Emerging popularity of multi asset funds

04 August 2014

Multi asset funds (often called balanced funds in South Africa) gained in popularity as investment vehicles after Dr Harry Markowitz (1952) published a seminal work on the nature of investments and investment markets.

This body of ideas became known as Modern Portfolio Theory and established the value of combining diverse assets to maximise risk-adjusted returns. It transformed the way the vast majority of asset management companies and investment advisors conducted business with investors.

The importance of multi asset funds in the South African investment landscape is illustrated by recent data released by Association for Savings and Investing in South Africa (ASISA). At the end of March 2014 the local unit trust industry held investments totalling R1.5trn.

Of this, R1.4trn (91%) comprised South African funds and R655.9trn or 47% of these funds were multi asset funds (Figure 1), up from just 25% at the end of 2010. Furthermore, these funds received 75% of domestic mutual fund net inflows over the three-year period to the end of March 2014.

This rise in popularity of multi asset investments in South Africa is partially ascribed to the financial crisis of 2007/2008 when equity markets lost a significant percentage of their market capitalisation and the appeal of a diversified portfolio of financial assets became readily apparent.

Modern Portfolio Theory advocates that the returns of all asset classes are not perfectly correlated, that is, do not move in lock-step and often move in opposite directions. An excellent example of the inverse correlation of different asset classes was illustrated through the performance of the South African equity and bond markets between May 2008 and November 2008. Over this time period the FTSE/JSE All Share Index declined by 46.4% and, in contrast, the All Bond Index recorded a positive return of 11.7%.Multi asset funds, in order to mitigate risk, hold a variety of investment instruments across various asset classes. Each exhibits unique financial properties compared to other asset classes and these differences are measurable in different economic conditions, which is critical in portfolio construction. Fund managers aspire to hold a variety of asset classes with varying correlations which, when combined, can provide superior returns on a risk-adjusted basis.

The increasing sophistication of financial markets and innovative product development has seen the use of asset classes for portfolio management purposes extend well beyond the traditional mix of equities, bonds and cash. Property, commodities and a wide range of alternative investments, including private equity, hedge funds, and debt vehicles, are now relatively common additions to portfolios in order to achieve reduced correlation benefits and add stability to their return profile. Derivative strategies are often used for efficient portfolio management purposes and to provide a measurable form of risk protection.

There is a body of research that is emphatic that asset allocation determines performance rather than stock selection. Brinston, et. al., (1986) determined that 94% of portfolio returns came from asset allocation decisions and not market timing (under or overweighting of an asset class due to market movements). Eugene Fama (1997) from a study of 31 pension funds with assets of $70bn, concluded that asset allocation accounted for 97% of returns while Ibbotson and Kaplan (2000), analysing the ten-year performance of 94 funds, concluded that 100% of absolute return is explained by asset allocation. Irrespective of the percentage, which can be very high, asset allocation and the implementation skill of the portfolio manager should determine the risk and reward of fund returns.

The increasing sophistication of financial markets and innovative product development has seen the use of asset classes for portfolio management purposes extend well beyond the traditional mix of equities, bonds and cash.

There is a body of research that is emphatic that asset allocation determines performance rather than stock selection. Brinston, et. al., (1986) determined that 94% of portfolio returns came from asset allocation decisions and not market timing (under or overweighting of an asset class due to market movements). Eugene Fama (1997) from a study of 31 pension funds with assets of $70bn, concluded that asset allocation accounted for 97% of returns while Ibbotson and Kaplan (2000), analysing the ten-year performance of 94 funds, concluded that 100% of absolute return is explained by asset allocation. Irrespective of the percentage, which can be very high, asset allocation and the implementation skill of the portfolio manager should determine the risk and reward of fund returns.

An example of the benefit of investing in a diversified fund is illustrated in Figure 2.

A R100 investment in a fund in 1988 comprising 80% South African assets and 20% offshore assets in the ratio 60% equity, 25% bonds and 15% cash (using index returns) would be worth R4,134.54 (May 2014) compared with R726.27 for investments producing purely an inflation return. Moreover, this theoretical fund would have declined around 14.8% during the 2008 financial crisis and recouped that loss within a year. Compare this to many global equity markets which took about five years to regain their 2007/2008 highs.

As an investor it is crucial, given the plethora of multi asset funds available for investment, to determine your investment objective. In all instances these funds, as a minimum, should have a mandate to beat inflation. In the South African single manager unit trust investment category, Ashburton Investments has two multi asset investment offerings. The investment mandate of the Ashburton Targeted Return Fund seeks to achieve a benchmark of CPI plus 3.5% over a rolling three-year period and aims to generate positive returns over a rolling 12-month period. This is a conservatively structured fund with a maximum equity holding of 40% including offshore equity. At the other extreme is the Ashburton Balanced Fund which falls within the ASISA Multi Asset high equity category. The Fund has as an internal benchmark of a 60% equity holding with an 80% local and 20% offshore geographic allocation. Furthermore the Fund has a maximum equity ceiling of 75%.

In South Africa, it is clear that multi asset investing is becoming a preferred way of investing for many investors and financial advisors. While the art of generating superior risk-adjusted returns lies in the blending of differently correlated asset classes, there is a further caveat of course. There remains a need to continuously manage asset allocation and, to a lesser extent, security selection on a tactical basis within a changing business cycle environment, the successful achievement of which can add significant value to the returns generated.

Multi asset funds holding a diversified number of asset classes do not represent the holy grail of portfolio safety, however, these funds do minimise the risk of negative returns and portfolio volatility which is even more pertinent given the stock market gains of the past five years.

References Cited

Brinson, G.P., Hood, L.R., Beebower, G.L., (1986). Determinants of portfolio performance. Financial Analysts Journal, Vol. 42, No.4, pp.39-44.

Fama, E., jr., (1997). Ninety-seven percent of performance variation is due to asset class structure. Dimensional Fund Advisors Conference, University of Chicago Graduate School of Business.

Ibbotson, R.G., and Kaplan, P.D., (2000). Does asset allocation policy explain 40%, 90%, or 100% of performance? Financial Analysts Journal, Vol. 56, No. 1, pp. 26-33.

Markowitz, H. (1952). Portfolio selection. Journal of Finance, Vol. 7, No. 1, pp. 71-91.