Chapter 1 Copy

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Changing views of asset allocation

Surviving in turbulent markets

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Nicolas Trindade, CFA | Senior Portfolio Manager

• Nicolas is a Senior Portfolio Manager within the London-based Active Credit team. He is responsible for managing both global and sterling credit portfolios amounting to approximately £2bn as at 31 January 2018. He is the lead portfolio manager of the AXA Sterling Credit Short Duration Bond Fund, AXA Global Short Duration Bond Fund and AXA WF Global Credit Bonds. In addition to his portfolio management responsibilities, Nicolas heads the ‘Sterling Credit Alpha Group’ during the Fixed Income department’s quarterly Forecasting Forum. • Nicolas joined AXA IM in 2006. Prior to his appointment within the investment team, he was a Fixed Income Product Specialist responsible for the development of the UK, US and high-yield product ranges. • Nicolas holds two Master’s degrees, one in Diplomacy and International Strategy from the London School of Economics and one in IT Engineering from Telecom Sud Paris. He is also a CFA Charterholder.

If you get the risk of a portfolio right then, over time, returns will generally follow

“The flow of money created by quantitative easing has been artificially suppressing volatility, but this is coming to an end.”

Equity markets have continued their bull run, in spite of Donald Trump’s bombastic take on the presidency (or because of, if you believe his account). Bond markets have rather fallen out of favour; a shelter from the storm is all well and good, but in the public conscience, when an investment returns less than inflation, it’s like a shelter slowly filling up with water. But there are signs that perceptions are turning. There are some very tough questions for active evangelists to answer when it comes to the fundamentals unpinning most equity markets. It’s not just the added security that should be a draw. When Treasury and emerging market yields are outstripping inflation, there is also an income case to be made in conjunction with the obvious benefits of a diversified portfolio. There are plenty of fish in the fixed income sea. If anything, the market trends present a compelling case for further diversification, and diversification that should not be limited to asset classes outside of fixed income. As our contributors for this supplement note, options in the strategic and absolute return sectors, as well as short and long-term durations, can often be overlooked. Performance rarely lies, and not all managers are alike either. Some have clearly made bad calls, but others will make good ones that will be to the benefit of both advisers and clients. Be it by geography, duration, structure or yield, there are opportunities out there, however tough they are to find. So, fixed income may be a tough sell, but one that still has a place in 2018, and the IFA community has a key role to play, with deep fact-finds and risk tolerance exercises helping to put a number on the right fixed income allocation for each client. If advisers want to stick to a traditional 60:40 allocation of equities and bonds, that is all well and good, but at a time where suitability requirements are being picked at with a fine tooth-comb, they would do well to illustrate why the rest of the options on the table did not suit their client’s needs.

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choosing the right product for your clients

Choosing between the two approaches will ultimately come down to what a client’s objectives are

A problem with this is that a fund may be selected because it has a certain risk rating, only for that to change as the asset allocation of the fund is adjusted in order for it to beat its benchmark. Schroders multi-manager product manager Joe Tennant explains: “As the portfolio changes in order to outperform its benchmark, the underlying risk of the fund also moves. That means a fund rated a four could move to a three or a five depending on market conditions and changes to the portfolio.” While that could be a concern, it is worth pointing out that of the 1,200 funds Dynamic Planner analyses each quarter, only around 10 per cent actually change their risk rating. Among those that do change, they are most likely to only move one place up or down the risk scale. Another issue that has been raised about risk-rated options is that the labels ascribed to them can mean different things to different people. One person’s “cautious” could be another’s “adventurous”. Seven Investment Management relationship manager Chris Justham says advisers should be sure to look under the bonnet of any fund to ensure it is a suitable choice. Finding out which benchmark a fund is using can be a good indicator of how much risk is likely to be taken, although this may not be as simple as it once was. Justham explains: “Investors who categorise themselves as cautious can easily take on more risk than they have bargained for.” He adds: “A heavy allocation to bonds, for example, might have been low-risk historically, but may not be so in a world of rising interest rates.” Risk-targeted funds, on the other hand, are judged not on the risk they have taken in the past but on the level of risk they intend to take in the future. These funds target a specific level of volatility, rather than aiming for a certain level of return, and that means their risk level should not fluctuate. Eling says: “Risk-targeted means that some sort of risk level is baked into the portfolio’s design and mandate. That can be expressed in different ways: a target level of volatility, a target asset allocation or a maximum loss level. Each has its own merits.” Quilter Investors investment director Danny Knight favours a risk-targeted approach where minimum and maximum volatility thresholds are clearly laid out. He thinks this is crucial in giving advisers and their clients certainty over how an investment can be expected to behave under different market conditions. He says: “When people invest their life savings, most of the time they want the reassurance of knowing exactly how much their portfolio can be expected to fluctuate in the short- to medium-term as they pursue their long-term financial goals.” The importance of this was particularly evident around the time of the financial crisis when many investors, who may have been comfortable with the notion of risk, baulked when they saw actual losses on paper and, as a result, may have panicked and sold out of the market. That means investors suffered two-fold as they were first surprised by their losses and then unable to enjoy the subsequent recovery because they had been spooked out of the market. This is where risk-targeted solutions could become valuable. Eling adds: “If you get the risk of a portfolio right then, over time, returns will generally follow. If you get the risk wrong, then the client is unlikely to stick things out for long enough to enjoy any returns.”

Whichever guise the rating takes, it is usually ascribed by an independent agency, which may give additional comfort to clients. There is a further benefit to this approach in that these funds often naturally fit into an IA sector, so their portfolios and performance are easily compared with similar products. A medium-risk fund, for example, will likely sit in the Mixed Investment 20 to 60 per cent Shares sector, offering clients a clear description that further helps to confirm what they can expect their investment to look like. A risk-rated portfolio typically aims to outperform a chosen benchmark, such as the FTSE All-Share or UK CPI inflation. This is where the issues with taking a risk-rated approach start to appear. Intrinsic technical director Rick Eling says: “A rating doesn’t mean that the portfolio is intended to deliver a certain level of risk or that it will deliver the rated level in the future. It is usually just a snapshot of where the portfolio sits on the scale at a point in time.”

Chase de Vere head of port-folio management Ben Willis agrees that the tighter control on the level of risk and the degree of volatility that risk-targeted funds can take may provide comfort to investors. But he points out these parameters could be restrictive to fund managers, who have to adhere to risk guidelines. He adds: “There is a danger that these funds are a case of the tail wagging the dog, where risk comes first and performance second.” He thinks risk-rated funds which sit in mixed asset investment sectors are potentially a better way to strike a balance between generating returns and managing risk, despite the fact that they have wider parameters within which to work. Despite that rationale, Dynamic Planner chief executive officer Ben Goss says risk-targeted solutions are seeing a surge in interest. He believes this is largely being driven by regulatory pressures on advisers: suitability reporting has become tighter under Mifid II and ongoing suitability reports are far easier to compile if you know that the strategy of a fund has not changed. Risk-targeted funds, by their very nature, will remain suitable as long as the client’s risk appetite has not altered. Goss points out that these products are also usually incredibly transparent and good value for money, both attributes that are becoming increasingly important to advisers and their clients, not to mention the regulator. He adds: “Delivering good client outcomes is becoming a greater focus for advisers. You may achieve a great return on an investment, for example, but if it comes because they have had to take more risk or at a greater cost then that’s probably not a good outcome.” While there are suggestions that clients could use a mixture of the two approaches if they do not want to choose between them, Goss thinks that is unhelpful. “Blending risk solutions sort of defeats the object, because the whole point is that you have already outsourced that job to a multi-manager,” he says. Choosing between the two approaches will ultimately come down to what a client’s objectives are and how much risk they are willing to take in order to achieve them. A client looking to achieve a certain level of income or to grow their money by a particular amount may be better off with a risk-rated fund as they have the flexibility to adjust their portfolio to achieve their objectives. The client whose priority is limiting their risk, meanwhile, may feel comfortable with a fund for which that is the prime focus. This might be the case for someone in drawdown in retirement, for example, who needs to know the value of their savings is not going to swing drastically. Tennant says: “We often get asked which approach is more suitable for certain market environments, but the reality is that the suitability decision needs to be taken at a client level, by the financial adviser.”Willis adds: “Risk-rated and risk-targeted funds are most suitable for investors essentially looking for a whole portfolio in one fund, and those who want a long-term buy and hold solution that they don’t have to review on a regular basis.”

On the face of it, fixed income assets do not look very attractive in today’s environment. One stop shop investments have become an increasingly popular option among advisers and their clients in recent years. The latest figures from the Investment Association show £539m was poured into mixed-asset funds in August alone, with a hefty £221.8bn now held in these products – some 16.1 per cent of all assets under management. But with so many different strategies and approaches available, whittling down the wide variety of products on offer can be difficult. Risk rating, for many investors, may be an obvious place to start. This is not least because it is already engrained in the advice process. Advisers will typically assess a client’s attitude to risk and capacity for loss before determining whether they should even be investing in the first place, so it makes sense for product providers to start to align themselves with an outcome suited to them. Risk ratings are also a relatively simple concept to explain to clients, as they can see clearly on a scale the nature of their investments. Solutions which take a risk-rated approach are typically given a number between one and seven, to indicate how much risk an investor is taking. Others may take a qualitative approach to their assessments, labelled “adventurous” or “balanced”, for example.

Understanding the basics is key when deciding between risk-rated or risk-targeted funds

November 2018

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