Multi-asset funds have been a staple in investor portfolios for decades, and are widely defined as diversified investments that can generate returns as markets rise as well as protect investors’ cash on the downside. The arrival of a number of new regulatory rules, notably post-pensions freedoms, have only increased the sector’s importance in recent years with investors requiring more flexible solutions that can provide them with a regular and steady income. To meet the increased demand for multi-asset solutions today, the sector has evolved. Whilst a decade ago, many multi-asset funds would have looked very similar to a strategically ‘balanced’ long only fund with a 60/40 split between equities and bonds, today multi-asset investors have a host of tools at their fingertips to help them achieve very specific goals. From investing in a range of alternative assets to market modelling tools that are able to mitigate correlation risk and more carefully align fund strategies with an investor’s desired outcomes. There has also been a rise in the use of liquid and non-listed alternative stocks among multi-asset managers. These often use strategies similar to hedge funds in order to find uncorrelated sources of alpha. This evolution of multi-asset funds has resulted in a blurring of the rules that once governed these strategies so carefully. The range of new funds coming to the market today offer investors an opportunity to choose a strategy that is not just aligned with their needs, but can provide a better idea as to the type of outcome they can realistically achieve. For fund managers this new era of multi-asset freedoms represents an unchallenged opportunity that is key to unlocking the best risk-adjusted returns as we navigate the potentially choppy end of the longest bull run on record. It might be a bumpy ride, but those multi-asset teams delivering a depth of research, working across both short and long timeframes, and using a range of tools are the ones most likely will succeed.
Why the rules are less clearly defined in multi-asset funds today
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he investment industry has been on a steep learning curve over the past decade, with regulatory change, political revolutions and monetary policy upheaval leading to unprecedented market economics. It has changed multi-asset investing in particular – not always for the better argues Andy Brown, Investment Director at Prudential Portfolio Management Group (PPMG). “An analysis of multi-asset funds over the last few years reveals there have been very few losses within the portfolios – if any at all. This sounds great. But multi-asset funds are not supposed to do this. It is not how or why they were built. A multi-asset fund should be able to hold up returns in good times, but balance off negative markets and provide an element of protection against risk when they fall. The fact that everything appears to be going up can lead to future expectations being unsatisfied.” Unorthodox monetary policy and a lack of volatility since the global financial crisis has created a unique set of investment circumstances for multi-asset investors, according to Brown. Investors who two decades ago would have been content to buy gilts alongside a few stable equity holdings to receive a monthly income are today having to incorporate high-dividend paying, and at times risky, stocks in order to achieve a similar level of return. The wave of money being invested in so-called risk assets has resulted in values of most assets in the UK and US rising, and that means the yields on said assets have fallen. Brown explains: “A multi-asset fund should help retail investors invest through market noise and risk-on/risk-off events to produce smooth, stable returns over long time periods.
"The problem is many investors think short term, and do not understand what market noise or volatility really means today. Especially as global central bank support has led many to view risk as effectively being ‘free’. This will no longer be the case as economies continue, or start, on a path of monetary tightening, however. The next three or four years will see investors experience a much rockier ride.” Multi-asset evolution For Brown the evolution of investment markets and fund strategies means rules are less clearly defined for some multi-asset funds. Many have moved on from single manager ‘cautious’ and ‘balanced’ strategies and there is an increased focus on outcome-orientated and targeted return vehicles. Some strategies in the multi-asset space now place less emphasis on long-term risk analysis and customer outcomes as they seek higher returns. “Fund groups constantly search for mechanisms that can reduce risk but still provide higher or a targeted return set. In my mind that is alchemy. By reducing one element of risk you might well be increasing risk somewhere else in a portfolio.” Brown insists fund groups must ensure the customer’s outlook is always at the forefront of investor strategies. In his experience, most investors don’t actually want to beat a benchmark; they want steady, consistent returns for the duration of time they are invested. “What we actually need to be doing today is providing investors with a better idea as to the kind of outcome they can realistically achieve in the market today, and give them real information as to how much they could lose on a 10, 15, or 20 year basis.”
Long-term outlooks PPMG’s multi-asset team does place long-term analysis and customer outcomes at the heart of its investment process. For PPMG, ‘long term’ means implementing an investment strategy for 10-15 years – and sometimes even longer. The team uses a range of tools to protect portfolios from extreme short-term impacts caused by market volatility and market noise through tactical allocation. The group also uses ‘smoothing’, a well-established process that forms a core part of the wider group’s With Profit’s Fund investment strategy (see box right). Smoothing allows the investor to ride out shorter-term event-driven volatility and looks to provide greater consistency in terms of customer outcomes.
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"The next three or four years will see investors experience a much rockier ride"
"If we are in the last upwards phase of a bull market today, we should be taking risk off the table. It should be decreasing from 90% to 85% and so on. We need to give up some return in order to protect our investor’s cash"
Multi asset is evolving…
As investors enter a new era of quantitative tightening, a focus on traditional, long-term metrics will be key to achieving success according to Prudential Portfolio Management Group’s Andy Brown
Andy Brown, Investment Director at Prudential Portfolio Management Group (PPMG)
The process has allowed PPMG’s multi-asset portfolios to be more flexible in their weighting to risk assets and deliver more predictable returns by avoiding the ups and downs of volatile markets on a day-to-day basis.
For Brown, this process has never been more important for multi-asset investors given where the market is heading: “To me, volatility cannot be analysed over a three or four year period. On a one-to-three year time horizon a manager will often be driven by where markets are in the economic cycle and short-term politics, such as a changing government for example. But by doing that investors often end up paying a higher price for assets because they are constantly behind market trends and chasing them. ”PPMG believes that volatility must be considered over an entire economic cycle if investors are to successfully navigate market events and protect portfolios from drawdowns that can eat into returns. “Some of the best investors talk about leaving the table before everybody else. In 1998, PPMG was criticised for moving out of the equity markets ahead of the dot com bubble. We probably did it 12-18 months too early. But, by 2003 we were streets ahead of the competition because we had assessed risk correctly ahead of the event and repositioned the portfolio. And again, if you look at the market today; if we are in the last upwards phase of a bull market today, we should be taking risk off the table. It should be decreasing from 90% to 85% and so on. We need to give up some return in order to protect our investor’s cash. Brown believe in most cases markets tend to do a lot of the heavy lifting, which means correct asset allocation of this type alongside risk assessment is key to successful returns. “There will always be short-term periods where markets turn against you,” says Brown. “But if a manager can make the right calls on a long-term basis using a much wider spread of assets within a reasonable set of risk boundaries, it will eventually deliver against the type of outcome clients want. And to us, success looks like giving an investor what they expect to get.”
Much of PPMG’s multi-asset expertise has been built on the same philosophy and values that serve Prudential’s With-Profits Fund – a portfolio that has produced positive results over the long term. Their approach to managing investments has meant that the group has maintained its annual bonus rates, and also delivered final bonuses for most customers in recent years. “A With-Profits Fund is set up to provide a bonus rate and you have to manage the capital accordingly to do that. Once you have attached a bonus to an individual’s policy, the regulator will ask how much capital you have and take a view as to whether your capital can pay out that promise," says Brown. "Management of the underlying fund is therefore with a much more liability-driven mind-set. And that overarching style of investing means we do try and focus on what the outcome should be at all times.” The With-Profits Fund has also helped the group to access a range of ‘newer’ assets within its multi-asset ranges which are less correlated with traditional equities and bond assets, but often inaccessible to most asset managers. For example, PPMG has been investing in diverse asset classes within the alternatives space, as well as African equities and Asian credit within its multi-asset vehicles since 2006. Brown explains that if investors can identify these types of longer-term trends and buy them before market momentum pushes the price of those assets up,they are able to benefit from a significant upswing. “We dipped our toe into African markets over a decade ago, and the small test investment has now resulted in a target allocation approaching £1.25 billion and we will probably be one of the largest UK based investors in African equities." Brown notes that while many investors found such asset classes inaccessible and too volatile to trade in, the wealth of experience of running the Prudential With-Profits fund, and a focus specifically on outcomes provides PPMG with confidence. “As risk-free assets disappear, investors today have to sit back and really think about where to invest. That is where the expansion into less correlated assets is key. And it is the bigger funds, those with a wide enough structure like Prudential and PPMG’s that can access them.”
Lessons learned
As the universe of multi-asset solutions continues to grow, the key to delivering long-term, stable returns often relies on how well the underlying drivers of risk and return are understood and managed in a portfolio. But how easy is it to model the possibilities?
Capital markets research and modelling: The engine of a multi-asset portfolio
he onset of the global financial crisis a decade ago instigated a new era for fund managers when it came to analysing risk and returns. Indeed, it was during the worst periods of market stress in 2008 and 2009 that the underlying interactions between asset classes became clearer. Investors who believed risk was evenly spread between a range of investments found the reality was quite different, as assets that were supposedly 'safe' and resillient fell in tandem with the rest of the portfolio. It is no surprise therefore that since the crisis there has been a renewed focus on risk and return analysis. In the multi-asset sphere, where asset correlations and market volatility can change significantly, the key to delivering long-term, stable returns now resides predominantly in how well the underlying drivers of risk and return are understood and managed. “In multi-asset fund management, a large part of the variation in investment returns are generated from a manager’s long-term, strategic asset allocation decisions. This is why investors should ensure they are investing in the right asset classes and the right markets, at the right time,” explains Dipanjan Roy, Senior Investment Strategist at Prudential Portfolio Management Group (PPMG). “But in order to achieve the best optimal allocation of assets in a portfolio, a manager needs to understand the risk and return characteristics of assets as well as how they can evolve over time. That is why capital markets research, assumptions and modelling is the first port of call within the strategic asset allocation process; we define this as the engine that drives a fund’s investment process.”
Blending and Bundling Most managers tend to use ‘off the shelf’ capital markets research and modelling technology in their fund management process. These quantitative analytic tools use historic data to analyse the xpected risks and returns of investing in different asset sub-classes. Managers then use this historical behaviour to model the future expectations of risks and returns which drive the asset allocation process. This is the reason why most managers are caught unaware when there is a large shift in the markets, such as the 2008-2009 financial crisis. In order to navigate volatile financial markets, investors need knowledge of what has happened in the past, but also a broad understanding of why asset classes behave the way they do on a long-term basis. Yet many ‘off the shelf’ asset allocation methods are regarded as being too short-sighted to do this, with outcomes heavily reliant on narrow frames of historical analysis. “Looking at past events and expecting an asset class to continue behaving in the same way in the future is likely to lead to the wrong conclusions,” explains Roy. “But if your analysis of risk and returns enables you to identify not just what has happened, but why it happened and the underlying factors that led to an asset moving in a specific way, this information allows you to make a more accurate call on how that asset class might behave in the future.” Roy argues popular asset-allocation processes are unable to do this however, predominantly because they have not kept up with the richness of data and technological improvements now available. As such, some asset-allocation tools may not be able to offer much choice beyond the somewhat limited and traditional conservative/adventurous multi-asset portfolios. He explains: “The financial models used by most fund managers were developed some time ago. They aim for simplicity and try to ensure that every outcome is mathematically tractable. However, the shortcomings of this method are that they do not always accurately reflect reality. Their limited range means in some cases, managers will be making certain simplifying assumptions about the way markets will behave.”
Looking at past events and expecting an asset class to continue behaving in the same way in the future is likely to lead to the wrong conclusions
Roy refers to the 2008 financial crisis as an example of an event that could have been better managed with a more sophisticated understanding of capital markets research and assumptions: “At the time, the heads of various financial institutions called the global financial crisis a 'one in 10,000-year scenario'. But if investors have an accurate understanding of how markets behave, then those sorts of events should be much more predictable, or at the very least, investors should be better prepared for such changes in the market.” He adds: “At PPMG, we use a variety of inputs to make our capital markets research and assumptions more robust and sophisticated across a range of different market conditions. Our starting point is to take all available inputs from all available research and analysis, both internal and external, making sure our sources are as varied and heterogeneous as possible. "The external research is sourced from academic literature as well as market practitioners - from university faculties, central banks, supranational organisations, industry bodies, sell-side analysts, buy-side analysts and independent research consultancies. "The internal research consists of research capabilities within the team and also leverages on resources within the Prudential Group including PPMG Manager Oversight, PPM America, M&G, EastSpring and PruCap. The analysis and the hypotheses are independently tested using historical capital markets returns obtained from numerous data sources, proprietary third-party databases, time series and cross-sectional analysis of returns distributions. Additionally we have our bespoke models for long-term structural factors like demographics, economic growth, inflation.” While the process is time-consuming and resource-intensive, understanding and modelling different asset classes properly proves invaluable in navigating multi-asset portfolios through different market conditions.
"The financial models used by most fund managers aim for simplicity and try to ensure that every outcome is mathematically tractable. However, the shortcomings of this method are that they do not always accurately reflect reality"
riven by the search for income in a prolonged low return environment, the growth of alternatives has continued at a faster pace over the past two decades. Demand for these assets is expected to rise to a staggering US$ 13.6tn by 2020* as investors hunt for uncorrelated sources of return outside of equity and bond sectors. “The opportunity set within the alternatives sector is truly global and spans a diverse range of often quite specialised sectors. Today this includes private equity, infrastructure, hedge funds, private credit, insurance-linked securities and pharmaceutical royalties to name a few. Yet it wasn’t that long ago that these types of alternative investments were the exclusive domain of institutional or specialist investors only,” notes Michael Howard, Head of Alternative Investments at Prudential Portfolio Management Group (PPMG). “Newer alternative assets are often idiosyncratic in nature and uncorrelated with both traditional asset classes. Therefore, it is no surprise that they are being accessed much more widely than before.” Alternative substitute Howard feels that rather than being a portfolio add-on, investments in alternatives can be a substitute for public equity or bond markets today. For example, private equity offers the potential for somewhere between 200 and 300 basis points of outperformance versus public markets over the long-term. Private equity is one area Howard and his team has invested in significantly over the past decade. The growth of this asset class has been driven by a number of factors. He explains: “More than 6,000 companies were listed in the US in 2000; today that figure is less than 4,000. The reason for that shrinking figure is that IPOs have dried up and when companies are choosing to list they are coming to the market with a much larger capitalisation than average." Effectively the growth period and when higher returns are on offer is all happening at a much earlier stage and predominantly via private capital. "You can see that quite clearly when you compare the investment return multiples since IPO for Amazon versus Google and Facebook; the latter two were much lower as the growth phase had been enjoyed by private equity groups.” While alternative assets are useful in providing sources of uncorrelated portfolio returns, in other cases, like private equity for example, returns may have a higher correlation to public markets.
Effectively the growth period and when higher returns are on offer is all happening at a much earlier stage and predominantly via private capital. "You can see that quite clearly when you compare the investment return multiples since IPO for Amazon versus Google and Facebook; the latter two were much lower as the growth phase had been enjoyed by private equity groups.” While alternative assets are useful in providing sources of uncorrelated portfolio returns, in other cases, like private equity for example, returns may have a higher correlation to public markets. Though private equity investments will be investing in different companies with varied outlooks, they are essentially affected by the same thing as publicly listed companies: the economic cycle. Of course, what you do get by investing in private equity is an enhanced return and that is a good reason to consider it over other equity investments in a multi-asset portfolio. Crucially, these enhanced returns are delivered net of fees. Niche expertise Around half of Howard’s team has a private credit and hedge fund background. Within some multi-asset portfolios the group has between 12 and 15 different types of hedge fund strategies. “We don’t always look for what I would determine as ‘classic’ hedge fund vehicles. Our aim is to ensure the aims and structure of the fund we invest in matches the time horizon of the investment and the characteristics of the asset class. Many of our investments are long duration in nature to provide strong alpha or absolute return diversifying strengths. In the hedge fund space for example, we have recently invested in insurance-linked securities.” Insurance-linked securities are a way for insurers and reinsurers to transfer risk onto investors who underwrite them. Investors then collect premiums and payout on losses as and when they materialise. Though this niche asset class used to predominantly be the exclusive haven of hedge fund providers, demand for capital in this space has seen further opportunities from insurance companies themselves. “Many investors may find there are significant structural and long-term barriers to entry in some types of complex alternative assets. Some of that is to do with regulation; but a lot of it is also down to the fact that capital has been constrained from a liquidity point of view ever since the global financial crisis. Few groups have the capital to lock away on a long-term basis in risk assets like alternatives because of the liquidity and regulatory constraints. Those that do, like PPMG, can benefit from these capital dislocations because they are able to step in and deploy long-term capital, sometimes alongside several expert partners." Howard highlights an investment the group undertook in the Italian solar sector in 2016 as an example of this. Though one of the biggest solar markets in the world, it remains a fragmented marketplace with room for significant consolidation. PPMG invested via a newly created fund with Next Energy Capital, a market leading solar asset manager in the UK and Italy. This fund allowed it to invest £150m in existing solar photovoltaics plants in Italy and by managing them collectively, plant performance and operations is improving. This investment provides the group’s multi-asset portfolios with the potential for stable returns and an annual dividend of around 8%-9% backed by long-term government incentives.
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"Many investors may find there are significant structural and long-term barriers to entry in some types of complex alternative assets"
The rise of the ‘new’ alternatives
As yields have compressed and forward-looking return expectations fall, multi-asset managers have sought alternatives to traditional asset classes to find new sources of income and boost returns
Asset accessibility Access to capital is not the only challenge for investors in this asset class. New regulatory changes and even natural disasters can impact the group’s investments in areas such as solar and reinsurance. Meanwhile, the complexity of some alternative investments, especially those with long-lock structures, means many instruments are difficult to price. Once invested, the secondary market is often extremely illiquid and unattractive for those selling assets. This means due diligence is key, not just from an investment perspective but also legal and operational. “The risks we face on the non-investment side of things are almost as concerning as financial risks,” he explains. “Our investments are long-term, we invest for 10 or 15 years. So, it is really important we are comfortable with the risks we take on in some of these newer areas. We take a three-prong investment approval process that covers investment, operational and legal due diligence before any investment is made, and the process is quite involved. For example, we typically run background checks on all key employees and the company itself using a specialist background checking agency. "We also instruct our own lawyers, often with the assistance of external legal counsel, to review all legal documentation and negotiate terms and protections that we are comfortable with before investing. These actions protect us and the partners we work with against some of the risks and things that can go wrong when investing in alternatives. ”Despite the challenges, Howard remains optimistic about the evolution of alternatives as the sector branches out into new areas like emerging market private equity, renewable energy and battery storage. These are all areas Howard and his team have accessed through the group’s multi-asset vehicles. “We continue to see attractive potential returns and yield premiums to traditional returns, despite the compression in recent years,” says Howard. “Moreover, alternative assets are today very much being used to enhance the returns of multi-asset portfolios overall, with tailored mandates by the right providers able to provide investors with access to the best opportunities and at a discounted rate as well.”
Pharmaceutical royalty funds in general terms are a category of private equity funds which specialise in buying consistent revenue streams driven from the payment of royalties. If a pharmaceutical company has a blockbuster drug under a patent; asset managers like PPMG are able to partner with a firm that will lend against specific royalty streams from that drug. Usually, asset managers will know the number of sales likely to be made (due to the patent held and lack of competition), which is what can make investing in this area profitable. “Investing in pharmaceutical royalties generates a similar cash flow to a bond, in so far as you roughly know how much you’re going to get. They are also high-yielding and uncorrelated to traditional assets in investors’ portfolios,” explains Howard. “The return you can get for lending against these future royalties’ cash flow streams is substantially more attractive than investing or lending through the high yield market.”
Pharmaceutical royalties
here are a range of fundamental characteristics of markets and economies that help drive multi-asset portfolio allocation decisions. Yet few long-term assumptions are cast in stone, and given the current confusing investment outlook, the need to step back from market noise and take note of the wider and more impactful economic ‘shifts’ happening around us has never been more important. “There is so much high-frequency analysis involved in the investment process today that the real challenge is being able to step back and think about how certain themes are having a dramatic effect on long-term portfolio allocation,” notes Parit Jakhria, Director of Long-term Investment Strategy at Prudential Portfolio Management Group (PPMG). “Some of the changes have been occurring for decades, but it is only when you think about them in the context of the investment market today that their impact on society makes sense. ”For Jakhria, one of the biggest structural shifts being seen today is the ongoing shift of the world’s economic centre, which in less than three decades will have transferred from the west of the globe to the east. This has been seen with the rise of China and Asia as a whole, which continue to grow in terms of their economic and investment influence. “Historically, the economic centre of gravity was broadly in line with the size of the global population and early civilisations grew around the banks of rivers like the Nile, Euphrates, Indus and Yangtse Kiang. Until 1500AD, the agrarian economy and trade in agricultural goods was primarily within Asian and African civilisations. At that point, Western Europe, North America and Australasia accounted for less than 20% of the world’s economic output,” explains Jakhria. This however changed rapidly with the arrival of the Renaissance era, and Western Europe emerged as a hub of scientific evolution (see graphic over). Both Europe and the Americas came to dominate the global landscape from the early 1800s onwards, using an accumulation of knowledge and ideas alongside its imperial military strength to maintain its position as the economic centre for some time. The two World Wars reversed this trend in the mid-20th century. European empires suffered at the same time as countries such as Japan, China and other ‘tiger’ economies experienced growth. Eastern economies were the main beneficiary of the globalisation of trade and the free flow of capital, labour, goods and services. Even today, the overall narrative remains focused on the economic importance of emerging economies in Asia and Africa in investment markets (see graphic below).
The macroeconomic implications of this shift are likely to alter many of the fundamental pillars of our world economy, according to Jakhria, and impact geographical asset allocation signficantly. For example, major OECD countries have followed a common template for the interaction between monetary and fiscal policy ever since the 1980s and 1990s. Over the years it has become accepted wisdom that an independent central bank with a primary mandate to keep inflation in the low single digits is best for the overall health of the economy. However, the rise of China could see the Chinese model become the norm as an alternative; where the primary goal of monetary policy is political and economic stability, rather than price stability. Jakhria explains: “If the Chinese economy was to avoid any major blow-ups in the immediate future, it would be a successful example of limiting the independence of central banks and running a centrally managed economy through monetary, fiscal and regulatory oversight.” Demographics and more Changing demographics are for a large part the reason behind such shifting economic centres. Those with larger populations and a younger demographic, such as India and Africa, have much higher prospects for GDP going forward. As such, this shifting ‘centre of gravity’, as Jakhria refers to it, is a core investment theme that all multi-asset investors should be aware of. “Our in-house economic growth model suggests that the shift ‘eastwards’ will continue largely due to demographics and productivity catch-up. In spite of the fact levels of education, rule of law and political stability all need to improve, countries in Africa parts of Asia don’t suffer from ageing populations in the same way as advanced economies. The improving level of per capita GDP from a low base also makes a material difference over the longer term.” (see graphic below). “Africa, for example, has leapt three generations in terms of technology in the space of ten years. Take something fundamental like banking; 10 years ago large parts of Africa were striving for establishing local branches to access other banks across the country. Large parts of Africa have gone straight to internet banking (largely bypassing telephone banking) and, in some areas, African countries are innovating and are moving to electronic cash, which in many ways is even more advanced relative to Western economies. Given their low starting point and the huge potential for technological catch-up, these countries don’t need to get everything right to advance rapidly.”
Technology shifts It is not just shifting economics driving PPMG’s long-term assumptions. The group uses a similar analogy to model a number of potential regime changes. Not all of them are clear cut however. Take technology for example. “Predicting technological change is a big challenge, especially when trying to frame long-term assumptions. This is because the current stock of human knowledge is vast and there are a huge number of areas where technology is still developing, whilst the pace of technological change is accelerating. Thus, it’s almost impossible to man mark each new technology, and one needs to think about it in aggregate." Secondly, the pace of change is increasing, and this is why Jakhria believes it is important to look at all regime shifts in context and analyse the effects of change over long time periods rather than be too exact as to what changes could occur. In the case of technology for example, Jakhria aims to model the effects of technological change for the group’s multi-asset strategies, rather than predict the exact forms of technology that could cause those changes. “Establishing a new economic order and an equilibrium around these sorts of ideas is a significant unknown, which is something we are very much aware of as we understand nothing can predict the future. But by properly analysing and incorporating long-term trends like these into our asset allocation process we are able to stay ahead of the curve. For example, long-term illiquid asset classes are potentially adversely impacted by technology; a classic example being retail shops. On the other hand the geographical distribution of technological innovations could be at a historical inflection point” Jakhria explains.
"Our portfolio allocation must at least keep up and ideally foresee shifting pattern as market economics accelerate away from the West"
Multi-asset allocation amid ‘shifting’ economic centres of gravities
Changing demographics, globalisation and technology are just some of the factors pushing capital from Western economies to Eastern economies over the past thirty years. Are multi-asset portfolios at risk of being left behind amid such historic regime shifts?
Source: McKinsey Global Institute, Angus Maddison (University of Gronongen, MGI Cityscope v2.0)
How 'economic centres' have shifted from East to West and are now moving back
Africa's High GDP and Growth Potential
Portfolio allocation From a multi-asset investment viewpoint, Jakhria believes the revolution at a long-term structural level needs to be echoed in asset allocations too. “We believe our portfolio allocation must at least keep up and ideally foresee shifting pattern as market economics accelerate away from the West. Thus, in our multi-asset portfolios we already have a lower allocation to the UK, US and Europe compared to most of our competitors and a correspondingly higher allocation to some of the high growth and developing areas in Asia and Africa. Importantly, we aim to have this theme across all asset classes (not just equities), which allows us to incorporate a lot more diversification into our portfolios than a lot of our peers.”
nvestment returns from even the most well-diversified multi-asset portfolios are likely to be subdued for the foreseeable future as an environment of super-normal monetary policy and low yields continues. Alongside stretched valuations in a number of asset classes, the need for proper asset allocation to generate sustainable alpha has never been greater. For many investors the key to delivering better multi-asset returns comes down to using complementary strategic and tactical asset allocation processes. While the difference between strategic and tactical allocation is fairly clear cut, more often than not the same fund team is involved in researching and implementing both. Yet the two forms of allocation require significantly different approaches and ways of thinking. “Investment markets constantly adjust to new information and asset prices can often be more volatile than the underlying fundamental. This can lead to them overshooting based on changing investor perceptions on a short-term basis,” explains Barry Widdows, Head of Multi-Asset Portfolio Management at Prudential Portfolio Management Group (PPMG). “This volatility can create mispricing of asset classes and it is only through a tactical asset allocation process that managers can take advantage of those trends and opportunities. We believe that the best way to generate strong absolute returns and alpha is to start with a really strong strategic asset allocation as a foundation and combine that with a modern dynamic tactical asset allocation process. Widdows believes an individual focus on both of these areas is key to delivering returns in multi-asset today, as both processes provide quite different market insights that are able to inform portfolio decisions in unique ways. The group’s long-term investment strategy team for example analyse a range of strategic factors and aim to position a portfolio to benefit from the medium to long-term capital market views. This process allows the team to take into account the secular views and associated regime changes likely to happen, as well as broad high level perspectives on the current cycle into the investment philosophy. Meanwhile, a separate portfolio management team focuses on tactical asset allocation which is a secondary research process that complements strategic asset allocation as a whole. On a tactical basis, the portfolio management team aims to analyse shorter-term behavioural and market timing insights on anything from a one month to 18 month outlook. Phil Butler, Multi-Asset Portfolio Manager at PPMG, explains: “The way we frame our theory is strategic asset allocation is looking at an outlook of three-to-five years plus. And whilst a rational investor should price an asset to return its objective over long time frames of this sort, in the short term assets do tend to deviate away from their true value. Our aim is to tactically take advantage of those opportunities that are presented before us.”
Mispriced opportunities The evolution of tactical asset allocation in the industry over the past 15 to 20 years has seen a growth in the asset class coverage, according to PPMG. At the time of the tech bubble in 2000 for example, tactical asset allocation was focused on stock/government bond decision. But the early 2000's brought a widening of opportunity sets, with regional equity and bond markets being added to the stocks/bonds/cash decision. This grew further to take in individual equity markets, sector baskets and investment styles as well as FX strategies, comprising the G10 developed currencies as well as emerging markets, plus commodities. Today, our tactical asset allocation process covers all of the main equity, government bond, credit and currency markets and potentially assets that are not held strategically in the fund. The process is designed to focus on identifying mispriced opportunities. In most instances the team look for “episodic or fundamental market events”. The tactical investments the team make are often only held for between three and six months.“Our overriding tactical asset allocation investment philosophy is to not take on a position unless we believe there is a significant mispricing or an enduring opportunity that has a high likelihood of being rewarded. We do not make decisions on a day-to-day basis. Therefore we typically have significantly fewer active positions on at any point in time compared to many global tactical allocation or macro hedge funds,” explains Butler. However, the team has implemented a number of tactical allocation decisions this year. Take the first quarter of 2018, when parts of the equity market saw large drawdowns as valuations came under pressure. Volatility returned with a vengeance, yet there was little negative economic data driving the falls. Because of this, Butler took a decision in early February to increase risk assets in the multi-asset portfolio range.
Despite this a tactical asset allocation process should not, says Butler, be based only on risk management “A lot of questions we receive from investors is how we protect the portfolio on the downside when tactically allocating, and the truth is we don’t aim to do that. Risk management is inherent in the process, however. We incorporate significant amounts of diversification and minimise the chance of a single position or risk impacting the portfolio adversely. We also consider the risk impact of every tactical decision we make. The team is constantly focused on risk management and works with our independent risk function.” “We abide by strategic asset allocation that guide our portfolios on a long-term basis but aim to add value in the shorter term where we can,” says Butler.
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"Volatility creates mispricing of asset classes but tactical allocation helps managers take advantage of trends"
Asset allocation: Why the strategic versus tactical debate matters
Seen as the building blocks of a portfolio, strategic and tactical asset allocation processes should work in tandem to deliver on-target and risk-adjusted returns. Here, the two processes are analysed to see how they complement each other to deliver long-term results
"In order to implement proper risk management it needs to be done a long-time in advance and at a strategic level"
This allowed the group to benefit from the market rally that followed at the end of the month and take profits. A similar train of thought followed the group’s view on Italy’s equity markets, which have taken a hit amidst election turmoil in Q1. Widdows adds “Italy and Turkey are two markets we’ve been taking a close look at increasing exposure in recently as we saw investor beliefs reacting to news flow and pricing potentially overshooting. We also look at areas where contagion appears to be happening even though underlying fundamentals haven’t changed and again these can be opportunities presented because of investor behaviour. ”PPMG portfolios periodically reset their strategic asset allocations too, to incorporate latest information on long-term return, risk and liquidity expectations.These regular reviews also allow new asset classes to be incorporated as they become viable. The evolving strategic allocation and the tactical element is a modern approach to multi-asset investing and somewhat unique in the industry. On the one hand the industry has passive funds with fixed weights or those that align themselves with a composite benchmark and rarely ‘reset’ portfolio allocation. Active managers on the other hand often choose to pick the best asset class they believe will outperform in a given time period. Contrarian investing The tactical allocation process can often be contrarian in nature, although this is not the main purpose of Butler’s tactical investing style. “One of the advantages of working with large, growing funds and taking a long-term approach is that we are able to take contrarian views when we believe that is appropriate. We are able to take, at times, a view against what the wider market is doing and hold it for a period of time. However, we are also trying to remove excesses. So for example when we believe markets have become overly valued we want to try and protect our portfolios on the downside as well. We are very cognisant of drawdown risk as we are aware that stability of income is extremely important to multi-asset investors today.”
2. Behavioural generally refers to shorter-term mispricing resulting from excess pessimism and optimism (leading to the opportunity for reversal trades
1. Valuation refers to developing investment insights relating to appropriate valuation parameters for various asset classes and sub-asset classes
Tactical Asset Allocation Research Framework
Alpha - Alpha is deemed to be the excess return of a fund, relative to the return of its comparative index. Alpha is often referenced to confirm that a portfolio manager has added to a portfolio’s value and fund return overall. Active investing - Active investing refers to an investment strategy where an appointed persons, such as a fund manager, buys and sells investments on an ongoing basis consistently monitoring performance to ensure the best returns possible area achieved. Alternative investment - An alternative investment invests in assets that do not form a part of the traditional bond or equity sphere. Alternative assets include, property, infrastructure, private equity, commodities and hedge funds to name a few. Asset - Anything investable that has a commercial value, or an exchange value and that is owned by a government, business or individual. An asset class is a group of securities that are similar in terms of their behaviour and/or characteristics. The four main asset classes are equities, fixed income (bonds), alternative investments and cash. Bear market - An economic scenario in which the prices of assets are falling and selling is encouraged. Bonds - Bonds are effectively a secured loan, in most cases issued by a government or a company which pays a fixed rate of interest over a given amount of time. At the end of the period, the borrowed amount is repaid in full. Bonds are also referred to as ‘fixed income’ for this reason.
Bull market - An economic scenario in which the prices of securities are rising. Investors are often optimistic on the back of strong returns.
Glossary
Capital growth - The increase in value of an asset over time; often ending with the current value of the investment being greater than the starting amount invested. Developed markets - Developed markets are generally regarded as those well-established economies with a high degree of industrialisation and secure governments. Standards of living and are often higher in developed markets and economies are more advanced. Diversification - Diversification is the practice of ensuring a portfolio is invested in a variety of assets to ensure capital is protected regardless of market economics. Diversification is also used to manage risk as any losses of one asset should be offset by another more defensive asset in the portfolio. Economic scenario generator - A computer generated model based on mathematics that is able to simulate possible future directions of markets based on a range of variable the user inputs. Emerging markets - Emerging markets are those economies still experiencing rapid growth. Emerging markets usually have more favourable demographics, thus more room for growth in the coming years. However, these markets are generally considered as being riskier than developed economies due to issues such as potentially unstable governments.
Equities - Equities are stocks or shares in a company. When an investor buys stocks, they are buying an equity stake in a company and thus own part of that company.
Index - An index refers to a particular segment of the market, and is often used as an indicator for average performance versus a fund or manager. An index-tracking strategy aims to match returns from this average indicator often by investing in the same stocks. This is often referred to as a type of passive investing. Liquidity - This is a measure of how much cash a company has as its disposal. For example, a company’s shares are considered 'highly' liquid if they can be easily bought or sold on the stockmarkets. The opposite is an illiquid company, which may represent a company with little cash at its disposal or in investment terms as something that is difficult to sell. Macroeconomic - When talking about macroeconomics, it often takes in a number of indicators of the health of an economy at a national level. These factors can be economic output, inflation and employment figures. Monetary easing - Monetary easing refers to global central banks using measures such as lowering interest rate or quantitative easing to help ease stresses on the economy. Monetary tightening - Monetary tightening is the opposite of easing. It often refers to the raising of interesting rates which increases the cost of borrowing, and options to decrease the amount of money in circulation. Multi-asset - This type of investing refers to a process of investing in a range of diverse assets and sectors. A multi-asset fund often combines traditional securities with alternative approaches and sometimes, hedging techniques. Multi-manager funds - Multi-manager funds focus on investing in multiple funds that specialise in specific sectors or themes in order to build a portfolio that generates higher returns.
Price-earnings ratio - A measure that compares a company's current share price to its earnings per share.
Risk-adjusted funds - Risk-adjusted funds measure how much risk is required to produce a specific fund return. The most widely used measure of risk-adjusted return is called the Sharpe Ratio. Risk-managed funds - A risk-managed fund aims to measure (and thereby control) the level of risk a fund manager can take to achieve a specific return. Risk-managed funds actively target a certain level of risk that is pre-defined and adhered to always. Risk profile - Risk profile is an evaluation of how risk tolerant (or averse) an individual is to take risks when investing in a fund portfolio or similar. This is an important tool wealth managers and financial advisers use in order to define how a client should invest. Strategic asset allocation - This type of allocation is focused on the longer term; investing in a broad range of assets, sectors and themes that take advantage of market efficiency and are not swayed by short-term market noise. Tactical asset allocation - Tactical asset allocation is the short-term equivalent of strategic asset allocation in many respects and actively adjusts a portfolio to improve overall fund returns. Total return - The gain or loss of an investment or asset when it is traded.
Unconstrained - An investment strategy or manager that has the ability to invest wherever they want according to their own strategy, without being constrained by a benchmark or specific weightings.
Underweight - When a portfolio holds a smaller amount of an investment when compared to the index or sector average. Valuation - How much an asset or company is worth based on its current price. Volatility - The degree of variation from the norm an asset price or fund might experience. If a stock experiences high volatility, it suggests a large amount of risk is entailed in investing in it. Yield - In equities, yield can refer to dividends received from a stock. In bonds, yield refers to the interest an investor receives from investing in it. It is expressed as an annual percentage, and is based on the security’s current value.
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