In the normal investment process, the investor’s risk profile will determine the strategic asset allocation. This asset allocation defines the overall risk-return characteristic of the portfolio and stay unchanged as long as the risk profile of the investor does not change. Within this is the tactical asset allocation, which depends on the specific forecasts for different markets, currencies, interest rates and so on. This leads to security selection and the final portfolio.

If the investor was investing in one balanced pooled fund, all these steps are included and all that is required is a specific fund for each specific investor’s risk profile.

An alternative approach is to define which pooled funds as the last step in the whole process. The individual still has their own asset allocation, but the pooled funds are used as instruments which help realise efficiently the desired asset allocation. The concentration is on asset allocation, which is the most important aspect of the portfolio and the security picking is delegated to specialists. Pooled funds in this situation are simply the building blocks.

But in order to use pooled funds in these ways, a number of features must be kept in mind. It is essential to have a clear investment objective. There must be benchmarks as an instrument to measure performance by and also as a means to to describe the target characteristics of the pooled funds. To avoid conflicting transactions, the in-vestment universes of the funds must not overlap. And also required is a clearly de-fined and understandable investment style, which is consistent and implemented on a disciplined basis.

The choice between pooled versus segregated funds depends on a number of factors, including cost. The fees for lawyers, consultants, administrators have to be paid for as part of the set-up and running costs involved in a fund can easily be added together compared with a segregated ac count. There it is more difficult to estimate the hidden costs, of which the most important are the costs of control.

In a pooled fund, there is usually an established control structure, based on a specific law structure, established quality controls are already in place. With a segregated account, the controls have to be checked to see that they are adequate and if necessary these have to be enforced, which can be a particular problem with in-house asset management and segregated accounts. Practice shows that without market pressure the incentive to establish adequate control structures is often too weak.

In theory, segregated accounts are the best solution to achieve exactly what the investor needs, as all the options are available. But in practice therestrictions on time, costs and expertise can result in a sub-optimal solution. By using existing well defined structures already established in pooled funds, costs can be reduced and full flexibility be retained. If there is a chance that requirements will change in the future, then flexibility is an absolute necessity. Flexibility does not depend on what your theoretical choices are but on what practically can be achieved.

What is needed is control over the important things, not over everything. Compare it to driving a car. Control over direction and speed are a must, but not control over the temperature of the cooling water in the engine.

The same is true for asset management. There has to be control over investment policy and the structure of the assets. For day-to-day control of the portfolio manager and the implementation of the investment process, someone else has to be relied on.

Many institutional investors think that pooled funds are not for them because they are often targeted at retail investors. Implicit in this are the following statements: ‘Advantages to retail investors are not important to institutions’; ‘My size as an institution allows an individual solution and therefore a segregated account is preferred’.

Both these statements do not hold. If retail investors have advantages, institutions should try to get the same. This might require some adjustment, but the advantages do exist. The second is the same as saying: I have to have my own aeroplane because I can afford it and not because I need it”.

The approach is to think about pooled funds as an instrument and not as an individual solution.

Dr Fischer is head of investment funds at Vontobel Fond Services in Zurich