The role of multi-asset funds in a volatile environment

How advisers can use multi-asset funds to achieve returns for their clients

Multi-asset funds are rising in popularity on the back of geopolitical uncertainty on both sides of the Atlantic. 

But what is it about multi-asset funds that make them useful for less experienced investors? 

Experts in the industry stress that they provide great diversification potential and give clients access to asset classes that they may not been able to invest in on their own. 

But they also point out that absolute return funds, a type of multi-asset class have underperformed other types of multi-asset funds in recent years. 

The US yield curve, the difference between yields on longer-term US debt versus shorter-term debt also inverted in August. 

This means a recession may be in the offing, as yields should typically be higher for longer-term debt, to compensate investors for taking greater risk. 

Some in the industry believe that investing in multi-asset funds could be a way to prepare should there be another recession.

Advisers think multi-asset funds are good for novice investors

Most advisers think using multi-asset funds is useful for creating diversified portfolios for novice investors, according to the latest FTAdviser Talking Point Poll. 

The poll asked advisers the following question: “How useful are multi-asset funds in building a diversified portfolio for novice investor?” 

Almost three in four (72 per cent) answered very useful, while 17 per cent said multi-asset funds are reasonably useful. 

Only 11 per cent found them not at all useful to novice investors seeking to diversify returns. 

Matthew Riley, head of research in the portfolio research and consulting group at Natixis Investment Managers, said: “Multi-asset funds provide a cost-effective and efficient way of achieving a diversified portfolio." 

He added:  “Cost-effective in the sense that an investor only has to buy one fund to achieve the desired result instead of a selection of funds, whose suitability in turn would need to be assessed individually.”

While some in the industry stressed the benefits of using multi-asset funds, others warned about the risks of a mismatch in investment goals and fund objectives. 

Ricky Chan, director and chartered financial planner at IFS Wealth and Pensions, said as the underlying asset allocation varies widely between multi-asset funds, investors need to understand the fund’s objective, investment remit and underlying investment holdings to “ascertain whether or not a multi-asset fund is suitable”. 

 Typically multi-asset funds rely on one fund house’s investment process, style and expertise
Ricky Chan, IFS Wealth and Pensions

Jason Hollands, managing director at Tilney Investment Management, echoed this view. 

“There are many different products lumped under [multi-asset funds] from funds of funds that are fettered to a single group’s product range, products that solely invest via passive instruments, those that will stick within fairly tight asset allocation.” 

He added: “It is therefore important to clearly understand the mandate and approach on each fund and be comfortable that it suits the investor’s goals and risk appetite.” 

How multi-asset funds
shot to fame

Words: David Thorpe
Images: Fotoware

A combination of regulatory change and the unprecedented monetary policy pursued by global central banks since the financial crisis has altered the nature of multi-asset investing.

The introduction in recent years of the retail distribution review (RDR) and more recently the Markets in Financial Instruments Directive (MIFID) mean it has become less economical for financial advisers to provide ongoing investment management services for clients with smaller pots. 

Rise of multi-asset funds

This has led, according to research commissioned by fund house Liontrust, shows advisers have increasingly turned to multi-asset funds for smaller clients. They can also be useful for those new to investing.

Gary Waite, a portfolio manager at wealth management house Walker Crips said: “For smaller clients, we put them almost exclusively into multi-asset funds. They are a very cost effective way to provide diversification.”

He added that many clients have a particular target in mind, an annual level of income for example, and multi-asset funds can help to achieve this. 

Mr Waite added: “Multi-asset funds allow an investor who maybe has a small pot of assets to access specific expertise in certain markets, maybe they wouldn’t be able to do that outside of the multi-asset structure.” 

Chris Salih, of Fund Calibre, a fund research firm, said: “These vehicles are designed to take away the strain of fund selection but also asset allocation for investors or advisers. To do this they need to be a core part of a client's portfolio to allow them to gain the full benefit of the approach.”

Diversification is very important for most investors and multi-asset is a way to achieve that.”
David Jane, Miton

David Jane, who runs a range of multi-asset funds at Miton, said he does not regard his products as competing with investment funds that only invest in a particular country or region, or only in a single asset class.

Absolute return funds

Instead Mr Jane regards another type of multi-asset fund, the Absolute Return funds as the main competitor for his products.

Absolute Return funds are typically able to invest in a far wider range of instruments than a conventional multi-asset fund, while also being able to short-sell stocks and bonds. Short selling is the practice of investing in a security in such a way as to profit if its price falls. 

Such funds were once very popular with investors, but a poor level of performance more recently means this particular type of multi-asset fund has fallen from favour with investors.

As much as £500m was pulled from funds in the IA Total Return sector in the month of April 2019, while the Investment Association Targeted Absolute Return sector has returned a meagre 3 per cent in the past three years, according to FE Analytics data.

That 3 per cent return means the sector has starkly under performed most equity and bond markets in that time.

The fees on most absolute return funds are very high, but they have underperformed in both bull markets and bear markets.”
Gary Waite, portfolio manager at Walker Crips

Francis Klonowski, an adviser at Klonowski and Co in Leeds said: “These funds are very hard to understand, to understand what they are actually investing in, and the idea that an investment can achieve positive returns in all market conditions is something that can be achieved seems fanciful to me. If that were possible, we would all just do that.”

Mr Waite does believe one type of absolute return fund can add value for clients, those which are able to take “short positions”, that is, invest in such a way that the investor profits if the price of a security falls in value. 

He said funds such as these offer investors an opportunity to get diversification at a time of rising markets, without paying what he believes are the very high fees associated with absolute return funds. 

Advisers deploying capital to multi-asset funds must then decide whether to deploy  the capital to multi-asset funds that invest directly in the underlying securities, or those which deploy a multi-manager approach, whereby the multi-asset fund manager chooses other, single strategy funds.

Mr Salih said: “I would not say one is superior to the other, it very much depends on the vehicle you invest in.

“Both offer diversification through a wide range of investment strategies. Multi-manager funds are typically more expensive than multi-asset funds because they invest purely in underlying managers - this effectively means investors are paying two layers of fees for access - but there are a number of multi-managers who've proved this is worth the additional cost in the long-term.

“By contrast, you could say the performance of multi-asset funds is more dependant on the skills of one team.”

Big bets

Mr Jane said: “The advisers who invest in the funds I manage want me and my co-managers to run the money, the way we invest is, we don’t take big bets on individual stocks, we couldn’t do that, so we buy stocks of a similar theme.” 

Amanda Sillers, who jointly runs the long established Jupiter Merlin range of multi asset funds, believes choosing fund managers who have seen it all before is the key to investing in the current uncertain market conditions.

Ms Sillers said: “In the shifting sands of the current market conditions we seek to invest in underlying funds run by experienced, active managers with a blend of styles across different asset classes. 

The underlying managers held within the Jupiter Merlin portfolios are typically patient, long term investors.
Amanda Sillers, Jupiter

“The commonality between the majority of these is that they share our obsession; of trying to capture good performance in buoyant markets, while minimising as far as possible the risk of losses in more challenging conditions.

“This is not achieved via complex and opaque derivatives or structures; but instead, by superb, active stock selection. The underlying managers held within the Jupiter Merlin portfolios are typically patient, long term investors.  They use volatility as opportunities to buy cheaply.”

Bond and equity relationship

The second issue of concern for advisers creating multi-asset portfolios are the unique economic and market conditions experienced in the years since the global financial crisis. 

The twin policies of quantitative easing and historically low interest rates have resulted in both bond and equity markets rising steeply and in conjunction with each other.

This is in contrast to the traditional portfolio management theory that bonds and equities are inversely correlated, that is, move in opposite directions to each other. 

That view has influenced portfolio construction theory for multi-asset investors, which typically blended equities and bonds in roughly a 60/40 percent proportion, depending on the risk profile of the client. 

The policy of quantitative easing involves central banks buying bonds, this causes the price of the bonds to rise, and interest rates to fall. 

Lower interest rates leads to the price of equities rising, so the value of both assets rise in value. Equities rise in value because the higher price of bonds means the income available from the bonds falls in value, making the income available from equities relatively more attractive.

Alec Cutler, who runs the Orbis Global Balanced fund, a multi-asset fund said: “The traditional 60/40 approach has never really worked, there have been many times when bonds and equities have moved in the same direction.”

Is gold the flight to safety?

Mr Cutler’s fund has relatively little invested in equities, with significant exposure to gold. 

He said gold is an attractive investment at a time when other assets are expensive. Mr Cutler added that the prevailing low interest rate environment makes it an attractive time to buy gold.

This is because gold does not pay an income yield, making it relatively less attractive to government bonds, an asset class that is also viewed as defensive by investors, but has a yield.

This means the higher the yield on government bonds, the more income an investor in gold is sacrificing. But Mr Cutler noted that with US and UK government bonds trading at record low yields, the sacrifice associated with owning gold is diminished. 

Gold does not pay an income yield, making it relatively less attractive to government bonds

Mr Waite is also keen on gold as an investment in the current market conditions.

He invests in gold via a specialist commodity fund, BlackRock Gold and General.

Peter Elston, chief investment officer at multi-asset fund house Seneca, said:   “We do not own any safe haven bonds – we know they might perform well in the short term as a result of growth fears, but they are horribly expensive in the long term.

“We’ve been moving progressively underweight equities over the last two years which is starting to work. We don’t have much FX exposure as we do not think that is a risk our clients, many of whom are retirees, should have.

“In the UK we focus on mid-caps which over time should do better than large caps – they have more potential to grow after all. And we own a number of interesting UK specialist investment trusts that have high, sustainable yields and that can act as a substitute for those horribly expensive safe haven bonds. And we are very high conviction - over diversification is for cowards and passive funds.”

How different assets perform in an economic slowdown

It appears that the US is entering the slowdown phase of the economic cycle. But what might that mean for returns across asset classes? And can a recession be avoided?

For the first time in two years the Schroders US output gap model is signalling a change in the US business cycle. It suggests the economy is moving from “expansion” to “slowdown” (the other two stages in the cycle being “recession” and “recovery”).

The last slowdown period occurred during the Global Financial Crisis and so this should be seen as a warning sign to US policymakers that a recession could be on the horizon.

Is a recession in the offing?

The Schroders output gap model is a way to estimate the difference between the actual and potential output of the economy (GDP). It uses unemployment and capacity utilisation as variables.

Since the model was launched in 1978, there have been six separate instances when it has indicated the US economy was in slowdown mode. Of these six phases, four have been followed by a recession.

The two periods of slowdown that did not result in recession and reverted to expansion, occurred in early 1990 (when the slowdown was a false signal) and in the final months of 1998 (when it was a slowdown in the middle – not the end – of the cycle).

In our view, US growth has been supported by accommodative central bank policy and we expect that slowing US growth will force the Federal Reserve’s (Fed) hand in cutting rates in 2020 to bolster activity.

Although we feel that the slowdown phase will be prolonged and not end in recession, the balance of our scenario risks indicates that recession is a possibility, especially if policymakers don’t respond to the threat.

What might a slowdown mean for multi-asset performance?

Recession prospects aside, the slowdown phase of the economic cycle has historically had considerable implications for the performance of various asset classes.

Of course, past performance is no guide to what will happen in the future and may not be repeated.

The table below shows the average performance of US equities, government bonds, high yield (HY), investment grade bonds (IG) and commodities, over the various stages of the cycle, since February 1978.

During a slowdown phase in the output gap model, equity markets not only perform the worst compared to other phases of the business cycle but exhibit greater volatility.

During the slowdown phase, US equities have returned on average less than 5 per cent on an annual basis, with volatility of more than 15 per cent.

Periods of slowdown are historically the only phase when sovereign bonds outperform equities.

Also during slowdowns, sovereign bonds have outperformed investment grade corporate bonds, which in turn have outperformed high yield credit, by around 2 per cent and 4.5 per cent, respectively, on an annual basis.

During a recession, performance tends to reverse: high yield credit has outperformed both investment grade and sovereign bonds, by around 2 per cent and 5 per cent, respectively, on average.

This time could be different

The current slowdown phase could be different. The recovery from the Global Financial Crisis was the longest and shallowest in history.

With monetary policy remaining accommodative, there is the potential for the Fed to engineer a slowdown phase that is longer than average and which doesn’t end in recession – a period of so called “secular stagnation”.

On the surface, such a period of weak growth appears bad. But arguably, if it does not end in a recession, central bank policy may have finally delivered on an objective it has been trying to achieve for decades: smoothing growth and avoiding the boom and bust cycle of the economy.

Indeed, the Fed states that monetary policy works “by spurring or restraining growth of overall demand for goods and services”. In this way, it can “stabilise the economy” and “guide economic activity…to more sustainable levels”.

Time will tell and investors will likely keep their fingers crossed.

Martin Arnold, economist at Schroders