[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 

[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.

High risk, complex Exchange Traded Products that amplify (with “leverage”) index’ moves in the same (“long”) or opposite (“short”) direction are designed for sophisticated investors who want to trade and speculate over the short-term, rather than make a strategic or tactical investment decisions.  Whilst they can have a short-term role to play, they should be handled with care.  If you think you understand them, then you’ve only just begun.

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.

For more speculators and or more sophisticated risk managers there are a range of inverse (short) and leveraged (geared) ETPs that can rapidly add or remove upside or downside risk exposure in short-term (daily) market movements.
 
The difference between speculating and investing should be clearly defined.

• Investing implies a disciplined, rational approach to seeking a commensurate level of expected return for a given level of risk using the investor’s own capital.
• Speculating implies an unstructured, emotional approach to seeking outsize levels of possible return at any level of risk using the speculator’s own or borrowed capital.

 
Owing to the higher degree of risk management and understanding required to use these products,  they may not be suitable for DIY or long-term investors.  However a degree of knowledge is helpful to identify them within a managed portfolio or amongst research sites.
 
Defining terms
Unlike their more straightforward unleveraged ETF cousins, leveraged and inverse or “short” ETNs should be for sophisticated investor or professional use only. So hold onto your seat.  Shorting and leverage are important tools in a professional manager’s arsenal.  But first we need to define terms.
 
Going long: means buying a security now, to sell it at a later date at a higher value. The buyer has profited from the difference in the initial buying price and final selling price.
 
Going short: means borrowing a security from a lender and selling it now, with an intent to buy it back at a later date at a lower value. Once bought, the security can be returned to the lender and the borrower (short-seller) has profited from the difference in initial selling and final buying price.
 
Leverage: means increasing the magnitude of directional returns using borrowed funds.  Leverage can be achieved by:

• Borrowing (on a secured or unsecured basis) from lender to invest in risk assets, in the expectation that the returns are greater than the interest rate charged for borrowing those funds. Use of borrowing within ETNs to create Leveraged ETNs introduces interest costs into the overall cost of the ETN.

 

• Options: leverage can be achieved synthetically by buying call options (the right to buy a stock (including ETFs on whole markets) at a certain strike price in the future.  As markets move further away from the strike price, the value of that option increases exponentially. A leveraged short position can be achieved by selling call options.

 

• Contracts for Difference (CFD): leverage can be achieved synthetically by entering into a contract for difference (where one party contracts to pay the other party the difference between a current value and the value at the start of the contract).  The buyer can use current cash and trade on margin that is based on the size of the trade. Effectively, it means buyers of CFDs only need a small amount of capital to access a much larger position.

 
Underlying index: is the underlying index exposure against which a multiplier is applied.  The underlying index could be on a particular market, commodity or currency.
Potential applications
Managers typically have a decision only whether to buy, sell or hold a security.  By introducing products that provide short and/or leveraged exposure gives managers more tools at their disposal to manage risk or to speculate.  Going short, and using leverage can be done for short-term risk management purposes, or for speculative purposes.  Leverage in either direction (long-short) can be used either to amplify returns, profit from very short market declines, or change the risk profile of a portfolio without disposing of the underlying holdings.
 
 
Short/Leveraged ETPs available to DIY investors
The following types of short/leveraged ETPs are available to implement these strategies.
 
Fig.1. Potential application of inverse/leveraged ETPs

The ability to take short and/or leveraged positions was previously confined to professional managers and ultra-high net worth clients.  The availability of more complex Exchange Traded Products gives investors and their advisers the opportunity to manage currency risk, create short positions (profit from a decline in prices) and create leveraged positions (profit more than the increase or decrease in prices).
Risks
Leveraged and short ETPs have significantly greater risks than conventional ETFs.  Some of the key risks are outlined below:

• Complexity: short and leveraged products are complex products making them harder to understand and deploy.

 

• Counterparty risk: furthermore short/leveraged ETPs carry bank counterparty risk as they are swap based agreements unlike traditional ETFs which are physical and own the underlying asset.

 

• Decay: leveraged products exhibit decay (their ability to perfectly track an index with leverage) diminishes over time from the combined effects of fees and expenses, rebalancing costs and volatility decay[1].

 
If concerned regarding risk of deploying short/leveraged ETPs, set a capped allocation i (eg no more than 3% to be held in leveraged/inverse ETPs, and a holding period for leveraged/inverse ETPs not to exceed 1-5 days). 
 
US Case Study: Inverse Volatility Blow Up
VelocityShares Daily Inverse VIX Short-Term ETN (IVX) and ProShares Short VIX Short-Term Futures ETF were products created in the US for professional investors who wanted to profit from declining volatility on the US equity market by tracking the inverse (-1x) returns of the S&P VIX Short-Term Futures Index.  The VIX is itself an reflecting the implied volatility of options on the S&P 500.  As US equity market volatility steadily declined the stellar performance of the strategy in prior years not only made it popular with hedge funds[2], but also lured retail investors who are unlikely to have understood the complexity of the product.  By complexity, we would argue that a note inversely tracking a future on the implied volatility of the stock market is hardly simple.
 
On 5th February, the Dow Jones Industrial Average suffered its largest ever one day decline.  This resulted in the VIX Index spiking +116% (from implied ~12% volatility to implied ~33% volatility).  The inverse VIX ETNs lost approximately 80% of their value in one day which resulted in an accelerated closure of the product, and crystallising the one day loss for investors[3].  The SEC (US regulator) focus was not on the product itself but whether and why it had been mis-sold to retail investors who would not understand its complexity[4].

Summary
In conclusion, on the one hand, Leveraged/Inverse ETP are convenient ways of rapidly altering risk-return exposures and provide tools with which speculators can play short-term trends in the market.  Used by professionals, they also have a role in supporting active risk management.  However, the risks are higher than for conventional ETFs and more complex to understand and quantify.

​RISK WARNING! Short and/or Leveraged ETPs are highly complex financial instruments that carry significant risks and can amplify overall portfolio risk.  They are intended for financially sophisticated investors who understand these products, and their potential pay offs.  They can be used to take a very short term view on an underlying index, for example, for day-trading purposes. They are not intended as a buy and hold investment.

[1] https://seekingalpha.com/article/1457061-how-to-beat-leveraged-etf-decay

[2] https://www.cnbc.com/2018/02/06/the-obscure-volatility-security-thats-become-the-focus-of-this-sell-off-is-halted-after-an-80-percent-plunge.html

[3] https://www.bloomberg.com/news/articles/2018-02-06/credit-suisse-is-said-to-consider-redemption-of-volatility-note

[4] https://www.bloomberg.com/news/articles/2018-02-23/vix-fund-blowups-spur-u-s-to-probe-if-misconduct-played-a-role

​Which asset classes are not indexable; what proxies do they have that can be indexed; and why it can make sense to blend ETFs and Investment Trusts for creating an allocation to alternative asset classes

​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.
 
Non-indexable asset classes
Whilst Equities, Bonds and Cash are readily indexable, there are also exposures that will remain non-indexable because they are:

• Illiquid in nature (inaccessible markets, for example infrastructure contracts (toll roads, power contracts, wind-farms, aircraft leasing, railway operating contracts))
• Require or reward subjective management and skill (“true active”, for example high conviction long only funds, or long/short hedge funds)
• Difficult to hold (for example commodities)

On the face of it, alternative assets seem less suitable to indexing: for example property, infrastructure, private equity, and hedge funds.

It is however possible to represent some of these alternative class exposures using liquid index proxies.  Index providers and ETF issuers have worked on creating a growing number of indices for specific exposures in the Liquid Alternative Asset space.

Some examples are set out below:

• For property as an asset class, exposure can be achieved via an index of listed property companies. This is a more liquid way to obtain exposure to that asset class than traditional property funds that own direct property, and means there is less liquidity risk (as we saw in 2016 Brexit and 2020 Covid market dislocations) compared to traditional open-ended property funds.  Unlike traditional funds, property ETFs saw no suspensions or gatings.
• For infrastructure, exposure can be achieved via an index of listed infrastructure equities, or a multi-asset infrastructure index that has both equities and bonds (reflecting infrastructure’s bond-like characteristics).
• For private equity, there are listed private equity firms which benefit from returns in that sector.
• For commodities, exposure can be achieved via diversified basket of commodities held via an exchange traded product that tracks a broad commodity index
• For gold, exposure can be either to gold-producers, or synthetic exposure to gold, or to a physical fund that tracks the gold price whose underlying holding is gold bullion.

These liquid index proxies for alternative assets have broadened the range of asset classes investable via ETPs.

​Alternative asset index proxies
Whilst these liquid proxies for those asset classes are helpful from a diversification perspective, it is important to note that they necessarily do not share all the same investment features, and therefore do not carry the same risks and rewards as the less liquid version of the asset classes they represent.

While ETFs for alternatives assets will not replicate holding the risk-return characteristics of that exposure directly, they provide a convenient form of accessing equities and/or bonds of companies that do have direct exposure to those characteristics.
​
Using investment trusts for non-index allocations
Ironically, the investment vehicle most suited for non-indexable investments is the oldest “Exchange Traded” collective investment there is: the Investment Company (also known as a “closed-end fund” or “investment trust”).  The first UK exchange traded investment company was the Foreign & Colonial Investment Trust, established in 1868.
​
Like ETFs, investment companies were originally established to bring the advantages of a pooled approach to the investor of “moderate means”.

For traditional fund exposures, e.g. UK Equities, Global Equities, our preference is for ETFs over actively managed Investment Trusts owing to the performance persistency issue that is prevalent for active (non-index) funds.  Furthermore, investment trusts have the added complexity of internal leverage and the external performance leverage created by the share price’s premium/discount to NAV – a problem that can become more intense during periods of market stress.
​
However, for accessing hard-to-reach asset classes, Investment Trusts are superior to open-ended funds, as they are less vulnerable to ad hoc subscriptions and withdrawals.

The Association of Investment Company’s sector categorisations gives an idea of the non-indexable asset classes available using investment trusts: these include Hedge Funds, Venture Capital Trusts, Forestry & Timber, Renewable Energy, Insurance & Reinsurance Strategies, Private Equity, Direct Property, Infrastructure, and Leasing.

A blended approach
Investors wanting to construct portfolios accessing both indexable investments and non-indexable investments could consider constructing a portfolio with a core of lower cost ETFs for indexable investments and a satellite of higher cost specialist investment trusts providing access to their preferred non-indexable investments.  For investors, who like non-index investment strategies, this hybrid approach may offer the best of both world.

Summary
The areas of the investment opportunity set that will remain non-indexable, are (in our view) those that are hard to replicate as illiquid in nature (hard to access markets or parts of markets); and those that require or reward subjective management and skill.  Owing to the more illiquid nature of underlying non-indexable assets, these can be best accessed via a closed-ended investment trust that does not have the pressure of being an open-ended fund.
ETFs provide a convenient, diversified and cost-efficient way of accessing liquid alternative asset classes that are indexable and provide a proxy or exposure for that particular asset class.  Examples include property securities, infrastructure equities & bonds, listed private equity, commodities and gold.

[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 Real Assets for diversification

• As Real Asset funds AUM increased, so too has their usage of ETFs and index-tracking funds to ensure good underlying liquidity
• Combining liquid real asset ETFs into a model portfolio enables access to similar performance characteristics, greater liquidity & transparency, at lower overall cost
• We contrast the performance of the Elston Liquid Real Asset index portfolio of ETFs to the largest Real Assets funds

 
What are “Real Assets”?
Real Assets can be defined as “physical assets that have an intrinsic worth due to their substance and property”[1].  Real assets can be taken to include precious metals, commodities, real estate, infrastructure, land, equipment and natural resources.  Because of the “inflation-protection” objective of investing in real assets (the rent increases in property, the tariff increases in infrastructure), real asset funds also include exposure to inflation-linked government bonds as a financial proxy for a real asset.

Why own Real Assets?
There are a number of rationales for investing in Real Assets.  The primary ones are to:

• Diversify a portfolio away from just equities and bonds
• Generate an income stream supported by the underlying asset’s cashflows
• Protect against expected and unexpected inflation

For these reasons there has been substantial allocation to real asset by both institutional and retail investors.

Accessing Real Assets
Institutional investors can access Real Assets directly and indirectly.  They can acquired direct property and participate in the equity or debt financing of infrastructure projects. Directly.  For example, the Pensions Infrastructure Platform, established in 2021 has enabled direct investment by pension schemes into UK ferry operators, motorways and hospital construction projects.  This provides funding for government-backed project and real asset income and returns for institutional investors.  Institutional investors can also access Real Assets indirectly using specialist funds as well as mainstream listed funds such as property securities funds and commodities funds.

Retail investors can access Real Assets mostly indirectly through funds.  There is a wide range of property funds, infrastructure funds, commodity funds and natural resources funds to choose from.  But investors have to decide on an appropriate fund structure.

• OEICs have the advantage of convenience and pooled scale, but have the risk of a liquidity mismatch (the daily liquidity of the funds is not reflected by the liquidity of the underlying assets
• Investment Trusts have the advantage of being able to borrow to invest, but have the disadvantage of a volatile premium or discount to NAV based on demand/supply for the shares
• ETFs have the advantage of transparency, liquidity and cost, but the disadvantage of being restricted to owning only listed or tradable securities.

For this reason, there has been a risk in the use of Real Asset funds to outsource these decisions to professional managers.

The rise of real asset funds
The first UK diversified real asset fund was launched in 2014, with competitor launches in 2018.  There is now approximately £750m invested across the three largest real asset funds available to financial advisers and their clients, with fund OCFs ranging from 0.97% to 1.46%.

Following the gating of an Equity fund (Woodford), a bond fund (GAM) and several property funds for liquidity reasons, there has – rightly – been increased focus by the regulator and fund providers (Authorised Corporate Directors or “ACDs”) on the liquidity profile of underlying assets.

As a result, given their increased scale, real asset fund managers are increasingly turning to mainstream funds and indeed liquid ETFs to gain access to specific asset classes.

Indeed, on our analysis, one real assets funds has the bulk of its assets invested in mainstream funds and ETFs that are available to advisers directly.  Now there’s no shame in that – part of the rationale for using a Real Assets fund is to select and combine funds and manage the overall risk of the fund.  But what it does mean is that discretionary managers and advisers have the option of creating diversified real asset exposure, using the same or similar underlying holdings, for a fraction of the cost to clients.
 
Creating a liquid real asset index portfolio
We have created the Elston Liquid Real Asset index portfolio of ETFs in order to:

• Gain exposure to real asset classes using the same or similar exposures to a real assets fund
• Have full transparency as regards underlying holdings and assured ETF liquidity
• Deliver a systematic, diversified exposure at a lower cost to clients

We have built the index portfolio using the following building blocks

• Liquidity: exposure to ultrashort duration bonds to provide ballast and stability
• Inflation protection: exposure to UK and government inflation-linked bonds
• Property & Asset backed securities: exposure to the capital value and income stream of property using property securities ETF, as well as being on the receiving end of mortgage payments using a mortgage backed securities ETF.
• Clean Energy & Infrastructure: clean energy means owning within an ETF the listed securities in providers of clean energy such as wind farms and solar farms.  Infrastructure means owning within an ETF the listed equity and bond securities of infrastructure providers.
• Gold & Commodities: direct exposure to Gold using a physical ETC, and indirect exposure to a broad commodities basket using a synthetic ETC.
• Natural Resources: owning ETFs with exposure to listed global water companies as well as listed global timber and forestry companies.

As regards asset allocation, we are targeting a look-through ~50/50 balance between equity-like securities and bond-like securities to ensure that the strategy provides beta reduction as well as diversification when included in a portfolio.  For the index portfolio simulation, we have used an equal weighted approach.
Fig.1. Performance of the Liquid Real Asset Index Portfolio (.ELRA)

Source: Elston research, Bloomberg data. Total returns from end December 2018 to end September 2020 for selected real asset funds.
Since December 2018, the Sanlam Real Assets fund has returned 19.99%, the Elston Real Asset Index Portfolio has returned +19.76%.  This compares to +5.86% for the Architas Diversified Real Asset fund and +0.16% for the Waverton Real Assets Fund.
What about Beta
Our Real Asset Index Portfolio has a Beta of 0.75 to the Elston 60/40 GBP index so represents a greater risk reduction than Waverton (0.86) and Sanlam (0.84), which are all higher beta than Architas (0.53).
Fig.2. Real Asset strategies’ beta to a 60/40 GBP Index

Source: Elston research, Bloomberg data. Weekly data relative to Elston 60/40 GBP Index, GBP terms Dec-18 to Sep-20.
Finally, by accessing the real asset ETFs directly, there is no cost for the overall fund structure, hence the implementation cost for an index portfolio of ETFs is substantially lower.
Fig.3. Cost comparison of Real Asset funds vs index portfolio of ETFs

Source: Elston research, Bloomberg data 

Fund or ETF Portfolio?
The advantage of a funds-based approach is convenience (single-line holding), as well as having a a manager allocate dynamically between the different real asset exposures within the fund.
The advantage of an index portfolio is simplicity, transparency and cost.  Creating a managed ETF portfolio strategy that dynamically allocates to the different real asset classes over the market cycle is achievable and can be implemented on demand.
​
Summary
The purpose of this analysis was to note that:

1. Real Asset Funds available to retail investors do not have any special access to an opportunity set of funds that cannot be accessed directly
2. The liquidity requirements on real asset funds is driving them more to the use of index funds and ETFs
3. It is possible to create a diversified, liquid real assets portfolios using ETFs and index funds.
4. There is a trade off between cost and convenience between having an index portfolio of ETFs and a unitised fund.
5. An equal-weight strategy can prove effective given the overall allocation to real assets within a portfolio.  A managed dynamic-weight strategy would be an interesting enhancement.

​[1] Source: https://www.investopedia.com/terms/r/realasset.asp

Investors should prefer the certainty of index funds which track the index less passive fees, than the hope and disappointment of active funds which, in aggregate, track the index less active fees.

​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.
 
Clarifying terms
We believe that typically an index fund or ETF can perfectly well replace an active fund for a given asset class exposure.  As with all disruptive technologies, many column inches have been dedicated to the “active vs passive” debate.  However, with poorly defined terms, much of this is off-point.
If active investing is referring to active (we prefer “dynamic”) asset allocation: we fully concur.  There need be no debate on this topic.  Making informed choices on asset allocation – either using a systematic or non-systematic decision-making process – is an essential part of portfolio management.
If, however, active investing refers to fund manager or security selection, this is more contentious, and this should be the primary topic of debate. 
Theoretical context: the Efficient Market Hypothesis
The theoretical context for this active vs passive debates is centred on the notion of market efficiency.  The efficient market hypothesis is the theory that all asset prices reflect all the available past and present information that might impact that price.  This means that the consistent generation of excess returns at a security level is impossible.  Put differently, it implies that securities always trade at their fair value making it impossible to consistently outperform the overall market based on security selection.  This is consistent with the financial theory that asset prices move randomly and thus cannot be predicted .
Putting the theory into practice means that where markets are informationally efficient (for example developed markets like the US and UK equity markets), consistent outperformance is not achievable, and hence a passive investment strategy make sense (buying and holding a portfolio of all the securities in a benchmark for that asset class exposure).  Where markets are informationally inefficient (for example frontier markets such as Bangladesh, Sri Lanka and Vietnam )  there is opportunity for an active investment strategy to outperform a passive investment strategy net of fees.
Our view is that liquid indexable markets are efficient and therefore in most cases it makes sense to access these markets using index-tracking funds and ETFs, in order to obtain the aggregate return for each market, less passive fees.
This is because, owing to the poor arithmetic of active management, the aggregate return for all active managers is the index less active fees.
The poor arithmetic of active management
Bill Sharpe, the Nobel prize winner, and creator of the eponymous Sharpe Ratio, authored a paper “The Arithmetic of Active Management” that is mindblowing in its simplicity, and is well worth a read.
We all know the criticism of passive investing by active managers is that index fund [for a given asset class] delivers the performance of the index less passive fees so is “guaranteed” to underperform.  That’s true, but it misses a major point.
The premise of Sharpe’s paper is that the performance, in aggregate, of all active managers [for a given asset class] is the index less active fees.
Wait.  Read that again.
Yes, that’s right.  The performance of all active managers is, in aggregate (for a given asset class) the index less active fees.  Sounds like a worse deal than an index fund? It’s because it is.  How is this?
Exploring the arithmetic of active
Take the UK equity market as an example.  There are approximately 600 companies in the FTSE All Share Index.
Now imagine there are only two managers of two active UK equity funds, Dr. Star and Dr. Dog.
Dr. Star consistently buys, with perfect foresight, the top 300 performing shares of the FTSE All Share Index each year, year in year out, consistently over time.  This is because he avoids the bottom 300 worst performing shares.  His performance is stellar.
That means there are 300 shares that Dr. Star does not own, or has sold to another investor, namely to Dr. Dog.
Dr. Dog therefore consistently buys, with perfect error, the worst 300 performing shares of the FTSE All Share Index each year, year in year out, consistently over time.  His performance is terrible.
However, in aggregate, the combined performance of Dr. Star and Dr. Dog is the same as the performance of the index of all 600 stocks, less Dr. Star’s justifiable fees, and Dr. Dog’s unjustifiable fees.
The performance of both active managers is, in aggregate, the index less active fees. It’s a zero sum game.
In the real world the challenge of persistency – persistently outperforming the index to be Dr.Star – means that over time it is very hard, in efficient markets to persistently outperform the index.
So investors have a choice.
They can either pay a game of hope and fear, hoping to consistently find Dr. Star as their manager.  Or they can be less exciting, rational investor who focus on asset allocation and implement it using index fund to buy the whole market for a given asset exposure keep fees down.
Given this poor “arithmetic” of active management, why would you ever chose an active fund (in aggregate, the index less active fees) over a passive fund (in aggregate the index less passive fees)? Quite.
Monitoring performance consistency
The inability of non-index active funds to consistently outperform their respective index is evidenced both in efficient market theory, and in practice.
Consistent with the Efficient Market Hypothesis, studies have shown that actively managed funds generally underperform their respective indices over the long-run and one of the main determinant of performance persistency is fund expenses .  Put differently, lower fee funds offer better value for money than higher fee funds for the same given exposure.  This is a key focus area from the UK regulator as outlined in the Asset Management Market Study.
In practice, the majority of GBP-denominated funds available to UK investors have underperformed a related index over longer time horizons.  Whilst the percentage of funds that have beaten an index over any single year may fluctuate from year to year, no active fund category evaluated has a majority of outperforming active funds when measured over a 10-year period.  This tendency is consistent with findings on US and European based funds, based on the regularly published “SPIVA Study”.
The poor value of active managers who “closet index”
“Closet indexing” is a term first formalised by academics Cremers and Petajisto in 2009 .  It refers to funds whose objectives and fees are characteristic of an active fund, but whose holdings and performance is characteristic of a passive fund.  Their study and metrics around “active share” and “closet indexing” caused a stir in the financial pages on both sides of the Atlantic as active fund managers started to watch the persistent rise of ETFs and other index-tracking products.  The issue around closet index funds is not simply about fees.  It’s as much about transparency and customer expectations.
Understanding Active Share
Active Share is a useful indicator developed by Cremers and Petajisto as to what extent an active (non-index) fund is indeed “active”.  This is because whilst standard metrics such as Tracking Error look at the variability of performance difference, active share looks at to what extent the weight of the holdings within a fund are different to the weight of the holdings within the corresponding index.  The higher the Active Share, the more likely the fund is “True Active”.  The lower the Active Share, the more likely the fund is a “Closet Index”.
How can you define “closet indexing”?
There has been some speculation as to what methodology the Financial Conduct Authority (FCA) used to deem funds a “closet index”.  In this respect, the European Securities and Markets Authority (ESMA), the pan-European regulator’s 2016 paper may be informative.  Their study applied a screen to focus on funds with 1) assets under management of over €50m, 2) an inception date prior to January 2005, 3) Fees of 0.65% or more, and 4) were not marketed as index funds.  Having created this screen, ESMA ran three metrics to test for a fund’s proximity to an index: active share, tracking error and R-Squared.  On this basis, a fund with low active share, low tracking error and high R-Squared means it is very similar to index-tracking fund.
Based on ESMA’s criteria, we estimate that between €400bn and €1,200bn of funds available across the EU could be defined as “closet index” funds.  That’s a lot of wasted fees.
Defining “true active”
We believe there is an essential role to play for “true active”.  By this we mean high conviction fund strategies either at an asset allocation level.
True active (asset allocation level): at an asset allocation level, hedge funds which have the ability to invest across assets and have the ability to vary within wide ranges their risk exposure (by going both long and short and/or deploying leverage) would be defined as “true active”.  Target Absolute Return (TAR) funds could also be defined as true active given the nature of their investment process.  Analysing their performance or setting criteria for performance evaluation is outside the scope of this book.  However given the lacklustre performance both of Hedge Funds in aggregate (as represented by the HFRX index) and of Target Absolute Return funds (as represented by the IA sector performance relative to a simple 60/40 investment strategy), emphasises the need for focus on manager selection, performance consistency and value for money. 
True active (fund level): we would define true active fund managers as those which manage long-only investments, either in hard-to-access asset classes or those which manage investments in readily accessible asset classes but in a successfully idiosyncratic way.  It is the last group of “active managers” that face the most scrutiny as their investment opportunity set is identical to that of the index funds that they aim to beat.
True active managers in traditional long-only asset classes must necessarily take an idiosyncratic non-index based approach.  In order to do so, they need to adopt one or more of the following characteristics, in our view:

• Conviction: the ability to show high conviction by allocating to securities with substantial deviation from benchmark weights (high active share)
• Concentration: the ability to create and manage a concentrated portfolio that includes sufficient securities for diversification purposes (for example, a minimum of 30 securities to create the possibility of a normal distribution), but not as many as the index they are trying to beat.
• Cash Limits: the ability and willingness to allocate up to the maximum level of cash allowed to dampen volatility in a risk off environment.

 
Their success, or otherwise, will depend on the quality of their skill and judgement, the quality of their internal research resource, and their ability to absorb and process information to exploit any information inefficiencies in the market.
True active managers who can consistently deliver on objectives after fees will have no difficulty explaining their skill and no difficulty in attracting clients.  By blending an ETF portfolio with a selection of true active funds, investors can reduce fees on standard asset class exposures to free up fee budget for genuinely differentiated managers.
Summary
In conclusion, “active” and “passive” are lazy terms.  There is no such thing as passive. There is static and dynamic asset allocation, there is systematic and non-systematic tactical allocation, there is index-investing and non-index investing, there are traditional index weighting and alternative index weighting schemes.  The use of any or all of these disciplines requires active choices by investors or managers.

[2 minute read, open as pdf]
Sign up for our upcoming webinar on incorporating ESG into model portfolios

Summary

• Indices codify a criteria-based approach to ESG investing
• Index methodology means screen, score and weight each company
• ESG indices enable similar performance, but with ESG compliance

 
Defining terms
With a growing range of ethical investment propositions available to portfolio designers, we first of all need to define and disambiguate some terms.

• Ethical investing: this is an established investment approach that considers investors’ social and moral preferences, and typically relied on exclusions (typically excluding companies with exposure to “vice” – for example armaments, gambling or alcohol).  Traditionally the approach of religious charities, this approach is becoming mainstream.
• Environmental, Social and Governance (“ESG”): the index provider, MSCI, rates companies based on their approach to Environmental issues (such as Climate change, Natural resources, Pollution & waste and Environmental opportunities); Social issues (such as approach to Human capital, Product liability, Stakeholder opposition and Social opportunities); and Governance issues (such as Corporate governance and Corporate behaviour)[1].
• Socially Responsible Investing (“SRI”): using MSCI’s definitions, this approach incorporates ESG ratings as for ESG, but goes one step further to exclude companies whose products have negative social or environmental impacts; removing companies involved in Thermal Coal mining and power generation; and exclude companies involved in controversies.

​Criteria-based approach works well for indices
Applying ESG criteria to a universe of equities acts as a filter to ensure that only investors are only exposed to companies that are compatible with an ESG investment approach.
Creating a criteria-based approach requires a combination of screening, scoring and weighting.
Looking at the MSCI World SRI 5% Capped Index, for example, means:

1. Screening: removing companies with exposure to Nuclear Power, Tobacco, Alcohol, Gambling, Military Weapons, Civilian Firearms, GMOs, Thermal Coal and Adult Entertainment.
2. Scoring: means only including companies that score above a certain level on their MSCI ESG Rating and MSCI Controversies score.
3. Weighting: to make sure the final index has similar risk-return exposure to the parent index (so as not to impact portfolio construction parameters such as risk, return and correlation); index methodology can target similar sector and region weights as the parent index.  Furthermore to ensure that, as a result of all this screening and scoring and weighting adjustments, single-stock exposure (which creates systematic risk) does not become too concentrated, a 5% cap restricts the allocation to any single stock.

 
Indices codify criteria
An index is “just” a weighting scheme based on a set of criteria.  A common, simple index is to include, for example, the 100 largest companies for a particular stock market.  SRI indices reflect weighting schemes, albeit more complex, but importantly, represent a systematic (rules-based) and hence objective approach.  However, the appropriateness of those indices is as only as good as their methodology and the quality of the screening, scoring and weighting criteria applied.

Proof of the pudding
To mix metaphors, the proof of the pudding is in the making of performance that is consistent with the parent index, whilst reflecting all the relevant scoring and screening criteria.  This allows investors to have their ESG cake, as well as eating its risk-return characteristics.
Contrast, for example, the MSCI World Index with the MSCI World Socially Responsible Investment 5% Issuer Capped Index.  The application of the screening and scoring reduces the number of companies included in the index from 1,601 to 386.  But the weightings adjustments are such that the relative risk-return characteristics are similar: the SRI version of the parent index has a Beta of 0.98 to the parent index and is 99.4% correlated with the parent index.
 
Fig.1. Comparative long-term performance

Source: Bloomberg data,
​Focus on compliance, not hope of outperformance
Indeed pressure on the oil price and the performance of technology this year (technology firms typically have strong ESG policies) means that SRI indices have slightly outperformed parent indices.
However, our view is that ESG investing should not be backing a belief that performance should or will be better than a mainstream index.  In our view, ESG investing should aim to deliver similar risk-return characteristics to the mainstream index for a given exposure but with the peace of mind that the appropriate screening and scoring has been systematically and regularly applied.

​[1] For more on this ratings methodology, see https://www.msci.com/esg-ratings

What kind of investor are you: a stock selector, a manager selector or an index investor?

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.
 
In previous articles, we looked at things to consider when designing a multi-asset portfolio.  Let’s say, for illustration, an investor decides on a balanced portfolio invested 60% in equities and 40% in bonds.  The “classic” 60/40 portfolio.

You now have a number of options of how to populate the equity allocation within that portfolio.
We look at each option in turn.

Equity exposure using direct equities: “the stock selectors”
This is the original approach, and, for some, the best.  We call this group “Stock Selectors”: investors who prefer to research and select individual equities and construct, monitor and manage their own portfolios.  To achieve diversification across a number of equities, a minimum of 30 stocks is typically required (at one event I went to for retail investors I was slightly nervous when it transpired that most people attending held fewer than 10 stocks in their portfolio).  Across these 30 or more stocks, investors should give due regards to country and sector allocations.

Some golden rules of stock picking would include:

1. understand the macroeconomic factors that impact a company and its trading and reporting currency
2. understand what drives a company’s future earnings, and the risks to that earnings
3. evaluate the management to understand their strategy for the company

 
The advantage of investing in direct equities is the ability to design and manage your own style, process and trading rules.  Also by investing direct equities there are no management fees creating performance drag.  But when buying and selling shares, there are of course transactional, and other frictional costs, such as share dealing costs and Stamp Duty.
The most alluring advantage of this approach is the potential for index-beating and manager-beating returns. 
But whilst the potential is of course there, as with active managers, persistency is the problem.
The more developed markets are “efficient” which means that news and information about a company is generally already priced in.  So to identify an inefficiency you need an information advantage or an analytical advantage to spot something that most other investors haven’t.  Ultimately you are participant in a zero-sum game, but the advantage is that if you can put the time, hours and energy in, it’s an insightful and fascinating journey.
The disadvantage of direct equity is that if it requires at least 30 stocks to have a diversified portfolio, then it requires time, effort and confidence to select and then manage those positions. 
The other disadvantage is the lack of diversification compared to a fund-based approach (whether active or passive).  This means that direct investors are taking “stock specific risks” (risks that are specific to a single company’s shares), rather than broader market risk.  In normal markets, that can seem ok, but when you have occasional outsize moves owing to company-specific factors, you have to be ready to take the pain and make the decision to stick with it or to cut and run.

What does the evidence say?
The evidence suggests that, in aggregate, retail investors do a poor job at beating the market.
The Dalbar study in the US, published since 1994, compares the performance of investors who select their own stocks relative to a straightforward “buy-and-hold” investment in an index funds or ETF that tracks the S&P500, the benchmark that consists of the 500 largest traded US companies.
The results consistently show that, in aggregate, retail investors fare a lot worse than an index investor.
Reasons for this could be for a number of reasons, including, but not limited to:

• Information asymmetry: retail investors dabbling in stocks do not have the same access to information as professional investment managers and therefore may be late on to news, developments, or turning points that affect a share price.
• Behavioural biases: retail investors are subject to a range of behavioural biases that means they may be reluctant to sell winners (confirmation bias), and/or not quick enough to sell losers (status quo bias)
• Over-trading: retail investors may be tempted to “tinker” with their portfolio.  Some studies show that the more frequently investors trade their portfolios, the worse the performance can get.

So whilst it may be in the interest of some brokerages who rely on dealing costs for income to encourage investors to trade frequently, it may be in investors’ best interests to “buy and hold” their chosen 30 stocks and review them just once or twice a year.
But selecting the “right” 30 or more stocks is labour-intensive, and time-consuming.  So if you enjoy this and are confident doing this yourself, then there’s nothing stopping you.
Indeed, you may be one of the few who can, or think you can, consistently outperform the index year in, year out.  But it’s worth remembering that the majority of investors don’t manage to.
For most people, a direct equity/direct bond portfolio is overly complex to create, labour intensive to manage and insufficiently diversified to be able to sleep well at night.  Furthermore owning bonds directly is near impossible owing to the high lot sizes.  So why bother?
Investors who want to leave stock picking to someone else have two options to be “fund” investors selecting active funds.  Or “index” investors selecting passive funds.

Equity exposure using active funds: the “manager selectors”
A fund based approach means holding a single investment in fund which in turn holds a large number of underlying equities, or bonds, or both.
Investor who want to leave it to an expert to actively pick winners and avoid losers can pick an actively managed fund.  We call this group “Manager Selectors”.  But then you have to pick the “right” actively managed fund, which also takes time and effort to research and select a number of equity funds from active managers, or seek out “star” managers who aim to consistently outperform a designated benchmark for their respective asset class.  And whilst we all get reminded that past performance is not an indicator of future performance, there isn’t much else to go by.
In this respect access to impartial independent research and high quality,unbiased fund lists is an invaluable time-saving resource.
The advantage of this approach that with a single fund you can access a broadly diversified selection of stocks picked by a professional.  The disadvantage of this approach is that management fees are a drag on returns and yet few funds persistently outperform their respective benchmark over the long-run raising the question as to whether they are worth their fees.  This is evidenced in a quarterly updated study known as the SPIVA Study, published by S&P Dow Jones Indices, which compares the persistency of active fund performance relative to asset class benchmarks.  For efficient markets, such as US & UK equities, the results are usually quite sobering reading for those who are prefer active funds.  Indeed many so-called active funds have been outed as “closet index-tracking funds” charging active-style fees, for passive-like returns.
So of course there are “star” managers who are in vogue for a while or even for some time.  But it’s more important to make sure a portfolio is properly allocated, and diversified across managers, as investors exposed to Woodford found out.
In my view, an all active fund portfolio is overly expensive for what it provides.  Whilst the debate around stock picking will run and run (and won’t be won or lost in this article), consider at least the bond exposures within a portfolio.  An “active” UK Government Bond fund has the same or similar holdings to a “passive” index-tracking UK Government Bond fund but charges 0.60% instead of 0.20%, with near identical performance (except greater fee drag).  Have you read about a star all-gilts manager in the press? Nor have I.  So why pay the additional fee?
What about hedge funds? Hedge funds come under the “true active” category because overall allocation exposure can vary greatly, and there is the ability to position a fund to benefit from falls or rises in securities or whole markets, and the ability to borrow money to invest more than the fund’s original value.  But most “true active” hedge funds are not available to retail investors who are more limited to traditional “long-only” retail funds for each asset class.

Equity exposure using index funds: the “index investor”
Investors who don’ want the time, hassle or cost of picking active managers, or believe that markets are “efficient” often use passive index-tracking funds.  We call this group “Index Investors” (full disclosure: I am a member of this group!).  These are investors who want to focus primarily on getting the right asset allocation to achieve their objectives, and implement and actively manage that asset allocation but using low cost index funds and/or index-tracking ETFs.
The advantage of this approach is transparency around the asset mix, broad diversification and lower cost relative to active managers.  The disadvantage of this approach is that it sounds, well, boring.  Ignoring the news on companies’ share prices are up or down and which single-asset funds are stars and which are dogs would mean 80% of personal finance news and commentary becomes irrelevant!
On this basis, my preference is to be a 100% index investor – the asset allocation strategy may differ for the different objectives between my parents, myself and my kids.  But the building blocks that make up the equity, bond and even alternative exposures within those strategies can all index-based.

A blended approach
Whilst my preference is to be an index investor, I don’t disagree, however, that it’s interesting, enjoyable and potentially rewarding for some retail investors and/or their advisers to spend time choosing managers and picking stocks, where they have high conviction and/or superior insight.  Traditionally the bulk of retail investors were in active funds.  This is extreme.  More and more are becoming 100% index investors: this is also extreme.  There’s plenty of ground for a common sense blended approach in the middle.
For cost, diversification and liquidity reasons, I would want the core of any portfolio to be in index funds or ETFs.  I would want the bulk of my equity exposure to be in index funds, with moderate active fund exposure to selected less efficient markets (for example) small caps, and up to 10% in a handful of direct equity holdings that you follow, know and like.

What would a blended approach look like for a 60/40 equity/bond portfolio?
60% equity of which
                Min 70% index funds/ETFs
                Max 20% active funds
                Max 10% direct equity “picks”/ideas
40% bonds of which
                100% index funds

Summary
For most investors, investing is something that needs to get done, like opening a bank account.  If you are in this group then using a ready-made model portfolio or low-cost multi-asset fund, like a Target Date Fund, may make sense.
For some investors, investing is more like a hobby – something that you are happy to spend time and effort doing.  If you are in this group, you have to decide if you are a Stock Selector, Manager Selector or Index Investor, or a blend of all three, and research and build your portfolio accordingly.

 

• Focus on index methodology
• Looking at concentration risk
• Index selection is an active choice

 
Focus on index methodology
Methodology is the genetic code of an index.  The rules that govern how an index is constructed determines what’s in it, at what weights, and therefore how it will perform in relation to the performance of all its components.
A handful of (mainly older) indices are price-weighted indices (such as the DJIA (in the US, since 1896), FT30 (in the UK, since 1935), and Nikkei 225 (in Japan, since 1950).  This means the weight of each stock in the index is determined by its price relative to the summed prices of all the constituents of the index.
The bulk of the most familiar, and most tracked, indices are capitalisation-weighted indices.  This means the weight of each stock in the index is determined by its (often free-float-adjusted) market capitalisation relative to the aggregated market capitalisation of all the constituents of the index.
This leads to one of an oft-cited critique of mainstream indices that they become “pro-cyclical”: namely, they allocate an increasing weight to the best performing stocks, and a decreasing weight to the worst performing stocks.  This is true, but is coloured by your view as to which comes first, the stock performance chicken, or the index performance egg.
​
Looking at concentration risk
What is certainly true is that changes in company capitalisation can create significant stock concentrations in mainstream indices.  For example, the top 5 holdings in the S&P 500 (Apple, Microsoft, Amazon, Alphabet and Facebook) currently represent 21.6% of that index.  The top 30 stocks represent 44.6%, and the top 100 stocks represent 69.9%.  The remaining 400 stocks are a long tail of relatively smaller companies whose individual change in value will not materially impact the overall index performance.

Fig.1. S&P500 Concentration

Size-bias is a choice not an obligation
Index concentration, and related “size-bias”, the relative over-weighting of the largest companies, is however a choice, not an obligation for index investors.
The existence of equal-weight indices enable a less concentrated exposure to the same components of an index.  Whilst this solves the stock concentration risk, it creates a “Fear of Missing Out risk” when those large stocks are doing well.
So, if choosing to use an equal-weighted index to reduce dependency on a concentrated index, communication is key.
Reducing stock-specific risk may be welcome with end clients in theory, but clear messaging is required to explain that investment performance will not be comparable to the performance of funds (whether active or passive) using traditional capitalisation weighted benchmarks.
End investors may feel they miss out when sentiment in the largest names is strong.  But will be relieved when the reverse applies.  On the basis that many investors are asymmetrically loss-averse, the more evenly distributed stock risk of an equal-weighted index could be something to consider.  But only once any potential “Fear of Missing Out” has been discussed and addressed.

Fig.2. S&P 500 vs S&P 500 Equal Weight, YTD Performance (USD terms); Fig.3. & FTSE 100 vs FTSE 100 Equal Weight, YTD Performance (GBP terms)

Source: Elston Research, Bloomberg data, as at 18-Sep-20
 
Index selection is an active choice
There’s no such thing as passive.  Index investing is about adopting a systematic, rules-based approach to stock selection.  There is an active choice to be made around methodology and index selection.  If you don’t want to always hold the largest stocks, then don’t use a cap-weighted index.  If you want to hold stocks based on other criteria – their earnings, their dividends, their style, or just equally weighted – there are plenty of other indices to choose from.  It’s up to the index investor to make that active choice.

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.

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

• Gold has rallied +34% YTD in GBP terms
• The largest 3 physically-backed ETPs are those from iShares, Invesco and Wisdom Tree
• Costings range from 0.19% to 0.39% TER

 
We look at the three largest ETPs that track the gold price and which are “physically-backed” (meaning they own the underlying asset), and track the same spot price index, the LBMA Gold Price Index.
Each of these ETPs offers a London-listed share-class, and each also offers a GBP-denominated listing.  This means that the share price is expressed in GBP-terms.  This is convenient for client reporting and essential for some platforms.  The returns, however, remain unhedged to GBP.
Whilst SGLN and SGLP are Irish-domiciled funds, PHGP is Jersey domiciled.  Each has UK tax reporting status.
In terms of scale and cost, iShares Physical Gold ETC (Ticker: SGLN, launched in 2011) is the largest at £11.9bn with TER of 0.19%, followed by Invesco Physical Gold (Ticker: SGLP, launched in 2009) at £10.7bn with TER of 0.19%, followed by WisdomTree Physical Gold (Ticker: PHGP, launched in 2007) at £7.1bn
With increasing choice available, the key differentiation amongst physically-backed ETPs is cost.
Fig.1. YTD performance of largest London-listed Gold ETPs

Source: Bloomberg, as at 7th August 2020, GBP terms

​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 as such and is to raise awareness and provide purely factual information as regards these portfolios and/or indices.
Image Credit: Shutterstock

• We look at 2 sub-sectors of Liquid Alternative ETFs available to UK investors: Liquid Alternative Assets and Liquid Alternative Strategies
• Within Asset Classes, Gold has proven its defensive qualities in market turmoil
• Within Strategies, Market Neutral has proven most defensive

 
Liquid Alternatives: Assets
We define Liquid Alternative Asset ETFs as tradable ETFs that hold liquid securities that provide access to a particular “alternative” (non-equity, non-bond) asset class exposure.
​
More specifically, we define this as Listed Property Securities, Infrastructure Securities, Commodities, Gold and Listed Private Equity.

Looking at selected ETF proxies for each of these asset classes, the correlations for these Liquid Alternative Assets, relative to Global Equity are summarised below.
Fig.1. Liquid Alternative Assets: Correlation Matrix

Incorporating these exposures within a multi-asset strategy provides can provide diversification benefits, both from an asset-based perspective and a risk-based perspective.
​
Looking at 5 year annualised performance, only Gold has outperformed Global Equities. Listed Private Equity has been comparable.  Meanwhile Infrastructure has outperformed property, whilst Commodities have been lack-lustre.

Fig.2. Liquid Alternative Assets Returns vs Global Equities

Looking at performance YTD, gold has returned +31.06% in GBP terms, outperforming Global Equities by 32.54ppt.  Infrastructure has also slightly outperformed equities owing to its inflation protective qualities.
​
Fig.3. YTD performance of Liquid Alternative Assets (GBP terms)

Source: Elston research, Bloomberg data

Liquid Alternatives: Strategies
We define Liquid Alternative Strategy ETFs as tradable ETFs that provide alternative asset allocation strategies.  By providing differentiated risk-return characteristics, these ETFs should provide diversification and/or reflect a particular directional bias.
​
Fig.4. Examples of European-listed Liquid Alternative Strategies

Each of these strategies provide a low degree of correlation with Global Equities and therefore have diversification benefits.
​
Fig.5. Liquid Alternative Strategies: Correlation Matrix

In 2020, the Market Neutral strategy has proven most defensive.
​
Fig.6. Liquid Alternative Strategies: YTD performance

Source: Bloomberg data, GBP terms, as at July 2020
Conclusion
ETFs offer a timely, convenient, transparent, liquid and low-cost way of allocating or deallocating to a particular exposure.

Blending Liquid Alternative ETFs – both at an asset class level and a strategy level - provides managers with a broader toolkit with which to construct portfolios.

• Options overlays can be used to create an alternative payoff profile
• Covered call and written put strategies are typically defensive for sideways markets/downside protection
• The ETF format enables access, economies of scale, transparency and timeliness

 
Why use options overlays?
Managers of larger investment portfolios sometimes use options overlays to create an alternative payoff profile relative to a straightforward “long-only” equity holding of a share or index.  This is done to reflect a particular investment view.
Examples of options overlay strategies include Covered Calls and Put Writes.  These strategies to protect investments when markets move sideways and there is higher potential for downside risk.  This typically comes at the expense of explicit costs and foregone returns.
What is a covered call strategy?
A Covered Call strategy combines a holding in equities with sales of call options (an option to buy an equity at a given price within a specific time) on those equities.  In other words, it can be seen as sacrificing unknown future gains on equities in exchange for a known income today.  These aim is 1) to generate returns through income from those sales and 2) reduce downside risk.
What is a written put strategy?
A Put Write strategy combines a cash exposure with sales of put options (an option to sell an equity at a given price within a specific time) on those equities, with the aim of generating an income from option sales whilst providing a cushion during market downturns.
What’s new?
UBS has launched a range of four ETFs that offer a choice of two underlying exposures (S&P 500 or Euro Stoxx 50) combined with these two types of options overlay strategies to give investors access to these defensive strategies that perform better in sideways or downward markets.  The ETFs available are:
​
Fig.1. UBS UCITS ETFs incorporating options strategies

Source: Elston Research, Bloomberg data
What does this launch mean for investors?
The launch of these ETFs gives investors of any size the opportunity to access these options overlay strategies within a fund exposure, rather than outwith a fund exposure, meaning that they benefit from:

1. access to the strategy in a way where there are economies of scale (rather than on a bespoke portfolio basis);
2. consistency and transparency of and index-based approach providing a standardised format for all investors within the fund;
3. timeliness to allocate or deallocate to that strategy quickly and conveniently.

Are covered call strategies new within a fund structure?
Not really.  Covered call strategies are used to enhance the income of traditional OEICs in the “Enhanced Income” sector.  Funds such as the Schroder Income Maximiser and Fidelity Enhanced Income use a covered call strategy within the fund to generate additional income at the expense for capital growth, as did Enhanced Income ETFs from BMO.  But this is typically done for yield enhancement rather than as a pure defensive strategy.  These UBS ETFs are not yield focus but are using that additional income to provide some cushioning.
Why the ETF format?
The advantage of the ETF format means that investors have the ability to allocate or deallocate to that strategy quickly and conveniently.  As we saw in March, in period of heightened daily volatility, the 4-5 day dealing cycles (8-10 days for an unfunded switch) of traditional OEICs create significant and unintended market timing risk.  The ETF format offers a more timely way of adding or removing a particular exposure.
Who might use these?
Discretionary managers and financial advisers using platforms that can access ETFs may find these strategies a useful addition to the toolkit as a Liquid Alternative strategy.
Are these Liquid Alternative ETPs?
Yes, we would classify them as such.  But we differentiate between Liquid Alternative Asset Classes and Liquid Alternative Strategies.  We would classify these ETFs as Liquid Alternative Strategies, alongside Managed Futures ETFs and Equity Market Neutral ETFs.
What are the drawbacks?
From a UK perspective, whilst the S&P500 product will be a useful proxy for overall market risk, it’s disappointing that there is these overlay strategies are not available for the UK’s FTSE 100 index as that would be of more appeal for UK investors, advisers and managers.
Furthermore, financial advisers using traditional fund-based platforms will not be able to access these type of options overlay strategies, limiting potential usage.
Performance Track record
Whilst the ETFs are new, the underlying indices has been created with data back to July 2012.
In the 8 years to end July 2020 in USD terms, the US Equity Defensive Covered Call Index returned +11.09%, compared to +13.71% for the S&P 500.  The foregone returns being part of the cost of downside protection.  By contrast, the maximum monthly drawdown (in March 2020) for the Covered Call index was -10.74%, compared to -12.51% for the S&P500, a -14% reduction in drawdown.
Over the same time frame, the US Equity Defensive Put Write Index returned +3.81% compared to +2.88% for US Treasuries.  By contrast, the maximum monthly drawdown (in March 2020) for the Put Write index was -8.14%.
Fig.2. Performance vs selected comparators

Source: Bloomberg data, 31st July 2012 to 31st July 2020, USD terms
In the 1 year to July 2020, the annualised daily volatility of the Covered Call Index was 29.75% compared to 34.10% for the S&P500 (a 12.8% reduction)
In more normal markets – in the 3 years to December 2019, the volatility of the Covered Call Index was 12.27% compared to 12.89% (a 4.8% reduction)

Conclusion
On our analysis, the Put Write index should work well in providing consistent returns in sideways markets in excess of cash/government bonds, but is not immune from severe market shocks.
The Covered Call Index provides a defensive bias whilst maintaining the potential for returns from the underlying exposure.
At a TER of 0.26%-0.29% the strategies are reasonably priced relative to either creating a bespoke options strategy or compared to the OCF of traditional OEICs with embedded options overlays.  Nonetheless, a FTSE 100 exposure would be additionally welcome.

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 as such and is to raise awareness and provide purely factual information as regards these portfolios and/or indices.
Image Credit: Shutterstock

• 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.
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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.

• Why does home equity bias exist?
• What does the research say?
• What does recent experience show?

 
Traditionally, UK pension fund managers and UK private client managers alike would have a bias towards home (i.e. UK) equities.  Why is this, what does the research say and what does recent experience show?

Understanding “home bias”
First of all, what do we mean by home bias? We define home bias is allocating substantially more to the investor’s “home” market, relative to its capitalisation-based weight in a global equity index.  Given the UK’s weight in global (developed markets + emerging markets) equity indices is now approximately 4% (it has been on a steady drift lower), any allocation above that level can be considered a home bias, from a UK investor’s perspective.

Yet traditionally UK pension schemes and private client managers would split an equity allocation between broadly 50% UK and 50% international (ex-UK) equities.  This represents a massive home equity bias, with a UK weight that is over 10x its market-cap based weight.

Why does this home bias exist?
The reasons given for such a massive home bias are typically the following:

1. From a currency-matching perspective, managers want sterling exposure for good chunk of their equities as investors’ base currency is sterling
2. The largest UK equities are “global” in nature, hence a share in, say Diageo plc represents revenues from all around the world
3. Managers have access to management and can greater insight as regards home companies

We can look at each of these in turn.

Firstly, we would argue that investing in equities is not for currency/liability matching, but for return seeking and inflation beating: in which case, the broader the opportunity set, the greater the potential for returns.

Put differently, a UK only investor is not only wilfully or accidentally ignoring 96% of the opportunities available in equities, by value, but would also thereby miss out almost entirely on the technology revolution led by US companies, for example, or the demographic revolutions of emerging markets.

So whilst a home bias makes sense for a bond portfolio (matching changes in inflation and interest rates), a home bias for equities does not.

Secondly, whilst the largest UK companies within the FTSE 100 are indeed “global” in nature, the broader, and more diversified (by sector and constituents), all share index is not.  Furthermore the sector allocation of the UK market is skewed by domestic giants, can be out of step with the sector allocation for world equity markets.

A UK equity bias is therefore a structural bias towards Consumer Staples, Materials and Energy, and a structural bias against Information Technology.

Fig. 1. Sector Comparison UK Equities relative to World Equities

Thirdly, whilst it is indeed true that UK managers will be able to get more access and insight to UK companies than, say, an overseas-based manager, for portfolio managers who focus on asset allocation over security selection, this access to management is less relevant and less valuable.

Whilst we can debate the detail of all three of these arguments, they are not individually or together enough to justify an allocation to UK equities that is over 10 times its market weight.  This is not a question of a rational overweight, it’s simply an irrational bias.
​
What does the research say?
There has been extensive research into why individual investors and professional managers have a preference for creating an equity portfolio with a strong home bias[1]. 

French & Porterba (1991) observed the predominantly home equity bias of investors based on the domestic ownership shares (as at 1989) of the largest stock markets.  In each case the high domestic ownership of each respective market implies a high home equity bias at that time:  US (92.2%), Japan (95.7%), and the UK (92%), for example.  In 1990 UK pension funds held 21% of their equity allocation in international equities from just 6% in 1979 (Howell & Cozzini 1990).  Now the figure could be closer to 50%, or even higher.  The shift away from home equity bias has been steady and pronounced in the UK institutional market, but is still ingrained.
 
However, it’s worth noting that subsequent home bias research is written in the US.  Given the US represents approximately 66% of the world equity market (a share that has been steadily increasing), the central tenet of that research is that home-biased US managers miss out on the diversification benefits and increased opportunity set available from investing in markets outside the US.  Hence home-bias for a US manager creates a smaller “skew” vs Global Equities than it does for a UK manager.
 
What is current practice?
Whilst the institutional UK managers have been gradually reducing home bias within equity allocations, what about UK retail portfolio managers?

We looked at the MSCI PIMFA Private Investor Indices[2] – and predecessor indices – to gain an insight as to what current asset allocation practice looks like for UK-based managers in the retail market.  These weightings of these indices are “determined by the PIMFA Private Indices Committee, which is responsible for regularly surveying PIMFA members and reflecting in each index the industry’s collective view for each strategy objective”[3].

Based on the “Balanced” index (and predecessor indices[4]), within a typical balanced mandate, the allocation within the allocation equities have decreased from a 70/30 UK/international split in 2000, to a 48/52 split today (see Fig.2.).  Whilst this reflects a reduction in the home equity bias, it is nonetheless a material bias towards UK equities by retail investment managers.

Fig.2. UK/international equity split within an indicative UK retail balanced mandate

Source: Elston research, FTSE data, MSCI data
In fairness, PIMFA has responded to this through the creation of a “Global Growth” index, which is 90% allocated to developed markets, and 10% allocated to emerging markets – so no UK home bias at all: but this is also a different risk profile to the Growth Index (100% equities, rather than 77.5% equities).
 
Zimbabwean investors go global – UK investors should too
We would make the case to advisers that if you were advising someone who lived in Zimbabwe, gut instinct would suggest that having the bulk of their equity allocation in Zimbabwean equities would feel like a poor and restrictive recommendation.  After all, Zimbabwe makes up only a fraction of the global equity market.

Without wanting to do UK plc down, the same gut instinct should apply to UK equities.  If the UK is only 4% of global equities – why allocate much more than that?
If you believe in equities for growth, it follows you believe in global equities to access that growth.  Clients benefit from being shareholders in the changing mix of the world’s best and largest companies, not just the local champions. 

What does recent experience showing
This debate was largely confined to theory given the relative stability of GBP to USD prior to Brexit.  But given the dramatic currency weakness on the Brexit referendum, and the UK’s lack of exposure to the technology “winners” from the COVID-19 crisis, the disconnect between UK and Global Equity performance could not be more acute.
 
Over the 5 years to 30th June, the FTSE All Share has delivered an annualised return of +2.87%p.a. in GBP terms, and MSCI World has delivered +7.53%p.a. in USD terms.  That represents the difference in the performance of the underlying securities within those markets.  Adjusting for currency effect too, and MSCI World has delivered +12.79%p.a. in GBP terms: an approximately 10ppt outperformance annually for 5 years.
When expressed, in cumulative terms, the disconnect is more clear: over the 5 years to 30th June, the FTSE All Share has returned +15.22% in GBP terms, and MSCI World has delivered +43.80% in USD terms, and +82.66% in GBP terms: a 67.44% cumulative performance difference between those indexes, and the ETFs that track them.

Fig.3. World vs UK Equity performance, 5Y to June 2020, GBP terms

Source: FTSE All Share, MSCI World, Bloomberg data
Delivering good portfolio returns is less about picking individual winners within each stock market, but making sure you have access to the right asset classes for the right reasons.  Index funds and ETFs are a low-cost, liquid and transparent way of accessing those asset classes.
UK multi-asset perspective
From a multi-asset perspective, the performance difference between MSCI PIMFA Global Growth (100% equity, no home bias), MSCI PIMFA Growth (77.5% equity, with home bias) and other risk profiles is presented in Fig.4. below.

Fig.4. MSCI PIMFA Private Investor Index Performance, 5Y to June 2020, GBP terms