[3 min read, open as pdf]

• Evaluating multi-asset funds on like-for-like basis is a challenge
• We look at realised risk-return frontiers as a starting point
• Design principles are key to performance outcomes

Design matters
The combination of GBP/USD rollercoaster since Brexit, the critical home bias decision and the market stresses of 2020 mean that the differentiating factors amongst multi-asset strategies have boiled down to three things.

1. To what extent is there a home bias or global bias to the equity allocation
2. Are global equity and any global bond exposures hedged back into GBP
3. Do strategies include or exclude Alternative assets beyond a binary equity/bond portfolio, and if so, which

These three “design principles” have nothing to do with timing the markets, tactical allocation decisions, or a manager’s fund selection prowess.
They are empirical and philosophical standpoints that portfolio designers must consider when developing a strategic asset allocation, and advisers should consider when looking under the bonnet of a multi-asset fund range.

Parameter decisions are key
Firms that use third-party asset allocation models that have a heavy UK equity allocation have been penalised.  We have highlighted earlier the disconnect between UK’s market cap weighting at 4% of global equities, compared to its weighting in private investor benchmarks where it can be as higher as 50%.  This is not rational and means UK-biased investors are penalised and missing out on world-changing trends of the broader global opportunity, set, this thing called “technology”, and demographic growth in Asia and Emerging Markets.
Firms that believe that all returns should be in an investor’s base currency have been penalised for being structurally overweight a weakening GBP.  There is a “hedging to your liability” argument that resonates for some liability-driven pension fund managers, but we believe that is a function of time-horizon and makes sense more for the bond portfolio, than the equity part of the portfolio.
The inclusion of Alternative Assets, such as listed private equity and real assets has boosted risk-adjusted returns for some multi-asset funds but the biggest drivers remain home bias and GBP hedging policy.

Results
We look at the universe of multi-asset funds in the IMA Mixed Asset and Unclassified Sectors.  By looking at realised risk-return, we can see how different ranges have fared relative to the median.
The first thing to note is the dispersion of returns.  There is very little consistency: the scattergram is more of a “splattergram” meaning selection of the right range of multi-asset funds is key.
We look at the standard deviations around a regression line to get a handle on this dispersion.  We also adjust these by risk “bucket”.  Finally we link up the performance of each fund within a multi-asset fund range to look at the consistency of the “frontier”.
Those that dominate have nothing to do with active or passive or fund selection, and everything to do with parameter design, namely UK or global equity bias and GBP hedging policy.

Fig.1. Multi-asset fund universe risk-return scattergram

Summary
Multi-asset funds are a convenient one-stop shop for a ready-made portfolio.  But evaluating their design parameters is key to ensure it resonates with your own philosophy.  Home bias, hedging policy and alternative asset policy are three due diligence questions to ask.  There are many more.
​
To see where your chosen multi-asset fund range appears in our analysis, or if you would like help reviewing your multi-asset fund choices, please contact us.
https://www.elstonsolutions.co.uk/contact.htm

[3 min read, open as pdf]
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• Restart will be sudden
• Inflation pressure persists
• Time to rethink the 60/40 portfolio

We look at 1Q21 in review and the outlook ahead.

Macro
The economic restart will be sudden, with substantial pent up demand.  Corporate and personal balance sheets have been supported which should provide confidence in investment and spending.
From a monetary policy perspective, the focus remains on the delicate balance between bond yield and inflation.  Stable, negative real yields are supportive of risk assets.  10 year breakeven rates have climbed further since year-end amplifying demand for inflation-hedges.
With nominal bonds under pressure, there is support for risk-asset.  Advisers looking at liquid alternatives to bonds such as property and infrastructure: need to balance the required exposure to inflation-protecting assets with up-risking client portfolios.  This balancing act means it’s time to rethink the 60/40 portfolio.

Markets
The rebound in risk assets is made even more pronounced, owing to a base effect from last year’s market lows.  Timber and Listed Private Equity have been the best performing asset classes in GBP terms on a 12 month view.
For factor-based strategies, World Equity Value factor outperformed all other factors +12.3%, compared to +3.79% for World Equity, for the first three months of 2021.
The breadth and deconcentrating have been rewarded in the first quarter with equal weight US equities returning +11.49%, compared to +6.17% for the traditional cap-weighted S&P500, in USD terms, in the year to March.

Regime
Regime indicators point to markets being overbought in the near-term.

For the full update, please view our Webinar
https://www.brighttalk.com/webcast/18493/482564

[5min read, open as pdf]

• What is the 60/40 portfolio, and why does it matter?
• The problem with Bonds in a 60/40 framework
• Rethinking the 40%: What are the alternatives?

 
We agree it’s time to rethink the 60/40 portfolio. It’s a useful benchmark, but a problematic strategy.

What is the 60/40 portfolio, and why does it matter?
What it represents?
Trying to find the very first mention of a 60/40 portfolio is proving a challenge, but it links back to Markowitz Modern Portfolio Theory and was for many years seen as close to the optimal allocation between [US] equities and [US] bonds.  Harry Markowitz himself when considering a “heuristic” rule of thumb talked of a 50/50 portfolio. But the notional 60/40 equity/bond portfolio has been a long-standing proxy for a balanced mandate, combining higher-risk return growth assets with lower-risk-return, income generating assets.
What’s in a 60/40?
Obviously the nature of the equity and the nature of the bonds depends on the investor.  US investor look at 60% US equities/40% US treasuries.  Global investors might look at 60% Global Equities/40% Global Bonds.  For UK investors – and our Elston 60/40 GBP Index – we look at 60% predominantly Global Equities and 40% predominantly UK bonds
Why does it matter?
In the same way as a Global Equities index is a useful benchmark for a “do-nothing” stock picker, the 60/40 portfolio is a useful benchmark for a “do-nothing” multi-asset investor.
Multi-asset investors, with all their detailed decision making around asset allocation, risk management, hedging overlays and implementation options either do better than, or worse than this straightforward “do-nothing” approach of a regularly rebalanced 60/40 portfolio.
Indeed – its simplicity is part of its appeal that enables investors to access a simple multi-asset strategy at low cost.
 
The problem with Bonds in a 60/40 framework
In October 2019, Bank of America Merrill Lynch published a research paper “The End of 60/40” which argues that “the relationship between asset classes has changed so much that many investors now buy equities not for future growth but for current income, and buy bonds to participate in price rallies”.
This has prompted a flurry of opinions on whether or not 60/40 is still a valid strategy
The key challenges with a 60/40 portfolio approach is more on the bond side:

• Government bond provide negligible or negative yield, so investors who want income need riskier asset, like equities, not bonds
• With interest rates at an all-time low, following a sustained bull-market in bonds, there is downside risk to bonds as/when the rate cycle turns
• Returns may not always be negatively correlated so there is reduced diversification effect
• Inflation risk puts growing pressure on nominal bonds

 
So is 60/40 really dead?
In short, as a benchmark no.  As a strategy – we would argue that for serious investors, it never was one.
We therefore think it’s important to distinguish between 60/40 as an investment strategy and 60/40 as a benchmark.
We think that a vanilla 60/40 equity/bond portfolio remains useful as a benchmark to represent the “do nothing” multi-asset approach.
However, we would concur that a vanilla 60/40 equity/bond portfolio, as a strategy offered by some low cost providers does – at this time – face the significant challenges identified in the 2019 report, that have been vindicated in 2020 and 2021. 
For example, during the peak of the COVID market crisis in March 2020, correlations between equities and bonds spiked upwards meaning there was “no place to hide”.  The growing inflation risk has put additional pressure on nominal bonds.  Real yields are negative.  Interest rates won’t go lower.
But outside of some low-cost retail products, very few portfolio managers, would offer a vanilla equity/bond portfolio as a client strategy.  The inclusion of alternatives have always had an important role to play as diversifiers.

 
Rethinking the 40%: What are the alternatives?
When it comes to rethinking the 60/40 portfolio, investors will have a certain level of risk budget.  So if that risk budget is to be maintained, there is little change to the “60% equity” part of a 60/40 portfolio.
What about the 40%?
We see opportunity for rethinking the 40% bond allocation by:
We nonetheless think it is important to:

1. Rethink the bond portfolio
2. Incorporate sensible alternatives
3. Consider risk-based diversification

 
1. Rethinking the bond portfolio
Whilst more extreme advocates of the death of 60/40 would push for removing bonds entirely, we would not concur. 
Bonds have a role to play for portfolio resilience in terms of their portfolio function (liquidity, volatility dampener), so would instead focus on a more nuanced approach between yield & duration.
We would concur that long-dated nominal bonds look problematic, so would suggest a more “barbell” approach between shorter-dated bonds (as volatility dampener), and targeted, diversified bond exposures: emerging markets, high yield, inflation-linked (for diversification and real yield pick-up).

2. Incorporating sensible alternative assets
Allocating a portfolio of the bond portfolio to alternatives makes sense, but we also need to consider what kind of alternatives.
Whilst some managers are making the case for hedge funds or private markets as an alternative to bonds, we think there are sensible cost-efficient and liquid alternatives that can be considered for inclusion that either have bond-like characteristics (regular stable income streams), or provide inflation protection (real assets). 
For regular diversified income and inflation protection, we would consider: asset-backed securities, infrastructure, utilities and property.  The challenge, however, is how to incorporate these asset classes without materially up-risking the overall portfolio.
For inflation protection, we would consider real assets: property, diversified, commodities, gold and inflation-protected bonds.
Properly incorporated these can fulfil a portfolio function that bonds traditionally provided (liquidity, income, ballast and diversification).

3. Consider risk-based diversification as an alternative strategy
One of the key reasons for including bonds in a multi-asset portfolio is for diversification purposes from equities on the basis that one zigs when the other zags.
In the short-term, and particularly at times of market stress, correlations between asset classes can increase, this reduces the diversification effect if bonds zag when equities zag.
We would argue risk-based diversification strategies have a role to play to here, on the basis that rather than relying on long-run theoretical correlation, they systematically focus on short-run actual correlation between asset classes and adapt their asset allocation accordingly.
Traditional portfolios means choosing asset weights which then drive portfolio risk and correlation metrics.
Risk-based diversification strategies do this in reverse: they use short-run portfolio risk and correlation metrics to drive asset weights.
If the ambition is to diversify and decorrelate, using a strategy that has this as its objective makes more sense.
 
Summary
So 60/40 is not dead.  It will remain a useful benchmark for mult-asset investors.
As an investment strategy, vanilla 60/40 equity/bond products will continue to attract assets for their inherent simplicity.  But we do believe a careful rethink of the “40” is required.

[5 min read, open as pdf]

• We look at Commodity Index basket weighting schemes
• Compare Traditional vs “Smart” weighting schemes
• Contrast equal weighted approaches

 
Commodity indices, and the ETPs that track them provide a convenient way of accessing a broad commodity basket exposure with a single trade. 
​
What’s inside the basket?
Commodity indices represent baskets of commodities constructed using futures prices.  The Bloomberg Commodity Index which was launched in 1998 as the Dow Jones-AIG Commodity Index has a weighting scheme is based on target weights for each commodity exposure.

These weights are subject to the index methodology rules that incorporate both liquidity (relative amount of trading activity of a particular commodity) and production data (actual production data in USD terms of a particular commodity) to reflect economic significance.

The index subdivides commodities into “Groups”, such as: Energy (WTI Crude Oil, Natural Gas etc), Grains (Corn, Soybeans etc), Industrial Metals (Copper, Aluminium etc), Precious Metals (Gold, Silver), Softs (Sugar, Coffee, Cotton) and Livestock (Live Cattle, Lean Hogs).

The index rules include diversification requirements such that no commodity group constitutes more than 33% weight in the index; no single commodity (together with its derivatives) may constitute over 25% weight); and no single commodity may constitute over 15% weight.

The target weights for 2021 at Group and Commodity level is presented below: 

Owing to changes in production and or liquidity, annual target weights can vary.  For example the material change in weight in the 2021 target weights vs the 2020 target weights was a +1.6ppt increase in Precious Metals (to 19.0%) and a -1.9pp decrease in Industrial Metals to 15.6%.

Traditional vs “Smart” weighting schemes
One of the drawbacks of the traditional production- and liquidity-based weighting scheme is that they are constructed with short-dated futures contracts.  This creates a risk when futures contracts are rolled because for commodities where the forward curve is upward sloping (“contango”), the futures price of a commodity is higher than the spot price.  Each time a futures contract is rolled, investors are forced to “buy high and sell low”.  This is known as “negative roll yield”.

A “smart” weighting scheme looks at the commodity basket from a constant maturity perspective, rather than focusing solely on short-dated futures contracts.  This approach aims to mitigate the impact of negative roll yield as well as potential for reduced volatility, relative to traditional indices.
​
This Constant Maturity Commodity Index methodology was pioneered by UBS in 2007 and underpins the UBS Bloomberg BCOM Constant Maturity Commodity Index and products that track it.

Illustration of futures rolling for markets in contango

An Equal Weighted approach
Whilst the traditional index construction considers economic significance in terms of production and liquidity, investors may seek alternative forms of diversified commodities exposure, such as Equal Weighted approach.

There are two ways of achieving this, equal weighting each commodity, or equal weighting each commodity group.

The Refinitiv Equal Weight Commodity Index equally weights each if 17 individual commodity components, such that each commodity has a 5.88% (1/17th) weight in the index.  This results in an 18% allocation to the Energy Group, 47% allocation to the Agriculture group, 12% allocation to the Livestock group and 23% allocation to Precious & Industrial Metals.

​An alternative approach is to equally weight each commodity group.  This is the approach we take in the Elston Equal Weight Commodity Portfolio, which has a 25% allocation to Energy, a 25% allocation to Precious Metals, a 25% Allocation to Industrial Metals and a 25% Allocation to Agricultural commodities.  This is on the basis that commodities components within each group will behave more similarly than commodity components across groups.

These two contrasting approaches are summarised below:

​Performance
In 2020, the Equal Weight component strategy performed best +6.28%.  The Constant Maturity strategy delivered +0.69%.  The Equal Weight Group strategy was flat at -0.05% and the traditional index was -5.88%, all expressed in GBP terms.

​Informed product selection
This summarises four different ways of accessing a diversified commodity exposure: traditional weight, constant maturity weighting, equal component weighting and equal group weighting.  Understanding the respective strengths and weaknesses of each approach is an important factor for product selection.

[3 min read, open as pdf]
​

• Negative Interest Rate Policy (“NIRP”) is a “last resort” policy tool
• The UK is getting ready for “NIRP”
• The hunt for yield and alternatives to cash

 
A “last resort” policy tool
Zero & Negative Interest Rate Policy are Non-Traditional forms of Monetary Policy is a way of Central banks creating a disincentive for banks to hoard capital and get money flowing.
Zero Interest Rate Policy (ZIRP) is when Central Banks set their “policy rate” (a target short-term interest rate such as the Fed Funds rate of the Bank of England Base Rate) at, or close to, zero.  ZIRP was initiated by Japan in 1999 to combat deflation and stimulate economic recovery after two decades of weak economic growth.
Negative Interest Rate Policy (NIRP) is when Central Banks set their policy rate below zero.  Japan, Euro Area, Denmark, Sweden are currently using a NIRP. US & UK are currently using a ZIRP, and are considering a NIRP.
​
Fig.1. Advanced economy policy rates

Whilst bond prices may imply negative real yield, or negative nominal yields, a NIRP impacts the rates at which the Central Bank interact with the wholesale banking system and is intended to stimulate economic activity by disincentivising banks to hold cash and get money moving.  A NIRP could translate to negative wholesale rates between banks, and negative interest rates on large cash deposits, but not necessarily retail lending rates (e.g. mortgages).

Ready, steady, NIRP
Negative Interest Rates were used in the 1970s by Switzerland as an intervention to dampen currency appreciation.  .  It was the subject of academic studies and was seen as a last resort Non-Traditional Monetary policy during the Financial Crisis of 2008 and during the COVID crisis of 2020. Sweden adopted NIRP in 2009, Denmark in 2012, and Japan & Eurozone in 2014.  The Fed started looking closely at NIRP in 2016.

According Bank of England MPC minutes of 3rd March 2021, wholesale markets are generally prepared for negative interest rates as have already been operating in a negative yield environment.  By contrast, retail banks may need more time to prepare for negative interest rates to consider aspect such as variable mortgage rates.

There are arguments for and against NIRP.  The main argument for is that NIRP is stimulatory.  The main argument against is that NIRP failed to address stagnation and deflation in Japan and can create a “liquidity trap” where corporates hoard capital rather than spend and invest.

The hunt for yield
With negative interest rates, there will be an even greater hunt for yield.    We look at the some of the options that advisers might be invited to consider.

• Foreign Exchange: This is what drove many Japanese retail investors to open savings accounts in foreign currencies that – despite the exchange rate risk – paid a greater interest rate.
• Structured Retail Products may offer high headline yields, these typically involve a complex return pay-off or conditionality linked to an index level such as the FTSE 100.  Return and risk cannot be created or destroyed.  Structured Products simply re-distribute the pay-offs between issuer and investor and – in aggregate – represent market returns less product costs and commissions.  We do not consider these as appropriate alternatives to Cash in a NIRP environment, or at all.
• Mini-Bonds that offer too-good-to-be-true interest rates that lure investors in to speculative investment schemes have, thankfully, been banned for promotion to retail investors.
• Up-risking: Alternative yield options necessarily require a modest “up-risking” relative to the zero-volatility and guaranteed (if paltry) return on cash deposits.  This up-risking could include money market funds (which will also come under interest rate pressure), longer dated bonds, and ultimately equities.

Getting the balance right between additional non-negative income yield and additional downside risk will be key for investors and their advisers when preparing for and reacting to a NIRP environment.

[3 min read, open as pdf]

• We look at the YTD performance of “inflation-hedge” asset classes in GBP terms, with reference to US and UK 5Y BEIR
• Commodities & Industrial metals have provided best defence, Gold and Inflation-Linked Gilts have provided least protection
• A layered approach to portfolio protection makes sense with Liquid Real Asset ETFs for the near- and medium-term, and inflation-linked bonds and equity income for the long-term

 
Focus on inflation
In our recent Focus on Inflation webinar we cited the study by Briere & Signori (2011) looking at the long run correlations between asset returns and inflation over time.
We highlighted the “layered” effect of different inflation protection strategies (1973-1990) with cash (assuming interest rate rises), and commodities providing best near-term protection, inflation linked bonds and real estate providing medium-term protection, and equities providing long-term protections.  Nominal bonds were impacted most negatively by inflation.

Source: Briere & Signori  (2011), BIS Research Papers

Given the growing fears of inflation breaking out, we plotted the YTD returns of those “inflation-hedge” asset classes, in GBP terms for UK investors, with reference to the US and UK 5 Year Breakeven Inflation Rates (BEIR).
Figure 2: Inflation-hedge asset class performance (GBP, YTD) vs US & UK 5Y BEIR

Source: Elston research, Bloomberg data, as at 5th March 2021

Winners and Losers so far
We looked at the YTD performance in GBP of the following broad “inflation hedge” asset classes, each represented by a selected ETF:  Gilts, Inflation Linked Gilts, Commodities, Gold, Industrial Metals, Global Property, Multi-Asset Infrastructure and Equity Income.
Looking at price performance year to date in GBP terms:

• The best protections thus far have been Broad Commodities +7.4% and Industrial Metals +4.8%
• The worst protections thus far have been Gold -11.5% and Inflation Linked Gilts -6.3%.

So Inflation-Linked Gilts don’t provide inflation protection?
Not in the short run, no.
UK inflation linked gilts have an effective duration of 22 years, so are highly interest rate sensitive.  Fears that inflation pick up could lead to a rise in interest rates therefore reduces the capital value of those bond (offset by greater level of income payments, if held to maturity).
So whilst they provide medium- to long-term inflation protection, they are poor protection against a near-term inflation shock.
 
Conclusion
In conclusion, we observe:

• To integrate an inflation-protection strategy within a portfolio, a layered approach to inflation-hedge assets makes sense to mitigate inflation risk over different time frames.
• Inflation-linked gilts, owing to their long duration, will not respond well near-term to fears of potential interest rate increases and or interest rate volatility.
• Each inflation-hedging asset class is available through liquid, transparent and cost-efficient ETFs, or as a portfolio of Liquid Real Assets ETFs.

[3 min read, pdf version]
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• We differentiate between moderate and high turnover strategies
• Moderate turnover strategies: markets continue to look overbought
• This drives preference for lower relative position in risk-assets

 
Moderate turnover strategies: Monthly Elson Market Indicator
The Monthly EMI ended January 2021 at 62.37 vs 63.12 at end December 2020.
For moderate turnover strategies, equity markets continue to look overbought.
This drives a preference for lower relative position in risk assets.
The Monthly EMI remains above the threshold (60) for a move to a Neutral position in risk assets.
Momentum in the VIX Index increased from 50.9 to 54.4, whilst in absolute terms, the VIX Index closed the month at 33.1, compared to 22.8 at previous month end.

High turnover strategies: Weekly Elston Market Indicator
Over the last 4 weeks, the Weekly EMI declined from 63.87 to 59.35, as at last Friday close, falling below the 60 threshold.
Momentum in the VIX Index increased from 48.56 to 54.35 over the last 4 weeks.

The conclusion of the Retirement Outcomes Review for non-advised customers is set out in the regulator’s Policy Statement PS19/21.

The key change is the introduction of mandatory highly governed investment pathways for non-advised drawdown (we prefer the term “Retirement Pathways”, for clarity) from February 2021.
In a nutshell Retirement Pathways is the new Stakeholder, but for decumulation, and with a soft price cap of 0.75% instead of 1.50%.

Whilst the policy changes impact non-advised providers, a “Dear CEO” letter was sent financial advisers in January this year announcing a review of the market for pensions and investment advice “Assessing Suitability 2” (AS2) with particular reference to retirement outcomes.

What are the key points of PS19/21?
The policy means that:

• direct to consumer providers must offer retirement pathways to their customers
• platforms that are both advisory and direct-to-consumer must offer retirement pathways to both their advised and non-advised customers
• advisers need to consider retirement pathways when assessing suitability for their clients considering drawdown

Retirement pathways will fundamentally change the landscape for retirement investing, so it’s worthwhile for advisers to ensure they are in the loop.
 
What is the point of this policy intervention?
The purpose of this policy intervention is to deliver better retirement outcomes for non-advised investors, who may not have the confidence to make robust and informed investment decisions.
Key protections include, but are not limited to: ensuring cash is not a default option, ensuring costs and charges are clear, reasonable and regularly communicated  ensuring investment strategies are appropriate through the introduction of default options for different objectives, and ensuring there is third party oversight of those default investment options either through an Independent Governance Committee (IGC) or a third-party Governance Advisory Arrangement (GAA).

If you are thinking that sounds a bit like the governance arrangements around automatic enrolment workplace pension schemes - you are right.  If you are also thinking it would have made sense to have those guidelines in place before or in conjunction with Pensions Freedom in 2014, you are also right!
 
What will d2c drawdown look like?
In the policy statement PS19/21, the regulator is requiring all d2c providers to offer mandatory investment pathways (Retirement Pathways) with effect from 1st February 2020.  Retirement pathways mean offering non-advised transaction or customers going into drawdown four investment options that align to four standardised objectives formulated by the regulator.

Providers must offer a single investment solution (a single fund, or a single fund from a suite of funds from the same solution such as target date funds) for each pathway.   These funds will be subject to intense scrutiny by the providers Investment Governance Committee in terms of appropriateness and value for money.
 
What are the standardised objectives?
The standardised objectives are intended to align to specific actions or intended actions that non-advisers may want to take.
The final wording for each standardised objective is below:

1. Option 1: I have no plans to touch my money in the next 5 years
2. Option 2: I plan to set up a guaranteed income (annuity) within the next 5 years
3. Option 3: I plan to start taking a long-term income within the next 5 years
4. Option 4: I plan to take my money within the next 5 years

Is there a price cap?
There is no price cap for Retirement Pathways.  However during the consultation, the regulator suggested that providers should be mindful of the fact that in automatic enrolment workplace pension schemes the Total Cost of Investing (a term which I define to be Platform/Admin Cost + Fund OCF + Fund Transaction Costs) is 0.75%.  This creates a fairly strong anchor within which d2c providers must operate.

Is that price cap achievable?
Yes: for example if we estimate a platform fee a for a d2c providers to be 0.30% for an investor with £100,000 at retirement, this leaves 0.45% budget for fund OCF plus transaction costs.  The price anchor indirectly forces providers down the road of offering multi-asset funds that are constructed with low-cost index funds.  And there’s nothing wrong with that - after all it’s the asset allocation that counts when it comes to delivering investment outcomes, not the type of fund.

What kind of funds align to the standardised objectives?
For investors expecting to purchase an annuity under one of the pathway options, we expect providers to offer funds that have similar asset exposures to what annuity providers hold to fund annuities.  That way, when investors purchase an annuity, there is a change in how an investors receives a payout (life-long guaranteed in exchange for surrendered capital), but not a change in the asset mix used to fund that annuity.  That way if annuity rates change, the assets the investor holds to purchase that annuity are the flip side of the same coin.

In the workplace pension world, there are pre-retirement funds that are designed to mirror annuity providers’ annuity matching portfolios.  We expect similar funds for the retail market, and are ready to construct “Annuity Conversion portfolios” should the demand arise. 

For the other three options, we expect that d2c providers will use multi-asset passive funds, with lower risk-return profile for investors starting to make near-term withdrawals and a medium-term risk-return profile for investors starting to make medium-term withdrawals.  Whilst “relative risk” traditional multi-asset passive funds could be one option for d2c providers, we expect Target Date Funds to have an important role to play in non-advised drawdown.
 
What does this mean for advisers?
Whilst the policy is aimed at direct-to-consumer providers, there have been consistent read-throughs for financial advisers from the outset.
Now that this is hardcoded into policy, we expect the forthcoming changes in the d2c market will create pressure on advisers in four different dimensions: comparison, cost, appropriateness and governance.

• Comparison: to evidence that the investment options they offer to customers in drawdown are of comparable appropriateness and value for money as what can be obtained in the Retirement Pathways non-advised market.  Indeed, there is talk that AS2 may result in the re-introduction of an RU64 style rule that makes comparisons to Retirement Pathways schemes mandatory, as with Stakeholder
• Cost: the cost of providing advice in retirement is not capped, and comes on top of the total cost of investing which is being anchored at 0.75%.  If advisers charge typically 0.50% to 1.00% we anticipate good value for money for advised clients in retirement will be a Total Cost of Ownership (a term I define for Advice plus Total Cost of Investing, defined above) of 1.25% to 1.75%.
• Appropriateness: whilst Target Date Funds have a key role to play in the non-advised market as a “one size fits all’ default strategy for different cohorts of investors, we believe that advisers can take a more nuanced approach to building a decumulation strategy.  Whereas Target Date Funds assume a single risk profile, and a single investment term starting from the year in the fund’s name, a managed portfolio approach, by contrast, enables a more granular approach to considering risk-return and time horizon.  This enables a more client-centric approach to retirement planning that can be more aligned to an investor’s “withdrawal profile”.  Finally because model portfolios are not unitised, they can be delivered at a lower cost than a multi-asset fund or target date fund. 
• Governance: just as d2c providers as manufacturers will have Product Governance obligations on the investment options they  facilitate for Retirement Pathways, advisers have Product Governance obligations on the investment options they select for their Centralised Retirement Proposition (CRP).  Every aspect of product governance should be considered with respect to CRPs, and again the decision as to whether to select funds or to delegate to managers should be viewed within this context.

 
Assessing Suitability 2
Assessing Suitability focused on CIPs in general but in an era where advisers’ responsibility was primarily for clients in the accumulation phase.

We believe Assessing Suitability 2 will focus on CRPs now that advisers’ responsibility includes clients in decumulation.

Helping clients invest for accumulation and decumulation requires a fundamentally different approach.
In accumulation, the focus is on attitude to risk, each client’s risk profile, and accumulation portfolios.

In decumulation, the focus should be on capacity for loss (not a volatility figure, but economic measures of shortfall risk, income replacement ratio and liability matching), each client’s withdrawal profile (amount of timing of withdrawals and their size relative to asset pool, and the degree of confidence in achieving a particular level of income durability), and decumulation portfolios (the investment engines that are designed to support term-specific withdrawals, rather than targeting long-term growth).
Retirement Pathways is transforming the investment approach for non-advised investors in decumulation.  Advisers need to position themselves accordingly.
 
The growing use of behavioural finance in policy interventions
Harnessing behavioural finance interventions that address behavioural biases, such structured choice architecture and default strategies, is a growing feature of regulatory policy.  It is based on the premise of investor “inertia” and is designed to provide protections for less confident and less engaged investors.
 
For this reason, investment strategies with built-in lifestyling, such as target date funds, have a growing role to play in the personal pensions market, as well as the workplace pensions market.
 
Needless to say, these highly governed pathway-type solutions then become a standard (in terms of design, appropriateness, and value for money) against which regulated advice can be compared and measured.
 
Key behavioural aspects and price points of policy interventions:

• Stakeholder Pensions (2001): default fund and “lifestyling” for gradual derisking towards retirement date, 1.50% hard price cap
• Workplace Pensions/Auto-Enrolment (2012): default fund, use of “lifestyling” or target date funds, 0.75% hard price cap
• Retirement Pathways (2021): structured choice architecture, single solution per each pathway, cash disallowed as a default option, 0.75% “soft” price cap* (investment solution only, non-advised)
• DB Pension Transfers (2020): consider recommending auto-enrolment workplace pension in the first instance (see 2 above) , 0.75% “soft” price cap** (investment solution only, excludes advice)

 
*Retirement Pathways: there is no price cap specified by the regulator.  My definition of a “soft” price cap is because there was a request by the regulator to providers to consider the comparative cost of auto-enrolment solutions when designing non-advised pathways.
**DB Pension Transfers: there is no price cap specified by the regulator.  My definition of a “soft” price cap is because, under PS20/6, it will become a requirement for advisers to consider and analyse a transfer to a workplace scheme, in the first instance, where the hard price cap of 0.75% does apply.

 

[7 min read, open as pdf for full report]
[See CPD webinar on risk-weighted diversification]

• We look at latest performance for multi-asset risk-weighted strategies
• A 60/40 portfolio remains 97% correlated with global equities
• Risk Parity delivers highest risk-adjusted returns and greatest decorrelation

The challenge
A 60/40 portfolio delivers asset-based diversification: it represents a mix between equities and bonds.
However although a 60/40 portfolio reduces market beta, it does not provide “true” (risk-based) diversification: for example, a 60/40 portfolio, as represented by the Elston 60/40 GBP Index remains 97% correlated with Global Equities.
​
This problem only increases in stressed markets where correlations between assets increase, as we saw in 2020.

Risk-weighted strategies for “true” diversification
Risk-weighted stratetgies, which represent multi-asset portfolios constructed towards a specific portfolio risk outcome, enable an alternative, differentiated approach to investing and for incorporating "true“diversification”.  We look at the following risk-based strategies in our analysis: Risk Parity, Max Deconcentration, and Min Variance.  These are summarised in more detail in the report.

Comparing asset-weighted vs risk-weighted strategies
How can we compare the efficacy of traditional asset-weighted strategies (e.g. 20%, 40%, and 60% equity/bond strategies), vs these risk-weighted strategies?

One approach would be to compare the efficacy of risk-based strategies vs asset-based strategies from the perspective of 1) capturing equity returns, whilst 2) providing “true” diversification as measured by decorrelation impact (the reduction in correlation relative to global equities).

In summary, the findings are that a Risk Parity strategy captured a similar level of equity returns as a 40% equity strategy, but with almost twice the level of decorrelation, meaning it delivers far greater “true” diversification relative to an asset-weighted strategy with similar return profile.

Over the 5 years to December 2020, a 40% Equity strategy captured 44.3% of global equities annualised returns and delivered a correlation reduction of -22.3%.  By contrast, a Risk Parity strategy captured 48.5% of global equity reutrns, and delivered a decorrelation of -44.8%, relative to global equities.

So for portfolio constructors looking to deliver “true” risk-based diversification, whilst maintaining exposure to risk assets for the potential for returns, incorporating a risk-based strategy such as Risk Parity, Max Deconcentration, or Min Variance could make sense depending on portfolio risk budgets and preferences.

For full quarterly performance update, open as pdf 

[7 min read, open as pdf]
[See CPD webinar on introduction to factor-based investing]

• Fundsmith’s performance vs MSCI World is stellar
• But performance vs MSCI World Momentum Factor is marginal
• Is Fundsmith knowingly or unknowingly a Momentum investor?

Stellar performance
If there’s one word to describe the performance of Terry Fundsmith’s Fundsmith Equity Fund, it would be “stellar”.
Beloved by retail investors and advisers alike, it’s a key holding in many of the portfolio we see that are run by financial advisers.
The firm’s values are clearly set out “No performance fees, no nonsense, no shorting, no market timing, no index hugging, no hedging" and so on.  All this combined with great results, and it’s a compelling proposition.
But in this article, we set out to answer four questions:

1. Is Fundsmith a Momentum investor?
2. Where and how has Fundsmith added value?
3. Is Fundsmith fund “hugging” a Momentum index?
4. Are Fundsmith-like returns accessible using lower-cost index strategies?

In summary, the answers are, respectively: Possibly, Sector Allocation, Definitely Not, and Yes.
​
What is Momentum investing?
MSCI defines momentum factor as referring to “the tendency of winning stocks to continue performing well in the near term. Momentum is categorized as a “persistence” factor i.e., it tends to benefit from continued trends in markets”[1].

Following the lows of the Global Financial Crisis, it’s been a great time to be a Momentum investor.  Indeed, it has been the best performing style factor, much to the chagrin of many “purist” factor-based investors who focus only on the original Fama-French framework of Size and Value factors.
​
Question 1: Is Fundsmith a Momentum investor?
What’s the right comparator?
The Fundsmith Equity fund quite rightly uses MSCI World Index as a performance comparison on its factsheet.  Comparisons against UK equity funds or indices would not be appropriate.   In our research around factor-based investing, we thought it would be interesting to plot how the performance of a popular global equity fund like Fundsmith Equity fared against the various factor-based world equity indices.
​
We were astonished to see that the overall performance was almost identical to the iShares EDGE MSCI World Momentum Factor UCITS ETF (the “Momentum ETF”) which tracks the MSCI World Momentum Factor index (the “Momentum Index”).

Fig.1. Close call between Fundsmith & Momentum factor for trouncing MSCI World

Source: Elston research, Bloomberg data. Total Return in GBP terms as at 31-Dec-20
Indeed, over the last 5 years from Dec-15 to Dec-20, Fundsmith has delivered a cumulative total return of +137.39%, compared to the Momentum ETF’s return of +132.77% and +90.23% for iShares MSCI World Equity ETF (the "World Equity ETF").  In annualised returns this translates to +18.85%, +18.39% and +13.71% respectively[1].
[1] As at 31st December 2020

To be clear, Fundsmith Equity is not managing the fund to this benchmark, so could argue it’s not an appropriate comparison, and technically, that’s right.   But we thought nonetheless a comparative analysis would be informative, not least to show that Fundsmith-like returns were achievable with a Momentum-style investment approach.

How about 2020 performance?
In 2020, Momentum ETF returned +24.85% in GBP terms, compared to Fundsmith Equity’s +18.23% and the World Equity ETF +11.81%, possibly helped by its rebalancing in what very much a year of two halves..

Fig.2. Fundsmith vs Momentum in 2020

Factor investing: between active and passive?
Factor-based index investing has sometimes been described as being somewhere between passive (cap-weighted index beta) investing and active (non-index) investing.  Indeed factor-based investing became mainstream when Ang, Goetzmann and Schaefer (2009) conclude that the bulk of the apparent manager alpha within the Norwegian Sovereign Wealth Fund was explained by macro factors and style factors.  Factors therefore explain a large part of the difference between market beta and active returns, that were previously attributed to manager alpha. 
​
In the chart below, we compare the annualised performance over 5 years of the world equity ETF (beta), the Momentum ETF (style factor) and the residual difference (Alpha) between Momentum and Fundsmith.  Effectively we are using the Momentum ETF as a benchmark for Fundsmith’s style.
​
Fig.3. Relative Return Comparison: Fundsmith Equity vs iShares EDGE MSCI World Momentum  Factor ETF

So for evaluating manager skill: which is the right benchmark? A) World Equities against which both Fundsmith Equity and a low cost Momentum ETF look great; or B) if Fundsmith is indeed a Momentum-style investor – a Momentum benchmark, against which Fundsmith has still outperformed – but only marginally?

Applying a factor lens to active managers
What we like about the Fundsmith Equity fund is that it is a “true active” fund using high conviction, and high concentration, and see it as a powerful addition to portfolios. 

Fundsmith describes his process as “Quality focused” and yet performance is very different to a Quality factor and almost identical to a Momentum factor.  We are not saying that Fundsmith is not properly describing their investment process.  We are just noting the outcome of its results and similarity to the Momentum factor.

By applying this factor perspective to traditional active managers, we can see what factors those managers are knowingly or unknowingly allocating to, and hence to what extent their performance relates to a particular style factor.

Both Fundsmith and Momentum Index have had a high concentration to Information Technology, Health Care and Consumer Staples.  Fundsmith’s fund is not constrained and his more concentrated approach means that this sector concentration is even more extreme than the Momentum index.

Naturally there is significant overlap in the underlying stock within both Fundsmith and the Momentum ETF, but with Fundsmith able to take larger security weights than a rules-based index.
 
Question 2. Where and how has Fundsmith added value?
Performance Attribution
We ran an attribution analysis comparing the Fundsmith Equity fund to the Momentum ETF for the period from June 2016 to December 2019, a period where all look-through data is available.

For this period, Fundsmith returned +75.76% outperforming the Momentum ETF which returned +69.48%.
 
In terms of Total Returns, Fundsmith’s picks in the Information Technology sector delivered +145.22%, compared to Momentum ETF’s +156.32%, an underperformance of -11.1%.  This was offset by Fundsmith’s picks in the Health Care sector which returned +77.66%, compared to +67.58% for the Momentum ETF.  An outperformance of +10.08%.  Fundsmith’s picks in the Consumer Staples sector generated +35.62%, compared to +35.12% for the Momentum ETF.

After adjusting each sector for average weights, the large relative overweight in Information Technology – an advantage of a more concentrated approach – meant that technology was the largest relative contributor to overall return deliver 35.82ppt of the +75.76% return.  Similarly, for Momentum, information technology delivered 26.5ppt of the +69.48% return.
​
In summary for the time period under review Fundsmith has been excellent at sector selection.  Good in stock selection within the Health Care sector was offset by poor stock selection in the Information Technology sector.  Stock selection in the Consumer Staples sector added almost no value.
​
Fig.4. Sector-level Contributions To Return

Taking this further into an attribution analysis, the conclusion is that Fundsmith added greatest value by selecting the best performing sectors, where share price momentum was greatest.  There was moderate additional value from fund selection, and some detraction from currency effect.
​
Fig.5. Attribution analysis

Holdings analysis
We also looked at the average largest relative overweights for the Fundsmith Equity fund relative to the Momentum ETF, to look at security-level Contribution to Total Return.  During the period under review, Paypal, Idexx and Amadeus were the largest contributors to returns.
​
Fig.6. Security-level Contribution To Return

Fundsmith is “true active” because he is taking large absolute and relative bets relative to securities’ index weights be - that in a traditional cap-weighted index which is his benchmark, or in the Momentum factor-weighted index. which is not.
​
Fundamentals
Interestingly, looking at aggregate valuations, the overall Price Earnings Ratio (PER) for Fundsmith and for Momentum is not dissimilar, whilst Price Book Value (PBV) ratios – a traditional value metric – and debt levels were far higher for Fundsmith than Momentum.
​
Fig.7. Valuation Comparison

Question 3: Is Fundsmith Equity hugging the Momentum index?
No.  Not at all.  As a far more concentrated portfolio there are high levels of active weights relative to the much more diverse Momentum Index. 

The correlation between the strategies from December 2015 to December 2020 is high at 84.3%, but not too high
​
Fig.8. Top 5 relative weights

Question 4: Are Fundsmith-like returns replicable by lower cost index strategies?
The most interesting element of our analysis is this:  usually when comparing actively managed funds, you can often find two strategies that take a similar approach, but have led to very different outcomes.  In this case, comparing an actively managed fund with a Momentum index fund, we have two strategies that take a different approach, but reach a very similar outcome.  This is consistent with the concept of factors being the underlying drivers of returns.

Fundsmith is and remains a vindication of the potential value add of active management, and the ability to deliver returns well in excess of the market (cap-weighted) beta.  As such, we expect advisers to continue to want to include Fundsmith as a core holding within their equity allocation.  But we would note decompising returns to what is attributable to Factors provides additional insight.

However, if the question is are those type of returns accessible using index funds, the answer is emphatically yes.

An equal weight allocation across Consumer Staples, Health Care and Information Technology ETFs, or a single allocation to a Momentum ETF would have delivered similar returns to Fundsmith, but with TERs of 0.30% or so, instead of 0.95%.

So if you are looking for growth, being fully allocated to equities, and backing "winning" business: then you can implement that approach with active funds like Fundsmith, or index exposures like Momentum.

The holdings or “ingredients” might be different, but the factors or “nutrients” might be the similar.

Similarities and Differences
So, apart from the obvious, what are the similarities and differences between methodologies?
​
Similarities

• High concentration (sector-level): high concentration of sector exposures in Consumer Staples, Health Care & Information Technology at present.
• Max position sizes: Max positions of 5% in the Momentum Index - much higher than the traditional MSCI World Index, but not dissimilar to the larger position sizes within Fundsmith Equity
• Outcome: Both strategies – via very different methodologies – end up with a similar overall “momentum” philosophy, namely “backing winners”.

Differences

• Investment approach: stating the obvious, Fundsmith’s Equity Fund is a subjective manager-based approach; Momentum factor ETFs reflect a systematic rules-based approach
• Number Holdings: Fundsmith’s Equity fund is concentrated in 30 holdings.  The Momentum factor ETF has 350 or so holdings.  The Momentum factor ETF is therefore carries less idiosyncratic risk.
• Turnover: But given the dynamic nature of these trends, and semi-annual rebalancing, the Momentum index turnover is high at 149.48%[1].  Fundsmith’s turnover, by contrast is much much lower by design.
• Cost: the Fundsmith fund delivered performance at a cost of 0.95% OCF, the iShares Edge World Momentum Factor UCITS ETF delivered similar performance at a cost of 0.30%

Summary
Fundsmith’s performance is undeniably excellent.  We would note that it is consistent with that of a Momentum-style investment strategy.

Fundsmith’s “Alpha” can be measured not just against MSCI World, but against the MSCI World Momentum Index.  Using the standard MSCI World as a comparator implies Fundsmith’s Alpha is a phenomenal 5.14ppt pa over the last 5 years.  Using the MSCI World as a comparator implies Fundsmith’s Alpha is just 0.46ppt pa.

Incorporating factor-based exposures as a hybrid on the spectrum between traditional cap-weighted passive, and true active, creates more options for portfolio managers looking to isolate and capture specific styles and exposures without having to materially increase either the risk budget or the fee budget.

[1] MSCI factsheet as at December 2020 for last 12 months

[5 min read, open as pdf]

• Tech performance is skewing cap-weighted indices
• Increased concentration reduces diversification
• Using cap-weighted indices is an active choice

 
Tech performance is skewing cap-weighted indices
The run up in technology stocks and the inclusion of Tesla into the S&P500 has increased both sector concentration and security concentration.  The Top 10 has typically represented approximately 20% of the index, it now represents 27.4%. 
The chart below shows the Top 10 holdings weight over time.

​Rather than looking just at Risk vs Return, we also look at Beta vs Correlation to see to what extent each strategy has 1) not only reduced Beta relative to the market, but also 2) reduced Correlation (an indication of true diversification).  Strategies with lower Correlation have greater diversification effect from a portfolio construction perspective.

Ironically, the last time the index was anything close to being this concentrated was back in 1980 when IBM, AT&T and the big oil majors ruled the roost.

From a sector perspective, as at end December 2020, Information Technology now makes up 27.6% of the index.

Increased concentration reduces diversification
This level of concentration is indeed skewing indices that rely on a traditional market capitalisation-weighted (cap-weighted) methodology, and does therefore reduce diversification.
But the issue of the best performing stocks getting a larger weighting in the index, is not an accident of traditional index design.  It’s its very core.  Cap-weighted indices reflect the value placed on securities by investors, not the other way round.

We should not therefore conflate the debate around “active vs passive” investment approaches, with the debate around index methodology.

If portfolio managers are concerned about over-exposure to particular company or sector within a cap-weighted index, they can either chose an active, non-index fund, that is not a closet-tracker.  Or they can access the target asset class through an alternatively weighted index, which uses a security weighting scheme other than market capitalisation.

Using cap-weighted indices is an active choice
The decision to use a fund that tracks an cap-weighted index is an active choice.  And for those seeking differentiated exposure, there is a vast range of options available.

We categorise these into 3 sub-groups: Style, Factor-based and Risk-based.

1. Style-based: for example: Value, Growth, Income.  This is the classical style-based approach.  Value investing traces back to Graham & Dodd’s research in the 1930s.
2. Factor-based: for example: Value, Size, & Quality.  Factor-based investing weights securities by their internal fundamental characteristicss that relate to their expected drivers of returns: for example securities included in a Quality index would be included based on profitability and/or Return on Equity metrics.  Min Volatility (lowest and Momentum relate to the performance of the security rather than its fundamentals.  Our recent CPD webinar explores factor-based investing in more detail.
3. Risk-based: probably the least developed area.  Risk-based investing weights securities by their relationship to each other in order to target a particular target risk characteristic.  Examples include: Max Deconcentration (aka Equal weighted); Max Diversification; Max Decorrelation; Max Sharpe; Min Variance, Risk Parity (aka Equal Risk Contribution) and Managed Risk.  Our recent CPD webinar explores risk-based investing in more detail.
4. Min Volatility or Min Variance? What’s the difference? Semantics, but for differentiation, we refer to Min Volatility when a strategy ranks securities by their volatility, to include only those lowest volatility stocks (hence used when referring to Factor-based strategies).  We refer to Min Variance when a strategy looks at risk and correlation structure between stocks to target a “minimum variance portfolio” of those securities (hence used when referring to Risk-based strategies).  So similar, but different.

With that array of index methodologies for US equities to choose from, there’s no excuse for complaining about being fed-up with the traditional cap-weighted approach.  Index selection, depends, of course, on portfolio construction objectives, and index methodology due diligence remains key.

How have US equity risk-based strategies fared?
Risk-based strategies have been in existence for some time, so we are able now to consider 10 year data (to December 2020, in USD terms).  In terms of risk-adjusted performance, Managed Risk index strategies have fared best, whilst Min Variance has delivered higher returns for similar levels of risk of a Max Diversification strategy.  Meanwhile Equal Weight has actually exhibited greater risk than traditional cap-weighted approach.

In this respect, Equal Weight (Max Deconcentration), also disappoints delivering higher beta and >95% correlation.  Likewise Min Variance, whilst delivering on Beta reduction, does not deliver on decorrelation.  Max Diversification delivers somewhat on decorrelating the strategy from the S&P500, but only modestly, whilst Managed Risk achieves similar decorrelation, reduced beta and better returns.  Finally Risk Parity 10% Volatility cap has delivered most decorrelation as well as beta reduction.
For more information about the indices and funds used to represent these different strategies, please contact us.
​
Summary
There are a broad range of alternatives to cap-weighted index exposures.  But consideration of style-, factor- or risk-based objectives will necessarily inform portfolio construction.

• Fiscal and policy support should keep growth shock short and sharp
• Inflation looks bottled – for now, but this is the key focus
• Asset price recovery was welcome but vigilance now required

 
Find out more
For more insights and information on research, portfolios and indices, visit:
www.elstonsolutions.co.uk or NH ETF<Go>

[3 min read, open as pdf]

• Growth shock is short and sharp, for now
• Even lower for even longer interest rates
• Recovery extended, but vigilance required

 
Growth shock is short and sharp
The medium-term outlook for growth points more to a “short sharp shock” rather than a protracted downturn that followed the Global Financial Crisis.  However vigilance around economic growth, and ongoing dependency on vaccine rollout, fiscal and monetary policy support remains key.

Even lower for even longer interest rates
Even lower for even longer interest rates underpins an accommodative strategy to support recovery: but also has created frothiness in some asset classes.

Low nominal and negative real yields is forcing investors into refocusing income exposures, but should not lose sight of quality.

Inflation in a bottle: for now
Inflation caught between growths scare on the downside and supportive policy on the upside.  Should inflation outlook increase, nominal bond yields will be under greater pressure and inflation-protective asset class – such as equities, gold infrastructure, and inflation-linked bonds can provide a partial hedge.

Trade deal with EU should reduce GBP/USD volatility
The 11th hour trade deal concluded in December between the UK and the EU should dampen the polarised behaviour of GBP exchange rate, with scope for moderate appreciation, absent a more severe UK growth shock.

Market Indicators: recovery extended
Market indicators suggest equities are heading into overbought territory and whilst supported by low rates and bottled inflation, are looking more vulnerable to any deterioration in outlook.  Incorporating risk-based diversification that adapts to changing asset class correlations can provide ballast in this respect.

[2 min read, open as pdf]

• Momentum has been the best performing factor
• Can factors get crowded, but can they be timed?
• Will we see a persistent rotation to value?

 
A Factor-based approach to investing
Factor-based investing means choosing securities for an inclusion in an index based on what characteristics or factors drive their risk-return behaviour, rather than a particular geography or sector.
Just like food can be categorised simply by ingredients, it can also be analysed more scientifically by nutrients.  Factors are like the nutrients in an investment portfolio.
​
What are the main factors?
There is a realm of academic and empirical study behind the key investment factors, but they can be summarised as follows
The different factors can be summarised as follows:

• Size: smaller capitalisation companies
• Momentum: companies with upward price trend
• Quality: companies with strong and stable earnings
• Value: companies that are undervalued relative to their fundamentals
• Min Volatility: companies with lower volatility performance characteristics

 
Which has been the strongest performing factor?
Momentum has been the best performing factor over the last 5 years.  Value has been the worst performing factor.
 
Fig.1. World equity factor performance

Source: Elston research, Bloomberg data

A crowded trade?
Data points to Momentum being a “crowded trade”, because of the number of people oerweighting stocks with momentum characteristics.  This level of crowdedness can be an indicator of potential drawdowns to come.
​
Fig.2. Momentum Factor is looking increasingly crowded

Source: MSCI Factor Crowding Model

The best time to buy into a Momentum strategy has been when it is uncrowded – like in 2001 and 2009, which is also true of markets more generally.  MSCI’s research suggests that with crowding scores greater than 1 were historically more likely to experience significant drawdowns in performance over subsequent months than factors with lower crowding scores.
​
Fig.3. Factors with higher crowding score can be an indicator of greater potential drawdowns, relative to less crowded factors

Source: MSCI Factor Crowding Model

Rotation to Value
The value-based approach to investing has delivered lack lustre performance in recent times, hence strategists’ calls that there may be a potential “rotation” into Value-oriented strategies in coming months as the post-COVID world normalises.  But can factors be timed?

Marketing timing, factor timing?
Market timing is notoriously difficult.  Factor timing is no different.  To get round this, a lot of fund providers have offered multi-factor strategies, which allocate to factors either statically or dynamically.  Whilst convenient as a catch-all solution, unless factor exposures are dynamically and actively managed, the exposure to all factors in aggregate will be similar to overall market exposure.  This has led to a loss of confidence and conviction in statically weighted multi-factor funds.

Summary
Factors help break down and isolate the core drivers of risk and return.

• Factor investing looks at the “nutrients” of investment
• Static “catch-all” approach to multi-factor investing has clear constraints, so a more dynamic approach makes sense
• Factors can get crowded, but factor allocation is hard to time

 
For more on Factor investing, see
https://www.elstonsolutions.co.uk/insights/category/factor-investing  
​https://www.msci.com/factor-investing 

[7 min read, open as pdf]

Whether or not investors enjoy creating and managing their own ETF portfolios, ready-made portfolios and funds of ETFs and index funds offer a convenient alternative

In this series of articles, I look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work Elston does for discretionary managers and financial advisers.

Who needs or wants a ready-made portfolio?
Individual investors of all wealth levels may find the prospect of engaging with their investment daunting, time-consuming, or both.
 
This is heightened by the high number of investment products and services available.  In the UK, there are over 70 discretionary management firms, and over 3,000 investment funds and ETFs.
 
For this reason, DIY investors may want ready-made portfolios that are an easy-to-buy and easy-to-own investment.  Not only do these solutions look like a simple alternative but they can also address and can potentially mitigate behavioural mistakes.
 
We look at three alternative ways of delivering ready-made portfolios for DIY investors in more detail: multi-asset funds, ETF portfolios and multi-asset ETFs.

Multi-Asset Funds
Multi-Asset Funds (also known as Asset Allocation Funds or Multi-Manager Funds) are the most established type of ready-made portfolios.  By owning a single fund (or in some cases an investment trust), investors get exposure to a diversified portfolio of underlying funds to reflect a specific asset allocation.  This means that having selected a strategy, the investor does not need to worry about asset allocation, or about the portfolio construction to achieve that asset allocation, or about security selection within each asset class exposure.
 
We categorise Multi-Asset Funds into different categories by investment strategy:

• Managed Balanced Funds are the “original” multi-asset funds and represent an unfixed asset allocation between equities and bonds that the fund manager will adapt based on their view of the markets.  These funds may hold direct equities and bonds, or used collective equity and bond funds that are typically actively managed.

 

• Relative Risk Funds (also known as Risk Profiled Funds) target a risk (volatility) that is relative to equity risk and are designed for a group of investors that share a risk-return objective.

 

• Target Risk Funds: target a risk (volatility) band in absolute terms

 

• Target Date Funds target a date in the future when withdrawals are expected to commence and are designed for a group of investors that share a time-based objective.

 

• Target Absolute Return Funds target a return objective and are unconstrained in their investment approach.

Despite the cost of wrapping underlying funds within a fund structure, economies of scale mean that Multi-Asset Funds can be delivered to investors at highly competitive price points with very low minimums.  However, the disadvantage is that Multi Asset Funds have a one-size-fits-all approach that means there is little scope for customisation to the individual needs and characteristics of the investor’s objectives and constraints.

ETF Portfolios
ETF Portfolios are basket of individual ETFs providing an asset allocation.  Rather than wrapping an investment strategy within a fund, a model portfolio is made available as a basket of ETFs that can be bought individually to create the strategy.  Model portfolios may be “strategic” (rebalanced to fixed weights of the same securities) or “tactical” (rebalanced to changing weights of the same or different ETFs).  Model portfolios are research portfolios meaning that the model portfolio provider has no control of client assets so it is up to a portfolio manager, adviser or DIY investor to implement any changes should they wish to follow a given model portfolio strategy.​

The advantages of ETF Portfolios include: firstly, potentially lower fees owing to removal of a fund wrapper to hold the strategy; secondly greater flexibility and specificity with regards to asset allocation design; and lastly agility as strategies can be launched or closed with ease.
 
An example of an ETF Portfolio could be as simple as a classic global 60/40 Equity/Bond strategy constructed with ETFs.

The ability to design and create ETF Portfolios with an increasing number of ETF building blocks means that both traditional (asset managers, stock brokers) and non-traditional providers (e.g. trade publications, investment clubs, industry experts) can create investment strategies that can be “followed” by investors.  However, the usual due diligence rules for any investment provider should be applied as regards their investment process.
 
Whilst the rise of more bespoke ETF strategies is welcome, the convenience of having a single strategy delivered as a single security from a portfolio construction perspective is attractive.  This is where Multi-Asset ETFs could have a role to play.
 
Multi-Asset ETFs
Multi-Asset ETFs are an emerging way of delivering the returns of a managed ETF Portfolio using a single instrument.  Whereas multi-asset funds are often funds of index-tracking funds, Multi-Asset ETFs can be viewed as an “ETF of ETFs”.
 
In the US, there are a number of multi-asset ETFs available providing a ready-made allocation within a single trade.  In the UK, there are currently only two ranges of multi-asset ETFs available.
 
Multi-Asset Infrastructure (launched April 2015)
SPDR® Morningstar Multi-Asset Global Infrastructure UCITS ETF
 
ESG Multi-Asset ETFs (launched September 2020)
BlackRock ESG Multi-Asset Conservative Portfolio UCITS ETF (MACG)
BlackRock ESG Multi-Asset Moderate Portfolio UCITS ETF (MAMG)
BlackRock ESG Multi-Asset Growth Portfolio UCITS ETF (MAGG)
 
We expect multi-asset funds, constructed with ETFs and index funds, to gain more traction than multi-asset ETFs because as a “buy and hold” ready-made portfolio multi-asset funds do not need the intraday dealing availability that ETFs provide.
 
Multi-asset funds (constructed with index funds/ETFs), ETF Portfolios, and Multi-asset ETFs provide a ready-made one stop for delivering a multi-asset investment strategy for all or part of an investment portfolio, whether defined by a multi-asset index or not.

The advantages of a multi-asset fund of ETFs as a ready-made portfolio
The advantages of a “one and done” approach include collectivisation, convenience and consistency.
 
Firstly, is collectivisation of investor’s by objective which creates cost efficiency from the economies of scale.  Adopting a collectivised approach, can be done where each group of clients shares the same goal (as defined by, for example, a target risk level or income objective, or volatility objective or target date).  This can help achieve economies of scale and lower the cost of offering professionally managed asset allocations in at least three different ways. Firstly, each cohort becomes a multi-million pound ‘client’ of an asset manager who can deploy institutional-type bargaining power on the pricing of the underlying funds within their asset allocation. Secondly, the collective scale reduces frictional trading costs of implementing the asset allocation decisions: one managed investment journey is more efficient to manage and deliver than thousands of individual ones. Finally, by focusing on actively managing the asset allocation as the main determinant of the level and variability of returns[1] the asset allocation can be implemented with index-tracking ETFs to keep costs down.
 
Secondly is convenience.  Rather than focusing solely on building optimal multi-asset class portfolios that need monitoring, the proposition of investment offerings can be engineered to eliminate poor behavioural tendencies that prevent effective management. Engineering funds so that they offer a single investment journey which investors do not necessarily need to monitor regularly in order to reach their goals can help reduce the perceived hassle of investing.  This can motivate individuals to invest. Such professionally managed funds prevent investors from either not rebalancing the portfolio or doing it in an improper fashion due to behavioural tendencies such as status quo bias[2] and disposition effect[3]. Furthermore, a professionally managed strategy can respond to other risks aside from market risk such as shortfall, concentration or longevity risks which lay investors can overlook. An additional advantage of offering managed diversified funds is that it automatically curtails the number of products offered, thereby reducing cognitive load of making an investment decision and can prevent decision deferral.[4]
 
Finally is consistency.  Investors in each strategy experience the same time-weighted investment returns thereby reducing the likely dispersion of returns that a group of investors would experience through an entirely self-directed approach.  This consistency is why multi-asset funds have also been adopted by some financial advisers as a core or complete holding within a centralised investment proposition.
 
The disadvantage of a ready-made portfolio are not secret.  They are designed as a “one-size-fits-all” product with no scope for customisation.
 
The respective features of the various types of ready-made portfolio are set out below.  Whereas multi-asset funds of ETFs, and multi-asset ETFs can be accessed via a single trade, their scope for customisation is low.  ETF Portfolios have the highest degree of flexibility for creating custom strategies, but are not accessible via a single trade.

Summary
Ready-made portfolios are easy to buy and easy to own.  They enable a “set and forget” approach to investment management which can help design out key behavioural risks, or provide a useful core holding to a broader strategy.​

Obviously the primary choice is which strategy an investor must choose, or their adviser should recommend depending on their risk-return objectives and suitability considerations.

[7 min read, open as pdf]

Fee pressure is here to stay.  In the “race to the client” being run by platforms, DFMs and fund houses, it’s up to advisers to rethink their business model, and make sure they stay in the lead.
​
In this series of articles, I look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work Elston does for financial advisers.

Fee pressure is here to stay
Between competition, regulation and ultra-low interest rates, there is understandable and justified pressure on costs.

Looking at the overall “value chain” – the cost of advice, platform, discretionary manager, and underlying funds – means that without careful scrutiny, investing a pension or an ISA ends up meaning its client money risked for the financial service industry’s reward.

With these “all-in” costs sometimes as high as 2.50%-3.00%, the situation is untenable, particularly when contrasted with non-advised workplace pensions and non-advised d2c solutions that can deliver a manager multi-asset investment solution at an all-in (excluding advice) cost of 0.50-0.75%.

Put simply, if we imagine a price anchor/price cap of 0.75% for workplace and pathway-style non-advised investments, there is effectively a soft-price cap of 1.75% for advised investments, in our view, from a Value for Money perspective.

MiFID II has been a tremendous driver of total cost transparency, and has sharpened the minds, and the pencils, of clients and advisers alike.
​
The cost of delivering investment solutions (excluding advice) differs vastly depending on whether accessed via advised, workplace and non-advised channels (see Fig.1.).  This is not sustainable.

Changing landscape
Given the inevitability of fee pressure and a steadily shrinking pie, there are three key trends emerging:

• The race to the client: the only part of the value chain that is non-commoditisable is client relationships.  Either having them, or not.  This is driving a huge surge in M&A activity and vertical integration and business transformation, as platforms set up DFM businesses, DFMs offer advisory services, and fund houses go direct to client.  In this race to the client, advisers are in the lead, but will have to fight to keep it that way.
• Control of the Value Chain is key: "whoso looketh after the client, controlleth the value chain".  Next generation advisers are using their muscle to be price setters to platforms, DFMs, and funds not price takers.
• The institutionalisation of retail: As technology makes platforms and investment management more efficient, the boundaries between institutional and retail investment solutions and pricing has started to blur.

 
The Race to the Client
Sustained fee compression across the value chain, means that there is a growing awareness amongst providers within the industry that their position in the value chain can be commoditised.

That’s why there is so much corporate activity and proposition change from all the different parties within the value chain. Fund houses are investing in platforms, platforms are setting up advice firms, and advice firms are setting up DFMs.

All of these parties are afraid of watching their products or services being commoditised, and hence many want to move to a vertically integrated model. I call this the “Race to the Client”.

And yet at the end of the day, there is only relationship that matters and that cannot be commoditised. And that’s one of trust and personality which makes up the relationship between the adviser and their client.

Control of the value chain: who has the power?
Whilst some fund houes see advisers as “Distributors”, the truth is now the opposite.  Instead of being price takers, advisers are becoming price setters.  In the race to the client, advisers are and should aim to stay in the lead. But only if they take control of the value chain and align it to their clients’ best interests.

Next generation advisers are no longer fund pickers, or model pickers, or manager pickers: they are fiduciaries who owe a duty of care to their clients and help them navigate the maze of financial services to ensure good customer outcomes, and excellent value for money.

The institutionalisation of retail
As workplace schemes become more individualised, and individual schemes become more mass-market, the retail and institutional worlds are beginning to collide, and this “institutionalisation of retail” means a focus on greater governance, increased professionalism, at substantially lower end-client costs.

Strategic options for advisers
Advisers have a number of options to compress all-in costs, whilst enhancing their business model.

• Option 1: reduce your advice fees from 1.00% to 0.75%, 0.50% or even 0.25%?  Erm, no.  That would be misplaced, as out of all parts of the value chain, the value of advice as well as the time-cost in delivering it, is highest.  But amazingly, in the absence of thinking through alternatives, some advisers do take this approach.
• Option 2: leverage your scale and the competition in the platform market to use a lower cost platform.  With little to differentiate platforms, their pricing power is weak, and susceptible to commoditisation, particularly from more technology enabled disrupters..
• Option 3: leverage your scale and the competition in the DFM market to use a lower cost investment solution, both in terms of the DFM fee and the underlying fund fees.
• Option 4: a combination of Options 2 & 3.  But with a twist: by creating your “own” proposition you can ensure you have ongoing and permanent control of the overall value chain, to ensure you can protect client’s interest by leveraging your scale to plug and play the right manager and/or platform for your mandate.  This is not a loss of independence, but using your clients’ aggregate scale to obtain best terms from suppliers.

If Option 4 can be done with a recalibration of business focus to devote time and energy to new business and excellent, empathetic client service, then so much the better.

Stop feeding the hand that will bite you
The race to the client is hotting up, and is all too visible from the M&A activity in the sector, and the rush of private equity capital into the UK advice market. 
And yet many adviser firms seem determined to feed the hand that’s going to bite them.
Why use a DFM whose stated aim is to cut you out of the value chain, and who spends more on Facebook ads, than your entire turnover?
Why use a fund house whose billboards at every station reach out to your clients to go direct?
Why use a platform that prefers to offer accounts to customers directly?
Looking after clients is the most valuable part of an adviser business.  Don’t give them away to your larger, bigger branded competitors.

Summary
As the race to the client hots up, the good news for advisers is that you are already in the lead.  So stop feeding your competitors – the DFMs, the fund houses, the platforms, and take back control of the value chain to ensure you can protect clients’ best interests.

© Elston Consulting Limited All Rights Reserved

[3 minute read, open as pdf]

• There’s no single measure for Dividend Concentration Risk
• Contribution to Yield and concentration metrics can help
• A quantitative and qualitative approach makes most sense

 
Dividend Concentration Risk
Dividend Concentration Risk is the over-dependence of a portfolio on a handful of holdings to generate the overall portfolio income.

Dividend Concentration Risk became even more apparent in 2020 when large cap companies suspended or cut their dividends.

Too often, Dividend Concentration Risk has been looked at in hindsight rather than as part of ongoing due diligence and challenge to portfolio constructors.
We look at potential evaluation metrics and conclude that a quantitative and qualitative approach makes most sense.

Understanding dividend dependency
We look at Contribution to Yield to understand the asset-weighted income generated by each underlying holding as a proportion of the overall yield of a portfolio.

Thus a 5% weighting to a 4% yielding stock A (an asset weighted yield of 0.20%) will have a greater contribution to yield than a 3% weighting to a 6% yielding stock B (an asset weighted yield of 0.12%).  For a portfolio with an overall yield of 3.0%, stock A has a 6.67% Contribution to Yield (0.20% / 3.0%) and Stock B has a 4.0% Contribution to Yield.

For income investors, looking at a portfolio from the perspective of income-weighted Contribution to Yield is as important as looking at its asset-weighted allocation.

Portfolios where there are a greater number of stocks with a higher Contribution to Yield are more dependent on those dividends than a portfolio where there are a greater number of stocks with a lower Contribution to Yield.
​
Contribution to Yield is therefore a way of looking at the vulnerability of a portfolio to the idiosyncratic risks of specific stocks cutting or suspending their dividend.
 
Fig.1. Contribution to Yield of the iShares FTSE 100 UCITS ETF

Source: Elston research, Bloomberg data. As at 30th June 2020

Screening & Weighting
Screening methodologies and weighting schemes can substantially alter the components and concentrations of an income portfolio.
​
For example, a fund using an index which ranks securities by their yield alone, such as the iShares UK Dividend UCITS ETF, will have a different composition to a fund that uses an index which ranks securities by their dividend consistency, such as the SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV).

Fig.2. Contribution to Yield of the iShares UK Dividend UCITS ETF

Source: Elston research, Bloomberg data. As at 30th June 2020
​
Fig.3. Contribution to Yield of the SPDR S&P UK Dividend Aristocrats UCITS ETF

Source: Elston research, Bloomberg data. As at 30th June 2020

What about Concentration?
We can look at what number of holdings contribute to a threshold level of income.  For example, of the funds above it takes 11, 14 and 9 underlying holdings for ISF, IUKD and UKDV respectively to generate an ad hoc threshold, e.g. 60% of overall income.

Another concentration metric would be to look at a Herfindahl-Hirschman Index (HHI) measure.  This measure of concentration (the sum of the squares of each weighting) is typically used to assess market competitiveness for an industry, but could also be used as a measure of concentration of Contribution to Yield.  For example, a portfolio with equally weighted Contributions to Yield of 5% would have a HHI score of 500 (less concentrated).  A portfolio with equally weighted Contributions to Yield of 10% would have a HHI score of 1,000 (more concentrated).
​
On this basis, the HHI score of Contributions to Yield for ISF, IUKD and UKDV are 484, 406 and 525 respectively, suggesting that UKDV is more concentrated, than ISF which is more concentrated than IUKD in relative terms.  Nonetheless, in absolute terms, each of them are relatively unconcentrated (a score of >1,000 would imply high concentration).

Fig.4. Dividend Contribution Concentrations (HHI Scores)

Source: Elston research, Bloomberg data. As at 30th June 2020
 
A quantitative and qualitative approach
Whilst Contribution to Yield and concentration measures can provide a quantitative approach, it is the qualitative dimensions of dividend risk that are the key drivers to understanding and mitigating Dividend Concentration Risk.

The qualitative dimensions include a company’s dividend history, its outlook based on its willingness (dividend policy) and ability (dividend cover) to pay and the underlying industry-specific exposures that are driving corporate earnings and dividend potential.

It therefore makes sense to combine a quantitative and qualitative approach to portfolio constructing when considering dividend concentration risk.
​
Mitigating dividend concentration risk
Ways of mitigating Dividend Concentration Risk include:

• Broadening number of directly held securities used to generate an income
• Using different funds within an asset class to provide greater security-level diversification, but noting aggregate underlying exposure
• Using securities/funds from different regions to provide geographic diversification, but considering currency too

Whether building a portfolio using direct securities, active funds or index funds/ETFs, when reviewing Dividend Concentration Risk, the key is to be able to look at the portfolio on an X-ray or look-through basis in order to understand the aggregate exposures to individual securities, to perform the quantitative evaluation of Contribution to Yield and Concentration measures.  This only becomes meaningful with a more qualitative assessment of the holdings that have the highest Contributions to Yield.

More on this topic
View the structured CPD webinar on this topic

[7min read, open as pdf]
After deciding on an asset allocation and which funds or ETFs to populate it, how best to put the plan into action?  All at once or in stages? If in stages, how many and for how long?  Looking out for portfolio “drift” and the options for rebalancing.  These implementation decisions can have far greater impact on the value of investments than picking the “right” fund or portfolio.

​In this series of articles, I look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work Elston does for discretionary managers and financial advisers.
 
Implementation is the process of putting an investment strategy plan into action.  Implementation is key to investment outcomes whether transitioning an existing portfolio from one strategy to another, or whether investing fresh capital.
 
Implementing a new portfolio
Having decided on an amount to invest, the next hardest decision is when and how to start investing.  Your entry level will be directly impacted by the immediate direction (sequence of returns) from the day you invest.  You could think the market is too high and wait but it could climb higher.  You could think you’ve bought the dip only to be catching a falling knife that marks the start of a steady and protracted decline.  Deciding the “right time” to move assets from cash into risk assets can be tricky but staying out of the market is much more costly in the long run. So how best to invest: with a lump sum, or gradually phased over time? 
 
Lump sum investing: in the very long run research suggests that investing with a lump sum delivers better returns in the long run (as capital is in the market for longer, despite near-term fluctuations).  However in the short-run it can be a scary and stressful experience, particularly for new investors, if they see immediate paper losses.  If the sight of those paper losses is likely to cause an investor to withdraw their capital from the market then real damage is done.  So whilst from an academic perspective lump sum investing makes sense, for practitioners considering investor experience and behavioural risks, a phased approach may be less stressful.
 
Phased investing: Phased investing is a less stressful approach.  By investing in regular intervals, short-term fluctuations smoothen out, and the investor achieves an entry price to risk assets that is the average over that implementation period.
 
The pace of phased investing consideration should be given to client needs, portfolio size and market conditions.  If markets are upward trending, implementation should be rapid.  If markets are uncertain or downward trending, implementation should be gradual.  Timing the markets is impossible, hence the best approach is to make a plan and stick to it.  This enables better acceptance of the outcome.
 
Implementing an existing portfolio where the asset allocation changes
Implementing an existing portfolio where there is a change in the asset allocation may also benefit from a phased approach to help smooth returns (ignoring any tax considerations).  A rolling benchmark can be used to calibrate performance evaluation.  An implementation window should be agreed and any evaluation metric adjusted accordingly.  Changes in tactical asset allocation should continue to be reflected immediately. By using a phased approach this can reduce portfolio sensitivity to short term market directional movements as it transitions to its new strategic posture.
 
Implementing an existing portfolio where there are only changes to underlying holdings
Implementing an existing portfolio where there is no change in asset allocation, but a material change in the underlying holdings (for example switching from active funds to ETFs) we recommend an immediate approach (assuming no tax considerations).  This is because with no change in asset allocation, there is no change in the risk profile of the portfolio.  Changes in tactical asset allocation should continue to be reflected immediately. 
 
Drift and rebalancing
A key implementation decision is around portfolio rebalancing.  Once a strategic allocation is set, investors need to decide what is an acceptable amount of drift, how frequently or infrequently to rebalance and on what basis to do so[1].
 
Allocation ranges
As the asset returns of each asset class in the allocation vary, the weight of each asset class will “drift” from its start weight.  Left unchecked, or if rebalancing is too infrequent, the risk profile (expected risk-return) of the allocation may vary significantly from target weights.  Investors should specify to what extent they will allow such “drift” by specifying the minimum and maximum asset allocation ranges for each asset class.  This can be expressed arithmetically (e.g. a 50% strategic allocation to equities can drift between +/-2.5ppts from the target weight), or geometrically (e.g. a 50% strategic allocation to equities can drift between 0.95x and 1.05x of the target weight).
 
Rebalancing policy
After deciding on allowable ranges of drift, investors must consider the frequency of rebalancing. 
 
The advantages of frequent rebalancing are:

• Alignment to objectives: the portfolio remains on track with its original objectives
• Investment discipline: by having a clearly articulated rebalancing process, investors are less swayed by short-run information overload which can lead to inertia[2].
• Contrarian approach: by rebalancing back to original weights, investors are forced to sell a portion of their outperforming asset classes and top up on their underperforming asset classes.  This will appeal to contrarian investors[3].

 
The disadvantages of frequent rebalancing are:

• Transaction costs: the cost (dealing costs, bid-ask spread, and any tax considerations) of selling outperforming and buying underperforming securities to realign to original weights is a drag on performance.
• Assumptions risk: the capital market assumptions and relationships (asset class risk, return and correlation) for the original allocation may have changed.
• Momentum approach: by rebalancing back to original weights, investors are forced to sell a portion of their outperforming assets.  This will not appeal to momentum investors.

 
In conclusion, for contrarian investors, regular rebalancing makes sense, but investors need to achieve a balance between frequency and trading and other frictional costs.  Hence the more long-term your portfolio, the less frequently you need to rebalance. The more short-term your portfolio the more frequently you need to rebalance.  A useful rule of thumb would be to consider quarterly rebalancing for medium-term portfolios (3-10 years), semi-annual rebalancing for long-term portfolios (10-20 years) and annual rebalancing for longer term portfolios (>20 years).  It follows that the less frequent the rebalancing, the greater the range of allowable drift should be.
 
Bringing this together, the investment time horizon, rebalancing frequency, and allowable drift ranges will differ from mandate to mandate.
 
Rebalancing triggers
When selecting a rebalancing trigger, investors can select one of the following:

• Time-based: asset allocation is rebalanced on a particular calendar day, for example, the last day of each quarter, or the last day of each year, regardless of the degree of drift.
• Weight-based: asset allocation is rebalanced at any time when drift weights exceed the allowable range.
• Time- and weight-based: asset allocation is rebalanced on a particular calendar day only if drift weights exceed the allowable range

 
After deciding on frequency of review, drift ranges, and type of trigger investors need to decide on what weighting scheme to implement.
 
Types of rebalancing
When selecting a weighting scheme, investors can select one of the following:

• Rebalancing to the original strategic allocation: this is the simplest approach.  However over the long run (e.g. 11-20 years) the assumptions that underpinned that original allocation may be out of date in which case the allocation may no longer be appropriate to the objectives
• Rebalancing to a new strategic allocation: all assumptions (e.g. asset class risk, return, and correlation together with optimisation process) regarding the original strategic allocation are reviewed and a new strategic allocation is created.  This can be a laborious process, and given strategic allocations are meant to be long-term, this approach makes sense no more frequently than every 5 years.
• Rebalancing to tactical allocation weights: rather than rebalancing to strategic weights, the rebalancing process could be used to express a tactival view each time.  This approach makes sense where there is a clear framework for implementing tactical asset allocation decisions and reviewing them frequently. 

 
Rebalancing and cash flow
Finally there investors can use cashflows where available to mitigate trading costs.  Where there is no new capital introduced, the rebalancing process will necessarily consists of sales and purchases of each asset class to realign to target weights.  Where there is sufficient capital being introduced, that opportunity can be used to make purchases only, to realign the portfolio to target weights.  This reduces trading costs.
 
Rebalancing enforces investment discipline, but there is a balance to be struck between accuracy of target weights and trading costs.  The degree to which a portfolio is traded (with associated transaction costs) is called portfolio turnover, and this is one of the technical considerations for portfolio implementation.
Technical considerations
Portfolio turnover
Decisions around rebalancing will directly impact portfolio turnover.  Turnover is the measure of the extent to which a portfolio is changed.  Annual turnover is calculated by taking the lesser of the value of securities purchased or sold during one year and dividing that by the average monthly value of the portfolio for that period.  Lower portfolio turnover (e.g. 0-20%) is closer to a “buy-and-hold” strategy which has lower transaction costs.  Higher portfolio turnover (e.g. 80% or more) is closer to a frequent trading strategy, which has higher transaction costs.  The type of strategy and related turnover should be consistent with the investment objectives.
 
Taking the inverse of the annual turnover figure gives the average holding period.  For example, for a portfolio with annual turnover of 20%, the average holding period for a security is 5 years,  For 200% it is 0.5 years.
 
Whilst evidence suggests that lower turnover strategies tend to outperform higher turnover strategies[4], the main value of the turnover ratio is to ensure that the portfolio is being managed in alignment with the agreed mandate.
 
Regular investing with Pound Cost Averaging
For DIY investors who don’t have large lump sums to invest  one of the most effective ways to resolve implementation risk is to adopt a permanent phased investment approach known as a regular investment plan. The benefit of this approach is known as pound cost averaging.  Pound-cost averaging is a popular investment strategy where the same dollar amount is invested sequentially over a number of time-periods.
 
Pound cost averaging[5] smooths the entry point for investments over each year.  It means investors are topping up when markets are down and are buying less when markets are up.  In this respect the approach is contrarian.  The primary benefit of pound cost averaging is not necessarily that it improves returns, but it reduces the stress and anxiety associated with worrying about market levels.  By breaking one large investment decision into a sequence of investments, the investor essentially diversifies their risk to obtain an entry price of an investment closer to the average price of an investment for the given time frame that was used to purchase it.
 
While the majority of academic research notes the inferior performance of pound-cost averaging relative to lump sum investing over the long run[6], there is evidence that pound-cost averaging can lead to higher returns in the case of lower volatility funds or when there is a substantial chance of an investment losing value[7].
 
There is also the practical considerations ignored by academics that many DIY investors find it easier to allocate a certain portion of monthly income to their investments rather than a lump sum.  For example, for most DIY investors it’s easier from a cashflow perspective to invest £500 per month into an ISA than to make a lump-sum investment of £6,000.
 
Finally, evidence suggest that DIY investors tend to be their own worst enemy when attempting to time the market. Analysis of equity allocations for the period 1992-2002 for over a million accounts reveals that individuals frequently end up buying high and selling low[8] and there is also evidence that an average investor performs worse than the corresponding benchmark[9].
 
A disciplined investment approach of pound-cost averaging mitigates investors’ temptation to time the market[10] and therefore protects against the cognitive errors that lead to suboptimal investment outcomes[11]. Furthermore, it nudges right decisions in a bear market, “buy low”, precisely when investors’ confidence in the stock market is weakened[12]. Studies in the UK market suggest that retail net fund flows are broadly influenced by the direction of the market with inflows chasing up-markets, and out-flows chasing down-markets.  This contrary to the principles of value investing.
 
Pound cost averaging is therefore an antidote to many of the behavioural pitfalls that can catch investors out.
 
 
Summary
These are the main implementation considerations when setting up a new or transitioning an existing portfolio.

• Decide on takin either a lump sum or phased investment approach
• Remember how portfolios can drift from their target allocation
• Examine the different approaches for implementing a rebalancing policy to strategic or tactical weights. 
• Budget for portfolio turnover
• Consider pound cost averaging of regular contributions as this helps design out some of the more common behavioural pitfalls associated with investing as well as creating an regular investing habit.

 


[1] Dayanandan and Lam, “Portfolio Rebalancing–Hype or Hope?”

[2] O’Neill, “Overcoming Inertia”; Benartzi and Thaler, “Heuristics and Biases in Retirement Savings Behavior.”

[3] Sharpe, “Adaptive Asset Allocation Policies.”

[4] Cremers and Pareek, “Patient Capital Outperformance.”

[5] Agarwal, “Exploring the Benefits of Pound Cost Averaging”; Morningstar Equity Analysts, “The Benefits of Pound Cost Averaging.”

[6] for example see http://www.morningstar.co.uk/uk/news/96177/is-pound-cost-averaging-overrated.aspx/

[7] Leggio and Lien, “An Empirical Examination of the Effectiveness of Dollar-Cost Averaging Using Downside Risk Performance Measures.”

[8] Benartzi and Thaler, “Heuristics and Biases in Retirement Savings Behavior.”

[9] Dalbar, Inc. & Lipper, “Quantitative Analysis of Investor Behavior.”

[10] Kahneman and Tversky, “Prospect Theory.”

[11] Statman, “A Behavioral Framework for Dollar-Cost Averaging”; Benartzi and Thaler, “Heuristics and Biases in Retirement Savings Behavior.”

[12] Cohen, Zinbarg, and Zeikel, Investment Analysis and Portfolio Management, Homewood, Illinois.

[3 min read, open as pdf]

• As “relative risk” strategies multi-asset passive funds experienced similar drawdowns in the COVID crisis
• Their recoveries, however, are differentiated
• Strategic design parameters – such as global or UK equity bias – as well as any tactical asset allocation decisions have been key

 
What do we mean by “Relative Risk” strategies
We refer to asset-weighted multi-asset strategies with clearly defined equity allocations “relative risk” strategies.  Why?  Because as their asset weightings are relatively stable, their risk will fluctuate relative to equity risk, which is itself dynamic.  The alternative to this approach is “target risk” strategies, where the asset weightings fluctuate to target a stable portfolio risk.  The vast majority of risk profiled multi-asset portfolio and multi-asset funds are relative risk strategies, where risk can be defined as % equity exposure.

Nowhere to hide
The sudden severity of the COVID-related market downturn mean that the impact on “relative risk” strategies was similar.  Broadly speaking, they took ~60% of the drawdown in global equities.  A traditional asset-weighted approach can reduce beta to global equity, but not necessarily reduce correlation.  In this respect, there was nowhere to hide for traditional relative risk multi-asset funds whose asset allocation is relatively stable.

Fig.1. YTD Performance of “balanced” multi-asset passive funds

Source: Elston research, Bloomberg data. Total returns from end December 2019 to 28th October 2020

What is visible, however, is the differing shape of recoveries.  And this was predominantly a function of:

• Strategic design parameters (e.g. UK or Global Equity bias)
• Any tactical asset allocation decisions made

As outlined previously, home equity bias is irrational and has penalised UK investors, and this is now a key distinguishing feature between multi-asset funds.

We look at summary YTD performance of selected multi-asset passive funds, relative to our Elston 60/40 GBP Index, Global Equities and UK Equities.

At +2.42%, HSBC Global Strategy Balanced has delivered strongest return YTD, outperforming the Elston 60/40 GBP Index by 1.40ppt.
​
At -2.46%, BlackRock Consensus 60 has delivered weakest return YTD, underperforming the Elston 60/40 GBP Index by -3.48ppt.

Fig.2. 2020 YTD Performance

Source: Elston research, Bloomberg data. Year to date as at 28/10/20.  Total Returns in GBP terms.  Global Equities represented by SSAC. UK Equities represented by ISF.
​
Risk-adjusted returns
For risk-adjusted returns, we compare YTD performance to the 260 day rolling volatility.  On this basis, HSBC Global Strategy Balanced has delivered best risk-adjusted returns.
On a risk-adjusted basis, HSBC Global Strategy Balanced delivered positive YTD returns and +1.40ppt outperformance relative to the Elston 60/40 GBP Index with approximately 84% of the volatility of the Elston 60/40 GBP Index.
By contrast Vanguard LifeStrategy 60% Equity delivered positive YTD returns nd +0.58%ppt outperformance relative to the Elston 60/40 GBP Index with 102% of the volatility of the Elston 60/40 GBP Index.
​
Fig.3. Risk-adjusted returns

Source: Elston research, Bloomberg data, as at 28/10/20 Total Returns in GBP terms

Summary
Based on this analysis

1. Relative risk strategies can be defined by their equity allocation
2. Whilst the COVID shock impacted relative risk strategies similarly, their recovery paths are differentiated
3. UK vs Global bias with respect to, primarily equities is a key differentiator

[2 min read, open as pdf]

• Target Absolute Return funds were billed as “all-weather” funds
• How have they fared in 2020 relative to our Risk Parity Index?
• We look at Total Return, Max Drawdown and change in correlations in this analysis

 
Targeted Absolute Return funds
Targeted Absolute Return funds (“TAR”) were billed as “all weather” portfolios to provide positive returns in good years, and downside protection when the going gets rough.  How have they fared in the COVID rollercoaster of 2020?
Using our Risk Parity Index as a more relevant comparator
We benchmark TAR funds to our Elston Dynamic Risk Parity Index: this is a risk-based diversification index whose construction (each asset class contributes equally to the risk of the overall strategy) and purpose (return capture, downside protection, moderate decorrelation) is closer in approach to TAR funds than, say, a Global Equity index or 60/40 equity/bond index.
Absolute Return
In terms of Absolute Return, ASI Global Absolute Return Strategies has performed best YTD +4.70%, followed by BNY Mellon Real Return +2.43%, both outperforming the Elston Dynamic Risk Parity Index return of +2.37%.
Fig.1. YTD Performance Targeted Absolute Return funds

Source: Elston research, Bloomberg data. Total returns from end December 2018 to end September 2020 for selected real asset funds.

Downside risk
If downside protection is the desired characteristic, then it makes sense to look at drawdowns both by Worst Month and Maximum (peak-to-trough) Drawdown, rather than volatility.
In this respect, Invesco Global Targeted Return provided greatest downside protection with a March drop of -1.11% and Max Drawdown of -1.99%; followed by ASI Global Absolute Return Strategies with a March drop of -2.74% and Max Drawdown of -3.81%.  This compares to -5.14% and -10.23% respectively for the Risk Parity Index.
Fig.2. YTD Total Return, Worst month, Max Drawdown

Source: Elston research, Bloomberg data. Year to date as at 27/10/20.  Maximum drawdown: peak-to-trough drawdown in 2020.  Total Return in GBP terms.
 
Risk-adjusted returns: Total Return vs Max Drawdown
Bringing it together, we can adapt the classic “risk-return” chart, but replacing volatility with Max Drawdown.  On this basis, ASI Global Absolute Return Strategies has provided the best Total Return relative to Max Drawdown, followed by the Elston Dynamic Risk Parity Index.  Whilst Invesco Global Targeted Return provided least drawdown, it also provided worst returns.
Fig.3. Risk (Max Drawdown) vs Total Return (YTD, 2020)

Source: Elston research, Bloomberg data, as at 27/10/20 in GBP terms

Rolling Correlations
We look at the change in Correlation (sometimes referred to as “ceta”) as a dynamic measure of diversification effect. By plotting the rolling 1 year daily correlation of each TAR Fund and our Risk Parity Index relative to a traditional 60/40 portfolio (we use the Elston 60/40 GBP Index as a proxy), we can see whether correlation increased or decreased during market stress. 
Elston Risk Parity Index correlation to the 60/40 GBP Index was relatively stable.  Janus Henderson MA Absolute Return fund and BNY Mellon Real Return fund showed an increase in correlation into the crisis; ASI Global Absolute Return Strategies showed greatest correlation reduction into the crisis, delivering the diversification effect.
Fig.4. Rolling -1year daily correlation to Elston 60/40 GBP Index

Source: Elston research, Bloomberg data, as at 27/10/20 in GBP terms

Summary
Based on this analysis:

1. Comparing TAR funds to a Global Equity or even 60/40 benchmark is interesting, but less directly relevant.  A Risk Parity Index could be a more appropriate additional comparator.
2. Despite longer-term performance issues, 2020 has been a good year for ASI Global Absolute Return Strategies delivering solid Total Returns, with low Max Drawdown and a visible decrease in correlation (increase in diversifier effect)
3. Other absolute return funds have failed to beat the Risk Parity benchmark from a risk (Max Drawdown)/ total return perspective.

High risk, complex Exchange Traded Products that amplify (with “leverage”) index’ moves in the same (“long”) or opposite (“short”) direction are designed for sophisticated investors who want to trade and speculate over the short-term, rather than make a strategic or tactical investment decisions.  Whilst they can have a short-term role to play, they should be handled with care.  If you think you understand them, then you’ve only just begun.

In this series of articles, I look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work Elston does for discretionary managers and financial advisers.

For more speculators and or more sophisticated risk managers there are a range of inverse (short) and leveraged (geared) ETPs that can rapidly add or remove upside or downside risk exposure in short-term (daily) market movements.
 
The difference between speculating and investing should be clearly defined.

• Investing implies a disciplined, rational approach to seeking a commensurate level of expected return for a given level of risk using the investor’s own capital.
• Speculating implies an unstructured, emotional approach to seeking outsize levels of possible return at any level of risk using the speculator’s own or borrowed capital.

 
Owing to the higher degree of risk management and understanding required to use these products,  they may not be suitable for DIY or long-term investors.  However a degree of knowledge is helpful to identify them within a managed portfolio or amongst research sites.
 
Defining terms
Unlike their more straightforward unleveraged ETF cousins, leveraged and inverse or “short” ETNs should be for sophisticated investor or professional use only. So hold onto your seat.  Shorting and leverage are important tools in a professional manager’s arsenal.  But first we need to define terms.
 
Going long: means buying a security now, to sell it at a later date at a higher value. The buyer has profited from the difference in the initial buying price and final selling price.
 
Going short: means borrowing a security from a lender and selling it now, with an intent to buy it back at a later date at a lower value. Once bought, the security can be returned to the lender and the borrower (short-seller) has profited from the difference in initial selling and final buying price.
 
Leverage: means increasing the magnitude of directional returns using borrowed funds.  Leverage can be achieved by:

• Borrowing (on a secured or unsecured basis) from lender to invest in risk assets, in the expectation that the returns are greater than the interest rate charged for borrowing those funds. Use of borrowing within ETNs to create Leveraged ETNs introduces interest costs into the overall cost of the ETN.

 

• Options: leverage can be achieved synthetically by buying call options (the right to buy a stock (including ETFs on whole markets) at a certain strike price in the future.  As markets move further away from the strike price, the value of that option increases exponentially. A leveraged short position can be achieved by selling call options.

 

• Contracts for Difference (CFD): leverage can be achieved synthetically by entering into a contract for difference (where one party contracts to pay the other party the difference between a current value and the value at the start of the contract).  The buyer can use current cash and trade on margin that is based on the size of the trade. Effectively, it means buyers of CFDs only need a small amount of capital to access a much larger position.

 
Underlying index: is the underlying index exposure against which a multiplier is applied.  The underlying index could be on a particular market, commodity or currency.
Potential applications
Managers typically have a decision only whether to buy, sell or hold a security.  By introducing products that provide short and/or leveraged exposure gives managers more tools at their disposal to manage risk or to speculate.  Going short, and using leverage can be done for short-term risk management purposes, or for speculative purposes.  Leverage in either direction (long-short) can be used either to amplify returns, profit from very short market declines, or change the risk profile of a portfolio without disposing of the underlying holdings.
 
 
Short/Leveraged ETPs available to DIY investors
The following types of short/leveraged ETPs are available to implement these strategies.
 
Fig.1. Potential application of inverse/leveraged ETPs

The ability to take short and/or leveraged positions was previously confined to professional managers and ultra-high net worth clients.  The availability of more complex Exchange Traded Products gives investors and their advisers the opportunity to manage currency risk, create short positions (profit from a decline in prices) and create leveraged positions (profit more than the increase or decrease in prices).
Risks
Leveraged and short ETPs have significantly greater risks than conventional ETFs.  Some of the key risks are outlined below:

• Complexity: short and leveraged products are complex products making them harder to understand and deploy.

 

• Counterparty risk: furthermore short/leveraged ETPs carry bank counterparty risk as they are swap based agreements unlike traditional ETFs which are physical and own the underlying asset.

 

• Decay: leveraged products exhibit decay (their ability to perfectly track an index with leverage) diminishes over time from the combined effects of fees and expenses, rebalancing costs and volatility decay[1].

 
If concerned regarding risk of deploying short/leveraged ETPs, set a capped allocation i (eg no more than 3% to be held in leveraged/inverse ETPs, and a holding period for leveraged/inverse ETPs not to exceed 1-5 days). 
 
US Case Study: Inverse Volatility Blow Up
VelocityShares Daily Inverse VIX Short-Term ETN (IVX) and ProShares Short VIX Short-Term Futures ETF were products created in the US for professional investors who wanted to profit from declining volatility on the US equity market by tracking the inverse (-1x) returns of the S&P VIX Short-Term Futures Index.  The VIX is itself an reflecting the implied volatility of options on the S&P 500.  As US equity market volatility steadily declined the stellar performance of the strategy in prior years not only made it popular with hedge funds[2], but also lured retail investors who are unlikely to have understood the complexity of the product.  By complexity, we would argue that a note inversely tracking a future on the implied volatility of the stock market is hardly simple.
 
On 5th February, the Dow Jones Industrial Average suffered its largest ever one day decline.  This resulted in the VIX Index spiking +116% (from implied ~12% volatility to implied ~33% volatility).  The inverse VIX ETNs lost approximately 80% of their value in one day which resulted in an accelerated closure of the product, and crystallising the one day loss for investors[3].  The SEC (US regulator) focus was not on the product itself but whether and why it had been mis-sold to retail investors who would not understand its complexity[4].

Summary
In conclusion, on the one hand, Leveraged/Inverse ETP are convenient ways of rapidly altering risk-return exposures and provide tools with which speculators can play short-term trends in the market.  Used by professionals, they also have a role in supporting active risk management.  However, the risks are higher than for conventional ETFs and more complex to understand and quantify.

​RISK WARNING! Short and/or Leveraged ETPs are highly complex financial instruments that carry significant risks and can amplify overall portfolio risk.  They are intended for financially sophisticated investors who understand these products, and their potential pay offs.  They can be used to take a very short term view on an underlying index, for example, for day-trading purposes. They are not intended as a buy and hold investment.

[1] https://seekingalpha.com/article/1457061-how-to-beat-leveraged-etf-decay

[2] https://www.cnbc.com/2018/02/06/the-obscure-volatility-security-thats-become-the-focus-of-this-sell-off-is-halted-after-an-80-percent-plunge.html

[3] https://www.bloomberg.com/news/articles/2018-02-06/credit-suisse-is-said-to-consider-redemption-of-volatility-note

[4] https://www.bloomberg.com/news/articles/2018-02-23/vix-fund-blowups-spur-u-s-to-probe-if-misconduct-played-a-role