traditional multi-asset funds may fluctuate around risk profiles depending on the flexibility of a manager's mandate, their outlook and thus their willingness, or not, to take risk.

Without looking under the bonnet, and gaining a deeper understanding of a funds' positioning and the themes running through the portfolio, blending funds together can result in unintentionally high or low exposure to certain asset classes, regions, sectors, themes, or styles over time and therefore skew the risk of the fund blend in a specific direction unknown to the investor. This may distort the aspired level of risk one attempts to attain, and jeopardise the ability of the combined funds to reach the long-term objectives.

Under the bonnet

A more sophisticated method may be to use quantitative tools to measure correlations, volatility and drawdown across funds, in order to gauge how those funds have historically behaved, both in stressed and non-stressed environments.

However, given the complicated nature of multi-asset funds, it can be difficult to discern which parts of the portfolio have driven the performance, and therefore the correlations that have arisen as a result.

In addition, these indicators which have a rear-view perspective fall short when attempting to provide diversification on a forward-looking basis. Through periods of significant volatility, assets and funds that have historically exhibited a low correlation over the longer term can become highly correlated.

At a time when diversification is needed most these fast-changing environments, akin to what we have seen in the first quarter of the year, can be dangerous if there is a reliance on backward-looking statistical models. Longer-term relationships between multi-asset funds within a portfolio can swiftly breakdown, and leave investor's exposed to elevated levels of volatility.

A qualitative element of analysis to complement the quantitative side can be implemented into the portfolio construction process in order to provide a better forward-looking perspective. A manager's style, approach, process, and investment objectives will impact how the fund will fair under different market conditions and provide additional information which can be utilised to construct a mix that holds funds with complimentary features.

However, this requires an active and dynamic approach since managers can be pragmatic and drift away from their current style in order to take advantage of the opportunities they see in the market at the time.

Although long-term investment objectives will typically remain in place, a fund can morph as result of endogenous factors such as changes to the fund manager and/or underlying team, new parent company, client base, fund size as well as psyche of the manager, and these can all influence the way in which a fund will be invested and the risks it will take on. All of which can contribute to considerable adjustments to the structure of the underlying portfolio.

This is especially paramount for multi-asset funds where there is greater scope and flexibility to move into different asset classes and areas of the market and therefore change the overall shape of the fund. Blending multi-asset funds without a qualitative assessment could lead to significant distortions in a portfolio's diversification and risk level and hamper its ability to meet forward-looking performance objectives.

In summary, given absence of transparency and the diversified structure of multi-asset funds, combining different funds may not improve diversification and may be more prohibitive in terms of identifying the allocation of risks. As a result of these complications, the resources required to effectively monitor the interrelations between multi-asset funds could result in time and cost inefficiencies for advisers; therefore, defeating one of the key motives for using multi-asset funds in the first place.

However, through the application of rigorous quantitative and qualitative analysis, these risks can be mitigated and enable the blending of an effective investment strategy.

Alex Farlow is head of risk based solutions research at Square Mile Investment Consulting and Research

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