[3 min read, open as pdf]

• High inflation prints drive expectations of earlier sharper Fed tightening
• But inflation “catch-up” rates suggest room for “hotter for longer” inflation
• Catch-up rates look at cumulative inflation relative to long-term trend line

 
The inflation theme is resonating in US earnings calls with company CEOs seeing this "temporary regime" lasting longer into 2022.  In terms of prints, June CPI in the US was +5.4% and core CPI +4.5% - the highest print since November 1991.

Markets have been caught between a push-pull between inflation data and interest rate policy response.  Concerns that inflation is more persistent than transitory is driving flows to “risk on” assets.  Related concerns that the Fed might start tightening policy earlier and sharper has been the “risk off” trade.

Looking at inflation “catch-up” rates suggests that the Fed might let inflation run hotter for longer, pointing to a later lift off in rates from current low interest rates.  This would be supportive for risk assets.

What are “catch-up” rates?
In 2020 ahead of the annual Jackson Hole conference the Fed indicated that it would take a more accommodative approach to inflation crossing the 2% target threshold.

Why is this? Part of the answer is the concept of “catch up” rates.  Essentially this means that a rate above 2% temporarily is ok if it means we are getting back to a 2% long-term trend-line.

Effectively, letting inflation run hot and overshoot target in the short-term can make up for system slack/undershoots in prior years.

What are the reference points?
We don’t’ know the reference points (basis, trend-lines or catch-up period) the Fed will be using in its Policy decisions.

So to illustrate this concept of “catch up rates”, we created an example with cumulative inflation (left hand scale) and average inflation rates (right hand scale).

Our methodology
We took December 2005 as a base, applied a cumulative 2% target inflation path (in blue), and then plotted cumulative path based on actual inflation rate (in green, averaging (dotted green line) 1.87%p.a. to June 2020 – i.e. below target rate).

The red dashed line is the implied path back to trend-line assuming a “catch-up rate” of 2.65%p.a. (red-dotted line) that it would take for inflation to get back to the original trendline over 3 years. 

The catch up rate would be higher if using a shorter time-frame, and lower if using a longer-time frame.

Conclusion
Looking at implied three year “catch-up” rate helpso illustrate the concept and explains why Fed might let inflation run hotter for longer, pointing to a later lift off in rates.

In inflationary regime we favour value-bias equities and real assets for diversification.

Find out more in our quarterly review and outlook.

[10 min read, open as pdf]

• What underpins the Value/Inflation Relationship
• Understanding the Value Cycle
• Relative performance of Value in different inflationary regimes

[3 min read, open as pdf]

Inflation is on the rise
Easy central bank money, pent up demand after lockdowns and supply-chain constraints mean inflation is on the rise.  Will Central Banks be able to keep the lid on inflation?  The risk is that it could persistently overshoot target levels.

It matters more over time
Inflation erodes the real value of money: its “purchasing power”.  If inflation was on target (2%), £100,000 in 10 year’s time would be worth only £82,035 in today’s money.   But on current expectations, it could be worth a lot less than that.

Real assets can help
A bank note is only as valuable as the value printed on it.  This is called its “nominal value”.  Remember the days when a £5 note went a long way?  When inflation rises, money loses its real value.

By contrast, real assets are things that have a real intrinsic value over time whose value is set by supply, demand and needs: like copper, timber, gold, oil, and wheat.

Real assets can also mean things that produce an regular income which goes up with inflation, like infrastructure companies (pipelines, toll roads, national grid etc) and commercial property with inflation-linked rents.

Rethinking portfolio construction
Including “real assets” into the mix can help diversify a portfolio, and protect it from inflation.  Obviously there are no guarantees it will do so perfectly, but it can be done as a measured approach to help mitigate the effects of inflation.  The challenge is how to do this without taking on too much risk.

Find out more about our Liquid Real Assets Index

[3 min read, open as pdf]

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

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

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

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

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

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

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

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

[5 min read, open as pdf]

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

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

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

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

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

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

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

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

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

Illustration of futures rolling for markets in contango

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

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

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

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

These two contrasting approaches are summarised below:

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

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

[3 min read, open as pdf]
​

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

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

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

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

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

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

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

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

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

[3 min read, open as pdf]

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

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

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

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

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

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

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

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

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

[3 min read, 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