 Traditional indices weight companies based on their size. The resulting concentration risk and “the big get bigger” theory is a criticism levelled by many active managers who are critical of index investing.
Leaving aside the flaw in that argument (company's valuations determine their size in an index, not the other way round), it is important to remember that using traditional indices is a choice, not an obligation. One alternative weighting scheme is to weight each share within an index equally, regardless of the size of the company. Sounds simple? In a way, it is. But what’s interesting is understanding what an equal weight approach means from a diversification perspective, risk perspective and underlying factor-bias. The curious power of equal weight is why some equal weight strategies have seen significant inflows over the last 6-12 months. Register for our CPD event exploring this topic in more detail on Wed 23 June at 10.30am
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 [3 min read, open as pdf] Inflation is on the rise: equities provide long-term inflation protection Inflation risk means greater focus on intrinsic value such as dividends UK equities with value and/or income bias are attractive Inflation is on the rise, and whilst it’s broadly accepted that equities can provide a long-term inflation hedge, which kind of equities are best positioned to provide this. Since the financial crisis, Value investors have been jilted by a market love affair with Momentum. The switch back to Value was already being called on purely a valuation basis since late 2019. But the rekindling of inflation risk in the market is only making companies with a Value-bias and a progressive quality income stream back in the spotlight. What is quality income? Quality means persistency, focusing on companies that regularly pay a stable or increasing dividend, whilst mitigating dividend concentration risk. “One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back many years.” Benjamin Graham Indeed, research suggests that Dividends are a key anchor of Total Returns, although this differs from market to market.  Figure 1: Source: S&P Dow Jones Index Research August 2016
Figure 2: Source: JP Morgan, The Search for Income: A Global Dividend Strategy, 2012 How then to screen for companies that can deliver this type of strategy? Is it just about yield? We don’t think so. High yield is not high quality Screening for high dividend yield alone can lead to “value-traps” that negatively impact performance. The poor performance is because those high-yielding companies might be poor businesses with unstable dividends. Market cap weight or Dividend contribution weight Traditional equity indices are market-capitalisation weighted. The resulting dividend income for an index is therefore a function of each company’s size. An alternative approach is to weight the holding in each company by its contribution to overall dividends. This way the index is focused on the biggest dividend payers, rather than the biggest companies by size. This creates a direct bias towards Yield, and an indirect bias towards Value, from a factor-exposure perspective. Forward- or backward-looking Active equity income managers typically look at forward-looking dividend estimates. Index-based “passive” equity income strategies often look at historic dividend yield for ranking purposes. This is sub-optimal. We believe that index strategies that focus on equity income should use forward-looking estimates, to systematically capture upswings in earnings and dividend estimates. Equities as an inflation hedge It’s broadly accepted that equities can provide a long-term inflation hedge. But what kind of equities are likely to perform well in an inflationary regime? We believe there are three characteristics:
Why the Value focus in inflationary environment? When the two major styles of investing are compared, i.e., growth and value investing, the latter style rejects the efficient market hypothesis and choses an equity with lower expectations, which is often undervalued and would profit quickly when the market adjusts itself. During an inflationary environment, economic concepts direct that the ‘time value of money’ has a major role to play. Thus, an equity today, becomes of greater value, when compared to its worth tomorrow. Hence, value investing seems attractive in an inflationary world since the investors are less willing to pay up for future earnings and can regain their money sooner rather than later, when compared to growth investing. (Murphy, 2021) With a global pandemic, many predicted deflation as a threat; however, with the counter-balancing forces, investors soon realized inflationary threat. (Baron, 2021). Rising inflation is good for value investing for a number of reasons. In general, equity markets are dynamic and display a stronger corelation to inflationary environment, this lays a very strong premise that higher inflation and stronger earnings are co-dependent. Financially speaking, Sectors such as energy, financial are major drivers of the major economic growth. A rise in these value stocks tends to pace up the overall economic growth, thus outperforming others. (Lebovitz,2021) According to JP Morgan’s chief strategist, the change in investing style, this time around could be a more impactful due to several factors such as the failure of monetary and fiscal policies whilst recovering from a pandemic. (Ossinger, 2021) Dividends, dividends, dividends: a tried and tested approach The most fundamental explanation, by John Kingham, a value investor, states that a dividend discount model, attempts to find the true value of the stock, under any market circumstances and focuses on the dividend pay-out factors and the market expected returns. Historically, the companies with dividend have generated higher returns when compared to companies which either have no dividend or eliminated the dividend. (Park and Chalupnik, 2021) This means that dividends hold value when it comes to the total return of the portfolio. Moreover, with the market getting more and more inflationary, and equities getting exposed. Adding companies which can provide returns even in a low growth environment can create a sustainable portfolio. Government bonds have not performed well with rising inflation (Baron,2021) High yielding corporate bonds offered better protection compared to government gilts since these inflations linked bonds add value in-line with RPI Inflation according to Barclays Equity Guilt Study and can protect investors from unexpected inflation, yet they are still not considered as a safe haven like government gilts. (Dillow,2021) Investment manager of Iboss Chris Rush recently told Portfolio Adviser that in order to reduce the inflationary shock the firm had already reduced its positions from treasures and gilts and incorporated strategic bonds They also plan on holding a short duration fixed income. (Cheek, 2021) Although, it might have not been the fundamental goal, over the past several decades until 2017 dividends reported 42% of the S&P 500 Index’s total return. The global recession and now pandemic have created a lack of stability for the layer of support for future returns, however, analysts have assured there is room for recovery. (Markowicz, 2021) Summary Whether transitory or persistent, with inflation on the rise, there is a strong rationale for having an allocation to Value from a factor-exposure perspective. Those value-type firms that generate and pay a progressive dividend policy provides a level of inflation protection both in absolute terms and relative to bonds that is more than welcome, and potentially essential. Henry Cobbe & Aayushi Srivastava  [ 5 min read, open as pdf]
Since an article published in 2019 pointed the historic lows in bond yields, many investment firms are starting to rethink the 60/40 portfolio. This came under even more scrutiny following the market turmoil of 2020. While some affirm that the 60/40 will outlive us all, others argue against this notion. We take a look at the main arguments for and against and key insights What is a 60/40 portfolio? A 60/40 equity/bond portfolio is a heuristic “rule of thumb” approach considered to be a proxy for the optimal allocation between equities and bonds. Conventionally equities were for growth and bonds were for ballast. The composition of a 60/40 portfolio might vary depending on the base currency and opportunity set of the investor/manager. Defining terms is therefore key. We summarise a range of potential definitions of terms:  Furthermore, whilst 60/40 seems simple in terms of asset weighting scheme, it is important to understand the inherent risk characteristics that this simple allocation creates. For example, a UK Global 60/40 portfolio has 62% beta to Global Equities; equities contribute approximately 84% of total risk, and a 60/40 portfolio is approximately 98% correlated to Global Equities[1]. [1] Elston research, Bloomberg data. Risk Contribution based on Elston 60/40 GBP Index weighted average contribution to summed 1 Year Value At Risk 95% Confidence as at Dec-20. Beta Correlation to Global Equities based on 5 year correlation of Elston 60/40 GBP Index to global equity index as at Dec-20.  Why some think 60/40 will outlive us all. The relevance of 60/40 portfolio lies in its established historic, mathematical and academic backup. Whilst past performances do not guarantee future returns, it nonetheless provides us with experience and guidance. (Martin,2019) Research also suggests that straightforward heuristic or “rule-of-thumb” strategies work well because they aren’t likely to inspire greed or fear in investors. They become timeless. Thus, creating a ‘Mind-Gap’. (Martin,2019) In the US, the Vanguard Balanced Index Fund (Ticker: VBINX US) which combines US Total Market Index and 40% into US Aggregate bonds, plays a major role in showcasing the success of the 60/40 portfolio that has proved popular with US retail investors (Jaffe,2019). Similarly, in the UK the popularity of Vanguard LifeStrategy 60% (Ticker VGLS60A) showcases the merits of a straightforward 60/40 equity/bond approach. In 2020, for US investors VBINX provided greater (peak-to-trough) downside protection owing to lower beta (-19.5% vs -30.3% for US equity) and delivered total return of +16.26% volatility of 20.79%, compared to +18.37% for an ETF tracking the S&P 500 with volatility of 33.91%, both funds are net of fees. In this respect, the strategy captured 89% of market returns, with 61% of market risk.  For GBP-based investors in 2020 the 60/40 approach had lower (peak-to-trough) drawdown levels (-15%, vs -21% for global equities) owing to lower beta. The 60% equity fund delivered total return of +7.84% with volatility of 15.12%, compared to +12.15% for an ETF tracking the FTSE All World Index with volatility of 24.29%. In this respect, the strategy captured 65% of market returns, with 62% of market risk.  Why some think 60/40 has neared its end
Since its inception the 60/40 portfolio, derived 90% of the risk from stocks. In simple terms, 60% of the asset allocation of the portfolio was therefore the main driver of the portfolio. Returns (Robertson,2021). This hardly a surprise given that equities have a 84% contribution to portfolio ris, on our analysis, but the challenge made by some researchers is that if a 60/40 portfolio mainly reflects equity risk, what role does the 40% bond allocation provide, other than beta reduction? The bond allocation is under increasing scrutiny now is because global economic growth has slowed and traditionally safer asset classes like bonds have grown in popularity making bonds susceptible to sharp and sudden selloffs. (Matthews,2019) Strategists such as for Woodard and Harris, for Bank of America and Bob Rice for Tangent Capital have stated in their analysis that the core premise of the 60/40 portfolio has declined as equity has provided income, and bonds total return, rather than the other way round.. (Browne,2020) Another study shows that over the past 65 years bonds can no longer effectively hedge against inflation and risk reduction through diversification can be done more adequately by exploring alternatives such as private equity, venture capital etc. (Toschi, 2021). Left unconstrained, however, this can necessarily up-risk portfolios. With bond yields at an all-time low, nearing zero and the fact that they can no longer provide the protection in the up-and-coming markets many investors query the value provided by a bond allocation within a portfolio. (Robertson,2021) Key insights While point of views might differ about 60/40 as an investment strategy, one aspect that is accepted is that the future of asset allocation looks very different when compared to the recent past. Rising correlations, low yields have led strategists and investors to incorporate smarter ways of risk management, explore new bond markets like China, create modified opportunities for bonds to hedge volatility through risk parity strategies, as well as using real asset exposure such as real estate and infrastructure. (Toschi, 2021) Research conducted by The MAN Institute summarises that modifying from traditional to a more trend-following approach introduces the initial layer of active risk management. By adding an element of market timing investors further reduce the risk, when a market’s price declines. While bonds have declined in yield, they still hold importance in asset allocation for beta reduction. Further diversifying the portfolio with an allocation to real assets has potential to provide more yield and increased return than government bonds. Summary The 60/40 portfolio strategy has established itself over many decades, it has seen investors through four major wars, 14 recessions, 11 bear markets, and 113 rolling interest rate spikes. It has proved resilience as a strategy and utility as a benchmark. Our conclusion is that 60/40 is not dead: it is a useful multi-asset benchmark and remains a starting point for strategic asset allocation strategies. But the detail of the bond allocation needs a rethink. Incorporating alternative assets or strategies so long as any increased risk can be constrained to ensure comparable portfolio risk characteristics. Henry Cobbe & Aayushi Srivastava Elston Consulting Bibliography Browne, E., 2021. The 60/40 Portfolio Is Alive and Well. [online] Pacific Investment Management Company LLC. Available at: https://www.pimco.co.uk/en-gb/insights/blog/the-60-40-portfolio-is-alive-and-well Jaffe, C., 2019. No sale: Don’t buy in to ‘the end’ of 60/40 investing. [online] Seattle Times. Available at: https://www.seattletimes.com/business/no-sale-dont-buy-in-to-the-end-of-60-40-investing/ Martin, A., 2019. The 60/40 Portfolio Will Outlive Us All. [online] Advisorperspectives.com. Available at:https://www.advisorperspectives.com/articles/2019/11/11/the-60-40-portfolio-will-outlive-us-all#:~:text=As%20two%20recent%20commentaries%20demonstrate,40%20will%20outlive%20us%20all. Matthews, C., 2021. Bank of America declares ‘the end of the 60-40’ standard portfolio. [online] MarketWatch. Available at:https://www.marketwatch.com/story/bank-of-america-declares-the-end-of-the-60-40-standard-portfolio-2019-10-15 Robertson, G., 2021. 60/40 in 2020 Vision | Man Institute. [online] www.man.com/maninstitute. Available at:https://www.man.com/maninstitute/60-40-in-2020-vision Toschi, M., 2021. Why and how to re-think the 60:40 portfolio | J.P. Morgan Asset Management. [online] Am.jpmorgan.com. Available at: https://am.jpmorgan.com/be/en/asset-management/adv/insights/market-insights/on-the-minds-of-investors/rethinking-the-60-40-portfolio/  [3 min read, open as pdf] Inflation is on the rise Easy central bank money, pent up demand after lockdowns and supply-chain constraints mean inflation is on the rise. Will Central Banks be able to keep the lid on inflation? The risk is that it could persistently overshoot target levels.  It matters more over time Inflation erodes the real value of money: its “purchasing power”. If inflation was on target (2%), £100,000 in 10 year’s time would be worth only £82,035 in today’s money. But on current expectations, it could be worth a lot less than that.  Real assets can help
A bank note is only as valuable as the value printed on it. This is called its “nominal value”. Remember the days when a £5 note went a long way? When inflation rises, money loses its real value. By contrast, real assets are things that have a real intrinsic value over time whose value is set by supply, demand and needs: like copper, timber, gold, oil, and wheat. Real assets can also mean things that produce an regular income which goes up with inflation, like infrastructure companies (pipelines, toll roads, national grid etc) and commercial property with inflation-linked rents. Rethinking portfolio construction Including “real assets” into the mix can help diversify a portfolio, and protect it from inflation. Obviously there are no guarantees it will do so perfectly, but it can be done as a measured approach to help mitigate the effects of inflation. The challenge is how to do this without taking on too much risk. Find out more about our Liquid Real Assets Index  [3 min read, open as pdf]
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.
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]
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]
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:
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. 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]
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]
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.
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]
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:
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:
 [3 min read, pdf version]
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:
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:
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.
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:
*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]
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]
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:
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
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 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.
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.
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 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.  Summary
With respect to 2021 outlook
 [2 min read, open as pdf]
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:
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.
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:
 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.  Whilst ostensibly very simple – a two security portfolio – the underlying holdings of each ETF means that investors get exposure to 3,133 equities in global and developed markets (approximately 47 countries) and 1,660 investment grade bonds in over 24 countries. Put simply, the investor is able to buy the bulk of the global equity and bond markets with two simple trades. When manager, advisers or research firms create model portfolios, the weighting scheme can be one of three types as summarised in the table below.  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. [1] Ibbotson, “The Importance of Asset Allocation.” [2] Samuelson and Zeckhauser, “Status Quo Bias in Decision Making.” [3] Shefrin and Statman, “The Disposition to Sell Winners Too Early and Ride Losers Too Long”; Weber and Camerer, “The Disposition Effect in Securities Trading.” [4] Iyengar and Jiang, “How More Choices Are Demotivating”; Iyengar, Huberman, and Jiang, “How Much Choice Is Too Much?”  [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 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.
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]
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:
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