The bewildering variety of multi-asset funds can make them difficult to compare. But Martin Steward thinks that 2011 has revealed some useful patterns
This year has been testing for multi-asset managers. Despite bullish corporate earnings through 2010 lifting sentiment and pushing US 10-year yields towards 4%, it all started to go wrong in April 2011 as the macro picture darkened. The bond markets started to turn over, but equity markets refused to follow. We all know who was right, and how it all ended in tears in Q3.
Given those bond market signals there seems little excuse for multi-asset funds that found themselves over-exposed in August.
“Lessons were learned in 2008,” says Jenni Kirkwood, an investment consultant at Mercer. “This year, more funds put in defensive strategies as they saw things getting more difficult, and the managers that have done better are those who have that extra flexibility and are happy to use it.”
John MacDonald, head of alternatives at Hymans Robertson, agrees: “You should differentiate between funds that rely on diversification and those that are more active in protecting the downside.”
But is that fair, given that multi-asset strategies are so diverse?
“We don’t aim to be absolute return investors, and we don’t allocate to government bonds at all,” says Johanna Kyrklund, head of multi-asset investment and manager of the Schroder Life Diversified Growth fund - which targets inflation plus 5%. “It’s called a growth fund for a reason. It’s sold to UK pension schemes and they have other things for matching liabilities.”
The result: the fund was down 4% by the end of Q3. That’s not bad for a strategy that can’t hold bonds - especially as Kyrkland admits to coming into 2011 pro-cyclically positioned with 47% in equities. Buying cheap-looking equity put options in April, and some July selling, brought equity exposure to 27% through Q3 (within two percentage points of the strategy’s lower limit), and saved about 250 basis points.
“Year to date, flexibility has been key…. to navigate market volatility,” says Sara Morgan, managing director in the BlackRock Multi Asset Client Solutions group. Its Dynamic diversified growth fund can go up to 100% in cash or bonds - and has hit levels of 40% cash in the past. Like the Schroders fund, however, it also used derivatives to take off about a third of its equity exposure going into Q3. August and September were tough, but by the end of October the strategy was back to a 2.5% loss since its January launch.
Imtayaz Ahmed, a senior associate at Bfinance, notes that many passive products designed to achieve targets over three years have suffered drawdowns: “However, more flexible products have been able to protect the portfolio to an extent through put options on equities, [with] some selling call options to help finance the cost.”
Those decisions raise an important question. Diversification is not about short-term capital protection. But given that recognition, should growth portfolios be left to fend for themselves? Should there be separate tactical or strategic overlays to limit big drawdowns? Or should restrictions on asset classes be lifted so that dynamic allocation can be used to do the same job? Most claim to pursue the third way.
“It’s important to maintain stabilising assets, like bond duration and absolute return strategies, and dynamically manage the mix,” says Patrick Rudden, head of blend strategies at AllianceBernstein. The default portfolio of its Dynamic Diversified strategy is 60/40. It can be titled to 80% either way, but wasn’t in 2011: since its launch in April to the end of October it was down 1.8%, with 1.2% of that coming during Q3. Nonetheless, that is clearly an improvement in capital preservation over Schroders’ more explicit growth strategy and compares well with other diversified funds.
Henderson Global Investors’ Diversified Growth strategy targets LIBOR plus 4% over three years and has more flexible asset-allocation bands than the AllianceBernstein fund: 0-80% in equities, but 0-100% in cash and bonds.
“It’s worth pointing out that we don’t aim to be absolute-return,” says investment director Jane Shoemake. “But diversification is not enough - you need to allocate dynamically and more into alternatives.” The fund is down just over 3% gross year-to-date to the end of Q3.
Even managers who entered 2011 sounding gloomy did not always outperform over the summer. “We felt there wasn’t huge potential for upside, and also a good chance of the market being disappointed by events,” recalls Patrick Edwardson, head of diversified growth at Baillie Gifford.
His fund targets UK base rates+3.5% over five years with a 10% volatility limit. The volatility coming from any asset class is limited to half the risk budget. This maintains diversification, as do slightly more restrictive allocation bands: not more than 60% in bonds; not more than 40% in equities. This year only about 11% of the portfolio was in equities; a total of almost 65% was in emerging market and high yield bonds, infrastructure, absolute return (including a fund that sells out-of-the-money equity call options), and insurance-linked securities. These income-oriented positions got the fund to the end of October flat on the year - but not before losing about 4% to the end of September.
Either because of constraints or temperament, managers shied from big calls leading up to Q3. That might suggest that straightforward growth (with tactical hedges), Schroders-style, is the way to go. Or perhaps that even tighter constraints might not be a bad thing. ‘Absolute return’ as a label has come in for criticism lately, but if you take it as seriously as Schroders takes ‘growth’, there is no doubt that you can preserve capital against market volatility.
The SYZ OCEANO Absolute Return Institutional fund is highly conservative, targeting LIBOR plus 2% and volatility of just 2%. After giving up 1% in August, it finished October up about 0.8% year-to-date. That is our first positive result so far - and yet fund manager Jerome Schupp was “positive” as he entered 2011. The difference is that his “positive” translates into an allocation of 45% in bonds, 30% in cash, 15% in equities and 15% in hedge funds.
“A lot of managers try to use their risk budget to get the highest return possible,” says Schupp. “We do the opposite - trying to hit our return target with the lowest risk possible.”
And that is a strategic position. The portfolio does not swing around much, but the supremely tight risk limits truly define the strategy when times get rough; at the end of August the cash and bond allocation was up to 89%. “When the market is very volatile it’s fair to say that we focus more on capital preservation than on hitting the return target,” says Schupp.
Clearly the upside here is limited. But absolute-return strategies have delivered bigger returns this year. At Standard Life Investments, Global Absolute Return Strategies (GARS), which limits volatility to 8% in its pursuit of cash-plus-5% over three years, finished Q3 with a year-to-date return of 3.2%.
While GARS does have risk budget limits - no more than 40% in one asset class, for example - it is really a portfolio of strategies rather than an asset allocation fund. Its long-30-year/short-10-year US Treasury futures position is a net-zero bonds exposure but has positive duration, for example. That was the fund’s biggest risk exposure in September; the third biggest was Japanese equity volatility traded against that of US equities.
A similar multi-strategy approach is pursued by THEAM, the BNP Paribas Investment Partners’ boutique, in the Parvest family of funds. They struggled in the first half of the year with a short-US equities bet, but August and September were among their best-ever months: performance came from puts on US and German equities, Swiss franc trades, shorts against the Australian dollar and Brazilian real, Vix calls bought at 20% in July and yield-curve flatteners.
“At the end of September we began to take profits from our equity shorts, which was clearly well-timed for what was to be one of the strongest months ever for markets,” says absolute returns portfolio manager Tarek Issaoui. Parvest Multi Asset 4 Classic Cap, targeting 4% volatility, finished Q3 up around 1.2% year-to-date.
But before you conclude that multi-asset success in 2011 was all about risk-constrained absolute return or fancy trades, consider one of the best performers. At Invesco, the Premia Plus strategy’s Q3 year-to-date return was 9.13% - and it is arguably the most ‘static’ fund in this article.
It holds a risk-parity portfolio of assets that should do well during one of three scenarios - inflationary growth, non-inflationary growth and recession - typically 30% commodities, 30% equities and 90% government bonds (the fund is leveraged through derivatives to maintain 8% volatility). Asset allocation is limited to a 2% tracking error against risk-parity, but the manager can take security selection decisions. While that adds only marginal active risk, it is dynamic, in that it involves forecasting returns from each asset over just one month. This has evidently suited this year’s gyrations well.
So 2011 was a test for the structure of multi-asset strategies. Static, naïve diversification was the clear loser. But a flexible mandate is little use if it is not fully deployed. The most flexible (but also the more risk-constrained) multi-strategy absolute return did what its name suggests. But the best numbers might have come from relatively static - but risk-balanced - diversification.
This year was also a test for managers’ forecasting ability. Strong signals from bond markets over early summer should have made allocators think twice about risks they were running - and the majority did come into 2011 running risk.
We have already heard that the Schroders fund was pro-cyclical, and that was thanks to strong corporate-level data over-riding the weak macro picture. Rudden at Alliance Bernstein describes a similar outlook: “The European sovereign crisis remained a potential headwind which we were watching closely,” he says, “[but in Q2] we were comfortable being overweight return-oriented assets as stimulative financial conditions continued to support equities, while valuations and profitability were near long-term averages.”
Herold Rohweder, global CIO for RCM Multi Asset, says that the RCM Dynamic Multi Asset Plus fund had had 70% in high-volatility assets since November 2010, and went into Q3 with a neutral 50/50 portfolio. It had de-risked, but only by rotating out of commodities and into equities. After a strong Q1, it finished October down 7.8% year-to-date.
Some were more circumspect. Edwardson says that by Q3 2010 his team felt that, because the range of outcomes was “unusually wide”, the appropriate response was “to be diversified and slightly defensive”. Baillie Gifford’s income-oriented positions attest to that. At BlackRock, despite rising bond yields, portfolio manager Philip Brides’ team expected a long-term, low-rate environment, and tilted towards global dividend-paying equities and high-yield in its risk assets between October 2010 and May. “We’ve also lowered risk by about 40% since April,” he says.
It is interesting to note that our two multi-strategy absolute return managers were among the most bearish as they came into 2011. “We didn’t believe that QE stimulus was, in itself, a wonderful argument for buying equities,” says Euan Munro, SLIM’s head of multi-asset investing, who was long-duration and long-volatility in the first half of 2011. Losses from that were balanced out by some equity and credit exposures until the big pay-off in Q3. Similarly, we have heard how Issaoui at THEAM suffered in Q1 with a short-US-equity theme.
What should we take from this? An explicit absolute-return mandate and its tight risk constraints focus attention on the downside. If you can’t lose more than 2% in one month, maybe your market expectations are naturally gloomier. But these were also longer-term themes: very few managers made a significant call to ride the equity markets up to the end of April and then rotate out during the summer plateau.
“I don’t think anyone among our peers pre-empted Q3,” says Shoemake. “But some reacted very quickly to take risk off in Q3 - as did we. The risks of recession increased, and that’s been the big change from the first half of this year.” Henderson’s Diversified Growth fund went from 40% in equities to a low of 10% - but Shoemake concedes that most of that was done in August.
Schupp at SYZ Absolute Return also notes that the macroeconomic view changed significantly during - rather than before - August. Disappointing US and German Q2 GDP numbers were the final straws; it was at this point that SYZ increased both the duration and the size of its bonds allocation. “It’s true that we missed some of the trend early on in bonds,” he concedes. “But over the winter, clients were all worried about bonds looking expensive. We were happy to run low duration.”
Both Rudden at AllianceBernstein and Rohweder at RCM tell the same story of de-risking into, rather than before, the sell-off. Similarly, while Insight Investment gradually changed its “constructive” 2010 view as a faltering banking system tightened liquidity, head of multi-asset strategy Matthew Merritt admits that the consequent de-risking in its Broad Opportunities strategy only accelerated during late July and August. Equity exposure was cut by one-fifth to its lowest since 2008, and commodities by four-fifths.
“We’d been moving in the right direction, but it’s fair to say that the speed of the downdraft did mean that our risk-control systems led us to decrease exposures further,” he says. The fund lost 4.7% over Q3, leaving it down 3.4% for the year to the end of October.
In the end, then, the evidence from 2011 for multi-asset fund selectors suggests that big allocation moves tend to be reactive rather than pro-active. Don’t bank on ‘flexible’ asset-alloction strategies to protect much of your downside. Static but risk-balanced strategies appear to do that job just as well, if not better. There might be a case for preferring more pro-growth strategies that are willing to buy reasonably-priced protection - they appear less constrained by regret risk. If downside protection means more to you than growth, the most successful multi-asset funds of 2011 - strategic portfolios of asymmetric trades - suggest themselves. And you will need to go somewhere else - deep into the hedge fund world - for a true market-timing approach to navigating our volatile times.