When evaluating multi-asset funds and portfolio strategies we were often frustrated by a lack of straightforward “vanilla” multi-asset benchmarks for GBP investors. Instead there is a heavy reliance on peer groups.
Multi-asset funds are often compared to mixed asset fund sector performance, which reflects the average performance of funds within a category, which gives one dimension of comparison. Likewise, multi-asset portfolios are often compared to the median of a peer group of managed portfolios.
But peer groups are not always ideal comparators. By default, you cannot ever replicate peer group performance.
The accidental influence of multi-asset benchmarks
Whilst there are multi-asset benchmarks for retail investors, the methodology that underpins the decisions around asset allocation changes within those benchmarks is committee-led and subjective, rather than rules-based. Given the importance of asset allocation, why should a discretionary manager or multi-asset fund use a third party for asset allocation comparison that may have no bearing on that manager’s strategic view. Put differently, should the asset allocation of a benchmark indirectly influence the wealth management industry?
We think not. But at the same time, there is a clear and persistent need for an objective comparator, such as a composite.
Composites: helpful but inconsistent
In the institutional space, the objective comparator is often a highly customised composites. That’s understandable, as a composite will be designed to be a “strategic neutral” asset allocation for a particular investment style.
But more generally for investment research and comparison, 60/40 equity/bond composites are used for performance comparisons. But as with any composite, the selected assumptions and parameters around even a simple 60/40 index can differ widely. This means there is very low consistency or comparability between these composites used by different managers.
A straightforward 60/40 benchmark
Weirdly, despite its popularity in research and performance analysis, there has been no central, consistent and accessible point of reference as regards the performance of a 60/40 equity/bond strategy for GBP investors. Until now.
We set ourselves the challenge of how do we create a straightforward benchmark that represents a 60/40 equity/bond portfolio for GBP investors that meets the “SAMURAI*” benchmark tests.
To do this, we had to consider three issues:
1. Is a simple “heuristic” 60/40 approach intellectually ok?
2. What’s the background to the 60/40 approach anyway?
3. How should we construct a 60/40 benchmark for GBP-based investors?
Heuristic allocations: a pragmatic approach
Creating a heuristic (“rule of thumb”), rather than optimised, asset allocation is a long-standing, pragmatic approach by portfolio theorists and practitioners alike.
Even Harry Markowitz, the father of Modern Porfolio Theory, chose a simple 50/50 equity/bond allocation for his own pension scheme.
I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it–or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.
So we can be comfortable with creating a heuristic allocation because it is an accepted practice, some background towhich is outlined below.
Background to the 60/40 allocation
Any reference to a 60/40 portfolio prior to the 1970s would be most welcome. But from our research, we understand that in the 1970s and 1980s pension scheme trustees used a 60/40 equity/bond benchmark for plan assets. Whilst in theory a perfect immunisation strategy could be implemented with a 100% bond allocation of matching duration, the risk that actual returns might not keep pace with expected returns particularly in an inflationary environment, together with higher implicit cost and limited availability of implementing such strategies, led practitioners to incorporate a substantial allocation to equities to protect against inflation and to help generate growth of plan assets. Research at the time supported a 40-70% allocation to risk assets, thereby defending the 60/40 allocation as a pragmatic approach.
Jack Bogle, the founder of Vanguard, was a staunch believer in the 60/40 portfolio as a benchmark allocation (although in later years he moved closer towards 50/50).
So whilst we can accept heuristic allocations in general, and the 60/40 allocation in particular, we have to decide: how best to populate a 60/40 portfolio for GBP investors?
Whose 60/40 is it anyway?
How do we construct a 60/40 portfolio for GBP investors? It may seem straightforward, but design parameters are still required, for which the only consensus can be, that there will be no consensus on what is “right”. In this respect, we have attempted to make design decisions that implicitly reflect practitioner views as well as our own.
Whilst a 60/40 equity/bond allocation may seem straightforward, it requires thought depending on an investor’s base currency. For example:
1. Should the 60% equity reflect UK equity or global equity or both?
The bulk of portfolio research originates in the US which not only represents the bulk of global equity indices, but also has the world’s largest companies that have international revenue streams. Put simply the S&P500 gives investors exposure to US companies that have global revenues.
That’s why the debate around including international equities is a very different one when viewed from a US or UK perspective. Whilst US companies represent the bulk of global equity (developed and emerging markets combined) by market cap as well an international revenue dimension; UK companies represent a fraction of global equity by market cap, despite an international revenue dimension.
So whereas the decision for a US investor to use US only or Global equities in a 60% equity allocation is fairly nuanced, for a UK investor it is absolutely critical.
We decided that within the 60% equity allocation, a 100% allocation to UK equities would be too much, and yet a market allocation (~6%) would be too little. A 50/50 allocation would be too great a home bias, so we decided to have a 80% allocation to global equities and a 20% allocation to UK equities. A heuristic within a heuristic. What stopped us having a 100% allocation to Global Equities, is to reflect that asset allocation models used by UK managers and advisers typically have an element of UK equity bias.
2. Should the 40% bonds reflect UK bonds, or global bonds or both?
On the bond side, we believe the opposite is true. For bonds, it makes sense for UK investors to have a bias towards UK bonds as a buffer against changes in UK economy, interest rates and inflation, we therefore allocate 80% to UK bonds (corporates and gilts of different maturities), and 20% to international bonds (unhedged).
In summary, for our UK 60/40 benchmark we use predominantly global equities and predominantly UK bonds. If portfolio or multi-asset managers want to improve performance vs this “vanilla” index by optimising, or indeed ignoring these weights, then go for it.
The purpose of the index is not to provide a “right answer”, but to provide a representative multi-asset allocation that captures the broad opportunity sets for both equities and bonds.
Potential applications: a useful yardstick
Our 60/40 benchmark can provide consistent, transparent insight for performance evaluation of multi-asset funds and portfolios.
Furthermore, the advantage of a simple 60/40 benchmark is that it can be used test multi-asset portfolio construction hypothesis such as:
Why Elston 60/40 GBP Index?
Search “6040GBP Index” on leading data vendors such as Bloomberg, Reuters and Morningstar or visit http://www.elstonetf.com/indices.html
 https://jasonzweig.com/what-harry-markowitz-meant/ https://jasonzweig.com/what-harry-markowitz-meant/
 Pension Fund Asset Allocation: In Defense of a 60/40 Equity/Debt Asset Mix (Ambachtsheer, 1987)
* A publicly available index can be used as a benchmark so long as it has the following qualities*:
Specified: The benchmark is specified in advance - prior to the start of the evaluation period.
Appropriate: The benchmark is consistent with the manager’s investment style or area of expertise.
Measurable: The benchmark’s return is readily calculable on a reasonably frequent basis.
Unambiguous: The identities and weights of securities are clearly defined.
Reflective: The manager has current knowledge of the securities in the benchmark.
Accountable: The manager is aware and accepts accountability for the constituents and performance of the benchmark.
Investable: It is possible to simply hold the benchmark.
* See Managing investment portfolios: A dynamic process (CFA institute investment Series), Third edition, John L. Maginn, Donald L. Tuttle, Jerald E. Pinto, Dennis W. McLeavey