In periods of market volatility – such as the one we have seen following the UK’s decision to leave the European Union – it becomes more important to consider investment solutions that offer true asset diversification, writes Adrian Gaspar, Multi- Asset Investment Specialist, Prudential Portfolio Management Group (PPMG).
In period of market volatility, the focus of investors and their advisers naturally turns to the investment risk being undertaken and it becomes important to consider solutions that offer true asset diversification – and perhaps also those that have the ability to smooth out any large fluctuations in fund prices.
With a ‘lower for longer’ investment outlook predicted, advisers and their clients need to look beyond traditional assets, such as equities and fixed income, and seek out less-correlated assets such as alternatives in order to achieve sustainable investment growth and meet any income needs.
Many alternative assets can be difficult for retail investors to access as they require high degree of expertise, large amounts of capital and can have long, but often steady, payback periods. These assets can often only be accessed through large multi-asset funds where there is access to the skills of specialist asset allocators, large capital sums, and the necessary areas of fund management expertise.
The evolution of risk profilers and modelling tools in the retail market has influenced distribution as advisors seek a consistent, auditable and client specific investment selection process. Multi-asset funds remain a natural part of this process as asset allocation, risk management and stock selection can be outsourced.
Strategic asset allocation (SAA) is considered by many to be a key component of multi-asset portfolios. Understanding the SAA of portfolios can provide an insight in to a variety of asset class exposures across different funds. This could influence absolute and relative performance.
Most portfolio managers also make shorter-term tactical asset allocation (TAA) decisions to generate extra returns but some will have far greater latitude which can of course be beneficial or detrimental to performance.
Truly risk managed/risk targeted fund ranges will display all of the above characteristics whilst also emphasising the monitoring and maintaining of fund ‘shapes’ on a daily basis with the aim of not allowing asset class exposures to drift too far from the agreed SAA benchmark. This is particularly relevant if a fund has been matched to a client risk profile.
It is not a question of what is better but what is more appropriate for a client. With most well-constructed risk managed/risk targeted fund ranges the broad shape of the portfolios may not deviate significantly over many months.
This may be of comfort to some that have selected a fund based on it maintaining a particular risk profile.
Volatility and smoothing
Volatility is only one of many measures of risk but can provide guidance on the type of investment journey a client may take. Volatility still influences poor investment decisions with people looking to exit in negative conditions and add exposure when asset prices have been driven up.
Investors with long-term time horizons are unlikely to react too dramatically to short-term market volatility and would be more likely to seek to acquire assets at lower prices when volatility has driven markets down. Indeed, for long-term investors with positive cash flows, volatility can be a good thing.
The idea of ‘smoothing’ returns may seem outdated to some but, if clients set realistic goals and are prepared to accept that they may lose out on some performance in rising markets in exchange for the potential to limit losses in a downturn, there is a good chance of their long-term aspirations being met.
Diversification and risk management can be particularly important for those who have remained invested through income drawdown. The focus should very much be on using scale, true global diversification, uncorrelated assets and any other mechanisms available to try and limit losses if markets fall.
UK exposure post Brexit
Irrespective of the outcome of Brexit, many portfolios are less UK-centric than they have been in previous years – hence less exposed to negative sentiment towards the short-term prospects for the UK economy. With many FTSE 100 companies deriving a significant proportion of their revenue from overseas, exposure to this index via funds or stocks is effectively a global allocation as well.
For most multi-asset teams the process of strategically diversifying equity portfolios away from the UK began some time ago and the direction of travel has been similar within fixed income, property and alternatives.
Markets have evolved and offer an extremely diverse set of regional exposures and asset classes. There are now specialist fund managers with the necessary presence on the ground, and depth of local knowledge, to execute new opportunities in a cost-effective manner.
Alternative assets including private equity, infrastructure and hedge funds can provide demonstrably less correlated returns and attractive illiquidity premiums, although this requires an appetite to make long-term commitments and conduct an intensive operational, legal and investment due diligence process.
Investors in traditional areas like corporate bonds and commercial property, can also now access high quality assets in markets with different dynamics and at different stages of their economic cycle. This provides further diversification, often with relatively low historic correlation to the equivalent UK asset class.
Adrian Gaspar, Multi-Asset Investment Specialist. Adrian joined PPMG in July 2015 and has nearly 30 years’ industry experience, primarily in fund research. He was a founder member of staff of Old Broad Street Research Ltd (OBSR) and built their adviser investment consultancy proposition. As Senior Investment Consultant at Defaqto he led the project that designed and implemented their unique multi-asset Diamond Ratings and latterly he gained experience in an institutional product specialist role.