The concept of multi-asset investing has existed for many years, and many investors hold multi-asset funds in their retirement portfolio. But how much do investors really know about these funds?
"That, in a nutshell, is diversification"
In this piece I cover the basics, explain the strategies, and discuss the new style of multi-asset funds that have emerged in recent years.
Let’s start with the basics: what is multi-asset investing?
The term multi-asset investing is relatively new, although the idea itself has a long history. Simply put, it’s about allocating your investments to a number of different asset classes in order to generate a particular return. Old style balanced funds – otherwise known as diversified funds – are an early example of this style of investing. Today, the approach to multi-asset investing is much more sophisticated, but the principle remains inherently the same.
What are the different asset classes that might be used in multi-asset investing?
The range of asset classes in multi-asset portfolios can include equities, fixed income, property, commodities and ‘alternative’ investments (which includes a diverse range of investments, such as private equity, hedge funds and other ‘non-traditional’ investments). I define these investments in the ‘Back to Basics’ article in this issue of Investment Fundamentals and you can learn much more about equities and fixed income in the other series of Investment Fundamentals.
Why should I consider multi-asset investing?
The primary reason for taking a multi-asset approach is because every asset class has its own attributes and brings its own benefits to a portfolio. Blending two or more assets together in a portfolio will result in different performance than if the portfolio was invested in a single asset class. This concept is known as diversification, which is the idea of ‘not putting all your eggs in one basket’. Diversification is used to reduce risk in a portfolio and increase the possibility of performing well in a variety of market conditions. The idea that investors have exposure to different asset classes for different objectives across their entire portfolio is well understood; but for the purpose of this series of Investment Fundamentals we are looking specifically at multi-asset funds, that take this approach within the structure of a single managed fund.
Can you explain how diversification reduces risk?
To answer this, it is important to understand that different asset classes represent varying levels of risk. Generally, in exchange for higher risk is the offer of higher reward. For example, equities are typically considered higher risk than fixed income investments and are therefore expected to produce higher returns over the longer term (although, of course, there are no guarantees). But over the short term, equity price movements can be quite volatile.
Fixed income, on the other hand, is expected to produce lower returns than equities over the long term but perform more steadily, with less pronounced price fluctuations.
Although a portfolio invested purely in equities is expected to produce higher returns over the long term, not all investors will be comfortable taking on the associated level of risk. At the same time, the returns from a fixed income portfolio may not be high enough to meet an investor’s needs.
By investing in a portfolio that combines equities and fixed income the investor can enjoy some of the potentially higher returns from the equities position while mitigating the risk via the fixed income position. Add more asset classes and the diversification benefits become even greater.
As well as investing in different asset classes, investors can also diversify their portfolios by increasing the number of investments they hold, and spreading investment across different companies, industries, sectors and countries.
That, in a nutshell, is diversification. There’s more to it than this, and I delve deeper into the concept in the ‘Back to Basics’ article in this issue.
How do you decide which asset classes to invest in?
Decisions about which asset classes to invest in, and the relative weightings to these, are driven by the particular risk profile of the fund. Aiming to balance a fund’s risk and reward by investing according to its investment goals, timeframe, and risk levels is known as ‘asset allocation’.
Asset allocation is one of the most important decisions a fund manager makes. This, coupled with the quality of the individual securities, determines how a portfolio performs.
How does asset allocation work?
There are various methods of asset allocation, but traditionally fund managers use a portfolio management technique called ‘strategic asset allocation’. This technique involves deciding how a portfolio will be split between the various asset classes at the outset. As markets move, the portfolio will need to be regularly rebalanced.
For example, a fund manager may decide to split the portfolio equally between equities, fixed income and property. If the equity market rises, while the fixed income and property markets remain static, equities will then account for a larger weighting in the portfolio. The fund manager will therefore need to sell some of the equities exposure and reinvest the proceeds in fixed income and property in order to rebalance the portfolio.
Interestingly, many investors may already be unknowingly investing in this type of strategy. A traditional balanced (or ‘diversified’) fund – which is the default fund in many superannuation schemes in Australia – often applies a strategic asset allocation, investing, for example, 60% of the portfolio in equities and 40% in fixed income.
If strategic asset allocation is the ‘traditional’ method, what are other methods of asset allocation?
There are three main asset allocation strategies that can be used in portfolio management: strategic asset allocation (described above), tactical asset allocation, and dynamic asset allocation.
Tactical asset allocation is similar in some ways to strategic asset allocation, because a base asset allocation is decided at the outset. The difference is that if conditions change, the asset allocation can be altered. The intention is to allocate between assets to take advantage of current opportunities, to try to add value in the short term as well as the long term. Once conditions have settled down, the fund manager can return the portfolio to the original asset allocation.
Dynamic asset allocation has varying definitions, but for the purposes of Investment Fundamentals we will define this as an allocation strategy that is highly active. Unlike strategic and tactical asset allocation strategies, in a dynamic asset allocation strategy there are no pre-set weightings to particular asset classes. Instead, frequent adjustments to the weightings are made as managers look to maximise gains and minimise losses according to their outlook for asset classes. In most cases managers are relatively unconstrained in where they can invest.
Which is the best asset allocation strategy?
Each strategy has merits and flaws. Strategic asset allocation generally requires the least amount of management, because once the asset allocation has been set, fund managers only need to ensure the portfolio is rebalanced periodically (disregarding the requirement to select the individual securities, which is another job in itself). A point to note is that a portfolio with a strategic asset allocation will always have to allocate more funds to a falling asset class. As this asset class falls in value, the fund managers will have to take capital from a better performing asset class and reallocate it to the poorly performing asset class. Sometimes this could be beneficial, especially if the falling asset class is undervalued and expected to regain its losses. But if it is falling because the outlook is poor, managers have no choice but to continue to invest. Equally, as an asset class rises, managers of portfolios using strategic asset allocation are unable to allocate more to that asset class to benefit from the gains.
Tactical asset allocation requires that fund managers are aware of what is happening in markets so they can alter the asset allocation to take advantage of current conditions. There is greater flexibility in the amount that can be invested in each asset class, which means greater ability to take advantage of market fluctuations. Depending on the circumstances, managers are not forced to sell an asset class if it is performing well and can also reduce exposure to an underperforming asset class, if necessary. Managers can also think ahead and attempt to invest in asset classes that they think will outperform, not simply react to market movements and rebalance the portfolio after the event, as they do with strategic asset allocation. Managers can reallocate the portfolio into poorly performing assets by choice, in anticipation that they will rise in the future.
Dynamic asset allocation is the most flexible strategy and also requires the most intensive management. As there are no pre-set weightings to any asset class, managers have the freedom to look for profits in whichever asset class shows the most promise. They can take advantage of changing economic and market conditions and buy asset classes that look set to rise and sell those for which the outlook is poorer. A portfolio that uses this strategy should theoretically generate good returns when markets are rising, but more importantly, should be cushioned when markets are falling. The idea of dynamic asset allocation is to reduce the portfolio’s volatility and therefore smooth returns. Investors should benefit from the same positive returns as strategic and tactical asset allocation but with a much smoother ride along the way. It is worth noting, however, that a portfolio employing dynamic asset allocation relies more heavily on the manager making the right decisions. Dynamic asset allocation is often used in the ‘new style’ of multi-asset funds that have launched in recent years. In my next article I will write in more detail about the different types of asset allocation.
What do you mean by ‘new style’ multi-asset funds?
I’ve used this term to differentiate the newer approach to multi-asset investing from the ‘old style’ balanced – or diversified – funds. These old-style funds aim to beat an index and outperform their peer group. The ‘new style’ of multi-asset funds instead has a pre-determined objective to produce a positive return, regardless of how markets perform. Using dynamic asset allocation to switch between asset classes and having no obligation to maintain a particular weighting to an asset class, can help significantly in meeting this objective.
What has driven the move to these newer funds?
The popularity of traditional old style diversified funds lay in their aim of providing reasonably steady returns. Unfortunately, as experience has shown, having a fixed allocation to equities means these old-style diversified funds find it extremely difficult to produce a positive return during periods of equity market weakness. This became particularly apparent during the global financial crisis when equity markets plummeted and returns from these funds were anything but steady. Because they had to maintain a fixed weighting to equities, they performed poorly as markets fell, and their better performing holdings were sold in order to reinvest the proceeds in the falling equities market.
As a result, some investment managers decided to rethink their strategy. They concluded that in trying to generate a steadier return, it makes sense to focus less on outperforming a benchmark or peer group and more on delivering specific, pre-determined objectives.
If they don’t aim to beat a benchmark, what objectives are these multi-asset funds trying to achieve?
New style multi-asset funds tend to be managed to absolute return investment objectives, such as delivering a return over a cash rate or inflation rate (known as a ‘real return’), while preserving capital over the long term.
Many new style multi-asset funds set an objective to outperform the rate of inflation by, for example, 5% each year, while other funds look to provide a steady income. This is the premise of objective-based investing which I will write about in my next article.
Published in Aberdeen marketing
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.