This article is taken from FT Adviser, where Intelligent Partnership’s research was highlighted. Click here to read the original article
If you are a multi-asset investor, then you have inherently accepted that asset allocation is of primary importance.
The landmark study that supports this is Determinants of Portfolio Performance, published by Gary P. Brinson et al in 1986, which concluded that asset allocation is the primary determinant of a portfolio’s return variability. The headline from the paper that always gets quoted is that asset allocation accounts for 90 per cent of a portfolio’s level or return.
If you accept this principle, then your objective should be to implement your asset allocation as accurately as possible. This means indexing, because it removes the possibility of the active manager drifting away from the index or dramatically underperforming the index. Indexing is the purest way of implementing your asset allocation strategy – anything else is distorting your strategy.
Everybody knows passive investing is cheaper, but here’s more evidence. The first table shows the value weighted expense ratios in these markets as at 31 December 2012.
It is very difficult for active managers to achieve a level of outperformance that recovers these costs and beats the market over an extended period of time. As much as 67 per cent of UK active funds underperform their benchmark over 15 years, 74 per cent over 10 years and 72 per cent over five years, according to Vanguard Asset Management.
Here is another difficulty for active managers – it is very difficult to outperform in very liquid, well understood and well researched markets such as the US or UK. There is an argument to be made for a ‘horses for courses’ approach to multi-asset investing – indexing is used in developed markets and active managers are selected where they can add value in emerging markets.
Logically, this makes sense, but actually the jury is still out on this. Active managers tend to charge more for emerging market investing and therefore whether you genuinely get a net outperformance is questionable.
Control the controllables is the mantra of many sportsmen, but it could apply to advisers as well. When it comes to investment, it is very difficult to control the outcomes. Advisers whose proposition is based around beating the market may struggle to live up to expectations. Far better to focus on the two things that advisers can control when it comes to investment: costs and asset allocation. This conclusion points to multi-asset investing and indexing.
Where do advisers add value? My view is that advisers really add value by understanding their clients and helping them with financial planning and protection. These are the areas where advisers do have a very high degree of control over the outcomes.
By focusing on the approach outlined above – multi-asset investing and indexing – advisers do not have to spend time on fund selection or monitoring funds. That time can then be spent with clients in the areas where advisers really add value.
And if advisers explain the multi-asset/indexing strategy well, clients grasp and understand the ups and downs of the markets much better when the added complication of fund selection question is taken out of the equation. Why expose clients to the vagaries of the fund management industry, and why should advisers waste any time on it themselves, when it is so hard to pick the winning funds?
How to implement this strategy? Many providers have risk rated, multi-asset, passive funds now. Legal & General and Vanguard Asset Management have solutions that cost about 0.25 per cent to 0.30 per cent (on top of the underling fund costs). These solutions would be cheap, effective and easy to implement and maintain.
Here is another option for advisers who want to be truly independent. If you agree with the points made above, then there really is no point in your clients paying extra for active management, or for the services of a DFM, or even for a multi-asset, passive fund.
Advisers could construct their own risk graded, multi-asset portfolios from passive funds or ETFs. This removes an entire tranche of charging, leaving your client exposed to only the underlying fund charges (which will be around 0.2 per cent to 0.3 per cent), the platform charge (approximately 0.3 per cent) and the adviser charge (0.5 per cent to 1 per cent). The whole package can come in at something like a 1 per cent to 1.5 per cent charge to the client, considerably cheaper than some of the other solutions being used at the moment.
For the adviser who does this, they can say they:
• Reduced costs
• Retained their independence
• Invested clients according to their risk profile
• Diversified their clients’ investments
• Used a sensible centralised investment proposition
Will a strategy based on multi-asset investing and indexing attract more clients as the economy recovers? It pains me to say it, but perhaps not. Like a lot of the best investment strategies, it goes against human nature. We prefer to be pro-active, taking action and doing things. We like to think that (unlike that the vast majority of folk) we will be able to somehow pick the winners out of the active fund universe. Investing in a strategy that will by definition never beat the market and then sitting back and accepting that feels unnatural. And who wants to be known as passive? It sounds weak. As the economy picks up, investors will want to feel like they are making the most of the opportunities available. And strong markets and a strong economy will provide a smoke-screen for poor performance from active funds.
However, for investors who can put emotion to one side and can ignore short-term fluctuations in the market and in the economy, multi-asset indexing logically makes sense. Over the long term, diversifying into the appropriate asset allocation, keeping costs low and then staying the course is a solid strategy.