 [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 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.
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 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:
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:
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.
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” 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.
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:
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.
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 
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. 
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 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:
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.)
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.
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:
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:
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 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 |
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