[3 min read, open as pdf]

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

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

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

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

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

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

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

[2 min read, open as pdf]

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

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

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

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

Source: Elston research, Bloomberg data

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

Source: MSCI Factor Crowding Model

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

Source: MSCI Factor Crowding Model

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

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

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

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

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

[3 min read, open as pdf]

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

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

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

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

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

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

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

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

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

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

Fig.2. 2020 YTD Performance

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

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

Summary
Based on this analysis

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

[2 min read, open as pdf]

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

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

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

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

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

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

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

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

Summary
Based on this analysis:

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

[2 min read.  Buy the full report]

We compare the performance of risk-weighted multi-asset strategies relative to a Global Equity index and our Elston 60/40 GBP Index, which reflects a traditional asset-weighted approach.

Of the risk-weighted strategies, Elston Dynamic Risk Parity Index delivered best -1Y total return at +3.03%, compared to +5.01% for global equities and +0.95% for the Elston 60/40 GBP Index.

The periodic table shows lack of direction amongst risk-weighted strategies in the quarter.

​All data as at 30th September 2020
© Elston Consulting 2020, all rights reserved

[5 minute read, open as pdf]
Sign up for our upcoming CPD webinar on diversifying income risk

Summary

• Dividend concentration risk is not new, just more visible
• Quality of income, not quantity of yield, matters most
• The advantage of a multi-asset approach

​Dividend concentration risk is not new, just more visible
A number of blue chip companies announced dividend reductions or suspensions in response to financial pressure wrought by the Coronavirus outbreak. This brought into light the dependency, and sometimes over-dependency, on a handful of income-paying companies for equity income investors.
For UK investors in the FTSE 100, the payment of dividends from British blue chip companies provides much of its appeal.  However a look under the bonnet shows a material amount of dividend concentration risk (the over-reliance on a handful of securities to deliver a dividend income).
On these measures, 53% of the FTSE 100’s dividend yield comes from just 8 companies; whilst 22% of its dividend yield comes from energy companies.  The top 20 dividend contributors provide 76% of the dividend yield.
We measure dividend concentration risk by looking at the product of a company’s weight in the index and its dividend yield, to see its Contribution to Yield of the overall index.

Fig.1. FTSE 100 Contribution to Yield, ranked

Source: Elston research, Bloomberg data, as at June 2020

Quality of Income
More important than the quantity of the dividend yield, is its quality.
As income investors found out this year, there’s a risk to having a large allocation to a dividend payer if it cuts or cancels its dividend. 
Equally, there’s a risk to having a large allocation to a dividend payer, whose yield is only high as a reflection of its poor value.
Screening for high dividend yield alone can lead investors into “value-traps” where the income generated looks high, but the total return (income plus capital growth) generated is low.
Contrast the performance of these UK Equity Income indices, for example.
​
Fig.2. UK Equity Income indices contrasted

Source: Elston research, Bloomberg data. Total returns from end December 2006 to end June 2020 for selected UK Equity Indices.  Headline Yield as per Bloomberg data as at 30th June 2020 for related ETFs.

​The headline yield for the FTSE UK Dividend+, FTSE 100 and S&P UK Dividend Aristocrat Indices was 8.10%, 4.44%, and 4.07% respectively as at end June 2020.
However, the annualised long-run total return (income plus capital growth) 1.03%, 4.29% and 4.82% respectively.
Looking at yield alone is not enough.  The dependability of the dividends, and the quality of the dividend paying company are key to overall performance.
​
Mitigating dividend concentration risk: quality yield, with low concentration
The first part of the solution is to focus on high quality dividend-paying companies.  One of the best indicators of dividend quality is a company’s dividend policy and track record.  A dependable dividend payer is one that has paid the same or increased dividend year in, year out, whatever the weather.
The second part of the solution is to consider concentration risk and make sure that companies’ weights are not skewed in an attempt to chase yield.
This is evident by contrasting the different index methodologies for these equity income indices.
The FTSE 100 does not explicitly consider yield (and is not designed to).  The FTSE UK Dividend+ index ranks companies by their dividend yield alone.  The S&P UK Dividend Aristocrats only includes companies that have consistently paid a dividend over several years, whilst ensuring there is no over-dependency on a handful of stocks.
A look at the top five holdings of each index shows the results of these respective methodologies.
​
Fig.3. Top 5 holdings of selected UK equity indices

Put simply, the screening methodology adopted will materially impact the stocks selected for inclusion in an equity income index strategy.
​
What about active managers?
A study by Interactive Investor looked at the top five most commonly held stocks in UK Equity Income funds and investment trusts.
For funds, the most popular holdings were GlaxoSmithKline, Imperial Brands, BP, Phoenix Group & AstraZeneca.
For investment trusts, the most popular holdings are British American Tobacco, GlaxoSmithKline, RELX, AstraZeneca and Royal Dutch Sell.
Unsurprisingly, each of the holdings above is also a constituent of the S&P Dividend Aristocrats index, hence ETFs that track this index simply provide a lower cost way of accessing the same type of company (dependable dividend payers with steady or increasing dividends), but using a systematic approach that enables a lower management fee.
Understanding what makes dividend income dependable for an asset class such as UK equities, is only part of the picture of mitigating income risk.  Income diversification is enabled by adopting a multi-asset approach.
 
The advantage of a multi-asset approach
The advantage of a multi-asset approach is two-fold.
Firstly the ability to diversify equity income by geography for a more globalised approach, to benefit from economic and demographic trends outside the UK.
Secondly the ability to diversify income by asset class, to moderate the level of overall portfolio risk.
For investors who never need to dip into capital, have a very high capacity for loss, and can comfortably suffer the slings and arrows of the equity market, equity income works well – so long as the quality of dividends is addressed, as above.
But for anyone else, where there is a need for income, but a preference for a more balanced asset allocation, a multi-asset income approach may make more sense.  The rationale for a multi-asset approach is therefore to capture as much income as possible without taking as much risk as an all-equity approach.

Value at Risk vs Income Reward
There is always a relationship between risk and reward.  For income investors, it’s no different.  To be rewarded with more income, you need to take more risk with your capital.  This means including equities over bonds, and, within the bonds universe, considering both credit quality (the additional yield from corporate and high yield bonds over gilts), and investment term (typically, the longer the term, the greater the yield).
This overall level f risk being taken can be measured using a Value at Risk metric (a “worst case” measure of downside risk).
If you want something with very low value-at-risk, shorter duration gilts can provide that capital protection, but yields are very low.
Even nominally “safe” gilts, with low yields, nonetheless have potential downside risk owing to their interest rate sensitivity (“duration”).
UK Equities offer a high yield, but commensurately also carry a much higher downside risk.
The relationship between yield and Value-at-Risk (a measure of potential downside risk) is presented below.
​
Fig.4. Income Yield vs Value at Risk of selected asset classes/indices

Source: Elston research, Bloomberg data, as at 30th June 2020.  Note: an investment with a Value at Risk (“VaR”) of -10% (1 year, 95% Confidence) means there is, to 95% confidence (a 1 in 20 chance), a risk of losing 10% of the value of your investment over any given year.  Asset class data reflects representative ETFs.

Our Multi-Asset Income index has, unsurprisingly, a risk level between that of gilts and equities, and captures approximately 65% of the yield, but with only 52% of the Value-at-Risk.
​
Summary
How you get your income – whether from equities, bonds or a mix – is critical to the amount of risk an investor is willing and able to take, and is a function of asset allocation.  Understanding the asset allocation of an income funds is key to understanding its risks (for example, Volatility, Value at Risk and Max Drawdown).

The dependability of dividend income you receive - whether from value traps or quality companies; whether concentrated or diversified – is a function of security selection.  This can be either manager-based (subjective), or index-based (objective).

For investors requiring a dependable yield, a closer look at how income is generated – through asset allocation and dividend dependability – is key.

While there are no shortage of limitations and no “right” answers, portfolio theory nonetheless remains, rightly, the bedrock of traditional multi-asset portfolio design.

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.
 
Portfolio theory in a nutshell
Portfolio theory, in a nutshell, is a framework as to how to construct an “optimised” portfolio using a range of asset classes, such as Equities, Bonds, Alternatives (neither equities nor bonds) and Cash.  An “optimised” portfolio has the highest unit of potential return per unit of risk (volatility) taken.
The aim of a multi-asset portfolio is to maximise expected portfolio returns for a given level of portfolio risk, on the basis that risk and reward are the flipside of the same coin.
The introduction of “Alternative” assets, that are not correlated with equities or bonds (so that one “zigs” when the other “zags”), helps diversify portfolios, like a stabilizer.  Done properly, this can help reduce portfolio volatility to less than the sum of its parts.
Whilst the framework of Modern Portfolio Theory was coined by Nobel laureate Harry Markowitz in 1952, the key assumptions for portfolios theory – namely which asset classes, their returns, risk and correlations are, by their nature, just estimates.
So using portfolio theory as a guide to designing portfolios is only as good as the quality of the inputs assumptions selected by the user.  And those assumptions are ever-changing. Furthermore, the constraints imposed when designing or optimising a portfolio will determine the end shape of the portfolio for any given optimisation.  And those constraints are subjective to the designer.
So portfolio design is part art, part science, and part common sense.
Whilst there are no shortage of limitations and no “right” answers, portfolio theory nonetheless remains, rightly, the bedrock of traditional multi-asset portfolio design.
 
What differentiates multi-asset portfolios?
A portfolio’s asset allocation is the key determinant of portfolio outcomes and the main driver of portfolio risk and return.  Ensuring the asset allocation is aligned to an appropriate risk-return objective is therefore essential.  Getting and keeping the asset allocation on track for the given objectives and constraints is how portfolio managers – whether of model portfolios or of multi-asset funds – can add most value for their clients.
There are no “secrets” to asset allocation in portfolio management.  It is perhaps one of the most well-studied and researched fields of finance.
Stripping all the theory down to its bare bones, there are, in my view, three key decisions when designing multi-asset portfolios:

1. Strategic Allocation : to meet given objectives and constraints, and the quality of research, assumptions and design that underpin that strategy
2. Static or Dynamic approach: how the asset allocation is adjusted (or not) to adapt to changing markets and conditions; what drives the adjustment; and the extent of those adjustments
3. Access preferences: how to access a asset class exposure in a way that is efficient, transparent and good value for money

Strategic Allocation 
Strategic allocation is expected to answer the key questions of what are a portfolio’s objectives, and what are its constraints.
The mix of assets is defined such as to maximise the probability of achieving those objectives, subject to any specified constraints.
Objectives can be, for example:

• Absolute Return: an objective to deliver a stated level of return
• Real Return: an objective to deliver a return in a specified excess of inflation
• Relative Return: an objective to deliver a return relative to a benchmark or peergroup
• Matching Return: an objective to match a future set of one-off or regular withdrawals
• Income Yield: an objective to deliver a certain level of income yield
• An Outcome: an objective whose outcome is defined in words, rather than figures.

Constraints can be for example:

• Absolute volatility: the strategy is to remain within a certain range of explicit volatility
• Relative volatility: the strategy is to remain proportionate to the volatility of a certain benchmark
• Value at Risk: the strategy is to remain within a certain range of Value at Risk (potential loss over a given time frame).
• Maximum Drawdown: the strategy is not to breach a certain level of peak-to-trough declines
• Constraints can also relate to the composition of a portfolio, for example:
• Including or excluding certain asset classes, exposures, sectors or securities.
• Setting minimum and maximum weights to asset classes, exposures, sectors or securities.
• Portfolio turnover constraints
• Counterparty considerations
• Fee budget

When building a strategic asset allocation, managers need a robust set of capital market assumptions for each asset class and the relationship between asset classes.  Ideally these should be term-dependent, to align to an appropriate term-dependent investment objective.
Strategic allocations should be reviewed possibly each year and certainly not less than every 5 years.  This is because assumptions change over time, all the time.
 
Static vs Dynamic
One of the key considerations when it comes to managing an allocation is to whether to adopt a static or dynamic approach.
A strategy with a “static” allocation, means the portfolios is rebalanced periodically back to the original strategic weights.  The frequency of rebalancing can depend on the degree of “drift” that is allowed, but constrained by the frictional costs involved in implementing the rebalancing.
A strategy with a “dynamic” approach, means the asset allocation of the portfolios changes over time, and adapts to changing market or economic conditions.  Dynamic or Tactical allocation, can be either with return-enhancing objective or a risk-reducing objective or both, or optimised to some other portfolio risk or return objective such as income yield. 
For very long-term investors, such as endowment funds, a broadly static allocation approach will do just fine.  Where very long-term time horizons are involved, the cost of trading may not be worthwhile.  As time horizons shorten, the importance of a dynamic approach becomes increasingly important.  Put simply, if you were investing for 50 years, tactical tweaks around the strategic allocation, won’t make as big a difference as if you were investing for just 5 years.  This is because risk (as defined by volatility) is different for different time frames, and is higher for shorter time periods, and lower for longer time periods.  In a way this is also just common sense.  If you are saving up funds to buy a house, you will invest those funds differently if you are planning to buy a house in 3 years or 30 years.  Time matters so much as it impacts objectives and constraints, as well as risk and return. 
Access Preferences
Managers need to make implementation decisions as regards how they access particular asset classes or exposures – with direct securities, higher cost active/non-index funds, or lower cost passive/index funds and ETFs.  Fund level due diligence as regards underlying holdings, concentrations, round-trip dealing costs and internal and external fund liquidity profiles are key in this respect.  The choice between direct equities, higher cost active funds or lower cost index funds is a key one and is the subject of a later article.
Types of multi-asset strategy
There is a broad range of multi-asset strategies available to investors, whose relevance depends on the investor’s needs and preferences.  To self-directed investors, these multi-asset portfolios are made easier to access and monitor through multi-asset funds, many of which are themselves constructed wholly or partly with index funds and/or ETFs.
We categorise multi-asset funds into the following groups (using our own naming conventions based on design: these do not exist as official “multi-asset sectors”, unfortunately):
Relative Risk
Relative risk strategies target a percentage allocation to equities so the risk and return of the strategy is in consistent relative proportion the (ever-changing) risk and return of the equity markets.  This is the most common approach to multi-asset strategies.  Put differently, asset weights drive portfolio risk.  Examples include Vanguard LifeStrategy, HSBC Global Strategy and other traditional multi-asset funds. 
Target Risk
Target risk strategies target a specific volatility level or range.  This means the percentage allocation to equities is constantly changing to preserve a target volatility band.  Put differently, portfolio risk objectives drive asset weights.  Examples of this approach include BlackRock MyMap funds.
Target Return
Target return strategies target a specific return level in excess of a benchmark rate e.g. LIBOR, and take the required risk to get there.  This is good in theory for return targeting, but results are not guaranteed.  Examples of this approach include funds in the Target Absolute Return sector, such as ASI Global Absolute Return.
Target Date
Target Date Funds adapt an asset allocation over time from higher risk to lower, expecting regular withdrawals after the target date.  This type of strategy works as “ready-made” age-based fund whose risk profile changes over time.  Examples of target date funds include Vanguard Target Retirement Funds, and the Architas BirthStar Target Date Funds (managed by AllianceBernstein)*.
Target Income
Target income funds target an absolute level of income or a target distribution yield.  Examples of this type of fund include JPMorgan Multi-Asset Income.
Target Term Funds
These exist in the US, but not the UK, and are a type of fund that work like a bond: you invest a capital amount at the beginning, receive a regular distribution, and then receive a capital payment at the end of the target term.
For self-directed investors, choosing the approach that aligns best to your needs and requirements, and then selecting a fund within that sub-sector that has potential to deliver on those objectives – at good value for money – is the key decision for building a robust investment strategy.
The (lack of) secrets
The secret is, there are no secrets.  Good portfolio design is about informed common senses.  It means focusing on what will deliver on portfolio objectives and making sure those objectives are clearly identifiable by investors.
Designing and building your own multi-asset portfolio is interesting and rewarding.  Equally there are a range of ready-made options to chose from.  The most important question is to consider to what extent a strategy is consistent with your own needs and requirements.
 
* Note: funds referenced do not represent an endorsement or personal recommendation.  Disclosure: until 2015, Elston was involved in the design and development of this fund range, but now receives no commercial benefit from these funds.

• Understanding Target Date Funds
• Why a cohort-based approach makes sense
• The performance experience this year by cohort

 What are Target Date Funds?
Target Date Funds are multi-asset funds whose risk profile changes over time, becoming less risky on approach to, and after the target date in the fund’s name.
Investors, or their advisers, can use target date funds as an investment strategy that is purpose-built for retirement.  By selecting a fund whose target date matches a planned retirement year, investors get access to an accumulation-oriented investment strategy prior to the target date, and a decumulation-oriented strategy after the target date.  This makes target date funds a convenient “all-in one” fund which explains why they are often used as default funds within pension schemes, including NEST.
Why a cohort-based approach makes sense
It’s common sense that the risk capacity for an investor’s exposure to market risk is different at different stages of life and wealth levels.
For younger investors, where wealth levels are typically lower and time horizons are longer, there is a higher capacity for loss, hence a higher exposure to higher risk-return assets makes sense.
For older investors, where wealth levels are typically higher and time horizons are shorter, there is a lower capacity for loss, hence a lower exposure to higher risk-return assets makes sense.
If customers can be segmented by cohorts, it makes sense that investment strategy can be too.
What is the performance experience for different cohorts this year (time-weighted)?
The 2015-20 Target Date Fund from Architas experienced a moderate maximum monthly drawdown of -4.71% in March 2020.  By comparison, the 2020 Target Date Fund from Vanguard experienced a -6.66% drawdown.  This contrasts with -9.37% for the Elston 60/40 GBP Index, -10.94% for MSCI World, and -13.81% for the FTSE 100, all in GBP terms.
In this respect, investors who were in default decumulation strategies, with lower capacity for loss, saw better mitigation of downside risk relative to a traditional 60/40 “balanced” mandate.
Fig.1. YTD performance of UK Target Date Funds (GBP terms) for those retiring 2015-20.

 Source: Elston research, Bloomberg data
How Target Date Funds could fit in with policy evolution
Ensuring there is some form of in-built lifestyling is a longstanding feature of consumer protections for pensions investment since Stakeholder times.  Using behavioural finance in proposition design can provide a degree of consumer protection from poor outcomes for less confident, less engaged investors.  That’s why a growing number of regulatory interventions incorporate some form of built-in lifestyling.  Whilst this is complex to achieve from an administrative perspective, the fact that Target Date Funds deliver lifestyling within the multi-asset fund structure makes them a useful product type for default investment strategies.
Fig.3. Key behavioural aspects and price anchors of policy interventions

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.
Aligning investment strategy with objectives
Investing can be defined as putting capital at risk of gain or loss to earn a return in excess of what can be received from a risk-free asset such as cash or a government bond over the medium-to long-term.
There can be any number of motives for investing: it could be to fund a future retirement via a SIPP, or to fund future university fees via a JISA.
Online tools and calculators can help estimate how much is required to invest today to fund goals in the future.
Investors can target a particular return, but learn to understand that the higher the required return, the higher the required level of portfolio risk.  Risk and return are the “ying and yang” of investment.  You can’t get one without the other.
Total return can be broken down into income yield (dividends from equities and interest from bonds) and capital growth.  In the UK, income and gains are taxed at different rates.  If investing within a tax-efficient account, like a SIPP or an ISA, then income and gains are tax-free.  If investing outside a tax-efficient account, investors must also then consider in their objectives how they want to receive total return – with a bias towards income or with a bias towards growth.
Given the majority of DIY investors are able to make use of tax-efficient accounts, there is less need to consider income or growth, with many investors opting to focus on Total Returns and to use funds that offer “Accumulating” units that reinvest income, and reflect a fund’s total return.
How then to build a portfolio to deliver an appropriate level of risk-return?
What matters most when investing?
For the purposes of these articles, I assume that readers need no reminder of the basic checklist of investing: to start early, to maximise allowances, keep topping up regularly, and to keep costs down.  Then comes the key decision – what to invest in.
The main driver of portfolio risk and return is not which stocks or equity funds are within a portfolio, but what the proportion is between higher risk-return assets such as equities, and lower risk-return assets such as shorter duration bonds.
Put simply, whether to invest 20%, 60% or 100% of a portfolio in equities, will have a greater impact on overall portfolio returns, than the selection of shares or funds within that equity allocation.
For example, when making spaghetti Bolognese, the ratio between spaghetti and Bolognese impacts the “outcome” of the overall meal, more than how finely chopped the onions are within the Bolognese recipe.
While this may seem obvious, it gets lost in all the noise and news that focuses on hot stocks, star managers and performance rankings.
For those that want to back up common sense with academic theory, the academic articles most referenced that explore this topic are Brinson Hood & Beebower (1986), Ibboton & Kaplan (2000), and Ibbotson, Xiong, Idzorek & Cheng (2010), all referenced and summarised in my book.
Building a multi-asset portfolio to an optimised asset allocation to align to a particular risk-return objectives sounds like hard work and it is.  That’s why multi-asset funds exist.
The rise of multi-asset funds
As investing becomes more accessible to more people, there is less interest in the detail of how investments work and more interest in portfolios that get people from A to B, for a given level of risk-return.  After all, there are fewer people who are interested in the detail of how engines work than there are who are interested in how a car looks, how it drives and what they need it for.
There is nothing new about multi-asset funds, indeed one could argue that the earliest investment trust Foreign & Colonial Investment Trust, founded in 1868, invested in both equities and bonds "to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk by spreading the investment over a number of stocks”.  In the unit trust world, managed balanced funds have been around for decades.  I would define a multi-asset fund as a strategy that invests across a diversified range of asset classes to achieve a particular asset allocation and/or risk-return objective.
They offer a ready-made “portfolio within a fund” thereby enabling a managed portfolio service for the investor from a minimum regular investment of £25 per month.  .  In this respect, multi-asset funds help democratise investing, and make the hardest part of the investor’s checklist – how to construct and manage a diversified portfolio.  The different types of multi-asset fund available is a topic in itself.
The ability for investors to select a multi-asset fund for a given level or risk-return characteristics for a given time frame is one of the most straightforward ways to implement a strategy once that has been aligned to a given set of objectives.
Multi-Asset Fund or ETF Portfolio?
The main advantage of a ready-made multi-asset fund is convenience.  Asset allocation, and portfolio construction decisions are made by the fund provider.
The main advantages of an ETF Portfolio are timeliness, cost and flexible.  ETF Portfolios are timely.  You can adjust positions the same day without 4-5 day dealing cycles associated with funds – an important feature in volatile times.  ETF portfolios are good value.  You can construct a multi-asset ETF portfolio for a lower cost than even the cheapest multi-asset fund.  ETF Portfolio are flexible – you can tilt a core strategy to reflect your views on a particular region (e.g. US or Emerging Markets), sector (e.g. healthcare or technology), theme (e.g. sustainability or demographics), or factor (e.g. momentum or value), to reflect your views based on your research.
Conclusion
Setting the right objectives to meet a target financial outcome, such as funding future retirement, university fees, or creating a rainy day fund is the primary consideration when making an investment plan.
Getting the asset allocation right – choosing a risk profile – in a way best suited to deliver that plan is the second most important decision.
Finding a straight forward to deliver that risk-return profile, by building your own ETF portfolio or using a ready-made multi-asset index fund, is the final most important step.
All the while, it makes sense to stick to the investing checklist: to start early, keep topping up, and keep costs down.

In this series of articles, we 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 we do for discretionary managers and financial advisers.
 
From space pens to pencils
There’s a famous story, probably an urban myth, about NASA spending millions of dollars of research to develop a space pen whose ink could still flow in a zero gravity environment.  When the Russians were asked whether they planned to respond to the challenge to enable their cosmonauts be able to write in space, they answered “We just use a pencil.”
Sometimes sensible and straightforward answers to problems prove more durable than more elaborate and costly alternatives.
The same could be said of investments.  The quest for high-cost star-managers in the hope of alchemy, is under pressure from low-cost index funds that get the job done, by giving low cost, transparent, and liquid exposure to a particular asset class.
How an active stock picker became a passive enthusiast
I spent my early years in the City working for active managers.  My job was to pick stocks based on proprietary models of those companies’ operating and financial models.  I was fortunate enough to work in a very successful hedge fund, whose style was “true active”: it could be highly concentrated on high conviction stocks, it could be long or short a stock or a market, it could (but didn’t) use leverage.  If you enjoy stockpicking, as I did, working for a relatively unconstrained mandate was at times highly rewarding, at times highly stressful and always interesting.
Investors, typically large institutions, who wanted access to this strategy, had to have deep pockets to wear the very high minimum investment, and the fund was not always open for new investors.  It certainly wasn’t available to the man on the street.
Knowledge gap entrenches disadvantage
When I started my own family and started investing a Child Trust Fund I became all too aware of the massive disconnect and difference between the investment opportunities open to hundreds of institutional investors and those available to millions of ordinary individual retail investors.
I was staggered and rather depressed to see how few people in the UK harness the power of the markets to increase their long-term financial resilience.  Of the 11m ISA accounts held by 30m working adult, only 2m are Stocks and Shares ISAs.  The investing public is a narrow audience.  The vast majority is put off from learning to or starting to invest by complexity, jargon and unfamiliarity.
Casual conversations with people from all walks of life showed that whilst they may fall prey to some scheme that promised unrealistic returns, they were less inclined to put a “boring” checklist in place to contribute to their own ISA or Junior ISA, perhaps unaware that this could be done for less than the cost of a coffee habit at £25 per month.
The lack of knowledge on investing was nothing to do with gender, age or education.  It was almost universal.  People either knew about investments or they didn’t.  And that knowledge was usually hereditary.  And it entrenches disadvantage.
Retail investments need a shake up
Looking at the retail fund industry, it was clear that there wasn’t much that was truly “active” about it.  Most long-only retail managers hugged benchmarks for chunky fees that befitted their brand or status (now known as “closet indexing”).  Until recently, the bulk of personal finance pages and investment journalism was more about a quest for a handful of “star managers”, in whatever asset class, who were ascribed the status of an alchemist, that investors would then herd towards.  It seemed like the retail fund industry was focused on solving the wrong problem: on how to find the next star manager, rather than how to have a sensible, robust diversified portfolio.
By contrast, in the US, there has always been a higher culture of equity investing (New York cabbies talk more about stocks than about sport, in my experience).  So I was fascinated to read about the behavioural science that underpinned the roll out of automatic enrolment in the USA in 2005 where investors who were not engaged with their pensions plan were defaulted into a Target Date Fund – a multi-asset index fund whose mix of assets changes over time, according to their expected retirement date.  I also read about the mushrooming of so-called “ETF Strategists”, investment research firms that put together ultra-low cost managed portfolios for US financial advisers built entirely with Exchange Traded Funds.
Winds of change
Conscious of these emerging trends, it seemed that mass market investing in the UK was about to enter a period of structural change: namely with the ban of fund commissions (Retail Distribution Review), and the launch of automatic enrolment, as well as other planned “behavioural finance” interventions to improve savings rates and financial capability.
So in 2012, I set up my own research firm to see what, if any, of that experience in the US might apply in the UK.  We work with asset managers to develop low-cost multi-asset investment strategies for the mass market, constructed with index-tracking funds and ETFs.  It is bringing the rather dry science of institutional investing into the brand-rich and personality-heavy world of personal investing.
 
Why index investing?
I try and avoid the terms active and passive and will explain why.  For most people, a multi-asset approach using index funds makes sense.  This can be called “index investing”.  Surprisingly, one of it’s biggest supporters is Warren Buffett.
“Consistently buy a low cost…index fund.  I think it’s the thing that makes the most sense practically all of the time…Keep buying through thick and thin, and especially through thin.”
(Warren Buffet, Letter to shareholders, 2017)
 
In this series of articles, I share some of the experience I have had in developing investment strategies and products for asset managers built with index funds and ETFs.  I look at the concepts underpinning multi-asset investing, focus on the importance of getting the asset allocation right for a given objective, summarise my view on the active vs passive debate (and attempt to clarify some terms), as well as some practical tips on building and managing your own portfolio.
Each of the articles can be explored more deeply in a book I wrote with my former colleague and co-author Shweta Agarwal on How to Invest with Exchange Traded Funds: a practical guide for the modern investor

• Of alternative multi-asset strategies, Max Deconcentration delivered best returns in 2q20
• Risk Parity has outperformed a 60/40 approach on a risk-adjusted basis over 1, 3 and 5 years
• Risk Parity has provided greatest level of “true diversification” relative to Global Equities

The second quarter of 2020 saw a rebound in Global Equity markets with a total return of +17.6% in GBP terms.  Unsurprisingly a 60/40 equity/bond portfolio captured approximately 60% of this upside with a total return of +11.2%.

Of the multi-asset risk-based strategies we track, a Maximum Deconcentration approach (also known as an equal weight approach, because each asset class is equally weight), fared best with a return of +10.3%.  By contrast a Min Variance approach and Risk Parity approach returned +9.0% and +5.7% respectively.  Given their relative betas to Global Equity, the results are not surprising.
Fig.1. Total Return (discrete quarter, GBP terms)

Risk-adjusted basis
On a risk-adjusted 1 year basis, Risk Parity outperformed Global Equities, UK Bonds, a 60/40 portfolio and other multi-asset strategies.
Fig.2. Risk-Return to 30-Jun-20 (1 year, GBP terms) 

On a 5 year basis, Risk Parity also has the best risk-adjusted returns, with the highest Sharpe ratio at 0.94.
Fig.3. Sharpe Ratio to 30-Jun-20 (5 year, GBP terms)

Risk-based strategies for “true diversification”
If we define “true diversification” as combining two or more uncorrelated asset classes such that the combined volatility is less than its constituent parts, then a traditional 60/40 portfolio fails to deliver.

We look at correlation reduction and beta reduction to articulate “differentiation impact”.  The greater the reduction of both, the greater the differentiation.

Over the 5 years to 30th June, a 60/40 portfolio (as represented by the Elston 60/40 GBP Index [ticker 6040GBP Index] delivers a reduction in Beta of -41.1% (broadly commensurate with its equity allocation), it only reduces correlation to Global Equities by -2.8%.  Put differently a 60/40 portfolio is almost 100% correlated with Global Equities, and does not therefore provide “true” diversification.

By contrast, a Risk Parity approach not only delivered better risk-adjusted returns, it also delivered “true diversification”.  With a beta reduction of -78.3% and a correlation reduction of -46.6%.  The Differentiation impact of the various multi-asset strategies is summarised below.
Fig.4. Differentiation impact to 30-Jun-20 (5 year, GBP terms)

Summary
Max Deconcentration provided the highest level of returns in 2q20.  On a 1, 3 and 5 year basis, Risk Parity offers better risk-adjusted returns.  The differentiation impact is greatest for Risk Parity, relative to other multi-asset strategies for "true diversification".

NOTICES
Commercial Interest: Elston Consulting Limited creates research portfolios and administers indices that may or may not be referenced in this article.  If referenced, this is clearly designated and is to raise awareness and provide purely factual information as regards these portfolios and/or indices.

• Targeted Absolute Return (TAR) funds were meant to be “all weather”
• TAR funds can be complex, opaque and inefficient
• We measure how four key TAR funds fare vs a Risk Parity approach

​Targeted Absolute Return (TAR) funds were meant to be “all-weather” funds that could deliver returns in up markets, whilst protecting capital in down markets.  If that sounds like a “goldilocks” strategy, it’s because it is.
However, the way these funds-of-strategies are managed can be complex and/or opaque, and the performance has been inefficient.  They are not delivering.
Given there’s been a lot of bad weather globally in the first half of this year, we look at how four leading (by AUM) TAR funds have fared against our Elston Dynamic Risk Parity Index.

Absolute Return funds
Targeted Absolute Return funds are designed to fulfil a diversification function within a portfolio.  This means performing in a way that is less or not correlated with equity markets, whilst offering greater return than cash or bonds.
The portfolio construction approach to TAR funds differs from manager to manager.  But the guiding principle is to achieve diversification by “spreading risk” across multiple, uncorrelated strategies, and “having the potential to make money in falling markets”.

Risk-based strategies as an alternative
Our view is that if the objective is diversification, a risk-based approach to portfolio construction makes sense, using strategies such as Risk Parity for diversification purposes.  Risk Parity ensures “true diversification” by allowing the ever-changing risk characteristics of each asset class to determine portfolio weights, such that each asset class contributes equally to overall portfolio risk.
Furthermore, by constructing the strategy as a straightforward “long-only” approach that does not use leverage, the holdings within the strategy are liquid, transparent and low-cost ETFs, whilst the dynamic weighting scheme is the tool for ensuring equal risk contribution and volatility constraint.

• To counter complexity, we believe in creating a strategy in a systematic, rules-based approach (i.e. as an index).
• To counter opacity, we believe in ensuring that a strategy can be implemented using transparent, liquid and low-cost instruments (i.e. physically-replicated Exchange Traded Funds).
• To ensure efficiency, unlike some institutional risk parity funds, we ensure our risk parity strategy is constructed a mixture of Global Equities and UK Bonds (rather than Global Equities and US Bonds hedged to GBP)

Whilst Targeted Absolute Return funds do not use Risk Parity indices as a benchmark – the fundamental principle – diversifying portfolio risk across a number of contributors of portfolio risk – is nonetheless similar at its core, albeit very different in its implementation.
So how have the strategies fared?

Relative Performance
Year to date, through an extreme stress-test, absolute return strategies have underperformed a Risk Parity approach by 2-4.5%.
Fig.1. YTD performance

Source: Elston research, Bloomberg data.  Total returns, GBP terms, as at end June 2020
On a 1 year view, these absolute return strategies have underperformed a Risk Parity approach by 6-8%.
Fig.2. 1 year cumulative performance

Source: Elston research, Bloomberg data.  Total returns, GBP terms, as at end June 2020
On a 3 year view, these absolute return strategies have underperformed a Risk Parity approach by 7-20%.
Fig.3. 3 year cumulative performance

Source: Elston research, Bloomberg data.  Total returns, GBP terms, as at end June 2020
 
Mixing metaphors: a goldilocks approach to an all-weather portfolio
To achieve all-weather diversifier status is a tall order for any investment strategy.  It requires a “goldilocks” portfolio that:

• Ensures that risk sufficiently rewarded
• Allows some volatility to achieve returns, but not too much risk to create excessive downside risk
• Constrains volatility to reduce downside risk, but not so much as to forego returns,
• Permits enough beta to keep pace with the market, but without too much correlation
• Reduces correlation to ensure differentiation, but without foregoing any of the above

As you can see it’s a tall order.  But we can measure how these absolute return funds fare relative to our Risk Parity index on those metrics by comparing

• Return per unit of risk (Sharpe ratio – is risk rewarded?) in absolute terms, and relative to Global Equities
• Level of volatility relative to a global equities (is volatility constrained?)
• Level of returns capture, relative to global equities (is there potential for returns?)
• Level of beta relative to global equities (is there sufficient reduction for downside protection?)
• Level of correlation to global equities (is there true differentiation for diversification?

On this basis, the Risk Parity approach

• Offers best risk-adjusted returns with Sharpe ratio of 0.67
• Improves risk-adjusted returns significantly vs global equities and a 60/40 portfolio (TAR funds provide poor risk-adjusted returns, as the risk taken is unrewarded)
• Reduces volatility by -60.0% (more than for a 60/40 strategy, but less than TAR funds (-65 to 80% reduction))
• Reduces returns by just -30.7% (similar to a 60/40 strategy, and significantly better returns capture than TAR funds)
• Reduces beta by -78.3% (less so than for TAR funds (~90%), but moreso than a 60/40 portfolio (-40.6%))
• Reduces correlation by -45.8% (less when compared to -60 to 66% for TAR funds, but substantially more than a 60/40 portfolio that do not provide “true diversification”).

On this basis, our Risk Parity strategy fares well as a decorrelated “diversifier”, without foregoing returns, for a similar level of risk to TAR funds.

What’s wrong with TAR funds? We can’t analyse the individual strategies within the funds, but in aggregate, the statistics below suggest that as a result of their complexity, TAR funds have potentially “over de-correlated”, with insufficient beta to capture the returns available for the risk (volatility) being taken.

Findings are summarised in the table below.
​
Fig.4. 3Y Performance Statistics

Risk-based strategies: an alternative to absolute return funds?
Targeted Absolute Return funds are opaque, complex and inefficient.

Creating a true diversification strategy is challenging but achievable.

A systematic risk-based approach that adapts to changing relationships between each asset classes is an alternative.

​By ensuring that each asset class contributes equally to the risk of the overall portfolio, without resorting to leverage, could provide a more dependable approach to incorporating a “true diversifier” into a portfolio, without necessarily compromising returns.

NOTICES
Commercial Interest: Elston Consulting Limited creates research portfolios and administers indices that may or may not be referenced in this article.  If referenced, this is clearly designated and is to raise awareness and provide purely factual information as regards these portfolios and/or indices.

• Four different approaches to constructing a multi-asset portfolio are summarised
• YTD return and COVID-related drawdowns of these strategies are compared
• Risk-weighted strategies can help decorrelate a portfolio for “true diversification”

 
The standard rationale for multi-asset investing is to ensure diversification between equities and bonds.

But how to construct that multi-asset portfolio.  We summarise 4 approaches and look at performance through the “live ammo stress test” of 2020.

The classic 60/40 portfolio: This represents a traditional asset-weighted portfolio for UK investors with predominantly global equities and predominantly GBP bonds.  This strategy is represented by the 60/40 GBP Index [6040GBP].

The equal weight or "1/N" portfolio: This represents an equal-asset-weighted portfolio to remove overallocations to size and/or domestic biases within equity and bond exposures.  This strategy is represented by the Elston Max Deconcentration portfolio [ESBGMD].

However, the problem with any asset-weighted investing is that in extreme stress periods, correlations between asset classes increase meaning that any asset-weighted diversification effect is reduced just when you need it most.

Enter risk-weighted multi-asset strategies.  Rather than allowing asset weights to drive portfolio risk & correlation, risk-weighted multi-asset means allowing the portfolio risk (volatility, correlation) to drive asset weights.

The Min Variance portfolio:  This looks at the volatility and correlation between asset classes and aims to deliver the combination of equities and bonds required to achieve the minimum variance (lowest risk) portfolio whilst remaining exposed to risk assets.  This strategy is represented by the Elston Min Variance Index [ESBGMV].

The Risk Parity portfolio: This looks at the risk contribution of each asset class and aims to deliver a portfolio where each asset class contributes equal risk contribution to the overall portfolio.  This strategy is represented by the Elston Risk Parity Index [ESBDRP].

Year to date performance
Of these risk-based multi-asset strategies for GBP investors, the best performing YTD (to end May) has been Risk Parity +1.50%, followed by Max Deconcentration +0.76%, followed by Min Variance -1.78%, compared to -2.03% for the 60/40 GBP Index, and -3.77% for Global Equities.

​Drawdowns
From the start of the market turmoil to the trough of the 60/40 index on 18th March, Risk Parity provided most downside protection, closely followed by Max Deconcentration.  Unsurprisingly, the 60/40 index took approximately 60% of global equity downside.

How to get “true diversification”
To achieve true diversification, you need to combine uncorrelated/differentiated holdings alongside your core strategy.

An asset-weighted approach, such as 60/40 portfolio, does reduce beta (by definition you are taking 0.6x of market risk), but does not reduce correlation.  A 60/40 portfolio is almost 100% correlated to global equities.

By contrast, a risk-weighted approach creates the potential for decorrelation, thereby creating the potential for “true diversification” relative to a core portfolio.
The recent market turmoil has shown that when true diversification is needed most, a risk-weighted approach has a useful role to play.

For more on our risk-weighted portfolios and indices, see www.ElstonETF.com/etf-portfolios.html

• Traditional multi-asset strategies take a capitalisation-weighted approach to asset classes
• This creates concentrations towards size adjusted for domestic biases
• A deconcentration strategy provides an equal weight allocation across asset classes and geographies

We are adding the Elston Maximum Deconcentration Portfolio to our suite of multi-asset risk-based strategies.  The portfolio is now "live" with factsheets updated daily (portfolio ticker ESBMDC).

What is "Deconcentration"?
Put simply, in the context of multi-asset investing, if single asset investing is having all eggs in one basket; 60/40 investing is having all eggs in two baskets; then deconcentration is having one egg per basket.  It is diversification at its simplest: giving an equal weight to each asset class within the portfolio.

This portfolio construction approach is known as a "Deconcentration strategy" as it deconcentrates the portfolio from any single asset class.  It is also known as a (1 over N) approach, where N is the number of holdings within the portfolio.

What problem are we trying to solve?
Most traditional multi-asset strategies, such as a 60/40 portfolio, have a capitalisation-weighted approach to asset allocation.  Within  a classic global equity benchmark, for example, the US dominates with a ~60% allocation.  So within a vanilla 60/40 portfolio, US equities may have a 36% allocation (60% US exposure within 60% Global Equity allocation).  Nothing wrong with that, but it's an overweight based on capitalisation.  Likewise within the bond allocation rather than having a bias towards GBP issued bonds under a classic 60/40 approach.  Again, nothing wrong with that, but it limits the diversification impact of international bonds.

How does a max deconcentration portfolio work?
One way of creating differentiated risk-returns is to ignore these size-and-domestic biases is to create a "naive" or simple diversification strategy, such as an equally-weighted multi-asset approach.

We look at an opportunity set of 20 asset class exposures: regional equity markets, bonds by issuer type, maturity and currency, as well as alternatives such as gold, listed infrastructure, property securities.

We then create an equal-weight allocation (1/20 = 5%) to each asset class.  This portfolio thereby provides an alternative approach to multi-asset diversification with differentiated risk-return characteristics.

Does it work?
By default, the risk-return characteristics of a 1/N portfolio will be different to that of a traditional multi-asset portfolio, so a Max Deconcentration strategy will provide a differentiated risk-return characteristic for diversification purposes.

However, there is also research to suggest that a "simple" 1/N portfolio can outperform more "sophisticated" mean-variance optimised portfolios.  For more on this, see De Miguel, Garlappi and Uppal (2009) and related readings.

Obviously the nuance of any 1/N portfolio will depend on its design parameters: the performance of our Max Deconcentration strategy will be included in future multi-asset strategy reviews relative to a 60/40 benchmark as well as other risk-based strategies such as Min Variance and Risk Parity.

Keep updated
To view peformance of this strategy, please refer to our strategy factsheets, published daily, or request portfolio access via Bloomberg.  To replicate this strategy, subscribe to our Advanced Portfolios for weightings files and detialed performance analysis.

• Comparing balanced risk profile / 60% equity allocation multi-asset funds to our “plain vanilla” 60/40 GBP index enables performance insight and analysis
• Asset allocation design and investment process are key differentiators
• Architas Multi-Asset Passive range has delivered best risk-adjusted performance, whilst HSBC Global Strategy range offers lowest all-in costs

We analysed 5 year performance of major multi-asset index funds relative to the Elston 60/40 GBP Index to end December 2019, and a YTD update through the COVID-19 impact.

We focused on the following multi-asset index funds* for performance analysis:
Architas Multi-Asset Passive Intermediate fund, BlackRock Consensus 60 fund, HSBC Global Strategy Balanced fund, LGIM Multi-Index 5 fund and Vanguard LifeStrategy 60% Equity fund.

Cumulative Returns
Architas and HSBC have the best performing funds in absolute terms within this group:

Source: Elston research, Bloomberg data
Notes: Total returns in GBP terms, daily data, as at 31/12/19

Risk-adjusted returns
Within this group, Architas has delivered best risk-adjusted returns within:

Source: Elston research, Bloomberg data
Notes: Annualised total returns in GBP terms, daily data.  5 year annualised daily volatility data as at 31/12/19

Performance in COVID-19’s “live fire stress-test”
Looking at performance year to date, we see Architas, HSBC and Vanguard delivering performance most consistent with the 60/40 index.  BlackRock Conensus 60 and L&G Multi-Index have delivered least consistent performance relative to this index, underperforming the 60/40 index by -1.81ppt and -2.67ppt respectively.

Obviously those funds’ objectives are specific to each fund and are aiming neither to track nor beat the 60/40 index.  But now we can track the performance of a “no-brainer”** 60/40 portfolio in real-time, it’s easier to see the value that multi-asset index funds add or substract relative to that plain vanilla benchmark.  Multi-asset managers can add value through optimisation, tactical allocation and implementation efficiencies, for example.

Source: Elston research, Bloomberg.  As at 29/5/20 total returns basis, GBP terms.

Costs
Ranked by Total Costs and Charges (“TCC”) which represents OCF plus transaction costs, HSBC offers the lowest cost option.
                                OCF                        TCC
HSBC                     0.18%                    0.22%
BlackRock            0.22%                    0.29%
Vanguard            0.22%                    0.26%
LGIM                     0.31%                    0.31%***
Architas                0.47%                    0.48%
Source: manager data, as at end December 2019. ***estimated figure

Value For Money
Architas may look expensive on a TCC basis.  But it has delivered best risk-adjusted performance in the period under review owing to their more dynamic asset allocation approach, so arguably offers good value for money on a risk-adjusted basis.  For static allocation funds, the main differentiator is cost alone, on which basis HSBC offers best value for money, in our view.

A less inappropriate benchmark
Whilst our 60/40 benchmark by default may not be the "perfect" benchmark for these and other (balanced/medium-risk) multi-asset funds, it is certainly a less inappropriate benchmark than comparing a multi-asset fund to a FTSE 100 or Global Equity benchmark.  Whilst individual fund houses may use composites for comparison, these may not be publicly available for analysis.  The existince of a published standardised 60/40 benchmark enables cross-comparison, analysis and insights.

*Fund tickers: ARINTDA, BRC60DA, HSWIPCA, LGMI5IA, VGLS60A respectively.  Index ticker: 6040GBP Index
**Abraham Okusanya's coinage in https://finalytiq.co.uk/cobras-unintended-consequences-multi-asset-funds/​

• Multi-asset index funds are a useful tool for all or a core of DIY investors’ portfolios
• Consideration of investment philosophy and process is key
• A plain vanilla 60/40 GBP index can help comparison

 
Multi-asset index funds are a powerful and straightforward way for DIY investors to create a multi-asset, diversified and low-cost core holding within a portfolio.

How much should I have in my core?
For index investors not wanting to worry about creating and managing their own asset allocation, these funds can provide a one-stop shop and receive a 100% allocation.
For investors who enjoy picking their own stocks or funds, these funds can provide a helpful core exposure.  The extent to which multi-asset funds make up a core is up to the investor as a preference, and obviously impacts the similarity of portfolio performance to a multi-asset fund.
Investors who want the bulk of their risk-return characteristics to be self-selected should consider a lower allocation to a multi-asset fund core, for example 20-40%.
Investors who want the bulk of their risk-return characteristics to be consistent with the chosen multi-asset fund should consider a higher allocation to that core, for example 60-80%.  Self-selected single asset class investments would thereby represent satellite holdings.

Selecting a risk profile
Multi-asset funds typically come in “suites” with 3 to 5 versions to choose from based on risk profile.  Risk profile can be defined by percentage allocation to equities, so investors can select a risk-return profile that is consistent with their objectives.

How do they differ?
Multi-asset index funds will differ in the following ways in terms of philosophy and process:

• Strategic asset allocation: what is it and why.  Some multi-asset index funds use proprietary models, some are linked to third-party research firms.  There are no right answers here, but design preferences around issues such as home equity bias and construction of the bond portfolios are considerations that investors should be comfortable with.
• Static vs dynamic: for some funds, the mix between equities and bonds never changes.  We call this a “static allocation” approach.  Over the very long-term that’s not a problem.  But for investors with short- to medium-term (3 to 20 years in my view) time horizons, it makes sense to adapt to changing market and economic conditions.  We call this a “dynamic allocation” approach.  Understanding the extent, direction and process for dynamic allocation changes is key.
• Open vs closed architecture: some multi-asset funds exclusively use building block funds from their own stable.  We call these closed architecture.  This means that the allocation is constrained by the availability of their own product sets.  Other funds are open architecture.  This means they use whole of market index funds from third party asset managers.  Our preference is for the latter from a counterparty and competitive perspective.

Does it make sense to hold more than one multi-asset fund?
Not really.  Multi-asset funds of the same given risk profile (as defined by % equity allocation) will have similar risk-return characteristics.  The building block index funds they use will mean similar underlying equity/bond exposures.  They are all incredibly well diversified.  Having multiple multi-asset index funds just reduces economies of scale, introduces higher frictional dealing costs, and blurs transparency around asset allocation.  Investors should therefore select a multi-asset fund whose objectives and investment process resonates best and where value for money is keenest.

Comparing multi-asset funds
The IA Mixed Investment Sectors are peer groups of multi-asset funds.
There are four relevant “risk profiled” sectors for multi-asset funds (Target Volatility and Target Absolute Return funds are treated separately.)

• IA Mixed Investment 0-35% Shares
• IA Mixed Investment 20-60% Shares
• IA Mixed Investment 40-85% Shares
• IA Flexible Investment

These sector categorisations are overlapping which is problematic, as a fund with a 60% equity allocation could theoretically fit in to 3 of these sectors.  This is why many “risk profiled” multi-asset funds are classified as “Uncategorised”, which is as unhelpful.
However these remain popular peer groups for comparative purposes.

A 60/40 index can help comparison
As the bulk of assets flow into “balanced” multi-asset funds with a 60% equity allocation, we created a 60/40 equity/bond index for GBP investors to provide a comparator for multi-asset funds.  This means that investors can evaluate multi-asset fund managers skill at 1) creating optimised portfolios over a “boring” 60/40 portfolios; and 2) evaluate the value added by dynamic asset allocation decisions relative to a static-weight index.  While additional indices for different risk profiles may make sense in the future, we believe a 60/40 index is an important first step.
 

• Peer groups and subjective multi-asset benchmarks have significant limitations
• Composites are helpful but lack consistency
• A straightforward 60/40 benchmark designed for GBP-based investors provides a useful yardstick for multi-asset strategy and multi-asset fund comparison

The problem with peer groups
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.[1]
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[2].
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[3]).
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:

• A global 60/40 benchmark could consist of global equities and global bonds.
• A US 60/40 benchmark could consist of US equities and US bonds
• A UK 60/40 benchmark could consist of UK equities and UK bonds

There is no shortage of US 60/40 benchmarks, but these aren’t helpful to UK investors. When designing a 60/40 benchmark for GBP investors we had to make the following key parameter decisions:

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).

Summary
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:

• Does a multi-asset portfolio provide better risk-adjusted returns relative to an all equity portfolio?
• Does an optimised approach improve risk-adjusted returns relative to a heuristic approach?
• Does the inclusion of alternatives within an allocation improve risk-adjusted returns?
• Does an asset-weighted approach compare more or less favourable to an equal-weighted or risk-weighted approach?

Why Elston 60/40 GBP Index?

1. Accessible, daily-calculated benchmark reflecting a traditional 60/40 equity/bond portfolio
2. A straightforward, consistent alternative to composites and peer groups
3. Designed for GBP-based investors for evaluation of multi-asset strategies & funds

Search “6040GBP Index” on leading data vendors such as Bloomberg, Reuters and Morningstar or visit http://www.elstonetf.com/indices.html

​References
[1] https://jasonzweig.com/what-harry-markowitz-meant/ https://jasonzweig.com/what-harry-markowitz-meant/
[2] Pension Fund Asset Allocation: In Defense of a 60/40 Equity/Debt Asset Mix (Ambachtsheer, 1987)


[3] https://www.investopedia.com/articles/financial-advisors/012716/where-does-john-c-bogle-keep-his-HHmoney.asp
* 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

• Does theory work in practice?
  
• Risk-based multi-asset strategies as indices.
  
• Performance evaluation.

Whilst sound in theory, do risk-based strategies work in practice?
To find out, we took at the performance of a multi-asset Risk Parity Index and a multi-asset Minimum Variance index.
Risk Parity aims to achieve equal risk contribution from each asset class
Min Variance aims to combine each asset class to achieve a minimum variance portfolio
On a rolling five year basis, both multi-asset Min Volatility and Risk Parity offered superior risk-adjusted returns relative to a 60/40 Portfolio for GBP investors.
Both Min Volatility and Risk Parity offered a lower level of overall risk relative to a 60/40 portfolio.
Get the full report here
http://www.elstonetf.com/store/p3/Multi-Asset_Indices%3A_risk-based_strategies.html

• Elston has created a dedicated 60/40 Index as a public benchmark
• A 60/40 equity/bond portfolio is a popular comparator for multi-asset funds and portfolios
• This traditional asset-based multi-asset index is designed for UK investors with a base currency in GBP

Elston Consulting has launched a published 60/40 Index for UK investors.

The Elston 60/40 GBP Index represents a 60% strategic allocation to Global & UK equities and a 40% allocation to predominantly UK bonds. 

A “60/40” equity/bonds composite benchmark is a traditional comparator for multi-asset funds and portfolios.

However, there are no standardised views of what a 60/40 portfolio looks like.  For global investors this could mean 60% Global Equities, 40% Global Bonds.  For US investors, 60/40 could mean 60% US Equities, 40% US Bonds.

Elston’s 60/40 Index for UK investors provides a standardised comparator for multi-asset portfolio managers and multi-asset fund providers looking for a straightforward multi-asset benchmark.

The index is constructed using large liquid and low cost ETFs as the underlying securities so the benchmark is replicable and investable.  Its performance broadly represents the returns after fees of an index portfolio invested in the strategy.

The index values are available on Bloomberg (ticker 6040GBP Index), Morningstar and other leading data vendors.  The weightings scheme is available to licensees.

Henry Cobbe, Head of Research at Elston Consulting, which created the index says: “At the moment each multi-asset manager, portfolio manager or research firm creates their own internal composite for their version of 60/40.  By having a publicly available benchmark for UK investors, we are enabling decision-makers make comparisons, insights and analysis in a way that is consistent, straightforward and accessible.”

In 1q20 Risk Parity and Min Variance multi-asset strategies offered best downside cushioning relative to a 60/40 Equity/Bond portfolio for GBP investors.
Risk-based strategies:
1. Offer a systematic approach
2. Are designed to be differentiated
3. Have potential to enhance returns, mitigate risk or improve diversification
Get the full report here
http://www.elstonetf.com/store/p12/Multi-asset_strategies%3A_1q20_update.html