Since the events of 2008 which are now stamped in Economic history as, the Global Credit Crunch, investment professionals have struggled to persuade retail clients of their superior ability to manage volatility. Volatility being the accepted norm in measuring the amount of risk that an investor's portfolio is being, will be, or has been exposed to.
The ongoing crisis in the Eurozone, and continuing fears of double-dip are again creating the type of environment that long-only investors fear most.
The immediate reaction of the investment community to market swings was a massive increase in the number of investors being recommended Absolute Return funds by Financial Advisers. This was, of course, coupled with a greater supply of such funds in an effort to smooth out returns by permitting fund managers to take out short positions and utilize derivative instruments that profit from volatility. The leading collectives have been successful in delivering these solutions and certain Absolute Return funds remain popular with the market. Download Defaqto's latest Guide to Absolute Return Techniques at www.defaqto.com/adviser/insights
The issue with Absolute Return seems to be that whilst they do dampen downside risk, they do not eliminate potential losses. Many investors also seem to have underestimated the extent to which they may underperform recovering markets. As a result they remain a welcome element of a portfolio, perhaps as a cash proxy but have become varied in type and style. Absolute Return Funds are not guaranteed to perform and risk is involved in selecting them, and although , as a group of vehicles, they do reduce volatility they have tended to be adopted as alternatives to Cautious Managed Funds, Cash Funds, or as defensive plays for active investors. Still, the Absolute Return experience has certainly been successful and Absolute Return techniques have been integrated into many other funds that market themselves in other ways and give fund management teams additional abilities to defend against adverse conditions. A good example is the £Strategic Bond Sector where many funds follow an Absolute or Total Return Investment Philosophy. See Defaqto's latest Case Study on Strategic Bond Fund Techniques at www.defaqto.com/adviser/insights
What all this means is that in today's Retail Investment Markets the main risk control available to investors remains Asset Allocation. Asset Allocation is based on the theory that the value of individual asset classes respond to different macro-economic influences and have an imperfect correlation to each other. In very simple terms, the value of Equities can go up/down whilst the value of bonds goes down/up. Investors can therefore weight their holdings of different asset types and adjust the level of performance achieved. In this context performance always refers to returns and the risk taken to achieve them or Percentage Returns and Annual Volatility i producing the returns. Different Asset types have different levels of volatility and this is also a key factor in allocation decision making. ( View Defaqto's review of Managed Portfolios which demonstrates the effect of Asset Allocation on Performance and highlights different Performance Measures. www.defaqto.com/adviser/ifa-guides
It can be shown that Asset Allocation is more efficient as the number of asset classes employed increases,(the use of derivatives can negate this, but it can be argued that derivatives mirror the performance of additional asset classes by creating returns or hedging profiles on the back of movements in macro-economic variables). It can also be shown that the process is more effective as the frequency of allocation decision making increases (i.e. the more dynamic the Asset Allocation Process becomes).
Both factors are important in understanding why Asset Allocation has become more complex and expensive to conduct.
There are three standard types of Asset Allocation which Investment professionals use to manage investment portfolios.
Strategic : This is a medium term base of asset holdings which is normally set for a 12 month term and based on economic research over the same period. This is a core position which sets a benchmark for an optimum portfolio of headline assets based on the desired risk levels that an investor wishes to be exposed to. The major asset classes for a UK investor tend to be Equities, Fixed Income, Property and/or Alternatives and Cash. Strategic Asset Allocation tends to be offered by Asset Allocation Tools that market professional semploy.
Tactical : Tactical Asset Allocation examines the portfolio in the shorter term, monthly or quarterly, and attempts to increase it's efficiency by tweaking holdings based on near term economic events and views. Tactical Asset Allocation tends to be conducted by Investment Commitees within professional investment management organizations.
Dynamic : Where the process is continuous and trading within the portfolio consistent. The process has to be computerized so that trading is governed by non-human effects and is therefore instantaneous. The process is sometimes termed ''Black-Box'' to highlight the non-human nature of this type of risk management. (For an example of Dynamic Asset Allocation in motion Defaqto have produced a study of two Dynamic Asset Allocation Funds... www.defaqto.com/adviser/ifa-guides
Some investors may ask why, if the point of Asset Allocation is to reduce risk and risk is reduced by increasingly the frequency of the decision-making, doesn't every investment manager employ Dynamic Asset Allocation? The Answer lies in the process itself which has to be programmed into the computer on the back of historical data. It assumes repetitive market reactions to such variables and this is not necessarily the case. There is also an element of the ''efficient markets hypothesis'' in there and many investors do not believe that markets can ever be efficient due to illogical, unforeseen and emotional behaviours of humans. In addition whilst DAA removes human error, it also removes common sense, experience, information etc.....all valuable assets on the trading floor.
In summary modern Asset Allocation processes will consider the following asset classes:
- Equities
- Fixed Income
- Property
- Structured Return Products
- Commodities
- Private Equity
- Hedge Funds
- Currencies
- Cash
For further information on Tditional vs Alternative Asset Classes download Deaqto's Alternative Investments Review 2010 at www.defaqto.com/adviser/insights
The Market for Financial Planning
The resulting reaction from Investment Providers has been the supply of a wide number of products & services that attempt to service the growth in demand for Investment Expertise such as those discussed and introduced above.
Multi-Asset Funds. There has been a huge boost in the number of UTs/OEICs offering Multi-Asset investment solutions. This includes Multi-Manager (FoF) Multi-Asset solutions which have grown in supply and popularity over the past year or two. Further Details of Multi-Manager Funds can be viewed in Defaqto's Regular review of the Multi-Manager Market - www.defaqto.com/adviser/insights
Risk Rated Portfolios. Managed Portfolios that offer asset allocation solutions in packaged investment products and focus on the Risk Assessment models that Financial Planners employ
Discretionary Management Services. There has been a huge growth in the number of DFMs offering bespoke Financial Adviser solutions based on rigorous Asset Allocation Processes. Additionally there has been a swing of Funds towards the DFM Sector from the retail adviser market. Defaqto has produced a wide number of reviews of the Discretionary Marketplace to assist Financial Intermediaries in understanding the types of service available and the due diligence processes needed to compare and select suitable DFM Partners... www.defaqto.com/adviser/insights
Absolute Return Techniques: Many fund managers have adopted AR Strategy to help generate a Total or Real Return for Advisers and their clients. In the broadest sense the Fund Management team will employ derivatives to provide the synthetic hedging against volatility, and replicate the effect of diverse asset holdings in the fund or portfolio.
To access all of Defaqto's latest Official Reviews & Investment Guides visit : www.defaqto.com/adviser/ifa-guides