Improve returns with active asset allocation funds
Peter Brooke, boutique head: macro strategy investments at Old Mutual Investment Group SA (Omigsa)
“The fact that more than 90% of flow has been into fixed income in the last year is cause for concern,” says Peter Brooke, boutique head: macro strategy investments at Old Mutual Investment Group SA (Omigsa). He was speaking at a financial planner forum hosted by the Association for Savings & Investments SA (ASISA) in Johannesburg, 4 June 2009. This trend highlights the reluctance of collective schemes investors to stick to their long-term savings plans. Despite completing a comprehensive risk profile and selecting an appropriate investment vehicle investors tend to ‘drop’ their strategies the moment markets falter. They miss the opportunity to maximise long-term returns because they fail to purchase additional units when the market is relatively cheap.
Asset allocation funds remain an important and relevant segment of the investment market. He says there are three reasons financial planners should consider this product when ‘building’ an asset allocation portfolio for their clients. The first is a result of the increasing administrative load on financial professionals due to the FAIS Act and requirements of Fit & Proper advice. Brooke concludes that under such conditions it makes sense to “hand over the responsibility to an asset manager.” The second is that asset allocation products can be used to create every risk/reward profile imaginable. And the third is the advance in the ‘science’ of selecting assets for these products.
The science of asset allocation
The building block of asset allocation solutions is diversification. Brooke says the trick is to “blend different asset classes that correlate differently with each other [to ensure] a superior result.” If you get the mix right you magnify the potential return with the same level or risk. But the real magic of diversification is it allows you to use multiple asset classes to “create any type of risk/return plot.”
“Omigsa puts an enormous amount of energy and effort into building solutions,” says Brookes, adding that there’s plenty of ‘science’ behind building a CPI plus solution. The group uses 40-years of data in determining which benchmark is likely to deliver on a particular fund mandate. It’s difficult to describe the risk-return scatter graphs created from more than 60 000 portfolios! Computers are used to represent each of the portfolios as a single point on a risk-return axis, allowing fund managers to assess the composition of so-called Good Return / Good Risk portfolios. Brookes used the model to demonstrate the benefits of offshore diversification. Portfolios with 0% international exposure fell, for the most part, into the Poor Return / High Risk category. By introducing portfolios with up to 40% offshore exposure the scatter diagram showed a dramatic improvement.
Product solutions the way to go
There are a number of other benefits to using a provider solution rather than establishing your own asset allocation mix. Brooke says asset allocation products often use complex instruments such as derivative overlays to improve returns. “Another very important issue is when you buy a solution off the shelf from an asset manager they’re looking at the total risk of the fund,” said Brooke. If you build your own fund you often end up ‘double counting’ certain assets. A good example of this is when a particular sub-category of asset class becomes popular. You might decide to increase a portfolio’s exposure to small cap equities to (say) 10%. At the same time the fund managers of other assets in your portfolio are doing the same thing – and you end up overweight a risky asset. “You can end up with excessive risk in a single asset class, particularly when it’s very popular,” says Brooke, “and that’s usually just before it falls.”
Another difficulty relates to rebalancing a portfolio. If you created an asset allocation portfolio weighted 60% in equities in January 2003, chances are the equity weighting would have crept up to between 85% and 90% by 2008. The shift in weighting between assets in this portfolio mean your client is now invested in a wholly inappropriate risk/return profile. Fund managers have a responsibility to model a solution to a static benchmark. “If you bought a risk profile fund then the manager has to deliver the indicated risk profile,” says Brooke.
Where to invest with a five-year plus time horizon
Returns across different South African asset classes are much closer than in the US and UK. Omigsa is neutral equities and cash, negative bonds and positive property with a five year view. “We still get good returns on cash and bonds and property is yielding 9%,” said Brooke. But “the glory days of cash and bond returns are probably over.” Listed property remains attractive despite providing spectacular yields over more than a decade. The outlook for equity is pretty good. Unfortunately listed companies won’t be able to maintain the 20% per annum returns that local investors have become accustomed to. Returns are going to be lower and investors will simply have to save more! The offshore asset allocation debate is a bit simpler. “I’m convinced that offshore equity is going to be a better asset class than offshore cash and offshore bonds for the next five, 10 or even 20-years,” said Brooke. But market volatility makes it almost impossible to call short-term fluctuations.
Financial intermediaries should carefully weigh up the advantages of asset allocation products over handling the task in house. Brooke says the number crunching (science) in getting asset allocation strategies spot on is more complex than at any time in the past. He believes “active asset allocation is a powerful tool.” And he warns that “putting all your money into cash doesn’t make a lot of sense if you look at real expected returns.”
Editor’s thoughts: The asset allocation argument presented by Omigsa makes perfect sense if the client’s entire savings are in the unit trust space. The argument becomes more complex when a portfolio spans a variety of investment products. Do you use ‘solutions’ to take care of asset allocation, or do you handle this task in house? Add your comments below, or send them to [email protected]
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