 While there are no shortage of limitations and no “right” answers, portfolio theory nonetheless remains, rightly, the bedrock of traditional multi-asset portfolio design.
In this series of articles, I look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work Elston does for discretionary managers and financial advisers. Portfolio theory in a nutshell Portfolio theory, in a nutshell, is a framework as to how to construct an “optimised” portfolio using a range of asset classes, such as Equities, Bonds, Alternatives (neither equities nor bonds) and Cash. An “optimised” portfolio has the highest unit of potential return per unit of risk (volatility) taken. The aim of a multi-asset portfolio is to maximise expected portfolio returns for a given level of portfolio risk, on the basis that risk and reward are the flipside of the same coin. The introduction of “Alternative” assets, that are not correlated with equities or bonds (so that one “zigs” when the other “zags”), helps diversify portfolios, like a stabilizer. Done properly, this can help reduce portfolio volatility to less than the sum of its parts. Whilst the framework of Modern Portfolio Theory was coined by Nobel laureate Harry Markowitz in 1952, the key assumptions for portfolios theory – namely which asset classes, their returns, risk and correlations are, by their nature, just estimates. So using portfolio theory as a guide to designing portfolios is only as good as the quality of the inputs assumptions selected by the user. And those assumptions are ever-changing. Furthermore, the constraints imposed when designing or optimising a portfolio will determine the end shape of the portfolio for any given optimisation. And those constraints are subjective to the designer. So portfolio design is part art, part science, and part common sense. Whilst there are no shortage of limitations and no “right” answers, portfolio theory nonetheless remains, rightly, the bedrock of traditional multi-asset portfolio design. What differentiates multi-asset portfolios? A portfolio’s asset allocation is the key determinant of portfolio outcomes and the main driver of portfolio risk and return. Ensuring the asset allocation is aligned to an appropriate risk-return objective is therefore essential. Getting and keeping the asset allocation on track for the given objectives and constraints is how portfolio managers – whether of model portfolios or of multi-asset funds – can add most value for their clients. There are no “secrets” to asset allocation in portfolio management. It is perhaps one of the most well-studied and researched fields of finance. Stripping all the theory down to its bare bones, there are, in my view, three key decisions when designing multi-asset portfolios:
Strategic allocation is expected to answer the key questions of what are a portfolio’s objectives, and what are its constraints. The mix of assets is defined such as to maximise the probability of achieving those objectives, subject to any specified constraints. Objectives can be, for example:
Strategic allocations should be reviewed possibly each year and certainly not less than every 5 years. This is because assumptions change over time, all the time. Static vs Dynamic One of the key considerations when it comes to managing an allocation is to whether to adopt a static or dynamic approach. A strategy with a “static” allocation, means the portfolios is rebalanced periodically back to the original strategic weights. The frequency of rebalancing can depend on the degree of “drift” that is allowed, but constrained by the frictional costs involved in implementing the rebalancing. A strategy with a “dynamic” approach, means the asset allocation of the portfolios changes over time, and adapts to changing market or economic conditions. Dynamic or Tactical allocation, can be either with return-enhancing objective or a risk-reducing objective or both, or optimised to some other portfolio risk or return objective such as income yield. For very long-term investors, such as endowment funds, a broadly static allocation approach will do just fine. Where very long-term time horizons are involved, the cost of trading may not be worthwhile. As time horizons shorten, the importance of a dynamic approach becomes increasingly important. Put simply, if you were investing for 50 years, tactical tweaks around the strategic allocation, won’t make as big a difference as if you were investing for just 5 years. This is because risk (as defined by volatility) is different for different time frames, and is higher for shorter time periods, and lower for longer time periods. In a way this is also just common sense. If you are saving up funds to buy a house, you will invest those funds differently if you are planning to buy a house in 3 years or 30 years. Time matters so much as it impacts objectives and constraints, as well as risk and return. Access Preferences Managers need to make implementation decisions as regards how they access particular asset classes or exposures – with direct securities, higher cost active/non-index funds, or lower cost passive/index funds and ETFs. Fund level due diligence as regards underlying holdings, concentrations, round-trip dealing costs and internal and external fund liquidity profiles are key in this respect. The choice between direct equities, higher cost active funds or lower cost index funds is a key one and is the subject of a later article. Types of multi-asset strategy There is a broad range of multi-asset strategies available to investors, whose relevance depends on the investor’s needs and preferences. To self-directed investors, these multi-asset portfolios are made easier to access and monitor through multi-asset funds, many of which are themselves constructed wholly or partly with index funds and/or ETFs. We categorise multi-asset funds into the following groups (using our own naming conventions based on design: these do not exist as official “multi-asset sectors”, unfortunately): Relative Risk Relative risk strategies target a percentage allocation to equities so the risk and return of the strategy is in consistent relative proportion the (ever-changing) risk and return of the equity markets. This is the most common approach to multi-asset strategies. Put differently, asset weights drive portfolio risk. Examples include Vanguard LifeStrategy, HSBC Global Strategy and other traditional multi-asset funds. Target Risk Target risk strategies target a specific volatility level or range. This means the percentage allocation to equities is constantly changing to preserve a target volatility band. Put differently, portfolio risk objectives drive asset weights. Examples of this approach include BlackRock MyMap funds. Target Return Target return strategies target a specific return level in excess of a benchmark rate e.g. LIBOR, and take the required risk to get there. This is good in theory for return targeting, but results are not guaranteed. Examples of this approach include funds in the Target Absolute Return sector, such as ASI Global Absolute Return. Target Date Target Date Funds adapt an asset allocation over time from higher risk to lower, expecting regular withdrawals after the target date. This type of strategy works as “ready-made” age-based fund whose risk profile changes over time. Examples of target date funds include Vanguard Target Retirement Funds, and the Architas BirthStar Target Date Funds (managed by AllianceBernstein)*. Target Income Target income funds target an absolute level of income or a target distribution yield. Examples of this type of fund include JPMorgan Multi-Asset Income. Target Term Funds These exist in the US, but not the UK, and are a type of fund that work like a bond: you invest a capital amount at the beginning, receive a regular distribution, and then receive a capital payment at the end of the target term. For self-directed investors, choosing the approach that aligns best to your needs and requirements, and then selecting a fund within that sub-sector that has potential to deliver on those objectives – at good value for money – is the key decision for building a robust investment strategy. The (lack of) secrets The secret is, there are no secrets. Good portfolio design is about informed common senses. It means focusing on what will deliver on portfolio objectives and making sure those objectives are clearly identifiable by investors. Designing and building your own multi-asset portfolio is interesting and rewarding. Equally there are a range of ready-made options to chose from. The most important question is to consider to what extent a strategy is consistent with your own needs and requirements. * Note: funds referenced do not represent an endorsement or personal recommendation. Disclosure: until 2015, Elston was involved in the design and development of this fund range, but now receives no commercial benefit from these funds.
1 Comment
Target Date Funds are multi-asset funds whose risk profile changes over time, becoming less risky on approach to, and after the target date in the fund’s name. Investors, or their advisers, can use target date funds as an investment strategy that is purpose-built for retirement. By selecting a fund whose target date matches a planned retirement year, investors get access to an accumulation-oriented investment strategy prior to the target date, and a decumulation-oriented strategy after the target date. This makes target date funds a convenient “all-in one” fund which explains why they are often used as default funds within pension schemes, including NEST. Why a cohort-based approach makes sense It’s common sense that the risk capacity for an investor’s exposure to market risk is different at different stages of life and wealth levels. For younger investors, where wealth levels are typically lower and time horizons are longer, there is a higher capacity for loss, hence a higher exposure to higher risk-return assets makes sense. For older investors, where wealth levels are typically higher and time horizons are shorter, there is a lower capacity for loss, hence a lower exposure to higher risk-return assets makes sense. If customers can be segmented by cohorts, it makes sense that investment strategy can be too. What is the performance experience for different cohorts this year (time-weighted)? The 2015-20 Target Date Fund from Architas experienced a moderate maximum monthly drawdown of -4.71% in March 2020. By comparison, the 2020 Target Date Fund from Vanguard experienced a -6.66% drawdown. This contrasts with -9.37% for the Elston 60/40 GBP Index, -10.94% for MSCI World, and -13.81% for the FTSE 100, all in GBP terms. In this respect, investors who were in default decumulation strategies, with lower capacity for loss, saw better mitigation of downside risk relative to a traditional 60/40 “balanced” mandate. Fig.1. YTD performance of UK Target Date Funds (GBP terms) for those retiring 2015-20.  Source: Elston research, Bloomberg data For investors in accumulation with target retirement date in the future, a comparison of the 2050 Target Date Funds shows Vanguard outperforming Architas – presumably owing to a more aggressive equity allocation in its glidepath. Both ranges of TDFs clearly have a low domestic equity bias, given their outperformance of the FTSE 100. Fig.2. YTD performance of UK Target Date Funds (GBP terms) for those retiring 2046-50  Source: Elston research, Bloomberg data How Target Date Funds could fit in with policy evolution Ensuring there is some form of in-built lifestyling is a longstanding feature of consumer protections for pensions investment since Stakeholder times. Using behavioural finance in proposition design can provide a degree of consumer protection from poor outcomes for less confident, less engaged investors. That’s why a growing number of regulatory interventions incorporate some form of built-in lifestyling. Whilst this is complex to achieve from an administrative perspective, the fact that Target Date Funds deliver lifestyling within the multi-asset fund structure makes them a useful product type for default investment strategies. Fig.3. Key behavioural aspects and price anchors of policy interventions   In this series of articles, I look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work Elston does for discretionary managers and financial advisers.
Aligning investment strategy with objectives Investing can be defined as putting capital at risk of gain or loss to earn a return in excess of what can be received from a risk-free asset such as cash or a government bond over the medium-to long-term. There can be any number of motives for investing: it could be to fund a future retirement via a SIPP, or to fund future university fees via a JISA. Online tools and calculators can help estimate how much is required to invest today to fund goals in the future. Investors can target a particular return, but learn to understand that the higher the required return, the higher the required level of portfolio risk. Risk and return are the “ying and yang” of investment. You can’t get one without the other. Total return can be broken down into income yield (dividends from equities and interest from bonds) and capital growth. In the UK, income and gains are taxed at different rates. If investing within a tax-efficient account, like a SIPP or an ISA, then income and gains are tax-free. If investing outside a tax-efficient account, investors must also then consider in their objectives how they want to receive total return – with a bias towards income or with a bias towards growth. Given the majority of DIY investors are able to make use of tax-efficient accounts, there is less need to consider income or growth, with many investors opting to focus on Total Returns and to use funds that offer “Accumulating” units that reinvest income, and reflect a fund’s total return. How then to build a portfolio to deliver an appropriate level of risk-return? What matters most when investing? For the purposes of these articles, I assume that readers need no reminder of the basic checklist of investing: to start early, to maximise allowances, keep topping up regularly, and to keep costs down. Then comes the key decision – what to invest in. The main driver of portfolio risk and return is not which stocks or equity funds are within a portfolio, but what the proportion is between higher risk-return assets such as equities, and lower risk-return assets such as shorter duration bonds. Put simply, whether to invest 20%, 60% or 100% of a portfolio in equities, will have a greater impact on overall portfolio returns, than the selection of shares or funds within that equity allocation. For example, when making spaghetti Bolognese, the ratio between spaghetti and Bolognese impacts the “outcome” of the overall meal, more than how finely chopped the onions are within the Bolognese recipe. While this may seem obvious, it gets lost in all the noise and news that focuses on hot stocks, star managers and performance rankings. For those that want to back up common sense with academic theory, the academic articles most referenced that explore this topic are Brinson Hood & Beebower (1986), Ibboton & Kaplan (2000), and Ibbotson, Xiong, Idzorek & Cheng (2010), all referenced and summarised in my book. Building a multi-asset portfolio to an optimised asset allocation to align to a particular risk-return objectives sounds like hard work and it is. That’s why multi-asset funds exist. The rise of multi-asset funds As investing becomes more accessible to more people, there is less interest in the detail of how investments work and more interest in portfolios that get people from A to B, for a given level of risk-return. After all, there are fewer people who are interested in the detail of how engines work than there are who are interested in how a car looks, how it drives and what they need it for. There is nothing new about multi-asset funds, indeed one could argue that the earliest investment trust Foreign & Colonial Investment Trust, founded in 1868, invested in both equities and bonds "to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk by spreading the investment over a number of stocks”. In the unit trust world, managed balanced funds have been around for decades. I would define a multi-asset fund as a strategy that invests across a diversified range of asset classes to achieve a particular asset allocation and/or risk-return objective. They offer a ready-made “portfolio within a fund” thereby enabling a managed portfolio service for the investor from a minimum regular investment of £25 per month. . In this respect, multi-asset funds help democratise investing, and make the hardest part of the investor’s checklist – how to construct and manage a diversified portfolio. The different types of multi-asset fund available is a topic in itself. The ability for investors to select a multi-asset fund for a given level or risk-return characteristics for a given time frame is one of the most straightforward ways to implement a strategy once that has been aligned to a given set of objectives. Multi-Asset Fund or ETF Portfolio? The main advantage of a ready-made multi-asset fund is convenience. Asset allocation, and portfolio construction decisions are made by the fund provider. The main advantages of an ETF Portfolio are timeliness, cost and flexible. ETF Portfolios are timely. You can adjust positions the same day without 4-5 day dealing cycles associated with funds – an important feature in volatile times. ETF portfolios are good value. You can construct a multi-asset ETF portfolio for a lower cost than even the cheapest multi-asset fund. ETF Portfolio are flexible – you can tilt a core strategy to reflect your views on a particular region (e.g. US or Emerging Markets), sector (e.g. healthcare or technology), theme (e.g. sustainability or demographics), or factor (e.g. momentum or value), to reflect your views based on your research. Conclusion Setting the right objectives to meet a target financial outcome, such as funding future retirement, university fees, or creating a rainy day fund is the primary consideration when making an investment plan. Getting the asset allocation right – choosing a risk profile – in a way best suited to deliver that plan is the second most important decision. Finding a straight forward to deliver that risk-return profile, by building your own ETF portfolio or using a ready-made multi-asset index fund, is the final most important step. All the while, it makes sense to stick to the investing checklist: to start early, keep topping up, and keep costs down.  In this series of articles, we look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work we do for discretionary managers and financial advisers.
From space pens to pencils There’s a famous story, probably an urban myth, about NASA spending millions of dollars of research to develop a space pen whose ink could still flow in a zero gravity environment. When the Russians were asked whether they planned to respond to the challenge to enable their cosmonauts be able to write in space, they answered “We just use a pencil.” Sometimes sensible and straightforward answers to problems prove more durable than more elaborate and costly alternatives. The same could be said of investments. The quest for high-cost star-managers in the hope of alchemy, is under pressure from low-cost index funds that get the job done, by giving low cost, transparent, and liquid exposure to a particular asset class. How an active stock picker became a passive enthusiast I spent my early years in the City working for active managers. My job was to pick stocks based on proprietary models of those companies’ operating and financial models. I was fortunate enough to work in a very successful hedge fund, whose style was “true active”: it could be highly concentrated on high conviction stocks, it could be long or short a stock or a market, it could (but didn’t) use leverage. If you enjoy stockpicking, as I did, working for a relatively unconstrained mandate was at times highly rewarding, at times highly stressful and always interesting. Investors, typically large institutions, who wanted access to this strategy, had to have deep pockets to wear the very high minimum investment, and the fund was not always open for new investors. It certainly wasn’t available to the man on the street. Knowledge gap entrenches disadvantage When I started my own family and started investing a Child Trust Fund I became all too aware of the massive disconnect and difference between the investment opportunities open to hundreds of institutional investors and those available to millions of ordinary individual retail investors. I was staggered and rather depressed to see how few people in the UK harness the power of the markets to increase their long-term financial resilience. Of the 11m ISA accounts held by 30m working adult, only 2m are Stocks and Shares ISAs. The investing public is a narrow audience. The vast majority is put off from learning to or starting to invest by complexity, jargon and unfamiliarity. Casual conversations with people from all walks of life showed that whilst they may fall prey to some scheme that promised unrealistic returns, they were less inclined to put a “boring” checklist in place to contribute to their own ISA or Junior ISA, perhaps unaware that this could be done for less than the cost of a coffee habit at £25 per month. The lack of knowledge on investing was nothing to do with gender, age or education. It was almost universal. People either knew about investments or they didn’t. And that knowledge was usually hereditary. And it entrenches disadvantage. Retail investments need a shake up Looking at the retail fund industry, it was clear that there wasn’t much that was truly “active” about it. Most long-only retail managers hugged benchmarks for chunky fees that befitted their brand or status (now known as “closet indexing”). Until recently, the bulk of personal finance pages and investment journalism was more about a quest for a handful of “star managers”, in whatever asset class, who were ascribed the status of an alchemist, that investors would then herd towards. It seemed like the retail fund industry was focused on solving the wrong problem: on how to find the next star manager, rather than how to have a sensible, robust diversified portfolio. By contrast, in the US, there has always been a higher culture of equity investing (New York cabbies talk more about stocks than about sport, in my experience). So I was fascinated to read about the behavioural science that underpinned the roll out of automatic enrolment in the USA in 2005 where investors who were not engaged with their pensions plan were defaulted into a Target Date Fund – a multi-asset index fund whose mix of assets changes over time, according to their expected retirement date. I also read about the mushrooming of so-called “ETF Strategists”, investment research firms that put together ultra-low cost managed portfolios for US financial advisers built entirely with Exchange Traded Funds. Winds of change Conscious of these emerging trends, it seemed that mass market investing in the UK was about to enter a period of structural change: namely with the ban of fund commissions (Retail Distribution Review), and the launch of automatic enrolment, as well as other planned “behavioural finance” interventions to improve savings rates and financial capability. So in 2012, I set up my own research firm to see what, if any, of that experience in the US might apply in the UK. We work with asset managers to develop low-cost multi-asset investment strategies for the mass market, constructed with index-tracking funds and ETFs. It is bringing the rather dry science of institutional investing into the brand-rich and personality-heavy world of personal investing. Why index investing? I try and avoid the terms active and passive and will explain why. For most people, a multi-asset approach using index funds makes sense. This can be called “index investing”. Surprisingly, one of it’s biggest supporters is Warren Buffett. “Consistently buy a low cost…index fund. I think it’s the thing that makes the most sense practically all of the time…Keep buying through thick and thin, and especially through thin.” (Warren Buffet, Letter to shareholders, 2017) In this series of articles, I share some of the experience I have had in developing investment strategies and products for asset managers built with index funds and ETFs. I look at the concepts underpinning multi-asset investing, focus on the importance of getting the asset allocation right for a given objective, summarise my view on the active vs passive debate (and attempt to clarify some terms), as well as some practical tips on building and managing your own portfolio. Each of the articles can be explored more deeply in a book I wrote with my former colleague and co-author Shweta Agarwal on How to Invest with Exchange Traded Funds: a practical guide for the modern investor 
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 
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. 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 
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:
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 
A recent ruling on DFM fees implied that VAT is not chargeable on intermediated Model Portfolio Service offered by a DFM. This throws into question when is VAT chargeable on DFM services and when isn’t it, and how, if at all, does it impact the VAT on advice. Whilst we are not tax lawyers, we try and disentangle the guidance as it stands today and what the recent ruling could mean, to help frame the right questions rather than provide definitive answers. First of all we need to break DFM services into 3 parts:
Non-intermediated Direct DFM service Where DFMs contract directly with clients to manage portfolios either on an advisory basis (seeking confirmation with client), or on discretionary basis (investing as the manager sees fit, for pre-agreed mandate), the VAT position seems clear-cut. The DFM fees are VAT-able. See HMRC manual VATFIN5800 for more information. Fund/security dealing commissions are VAT exempt where charged separately. If charged within a bundled “all-in” fee, the whole fee is VAT-able. For intermediated DFM fees, we have to consider two different types of DFM relationships – direct DFM (where DFM contracts with client directly to manage a portfolio in its custody), and platform-based MPS (where DFM contracts with platform to manage investments, and advisers “link” clients to that model). Intermediated Direct DFM service Where advisers introduce and monitors a “direct DFM” relationship – where the client contracts directly with the manager (albeit with the adviser’s involvement and fees are referenced in the contract), the VAT position is likely to be the same as above. Namely VAT on the DFM fee is chargeable. This is because the manager is providing a service directly to the client. Both the adviser and the manager have separate direct contractual relationships with the client. Importantly, because the adviser is introducing the client to a VAT-able service, the advice fees in relation to “direct DFM” services are also potentially VAT-able. See HMRC manual VATFIN7600 for more information. Intermediated MPS service Where advisers recommend and oversee a platform-based model portfolio service (MPS), the adviser’s fee may not be VAT-able, as it is an intermediation of a non-VATable service (the platform). The primary service the platform supplies in return for such fees (however comprised) are made up of the following functions:
HMRC’s position has been that charges for additional platform-based services, such as portfolio management services would be liable to VAT under VIN5800 above. However, although the details of the Tatton case are not public, it’s possible that Tatton sought to differentiate MPS service from direct-to-client DFM service and position it more as a quasi “fund” rather than an individual service. Under VAT5800, there is a clear exemption for the management of Specialist Investment Funds, such as authorised unit trusts and OEICs. This is outlined in more detail in VATFIN5100 If MPS can be viewed more like a “fund”, then it’s possible that model portfolios of funds could be added to this list of exemptions. Who does this ruling benefit? If this change is confirmed in guidance (rather than on a case-by-case basis), and other MPS-based DFMs can obtain similar refund, then it will be for those DFMs to decide whether to return those fees to clients. As Tatton was clear that it’s fee was gross, and any VAT costs were absorbed, it’s fair enough for Tatton to retain the refund – it took that risk and won. For DFMs that have specifically charged for VAT additionally, then expectations may be different. As well as providing good news for platform-based DFMs and their end-clients, any potential VAT exemption on MPS services is also good news for advisers that rely on an intermediation exemption from VAT on adviser fees. Some advisers fear that intermediating VAT-able DFM services on platform could potentially require them to charge VAT too. By intermediating a non-VAT-able MPS service, those advisers’ fees remain clearly non VAT-able. VAT and the value chain The only – broader – question remaining is that if the whole value chain – advice, platform, DFM MPS and underlying funds are relying on complex and potentially conflicting VAT exemptions, then there is a broader policy questions as to whether, when and why should VAT be paid on the advice and/or management of client’s investments, at some stage in the value chain. If the answer is no, never, that’s good news for the industry and clients alike, but I can’t believe that HMRC will be so knowingly or unknowingly generous for too long. Clarity needed Whilst HMRC won’t comment on individual cases, some further – clearer – guidance would be welcome. For clarity on this point, advisers should seek information from platform-based DFMs as regards their VAT status. DFMs should seek legal advice before revising their charging structure, and, if necessary, obtain case-specific guidance from HMRC. However given the gaps in the published guidance from HMRC, as outlined above – it would be helpful if their guidance could be tightened up too as MPS services are not explicitly referenced in guidance anywhere, which has allowed uncertainty to prevail.
The second quarter of 2020 saw a rebound in Global Equity markets with a total return of +17.6% in GBP terms. Unsurprisingly a 60/40 equity/bond portfolio captured approximately 60% of this upside with a total return of +11.2%. Of the multi-asset risk-based strategies we track, a Maximum Deconcentration approach (also known as an equal weight approach, because each asset class is equally weight), fared best with a return of +10.3%. By contrast a Min Variance approach and Risk Parity approach returned +9.0% and +5.7% respectively. Given their relative betas to Global Equity, the results are not surprising. Fig.1. Total Return (discrete quarter, GBP terms)  Risk-adjusted basis On a risk-adjusted 1 year basis, Risk Parity outperformed Global Equities, UK Bonds, a 60/40 portfolio and other multi-asset strategies. Fig.2. Risk-Return to 30-Jun-20 (1 year, GBP terms)  On a 5 year basis, Risk Parity also has the best risk-adjusted returns, with the highest Sharpe ratio at 0.94. Fig.3. Sharpe Ratio to 30-Jun-20 (5 year, GBP terms)  Risk-based strategies for “true diversification” If we define “true diversification” as combining two or more uncorrelated asset classes such that the combined volatility is less than its constituent parts, then a traditional 60/40 portfolio fails to deliver. We look at correlation reduction and beta reduction to articulate “differentiation impact”. The greater the reduction of both, the greater the differentiation. Over the 5 years to 30th June, a 60/40 portfolio (as represented by the Elston 60/40 GBP Index [ticker 6040GBP Index] delivers a reduction in Beta of -41.1% (broadly commensurate with its equity allocation), it only reduces correlation to Global Equities by -2.8%. Put differently a 60/40 portfolio is almost 100% correlated with Global Equities, and does not therefore provide “true” diversification. By contrast, a Risk Parity approach not only delivered better risk-adjusted returns, it also delivered “true diversification”. With a beta reduction of -78.3% and a correlation reduction of -46.6%. The Differentiation impact of the various multi-asset strategies is summarised below. Fig.4. Differentiation impact to 30-Jun-20 (5 year, GBP terms)  Summary
Max Deconcentration provided the highest level of returns in 2q20. On a 1, 3 and 5 year basis, Risk Parity offers better risk-adjusted returns. The differentiation impact is greatest for Risk Parity, relative to other multi-asset strategies for "true diversification". NOTICES Commercial Interest: Elston Consulting Limited creates research portfolios and administers indices that may or may not be referenced in this article. If referenced, this is clearly designated and is to raise awareness and provide purely factual information as regards these portfolios and/or indices. 
Targeted Absolute Return (TAR) funds were meant to be “all-weather” funds that could deliver returns in up markets, whilst protecting capital in down markets. If that sounds like a “goldilocks” strategy, it’s because it is. However, the way these funds-of-strategies are managed can be complex and/or opaque, and the performance has been inefficient. They are not delivering. Given there’s been a lot of bad weather globally in the first half of this year, we look at how four leading (by AUM) TAR funds have fared against our Elston Dynamic Risk Parity Index. Absolute Return funds Targeted Absolute Return funds are designed to fulfil a diversification function within a portfolio. This means performing in a way that is less or not correlated with equity markets, whilst offering greater return than cash or bonds. The portfolio construction approach to TAR funds differs from manager to manager. But the guiding principle is to achieve diversification by “spreading risk” across multiple, uncorrelated strategies, and “having the potential to make money in falling markets”. Risk-based strategies as an alternative Our view is that if the objective is diversification, a risk-based approach to portfolio construction makes sense, using strategies such as Risk Parity for diversification purposes. Risk Parity ensures “true diversification” by allowing the ever-changing risk characteristics of each asset class to determine portfolio weights, such that each asset class contributes equally to overall portfolio risk. Furthermore, by constructing the strategy as a straightforward “long-only” approach that does not use leverage, the holdings within the strategy are liquid, transparent and low-cost ETFs, whilst the dynamic weighting scheme is the tool for ensuring equal risk contribution and volatility constraint.
So how have the strategies fared? Relative Performance Year to date, through an extreme stress-test, absolute return strategies have underperformed a Risk Parity approach by 2-4.5%. Fig.1. YTD performance  Source: Elston research, Bloomberg data. Total returns, GBP terms, as at end June 2020 On a 1 year view, these absolute return strategies have underperformed a Risk Parity approach by 6-8%. Fig.2. 1 year cumulative performance  Source: Elston research, Bloomberg data. Total returns, GBP terms, as at end June 2020 On a 3 year view, these absolute return strategies have underperformed a Risk Parity approach by 7-20%. Fig.3. 3 year cumulative performance  Source: Elston research, Bloomberg data. Total returns, GBP terms, as at end June 2020 Mixing metaphors: a goldilocks approach to an all-weather portfolio To achieve all-weather diversifier status is a tall order for any investment strategy. It requires a “goldilocks” portfolio that:
On this basis, our Risk Parity strategy fares well as a decorrelated “diversifier”, without foregoing returns, for a similar level of risk to TAR funds. What’s wrong with TAR funds? We can’t analyse the individual strategies within the funds, but in aggregate, the statistics below suggest that as a result of their complexity, TAR funds have potentially “over de-correlated”, with insufficient beta to capture the returns available for the risk (volatility) being taken. Findings are summarised in the table below. Fig.4. 3Y Performance Statistics  Risk-based strategies: an alternative to absolute return funds?
Targeted Absolute Return funds are opaque, complex and inefficient. Creating a true diversification strategy is challenging but achievable. A systematic risk-based approach that adapts to changing relationships between each asset classes is an alternative. By ensuring that each asset class contributes equally to the risk of the overall portfolio, without resorting to leverage, could provide a more dependable approach to incorporating a “true diversifier” into a portfolio, without necessarily compromising returns. NOTICES Commercial Interest: Elston Consulting Limited creates research portfolios and administers indices that may or may not be referenced in this article. If referenced, this is clearly designated and is to raise awareness and provide purely factual information as regards these portfolios and/or indices. 
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:
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  Source: MSCI PIMFA Private Investor Indices (formerly WMA), Bloomberg data The choice whether to embrace a UK home bias or avoid it has been critical and material and the main determinant of differences between multi-asset portfolio and multi-asset fund performance. The lack of UK home equity bias, is one of the key underpins of strong performance of the popular HSBC Global Strategy Portfolios and Vanguard LifeStrategy range, for example. A question of design Our preference for avoiding entirely any UK home bias for equities (but not for bonds) underpinned the construct of multi-asset funds and multi-asset portfolios that we have developed with and for asset managers. End investors in those products have benefitted from that key design parameter. Whilst we welcome managers launching global-bias multi-asset portfolios – it’s a bit late in the day as it won’t help their existing clients stuck in UK equities claw back the foregone performance of the last 5 years. The irony is that one of the reasons for the persistence of home equity bias is sustained by asset allocation providers used by wealth managers to construct multi-asset funds and portfolios. A closer interrogation of those research firms’ methodologies, parameters and constraints is required to think what makes best sense for end investors. Take action Looking to create your own investment strategy? Watch|Copy|Adapt our research portfolios Notes
[1] French, Kenneth; Poterba, James (1991). "Investor Diversification and International Equity Markets". American Economic Review. 81 (2): 222–226. JSTOR 2006858 [2] https://www.pimfa.co.uk/indices/ [3] https://www.pimfa.co.uk/about-us/pimfa-committees/private-investor-indices-committee/ [4] We define the predecessor indices to the MSCI PIMFA Private Investor Indices as: MSCI WMA Private Investor Indices, FTSE WMA Private Investor Indices, FTSE APCIMS Private Investor Indices Notices Image credit: Lunar Dragoon Commercial interest: Elston Consulting is a research and index provider promoting multi-asset research portfolios and indices. For more information see www.elstonetf.com Liquid Alt ETPs: success for alternative asset class exposure, less so for alternative strategies9/7/2020 
Following the severe market turbulence of 2020, it’s worth taking a fresh look at “Liquid Alts” within the ETF space. What are Liquid Alternative ETFs? We define Liquid Alternative ETFs as any ETF that is:
Rise in popularity post GFC The increased popularity in the US of “Liquid Alts” came after the Global Financial Crisis and related liquidity crunch. Following the crisis, there was a demand for portfolio diversifiers that were an alternative to bonds, but with a keen focus on liquidity profile of the underlying holdings. In the US, the tradability of the ETF format meant that a broad range of “Liquid Alt” ETFs were launched, providing access to asset classes such as gold, commodities, and property securities, as well as long/short and more sophisticated “active” or systematic investment strategies packaged up within an ETF. Liquid Alts became in vogue. What about Liquid Alts in the UK? First we need to distinguish between the “type” of Liquid Alts available. We distinguish between those Liquid Alts that give exposure to an alternative asset class; and those that give exposure to an alternative asset allocation strategy. In the UK, following the financial crisis, we saw the launch of ETFs that gave exposure to alternative asset classes – gold, commodities, property, listed private equity, and infrastructure, for example. In this respect, the growth – in depth and breadth – of Liquid Alts has been impressive, particularly in the commodities and property sectors. But when it comes to Liquid Alts to deliver an alternative strategy, the ETP format has not been popular: the preferred format remains daily-dealing funds. Diversifier strategies, for example absolute return funds such as GARS, systematic trading strategies, long/short funds and funds-of-structured-products, have all been typically manufactured as funds in the UK rather than exchange traded products. Reviewing the marketing in 2016, we were expecting the range of Liquid Alt strategies available to UK investors to broaden both in the mutual fund format and the ETP format. As regards mutual funds, that has proven to be the case. As regards ETPs, Liquid Alt strategies have failed to catch on. Only a handful of liquid alternative strategy ETPs were launched, and they have largely failed to gain any traction. Why is this? Whilst straightforward Liquid Alt asset class ETPs have been successful in the UK, Liquid Alt strategy ETPs have failed to gain traction in the UK for 4 reasons, in our view:
Evaluating success: complexity fails To summarise, in the UK, within the Liquid Alt ETF space, the more straightforward a product, the more traction it’s got. Importantly, the reverse applies. “Straightforward” liquid alt ETFs Straightforward liquid alt ETFs provide liquid exposure to a specific asset class, or proxy for an asset class. Fig.1. Liquid Alternative Asset Classes  We find these “Liquid Alt” ETFs very useful building blocks to build in some diversifiers in a targeted and transparent way. “Complex” liquid alt ETFs The more complex liquid alt ETFs launched into the European market, have had far less success, and have ended up in the ETF graveyard.. Examples of complex strategies include: ETFs tracking a proxy of the HFRX Hedge Fund Index, an equity long/short ETF, and a market neutral ETF. Fig. 2. Liquid Alternative Strategies  Liquidity lessons learned and relearned There were painful liquidity lessons learned in the 2008 GFC. Those liquidity lessons have been relearned for “less liquid alts” delivered by traditional fund formats, where investors were gated in direct property funds during Brexit in 2016 and Coronavirus this year. By comparison, investors who chose property securities ETFs as their “liquid” way of accessing that exposure experienced no such gating. Furthermore, the high profile gating of Woodford’s Equity Income fund and GAM absolute return bonds fund are further reminders as to why liquidity of the underlying asset, whether, within a fund or ETF, is so important. Where next? We see potential for increased competition in the single-asset class liquid alts, particularly infrastructure and listed private equity where there is little choice. Whilst we expect some ETF providers to continue to create liquid alt trading strategies, we are not convinced that ETPs are the best format for these diversifiers. Where we do expect innovation is in index-tracking funds that can be held on platform and provide a transparent, liquid and systematic approach to delivering true diversification strategies, as an alternative to opaque, higher cost absolute return funds. NOTICES Commercial Interest: Elston Consulting Limited creates research portfolios and administers indices that may or may not be referenced in this article. If referenced, this is clearly designated and is to raise awareness and provide purely factual information as regards these portfolios and/or indices.
The standard rationale for multi-asset investing is to ensure diversification between equities and bonds. But how to construct that multi-asset portfolio. We summarise 4 approaches and look at performance through the “live ammo stress test” of 2020. The classic 60/40 portfolio: This represents a traditional asset-weighted portfolio for UK investors with predominantly global equities and predominantly GBP bonds. This strategy is represented by the 60/40 GBP Index [6040GBP]. The equal weight or "1/N" portfolio: This represents an equal-asset-weighted portfolio to remove overallocations to size and/or domestic biases within equity and bond exposures. This strategy is represented by the Elston Max Deconcentration portfolio [ESBGMD]. However, the problem with any asset-weighted investing is that in extreme stress periods, correlations between asset classes increase meaning that any asset-weighted diversification effect is reduced just when you need it most. Enter risk-weighted multi-asset strategies. Rather than allowing asset weights to drive portfolio risk & correlation, risk-weighted multi-asset means allowing the portfolio risk (volatility, correlation) to drive asset weights. The Min Variance portfolio: This looks at the volatility and correlation between asset classes and aims to deliver the combination of equities and bonds required to achieve the minimum variance (lowest risk) portfolio whilst remaining exposed to risk assets. This strategy is represented by the Elston Min Variance Index [ESBGMV]. The Risk Parity portfolio: This looks at the risk contribution of each asset class and aims to deliver a portfolio where each asset class contributes equal risk contribution to the overall portfolio. This strategy is represented by the Elston Risk Parity Index [ESBDRP]. Year to date performance Of these risk-based multi-asset strategies for GBP investors, the best performing YTD (to end May) has been Risk Parity +1.50%, followed by Max Deconcentration +0.76%, followed by Min Variance -1.78%, compared to -2.03% for the 60/40 GBP Index, and -3.77% for Global Equities.  Drawdowns From the start of the market turmoil to the trough of the 60/40 index on 18th March, Risk Parity provided most downside protection, closely followed by Max Deconcentration. Unsurprisingly, the 60/40 index took approximately 60% of global equity downside.  How to get “true diversification”
To achieve true diversification, you need to combine uncorrelated/differentiated holdings alongside your core strategy. An asset-weighted approach, such as 60/40 portfolio, does reduce beta (by definition you are taking 0.6x of market risk), but does not reduce correlation. A 60/40 portfolio is almost 100% correlated to global equities. By contrast, a risk-weighted approach creates the potential for decorrelation, thereby creating the potential for “true diversification” relative to a core portfolio. The recent market turmoil has shown that when true diversification is needed most, a risk-weighted approach has a useful role to play. For more on our risk-weighted portfolios and indices, see www.ElstonETF.com/etf-portfolios.html 
We are adding the Elston Maximum Deconcentration Portfolio to our suite of multi-asset risk-based strategies. The portfolio is now "live" with factsheets updated daily (portfolio ticker ESBMDC). What is "Deconcentration"? Put simply, in the context of multi-asset investing, if single asset investing is having all eggs in one basket; 60/40 investing is having all eggs in two baskets; then deconcentration is having one egg per basket. It is diversification at its simplest: giving an equal weight to each asset class within the portfolio. This portfolio construction approach is known as a "Deconcentration strategy" as it deconcentrates the portfolio from any single asset class. It is also known as a (1 over N) approach, where N is the number of holdings within the portfolio. What problem are we trying to solve? Most traditional multi-asset strategies, such as a 60/40 portfolio, have a capitalisation-weighted approach to asset allocation. Within a classic global equity benchmark, for example, the US dominates with a ~60% allocation. So within a vanilla 60/40 portfolio, US equities may have a 36% allocation (60% US exposure within 60% Global Equity allocation). Nothing wrong with that, but it's an overweight based on capitalisation. Likewise within the bond allocation rather than having a bias towards GBP issued bonds under a classic 60/40 approach. Again, nothing wrong with that, but it limits the diversification impact of international bonds. How does a max deconcentration portfolio work? One way of creating differentiated risk-returns is to ignore these size-and-domestic biases is to create a "naive" or simple diversification strategy, such as an equally-weighted multi-asset approach. We look at an opportunity set of 20 asset class exposures: regional equity markets, bonds by issuer type, maturity and currency, as well as alternatives such as gold, listed infrastructure, property securities. We then create an equal-weight allocation (1/20 = 5%) to each asset class. This portfolio thereby provides an alternative approach to multi-asset diversification with differentiated risk-return characteristics. Does it work? By default, the risk-return characteristics of a 1/N portfolio will be different to that of a traditional multi-asset portfolio, so a Max Deconcentration strategy will provide a differentiated risk-return characteristic for diversification purposes. However, there is also research to suggest that a "simple" 1/N portfolio can outperform more "sophisticated" mean-variance optimised portfolios. For more on this, see De Miguel, Garlappi and Uppal (2009) and related readings. Obviously the nuance of any 1/N portfolio will depend on its design parameters: the performance of our Max Deconcentration strategy will be included in future multi-asset strategy reviews relative to a 60/40 benchmark as well as other risk-based strategies such as Min Variance and Risk Parity. Keep updated To view peformance of this strategy, please refer to our strategy factsheets, published daily, or request portfolio access via Bloomberg. To replicate this strategy, subscribe to our Advanced Portfolios for weightings files and detialed performance analysis. 
We analysed 5 year performance of major multi-asset index funds relative to the Elston 60/40 GBP Index to end December 2019, and a YTD update through the COVID-19 impact. We focused on the following multi-asset index funds* for performance analysis: Architas Multi-Asset Passive Intermediate fund, BlackRock Consensus 60 fund, HSBC Global Strategy Balanced fund, LGIM Multi-Index 5 fund and Vanguard LifeStrategy 60% Equity fund. Cumulative Returns Architas and HSBC have the best performing funds in absolute terms within this group:  Source: Elston research, Bloomberg data Notes: Total returns in GBP terms, daily data, as at 31/12/19 Risk-adjusted returns Within this group, Architas has delivered best risk-adjusted returns within:  Source: Elston research, Bloomberg data Notes: Annualised total returns in GBP terms, daily data. 5 year annualised daily volatility data as at 31/12/19 Performance in COVID-19’s “live fire stress-test” Looking at performance year to date, we see Architas, HSBC and Vanguard delivering performance most consistent with the 60/40 index. BlackRock Conensus 60 and L&G Multi-Index have delivered least consistent performance relative to this index, underperforming the 60/40 index by -1.81ppt and -2.67ppt respectively. Obviously those funds’ objectives are specific to each fund and are aiming neither to track nor beat the 60/40 index. But now we can track the performance of a “no-brainer”** 60/40 portfolio in real-time, it’s easier to see the value that multi-asset index funds add or substract relative to that plain vanilla benchmark. Multi-asset managers can add value through optimisation, tactical allocation and implementation efficiencies, for example.   Source: Elston research, Bloomberg. As at 29/5/20 total returns basis, GBP terms.
Costs Ranked by Total Costs and Charges (“TCC”) which represents OCF plus transaction costs, HSBC offers the lowest cost option. OCF TCC HSBC 0.18% 0.22% BlackRock 0.22% 0.29% Vanguard 0.22% 0.26% LGIM 0.31% 0.31%*** Architas 0.47% 0.48% Source: manager data, as at end December 2019. ***estimated figure Value For Money Architas may look expensive on a TCC basis. But it has delivered best risk-adjusted performance in the period under review owing to their more dynamic asset allocation approach, so arguably offers good value for money on a risk-adjusted basis. For static allocation funds, the main differentiator is cost alone, on which basis HSBC offers best value for money, in our view. A less inappropriate benchmark Whilst our 60/40 benchmark by default may not be the "perfect" benchmark for these and other (balanced/medium-risk) multi-asset funds, it is certainly a less inappropriate benchmark than comparing a multi-asset fund to a FTSE 100 or Global Equity benchmark. Whilst individual fund houses may use composites for comparison, these may not be publicly available for analysis. The existince of a published standardised 60/40 benchmark enables cross-comparison, analysis and insights. *Fund tickers: ARINTDA, BRC60DA, HSWIPCA, LGMI5IA, VGLS60A respectively. Index ticker: 6040GBP Index **Abraham Okusanya's coinage in https://finalytiq.co.uk/cobras-unintended-consequences-multi-asset-funds/ 
Multi-asset index funds are a powerful and straightforward way for DIY investors to create a multi-asset, diversified and low-cost core holding within a portfolio. How much should I have in my core? For index investors not wanting to worry about creating and managing their own asset allocation, these funds can provide a one-stop shop and receive a 100% allocation. For investors who enjoy picking their own stocks or funds, these funds can provide a helpful core exposure. The extent to which multi-asset funds make up a core is up to the investor as a preference, and obviously impacts the similarity of portfolio performance to a multi-asset fund. Investors who want the bulk of their risk-return characteristics to be self-selected should consider a lower allocation to a multi-asset fund core, for example 20-40%. Investors who want the bulk of their risk-return characteristics to be consistent with the chosen multi-asset fund should consider a higher allocation to that core, for example 60-80%. Self-selected single asset class investments would thereby represent satellite holdings. Selecting a risk profile Multi-asset funds typically come in “suites” with 3 to 5 versions to choose from based on risk profile. Risk profile can be defined by percentage allocation to equities, so investors can select a risk-return profile that is consistent with their objectives. How do they differ? Multi-asset index funds will differ in the following ways in terms of philosophy and process:
Does it make sense to hold more than one multi-asset fund? Not really. Multi-asset funds of the same given risk profile (as defined by % equity allocation) will have similar risk-return characteristics. The building block index funds they use will mean similar underlying equity/bond exposures. They are all incredibly well diversified. Having multiple multi-asset index funds just reduces economies of scale, introduces higher frictional dealing costs, and blurs transparency around asset allocation. Investors should therefore select a multi-asset fund whose objectives and investment process resonates best and where value for money is keenest. Comparing multi-asset funds The IA Mixed Investment Sectors are peer groups of multi-asset funds. There are four relevant “risk profiled” sectors for multi-asset funds (Target Volatility and Target Absolute Return funds are treated separately.)
However these remain popular peer groups for comparative purposes. A 60/40 index can help comparison As the bulk of assets flow into “balanced” multi-asset funds with a 60% equity allocation, we created a 60/40 equity/bond index for GBP investors to provide a comparator for multi-asset funds. This means that investors can evaluate multi-asset fund managers skill at 1) creating optimised portfolios over a “boring” 60/40 portfolios; and 2) evaluate the value added by dynamic asset allocation decisions relative to a static-weight index. While additional indices for different risk profiles may make sense in the future, we believe a 60/40 index is an important first step.
When evaluating multi-asset funds and portfolio strategies we were often frustrated by a lack of straightforward “vanilla” multi-asset benchmarks for GBP investors. Instead there is a heavy reliance on peer groups. Multi-asset funds are often compared to mixed asset fund sector performance, which reflects the average performance of funds within a category, which gives one dimension of comparison. Likewise, multi-asset portfolios are often compared to the median of a peer group of managed portfolios. But peer groups are not always ideal comparators. By default, you cannot ever replicate peer group performance. The accidental influence of multi-asset benchmarks Whilst there are multi-asset benchmarks for retail investors, the methodology that underpins the decisions around asset allocation changes within those benchmarks is committee-led and subjective, rather than rules-based. Given the importance of asset allocation, why should a discretionary manager or multi-asset fund use a third party for asset allocation comparison that may have no bearing on that manager’s strategic view. Put differently, should the asset allocation of a benchmark indirectly influence the wealth management industry? We think not. But at the same time, there is a clear and persistent need for an objective comparator, such as a composite. Composites: helpful but inconsistent In the institutional space, the objective comparator is often a highly customised composites. That’s understandable, as a composite will be designed to be a “strategic neutral” asset allocation for a particular investment style. But more generally for investment research and comparison, 60/40 equity/bond composites are used for performance comparisons. But as with any composite, the selected assumptions and parameters around even a simple 60/40 index can differ widely. This means there is very low consistency or comparability between these composites used by different managers. A straightforward 60/40 benchmark Weirdly, despite its popularity in research and performance analysis, there has been no central, consistent and accessible point of reference as regards the performance of a 60/40 equity/bond strategy for GBP investors. Until now. We set ourselves the challenge of how do we create a straightforward benchmark that represents a 60/40 equity/bond portfolio for GBP investors that meets the “SAMURAI*” benchmark tests. To do this, we had to consider three issues: 1. Is a simple “heuristic” 60/40 approach intellectually ok? 2. What’s the background to the 60/40 approach anyway? 3. How should we construct a 60/40 benchmark for GBP-based investors? Heuristic allocations: a pragmatic approach Creating a heuristic (“rule of thumb”), rather than optimised, asset allocation is a long-standing, pragmatic approach by portfolio theorists and practitioners alike. Even Harry Markowitz, the father of Modern Porfolio Theory, chose a simple 50/50 equity/bond allocation for his own pension scheme. I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it–or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.[1] So we can be comfortable with creating a heuristic allocation because it is an accepted practice, some background towhich is outlined below. Background to the 60/40 allocation Any reference to a 60/40 portfolio prior to the 1970s would be most welcome. But from our research, we understand that in the 1970s and 1980s pension scheme trustees used a 60/40 equity/bond benchmark for plan assets. Whilst in theory a perfect immunisation strategy could be implemented with a 100% bond allocation of matching duration, the risk that actual returns might not keep pace with expected returns particularly in an inflationary environment, together with higher implicit cost and limited availability of implementing such strategies, led practitioners to incorporate a substantial allocation to equities to protect against inflation and to help generate growth of plan assets. Research at the time supported a 40-70% allocation to risk assets, thereby defending the 60/40 allocation as a pragmatic approach[2]. Jack Bogle, the founder of Vanguard, was a staunch believer in the 60/40 portfolio as a benchmark allocation (although in later years he moved closer towards 50/50[3]). So whilst we can accept heuristic allocations in general, and the 60/40 allocation in particular, we have to decide: how best to populate a 60/40 portfolio for GBP investors? Whose 60/40 is it anyway? How do we construct a 60/40 portfolio for GBP investors? It may seem straightforward, but design parameters are still required, for which the only consensus can be, that there will be no consensus on what is “right”. In this respect, we have attempted to make design decisions that implicitly reflect practitioner views as well as our own. Whilst a 60/40 equity/bond allocation may seem straightforward, it requires thought depending on an investor’s base currency. For example:
1. Should the 60% equity reflect UK equity or global equity or both? The bulk of portfolio research originates in the US which not only represents the bulk of global equity indices, but also has the world’s largest companies that have international revenue streams. Put simply the S&P500 gives investors exposure to US companies that have global revenues. That’s why the debate around including international equities is a very different one when viewed from a US or UK perspective. Whilst US companies represent the bulk of global equity (developed and emerging markets combined) by market cap as well an international revenue dimension; UK companies represent a fraction of global equity by market cap, despite an international revenue dimension. So whereas the decision for a US investor to use US only or Global equities in a 60% equity allocation is fairly nuanced, for a UK investor it is absolutely critical. We decided that within the 60% equity allocation, a 100% allocation to UK equities would be too much, and yet a market allocation (~6%) would be too little. A 50/50 allocation would be too great a home bias, so we decided to have a 80% allocation to global equities and a 20% allocation to UK equities. A heuristic within a heuristic. What stopped us having a 100% allocation to Global Equities, is to reflect that asset allocation models used by UK managers and advisers typically have an element of UK equity bias. 2. Should the 40% bonds reflect UK bonds, or global bonds or both? On the bond side, we believe the opposite is true. For bonds, it makes sense for UK investors to have a bias towards UK bonds as a buffer against changes in UK economy, interest rates and inflation, we therefore allocate 80% to UK bonds (corporates and gilts of different maturities), and 20% to international bonds (unhedged). Summary In summary, for our UK 60/40 benchmark we use predominantly global equities and predominantly UK bonds. If portfolio or multi-asset managers want to improve performance vs this “vanilla” index by optimising, or indeed ignoring these weights, then go for it. The purpose of the index is not to provide a “right answer”, but to provide a representative multi-asset allocation that captures the broad opportunity sets for both equities and bonds. Potential applications: a useful yardstick Our 60/40 benchmark can provide consistent, transparent insight for performance evaluation of multi-asset funds and portfolios. Furthermore, the advantage of a simple 60/40 benchmark is that it can be used test multi-asset portfolio construction hypothesis such as:
Why Elston 60/40 GBP Index?
Search “6040GBP Index” on leading data vendors such as Bloomberg, Reuters and Morningstar or visit http://www.elstonetf.com/indices.html References [1] https://jasonzweig.com/what-harry-markowitz-meant/ https://jasonzweig.com/what-harry-markowitz-meant/ [2] Pension Fund Asset Allocation: In Defense of a 60/40 Equity/Debt Asset Mix (Ambachtsheer, 1987) [3] https://www.investopedia.com/articles/financial-advisors/012716/where-does-john-c-bogle-keep-his-HHmoney.asp * A publicly available index can be used as a benchmark so long as it has the following qualities*: Specified: The benchmark is specified in advance - prior to the start of the evaluation period. Appropriate: The benchmark is consistent with the manager’s investment style or area of expertise. Measurable: The benchmark’s return is readily calculable on a reasonably frequent basis. Unambiguous: The identities and weights of securities are clearly defined. Reflective: The manager has current knowledge of the securities in the benchmark. Accountable: The manager is aware and accepts accountability for the constituents and performance of the benchmark. Investable: It is possible to simply hold the benchmark. * See Managing investment portfolios: A dynamic process (CFA institute investment Series), Third edition, John L. Maginn, Donald L. Tuttle, Jerald E. Pinto, Dennis W. McLeavey
Whilst sound in theory, do risk-based strategies work in practice? To find out, we took at the performance of a multi-asset Risk Parity Index and a multi-asset Minimum Variance index. Risk Parity aims to achieve equal risk contribution from each asset class Min Variance aims to combine each asset class to achieve a minimum variance portfolio On a rolling five year basis, both multi-asset Min Volatility and Risk Parity offered superior risk-adjusted returns relative to a 60/40 Portfolio for GBP investors. Both Min Volatility and Risk Parity offered a lower level of overall risk relative to a 60/40 portfolio. Get the full report here http://www.elstonetf.com/store/p3/Multi-Asset_Indices%3A_risk-based_strategies.html 
Elston Consulting has launched a published 60/40 Index for UK investors. The Elston 60/40 GBP Index represents a 60% strategic allocation to Global & UK equities and a 40% allocation to predominantly UK bonds. A “60/40” equity/bonds composite benchmark is a traditional comparator for multi-asset funds and portfolios. However, there are no standardised views of what a 60/40 portfolio looks like. For global investors this could mean 60% Global Equities, 40% Global Bonds. For US investors, 60/40 could mean 60% US Equities, 40% US Bonds. Elston’s 60/40 Index for UK investors provides a standardised comparator for multi-asset portfolio managers and multi-asset fund providers looking for a straightforward multi-asset benchmark. The index is constructed using large liquid and low cost ETFs as the underlying securities so the benchmark is replicable and investable. Its performance broadly represents the returns after fees of an index portfolio invested in the strategy. The index values are available on Bloomberg (ticker 6040GBP Index), Morningstar and other leading data vendors. The weightings scheme is available to licensees. Henry Cobbe, Head of Research at Elston Consulting, which created the index says: “At the moment each multi-asset manager, portfolio manager or research firm creates their own internal composite for their version of 60/40. By having a publicly available benchmark for UK investors, we are enabling decision-makers make comparisons, insights and analysis in a way that is consistent, straightforward and accessible.”  In 1q20 Risk Parity and Min Variance multi-asset strategies offered best downside cushioning relative to a 60/40 Equity/Bond portfolio for GBP investors.
Risk-based strategies: 1. Offer a systematic approach 2. Are designed to be differentiated 3. Have potential to enhance returns, mitigate risk or improve diversification Get the full report here http://www.elstonetf.com/store/p12/Multi-asset_strategies%3A_1q20_update.html |
ELSTON RESEARCHInsights Archives
January 2021
Categories
All
|
RSS Feed