• A recent ruling implies that VAT on DFM services is not always applicable
• Differentiating between the types of service is important
• Owing to consequent impact on advice fees, additional clarity is needed

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
• Intermediated Direct DFM service
• Intermediated MPS service

​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:

• The aggregation of the investors’ capital to bulk purchase securities in funds and other investment products;
• The recording of the transactions and holdings;
• The holding of the investments in trust as nominee; and
• The disaggregation of the income from the holdings, including realisation of the assets, in accordance with the individual beneficiaries’ investments.

These services are VAT exempt.
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. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

On this basis, the Risk Parity approach

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

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

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

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

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

Creating a true diversification strategy is challenging but achievable.

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

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

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

• 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

• What are Liquid Alternative ETFs?
• What has adoption been like in the UK?
• Straightforward vs complex Liquid Alt strategies

 
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:

1. is providing exposure to an asset class or strategy that is an alternative to long-only Equities or long-only Bonds
2. holds liquid underlying securities and is traded intraday

 
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:

1. In the UK there was less familiarity with ETFs as a fund format, which were and are generally perceived to be 1) single asset class “building blocks”, rather than strategies; and 2) index-tracking, rather than “active”
2. As a structural “diversifier” to a portfolio, there seemed little need for investors to trade liquid alt strategies on an intraday basis.  A traditional fund format would do.
3. In the advisory market, most platforms were not configured to trade or hold ETFs, meaning that funds were the structure of choice from a distribution perspective
4. Where Liquid Alt strategy ETPs have been launched, the actual investment strategy has failed to deliver.

 
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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The problem with peer groups
When evaluating multi-asset funds and portfolio strategies we were often frustrated by a lack of straightforward “vanilla” multi-asset benchmarks for GBP investors. Instead there is a heavy reliance on peer groups.
Multi-asset funds are often compared to mixed asset fund sector performance, which reflects the average performance of funds within a category, which gives one dimension of comparison. Likewise, multi-asset portfolios are often compared to the median of a peer group of managed portfolios.
But peer groups are not always ideal comparators. By default, you cannot ever replicate peer group performance.

The accidental influence of multi-asset benchmarks
Whilst there are multi-asset benchmarks for retail investors, the methodology that underpins the decisions around asset allocation changes within those benchmarks is committee-led and subjective, rather than rules-based. Given the importance of asset allocation, why should a discretionary manager or multi-asset fund use a third party for asset allocation comparison that may have no bearing on that manager’s strategic view. Put differently, should the asset allocation of a benchmark indirectly influence the wealth management industry?
We think not. But at the same time, there is a clear and persistent need for an objective comparator, such as a composite.

Composites: helpful but inconsistent
In the institutional space, the objective comparator is often a highly customised composites. That’s understandable, as a composite will be designed to be a “strategic neutral” asset allocation for a particular investment style.
But more generally for investment research and comparison, 60/40 equity/bond composites are used for performance comparisons. But as with any composite, the selected assumptions and parameters around even a simple 60/40 index can differ widely. This means there is very low consistency or comparability between these composites used by different managers.

A straightforward 60/40 benchmark
Weirdly, despite its popularity in research and performance analysis, there has been no central, consistent and accessible point of reference as regards the performance of a 60/40 equity/bond strategy for GBP investors. Until now.
We set ourselves the challenge of how do we create a straightforward benchmark that represents a 60/40 equity/bond portfolio for GBP investors that meets the “SAMURAI*” benchmark tests.
To do this, we had to consider three issues:
1.      Is a simple “heuristic” 60/40 approach intellectually ok?
2.      What’s the background to the 60/40 approach anyway?
3.      How should we construct a 60/40 benchmark for GBP-based investors?

Heuristic allocations: a pragmatic approach
Creating a heuristic (“rule of thumb”), rather than optimised, asset allocation is a long-standing, pragmatic approach by portfolio theorists and practitioners alike.
Even Harry Markowitz, the father of Modern Porfolio Theory, chose a simple 50/50 equity/bond allocation for his own pension scheme.
I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it–or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.[1]
So we can be comfortable with creating a heuristic allocation because it is an accepted practice, some background towhich is outlined below.

Background to the 60/40 allocation
Any reference to a 60/40 portfolio prior to the 1970s would be most welcome. But from our research, we understand that in the 1970s and 1980s pension scheme trustees used a 60/40 equity/bond benchmark for plan assets. Whilst in theory a perfect immunisation strategy could be implemented with a 100% bond allocation of matching duration, the risk that actual returns might not keep pace with expected returns particularly in an inflationary environment, together with higher implicit cost and limited availability of implementing such strategies, led practitioners to incorporate a substantial allocation to equities to protect against inflation and to help generate growth of plan assets. Research at the time supported a 40-70% allocation to risk assets, thereby defending the 60/40 allocation as a pragmatic approach[2].
Jack Bogle, the founder of Vanguard, was a staunch believer in the 60/40 portfolio as a benchmark allocation (although in later years he moved closer towards 50/50[3]).
So whilst we can accept heuristic allocations in general, and the 60/40 allocation in particular, we have to decide: how best to populate a 60/40 portfolio for GBP investors?

Whose 60/40 is it anyway?
How do we construct a 60/40 portfolio for GBP investors? It may seem straightforward, but design parameters are still required, for which the only consensus can be, that there will be no consensus on what is “right”. In this respect, we have attempted to make design decisions that implicitly reflect practitioner views as well as our own.
Whilst a 60/40 equity/bond allocation may seem straightforward, it requires thought depending on an investor’s base currency. For example:

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

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

1. Should the 60% equity reflect UK equity or global equity or both?
The bulk of portfolio research originates in the US which not only represents the bulk of global equity indices, but also has the world’s largest companies that have international revenue streams. Put simply the S&P500 gives investors exposure to US companies that have global revenues.
That’s why the debate around including international equities is a very different one when viewed from a US or UK perspective. Whilst US companies represent the bulk of global equity (developed and emerging markets combined) by market cap as well an international revenue dimension; UK companies represent a fraction of global equity by market cap, despite an international revenue dimension.
So whereas the decision for a US investor to use US only or Global equities in a 60% equity allocation is fairly nuanced, for a UK investor it is absolutely critical.
We decided that within the 60% equity allocation, a 100% allocation to UK equities would be too much, and yet a market allocation (~6%) would be too little. A 50/50 allocation would be too great a home bias, so we decided to have a 80% allocation to global equities and a 20% allocation to UK equities. A heuristic within a heuristic. What stopped us having a 100% allocation to Global Equities, is to reflect that asset allocation models used by UK managers and advisers typically have an element of UK equity bias.

2. Should the 40% bonds reflect UK bonds, or global bonds or both?
On the bond side, we believe the opposite is true. For bonds, it makes sense for UK investors to have a bias towards UK bonds as a buffer against changes in UK economy, interest rates and inflation, we therefore allocate 80% to UK bonds (corporates and gilts of different maturities), and 20% to international bonds (unhedged).

Summary
In summary, for our UK 60/40 benchmark we use predominantly global equities and predominantly UK bonds. If portfolio or multi-asset managers want to improve performance vs this “vanilla” index by optimising, or indeed ignoring these weights, then go for it.
The purpose of the index is not to provide a “right answer”, but to provide a representative multi-asset allocation that captures the broad opportunity sets for both equities and bonds.

Potential applications: a useful yardstick
Our 60/40 benchmark can provide consistent, transparent insight for performance evaluation of multi-asset funds and portfolios.
Furthermore, the advantage of a simple 60/40 benchmark is that it can be used test multi-asset portfolio construction hypothesis such as:

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

Why Elston 60/40 GBP Index?

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

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

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


[3] https://www.investopedia.com/articles/financial-advisors/012716/where-does-john-c-bogle-keep-his-HHmoney.asp
* A publicly available index can be used as a benchmark so long as it has the following qualities*:
Specified: The benchmark is specified in advance - prior to the start of the evaluation period.
Appropriate: The benchmark is consistent with the manager’s investment style or area of expertise.
Measurable: The benchmark’s return is readily calculable on a reasonably frequent basis.
Unambiguous: The identities and weights of securities are clearly defined.
Reflective: The manager has current knowledge of the securities in the benchmark.
Accountable: The manager is aware and accepts accountability for the constituents and performance of the benchmark.
Investable: It is possible to simply hold the benchmark.
* See Managing investment portfolios: A dynamic process (CFA institute investment Series), Third edition, John L. Maginn, Donald L. Tuttle, Jerald E. Pinto, Dennis W. McLeavey

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

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

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

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

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

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

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

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

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

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

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

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

• Diversification is the only free lunch for investors
• Asset-based diversification has its limits
• A risk-based approach to diversification has more impact

Diversification: the only free lunch for investors
Portfolio theory holds, and experience affirms, that true diversification means that the overall risk of a portfolio can be less than the risk of its constituent parts.

The diversification effect is determined by correlation.  Broadly speaking, the lower the correlation between asset classes, the greater the diversification effect when combined in a portfolio.

This in the underlying principle behind combining equities and bonds to create a multi-asset approach.
Whilst this traditional “asset-based” approach holds for the long-term. It fails to consider that correlations are not static but are dynamic.  This means that diversification effect is also dynamic and changes with market conditions.

The limits of asset-based diversification
In stressed market conditions, the relationship (correlation) between asset classes tends to increase.
This means that the diversification effect created by mixing asset classes is reduced.

In order to introduce true diversification effect into a portfolio investors can use a risk-based approach to constructing portfolios.

Asset-based or risk-based approach?
The bulk of multi-asset portfolios in the UK market use what’s called a traditional “asset based” approach.  This means that the target asset allocation drives the level of portfolio risk.  The asset allocation for each portfolio is broadly fixed, and volatility therefore fluctuates.

An alternative approach is called a “risk-based” approach.  This means that a target risk characteristic for a portfolio – for example a minimum variance portfolio, or a risk parity approach – drives the asset allocation.
 
Risk-based approaches explained
We analyse three risk-based multi-asset strategies for GBP investors:

• Maximum Deconcentration: this is an equal weight approach to each asset class
• Minimum Variance: this is a combination of assets to target the minimum variance portfolio
• Risk Parity: this is a combination of assets such that there is equal risk contribution to the portfolio

These strategies are contrasted with traditional asset-based strategies, based on a percentage allocation to global equities, such as a 60/40 portfolio.

Differentiation impact
Relative to global equities, whilst a 60/40 approach, represented by the Elston 60/40 GBP Index [6040GBP Index], reduces beta by 40.6%, it only reduces correlation by 3.0%.  Put differently, there is very low diversification effect.
​
By contrast, a risk parity approach, represented by the Elston Dynamic Risk Parity Index [ESBDRP Index], offer the greatest diversification effect as it reduces beta by 78.0% and correlation by 48.1%.

5 year data to 31st March 2020, GBP terms

​​YTD performance
Year to date, risk parity has provided greatest capital preservation relative to asset-based and other risk-based strategies.

What next?
For investors looking at introduce true diversification into a multi-asset portfolio, incorporating an allocation to a dynamic multi-asset risk-based strategy, such as Max Deconcentration, Min Variance or Risk Parity makes sense.  These systematic strategies can be delivered using portfolios of ETFs for liquidity, transparency and efficiency.
For full report, see http://www.elstonetf.com/store/p12/Multi-asset_strategies%3A_1q20_update.htm

Asset-based diversification has its limits
Whilst a traditional asset-based approach to diversification can help reduce equity market beta, but it doesn't necessarily help reduce correlation.

Why does (de)correlation matter
The maths of diversification means that the less correlated an asset within a portoflio, the greater the diversification effect.

Comparing multi-asset approach
A 60/40 equity/bond portfolio (represented by 6040GBP Index), reflects a traditional multi-asset approach.  Year-to-date this strategy has a beta of 0.60x but a correlation of 98.9%.

By contrast, a risk-based approach to diversification not only reduces beta, but also reduces correlation.

A Minimum Variance multi-asset strategy (represented by ESBGMV Index) has a beta of 0.35x and a correlation of 88.0%.

A Risk Parity multi-asset strategy  (represented by ESBDRP Index) has a beta of 0.18x and a correlation of 58.7%.

A local problem?
​In January, when the Coronavirus story broke in China, the global response was that this was a localised issue.

Like other viral outbreaks such as SARS (2003) and H1N1 (2009), the issue look localised to China and Asian Emerging Markets.

Going global
In February, as the virus spread aggressively in South Korea and Italy, markets woke up to the fact that this was a global issue.  The questions being how far would it spread; how fast would it spread; and how long would it last?

All of these questions were to ascertain how materially the outbreak would impact global growth, as demand falls, businesses' cash flow struggles and supply chains are disrupted.

A false sense of security
What was deceptive is that the time from the first infection in a country to the virus "j-curving" has been quite long 20-30 days.  This gave Europeans a false sense of security that the outbreak was containtable.

The J-Curve
The chart below shows the J-curve as to how long it has taken for some key countries to reach 1,000 cases.  The reality is that once it gets going, containment is difficult without some of the extreme measures introduced quite promptly in Wuhan (wide area quarantines or "lockdowns"), and more recently in Italy.

Investors often seek out differentiated risk-return assets for inclusion within a portfolio for diversification purposes.

This is often the rationale used for inclusion of hedge funds, absolute return funds, diversified growth funds, and real assets in a portfolio.

An alternative approach
But is there an alternative way of achieving differentiation?
We believe so.  Risk-based strategies are multi-asset strategies that are designed to be differentiated.
Examples of multi-asset risk-based strategies include: Minimum Variance, Risk Parity, Maximum Deconcentration, Maximum Sharpe and Maximum Decorrelation.  These strategies target a particular risk objective and that risk objective drives the underlying asset weightings.

Has it worked?
On a rolling 5 year basis to end 2019, both multi-asset Min Volatility and Risk Parity delivered in providing both lower beta to, and reduced correlation with Global Equities, relative to a 60/40 portfolio, as well as delivering on their stated objectives.

Relative to global equities with a Beta of 1, a 60/40 strategy, a multi-asset Min Variance strategy and Risk Parity provide a -40.4%, -68.8% and -75.3% reduction in beta respectively.
Relative to global equities (correlation = 100%), a 60/40 strategy, a multi-asset Min Variance and Risk Parity provide -5.7%, -32.2% and -45.3% reduction in correlation respectively.

This highlights that although a 60/40 approach reduces beta, it doesn't much reduce correlation.  For an effective decorrelation approach to achieve true diversification, a risk-based approach to multi-asset investing provides a helpful diversifier.

Risk-based strategies are a portfolio construction approach and can be delivered using liquid ETFs with no leverage and no shorting.  We expect to see a growing role for multi-asset risk-based strategies within portfolios given their transparency, liquidty, and cost advantage relative to hedge funds and absolute return funds.

We believe that systematic strategies that are designed to be different are more likely to be different than strategies that are hoped to be different.
​
After all, portfolio construction is just maths.
Get the full report

For the analysis:
Global Equities proxy: iShares MSCI ACWI UCITS ETF [Ticker: SSAC LN Equity]
60/40 strategy: Elston 60/40 Index (GBP) [Ticker GBP6040 Index]
Multi-asset Min Variance strategy: Elston Min Variance Index (GBP) [Ticker ESBGMV Index]
Multi-asset Risk Parity strategy: Elston Risk Parity Index (GBP) [Ticker ESBDRP Index]

• Create a structured, systematic and evidenced-based investment process
• Don’t reinvent each wheel, but blend institutional-quality expertise
• Remain agile and adaptive as implementation options evolve

What actually delivers performance?
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 objective is therefore key. Getting and keeping the asset allocation on track for the given objectives and constraints is how portfolio managers can add most value for their clients.

What differentiates portfolio managers?
There are no “secrets” to asset allocation in portfolio management. It is perhaps one of the most well-studied and researched fields of finance.

Perhaps unusually for a competitive service industry, core know-how is not a barrier to entry. Anyone completing their Chartered Financial Analyst exam will have a comprehensive grounding in the principles of portfolio management.

There are, in my view, three differentiating factors for discretionary fund managers.

1. Quality of Process: how that know-how is deployed and implemented: the quality of design, research, implementation and risk control
2. Quality of People: how that know-how is explained and communicated to clients: the quality of brand, personalities and client service
3. Quality of Proposition: how that know-how adapts to changing research, tools and technologies

Quality of Process
To create a quality investment process, 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.

To create an appropriate asset allocation, managers need to consider what their objective is: is it risk-adjusted returns in which an asset-optimised approach makes sense (the bulk of retail multi-asset strategies take this approach); is it to match future liabilities, in which case a liability-relative approach makes sense (more akin to how a defined benefit pension scheme is managed); is to target a volatility level or band; or is to target a level of income distribution.

Managers also need to design a set of constraints – risk budget, fee budget, minimum and maximum position sizes, portfolio turnover constraints and counterparty considerations.

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.

Quality of People
Whilst we believe strongly in the deployment of technology to assist managers in designing, building and managing portfolios, that doesn’t mean that people aren’t core to a business. Investment managers must invest in their people to build on both quantitative skills that are necessary to finance as well as communication skills that are necessary to communicate with advisers and their clients. It’s people that make up a brand, and clients measure performance as much on client service as on returns.

Quality of Proposition
There are few firms, if any, that can build an end-to-end proposition entirely in-house.  Part of a manager’s skillset is to understand where their expertise lies. We believe that there is little value in reinventing the various wheels of a proposition. But there is tremendous value in bringing together best in class components that create a proposition in a way that is robust, repeatable and proprietary.

It’s the quality of choices around proposition that differentiate portfolio managers, and in this respect it is important to remain agile and adaptive, to a rapidly changing landscape in asset management and technology.

Bringing it all together
The objective for investment managers is no longer about “pushing” one product or another. It should be about providing solutions that help address a specific need.
​
Managers should ask themselves: what problem is the investment strategy trying to solve for their client? How can they do that in a way that is robust, repeatable and evidence-based, so that everyone can sleep well at night?

The secret is, there are no secrets. Good portfolio management is about focusing on what matters, using informed common sense.

• Conservatives win majority on mandate to Get Brexit Done
• Breakthrough in traditional Labour heartlands
• Labour’s Corbyn under pressure to step down and Liberal Democrat’s Swinson loses seat

Conservative majority
Conservatives are on track for a winning a clear majority in the UK general election.
The campaign has centred on a core message of Get Brexit Done which has appealed to traditional Tories and disgruntled Labour voters in Leave-oriented constituencies.  Furthermore, a distrust of Labour’s leadership under a hard-left Corbyn has led to a significant reduction in Labour seats despite his popularity with youth activists.

A Brexit election
Each party’s position on Brexit has been the key driver for voting intentions, despite efforts by all parties to also focus on domestic policy and leadership personalities.
The Conservatives message was to get Brexit done.  The Liberal Democrats was to Revoke Article 50, ignore the Referendum result and remain.  Labour’s stance was to hold another referendum.  Voters, like markets, wanted clarity over “dither and delay”.

With a clear majority, and an unambiguous mandate to deliver Brexit, some say that ironically, the bigger the majority, the softer the Brexit as Johnson will not be held hostage by hard-Brexit supporting “ultras” from the European Research Group.  Meanwhile, Conservative MPs that have become independents or defected to the Liberal Democrats will vanish into obscurity.
 
Breaking through the “Red Wall”
The changing composition of the Conservative win is radical.  Whilst some remain-leaning Conservatives voters (and MPs) have shifted allegiance to the Liberal Democrats, constituencies in Labour’s northern heartlands known as the “Red Wall” because they have not had a Conservative MP since the 1930s or 1950s.  As predominantly Leave constituencies, voters have “lent” the Conservatives their vote as more trusted to deliver on Brexit after the shambles of a hung Parliament.

Strategist vindicated
Love him or hate him, the result is a vindication of Johnson’s chief strategist Dominic Cummings who developed Johnson’s core strategy on becoming Prime Minister in July 2019 as “D.U.D.” standing for Deliver Brexit, Unite the Country, Defeat Labour.  With the two D’s on track, it will then be for the U and a pivot to a domestic agenda once UK has left the EU on or before 31st January.
 
The Election in 3 Charts
1. Poll tracker
Based on an analysis of polling data by the BBC, average voting intentions on 11th December, the day before the election, pointed to 43% support for Conservative, 33% for Labour, and 12% for the Liberal Democrats.

Source: BBC
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2. Cable
Sterling has rallied on exit polls that pointed to a clear Conservative win, with markets encouraged at the prospect at the end of political deadlock, the end of any risk of a hard left Labour government, and the beginning of constructive engagement with the EU to get a comprehensive trade deal in place by December 2020.
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On becoming PM, Johnson forewarned that “people are going to lose their shirts” by betting against Brexit, using the language of investment managers.  For anyone short sterling over the past few weeks, that’s proven absolutely true.

3. ETF Flows focus on UK Small Caps
In the three weeks in the run up to the UK election, investors have been positioning for a Conservative win, with a record £151m flowing into the iShares MSCI UK Small Cap UCITS ETF (Ticker: CUKS) that focuses on domestically oriented smaller capitalisation companies.

• Second fine by UK regulator for high-charging “closet index funds”
• Fund manager and specific funds named for first time
• Manager failed to communicate change of strategy with retail investors and left fees high

What just happened?
The UK’s financial services watchdog, the Financial Conduct Authority (FCA) has fined Henderson Investment Funds Limited, the fund provider that is now part of Janus Henderson, £1.9m ($2.5m) for “failing to treat fairly more than 4,500 retail investors in two of its funds.”

The funds named are the Henderson Japan Enhanced Equity Fund and the Henderson North American Enhanced Equity Fund, which had been originally set up and marketed as actively managed funds.

In November 2011, the funds’ appointed manager Henderson Global Investors Limited decided to reduce the level of active management of these funds – effectively making them more similar to a passively-managed tracker fund.

Who was affected?
While this change of strategy was communicated to institutional investors, who were also offered fees to be reduced to zero, there was no such communication or fee adjustment for the 4,713 direct retail investors (who represented 5% of fund value by AUM), and 75 intermediary companies (for example, financial advisers) who remained invested in those funds. 

How long did this go on for?
This discrepancy continued between November 2011 and August 2016, Henderson allowed this discrepancy to continue with retail investors seeing no change in prospectus, objectives or fee levels while the fund was deliberately reposition to a more passive-style strategy: effectively Henderson wilfully converted two of its funds into closet index funds, but just didn’t tell its retail clients.

What was performance like during this period?
The charts below show the performance of each fund between November 2011 and August 2016.  The charts show the funds underperforming the index owing to active fees which creates heavier and heavier drag.

​Henderson Japan Enhanced Equity (old name)