The 2.0 multi-asset comeback

The entrepreneur Tim O'Reilly coined the term "web 2.0" a few years ago to describe a second wave development in technology that would enable better and more interactive use of internet technology more attuned to the needs of users. Web 2.0 is more familiar to the most of us as the latest generation of file sharing and social networking sites that have attracted millions of users and high profits for their founders.

 

It is not hard to make a parallel with the way the evolution of financial thinking and practice has prompted investment managers to re-think the way balanced management, even if it has a longer history than the internet. The concept of balanced management has been dusted down in recent years, stripped off and recreated in a form that gives pension funds equity like returns from a multi asset portfolio but with lower volatility.

 

The chief diversification play with traditional balanced management is the weighting between domestic fixed income and domestic equities. In contrast, diversified growth products invest in a wider range of asset classes in a line up that pays more than a little lip service to the thinking behind the way in which US endowments, Yale in particular being the most famous, have invested their portfolios over the years.

 

The main trend in pension fund investment management over the last 10 years or so has of  course been towards specialised investment, and many larger funds - and even smaller ones - have replaced their balanced manager or managers with specialists, diversifying accordingly away from domestic markets and into other areas such as indirect real estate, emerging markets and alternatives.

 

This trend has of course taken its toll on those houses strongly orientated towards the traditional configuration of balanced management and many houses have restructured their investment operations either to highlight existing skills in more specialist areas of fixed income and equities, and to build alternatives capabilities. In investor relations language this means manufacturing and selling products that attract higher margins.

 

Theory is behind diversification, as literature has shown. David Swenson in Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment described the benefits of the approach from an endowment perspective.

 

This summer, a paper by Andrew Brigden, Andrew Clare and Shamik Dhar looked at the benefits of asset diversification from a DB perspective. It found that, even using quite conservative assumptions about asset class returns and risks DB pension funds adopting a diversified approach to asset allocation could achieve a "considerable reduction" in funding level volatility.

 

The paper found that the risk of underfunding should drop when moving from a 60/40 equity bond split - the classic split in old balanced - to one that uses between 30% and 50% in alternatives, which it defines as high yield bonds, commercial property, commodities futures, and to market neutral and macro hedge funds.

 

Fidelity sponsored the research: "We weren't necessarily surprised by the findings but this was the first time where this has been modelled on a real DB scheme," says Mark Miller head of business development for defined contribution at Fidelity.

 

Consultants have been promoting the concept of multi asset investing for several years now, and have been working with asset managers to create products targeted to the needs of clients wishing to diversify assets. Larger European pension  funds have been following their counterparts in a general embrace of diversifying into even more uncorrelated asset classes than just international property and emerging markets, or even alternatives. Commodities futures, infrastructure and forestry have recently joined the ranks of private equity and hedge funds as staple institutional fodder.

 

The problem for smaller pension funds is access and governance. The limited size of their assets and the lack of pooled funds in which to invest makes it difficult to make an allocation in the first place. This problem is compounded by the fact that the trustee boards of such smaller funds often meet irregularly, and if they have an investment committee at all it may not have sufficient expertise to make an independent decision at all on which diversifying assets to allocate to and how to allocate between them.

 

"It takes considerable time and resource to deal with legal issues, monitoring a range of managers and managing cashflows across a range of complex investments," says Mark Barry, a director at Russell in London . "Making the decision of which strategies to employ, how much to allocate and when  to allocate can often lead to either inertia, implementation of a partial solution, or a large amount of time and money being spent on a relatively small portion of assets."

 

Barry also points out that it is difficult to access best of breed managers across a range of investments: "Identifying skill is a significant driver of expected return."

 

In the last few years some consultants have championed what they termed new balanced or new multi asset funds, which took the concept of balanced management and changed into what some would describe as a sort of "balanced 1.5", using a greater range of international assets and some alternatives around the edges of the portfolio. But more recently consultants have approached asset managers in order to encourage them to develop products that fit the needs of  smaller and medium sized pension funds. The result, over a couple of years of fine tuning, has been diversified growth products that build on balanced and new balanced concepts.

 

"Our first real diversified growth pitch was two years ago and the product has moved on considerably since then," says Kitts at Henderson . "I think it is too trite to call this new balanced," adds Simon Chinnery, vice president for institutional business at JPMorgan Asset Management. "There is a lot of new thinking as asset classes become more available."

 

Diversified growth funds, simply put, are a new generation of multi asset unitised, open ended funds that are usually targeted at institutional clients who are interested in achieving diversification within their portfolios but who frequently do not have the governance resources or assets under management to select the underlying managers. They are also usually benchmarked against LIBOR, aiming to achieve equity-like returns but with lower volatility.

 

"We looked at what was wrong with the old approach said we want to create a better portfolio from the client's perspective," says Neil Walton, head of strategic solutions at Schroders, which manages nearly £80bn (€118bn) in assets. "There are a lot of pension schemes that may be small but they want the same quality of solution as a larger scheme, for example if they have a deficit to address. This is about helping them to get a solution."

 

Kitts sees potential for smaller pension funds still in balanced. "There is a market, in the  smaller to mid sized funds, where they are still in traditional balanced and that is not an efficient portfolio…From that starting point you can achieve less risk relative to liabilities and greater return. That seems like a step forward," he says.

 

Miller is also keen to stress that diversified growth is a stage beyond new balanced: "This is a very different approach from new balanced in terms of breadth and diversity." Fidelity's fund, for example, uses 23 managers, investing in 29 different strategies.

 

The diversified growth funds currently on offer or in preparation differ in several key respects - not only in the precise asset allocation between equities and other asset classes. Some managers have decided to outsource all or part of the asset management in key areas; others vary according to the level and geographic spread of the equities at the core of their portfolio.

 

Credit Suisse Asset Management launched a diversified growth fund last September - Credit Suisse Nova (Lux) Diversified Growth (£). The fund has a targeted return of LIBOR plus 400 basis points with between two thirds and three quarters the volatility of an equity portfolio. The fund divides its  portfolio into strategic assets targeting long term growth with medium to low volatility. These include private equity, hedge funds and property. A tactical component accesses more liquid assets - equities, fixed income and commodities.

 

Other asset managers, including Henderson and F&C, were putting the finishing touches to their diversified growth funds at the time of writing. "We are developing a diversified growth product," says Kitts. "We have quite a diversified product range at Henderson for the size of the house…I think we can put together quite a compelling proposition."

 

F&C's new fund will allocate to 10 different asset classes and will be run by its asset allocation team under Paul Niven and Toby Vaughan. The fund's ten strategic asset classes fund will all be managed in-house.

 

"The goal is diversification from equities but growth is key here, and assets that have low correlation. We carried out a lot of back testing…and have a mix that will give lower volatility and equity-like returns," comments Chinnery at JPMorgan Asset Management, referring to his firm's JPM Life Diversified Growth fund, which was launched last year. The mix includes global equities, private equity, commodities, absolute return assets and property.

 

John Collins, senior investment consultant at Watson Wyatt, sees around 30 products in the area of new diversified multi-asset products, and says they vary in terms of the level of exposure to market based returns as opposed to alpha. He also points out that there is a wide spectrum of equity allocations in the diversified growth funds that he has seen - from 20-70%.

 

JPMorgan's fund invests 30-50% in equities, and 10%, for example, in high yield. It has the ability to under or overweight around the strategic benchmarks, although it would never go to 0% in an asset class.

 

However, only 25% of Fidelity's fund is invested in equities, with 25% in high alpha bonds and emerging market debt and 50% in a wide range of alternative investments. "Research we did with clients and consultants told us that if you want diversification, you want diversification with other parts of your portfolio, where you might be 80-90% in equities. You want to have a range of lowly correlated assets working together."

 

While other funds are benchmarked against LIBOR or RPI, JPMorgan's fund uses an  MSCI World benchmark. Chinnery says this was chosen to reflect the equity benchmarking mindset of many pension fund trustee boards. The return target is 8-10% with annual volatility of 15-16%.

 

Clearly larger and generalist houses with an multi asset capability can use the skills of their asset allocation team to solve the problem of strategic and tactical allocations to the different underlying asset classes within the fund. But investment management firms are taking differing approaches on merits of in-house investing versus outsourcing. Fidelity has conceived its fund as a multi management product and will in principle outsource all assets although its own capabilities will come into the running.

 

"In the old balanced world it was not unreasonable for one manager to run the whole fund but with the range of assets in a diversified growth fund, we thought it would be odd for one manager to do all of that," comments Miller.

 

Assets for Fidelity's fund will include real estate, funds of hedge funds and commodities and the product will be managed by Richard Skelt, CIO for the  firm's investment strategies group. The group will also not necessarily access the underlying managers through traditional mandates: "Some of the talent can only be accessed through funds or investment trusts," explains Miller.

 

JP Morgan's fund, which was launched last year, will invest 20% of assets using external vehicles such as investment trusts for less liquid asset classes in order to ensure the fund itself has enough liquidity.

 

Aberdeen Asset Management is still in the process of migrating its existing balanced capability into a new generation multi asset product. It will be run by Anne Richards, head of multi asset, and it is intended that most of the management will be run using in house teams although areas like alternatives are likely to be mandated to third parties.

 

Mike Turner, head of global strategy and global asset allocation at Aberdeen Asset Management, says that his firm intends to focus on the risk control perspective with its multi asset capability: "We emphasise the ability to control risk and you can do that better if you are working with the people who are managing the various components."

 

"There is no one single preferred route," says Collins of Watson Wyatt. "But as a general rule, we do not see many firms where we can rate everything they do internally at the highest skill rating, so being able to choose the best-breed managers in the market is appealing.

 

"We still have issues with a lot of products in terms of their construction," continues Collins. "Some offerings are more equity and bond orientated and there are some with high fees for market exposure." He contrasts managers who make allocations to alternatives through listed vehicles, for example, for liquidity purposes with those who access areas such as private equity, hedge funds and infrastructure directly where underlying fees are more transparent and there is a wider manager opportunity set.

 

Differing structures are emerging for diversified growth funds: CSAM's fund is a Luxembourg SICAV and Aberdeen 's is also a UCITS structure. Fidelity has opted for a UK domiciled non-UCITS retail scheme (a NURS) - designed to wrap differing investment classes for retail investors - even though the product itself is aimed at institutional investors and the structure does not have a passport for Europe.

 

The reason behind this decision, as Miller explains, was ease of access to some asset classes that may not currently be accessed through a UCITS vehicle, such as derivatives and property. JPMorgan, in contrast, has wrapped its portfolio within a life fund wrapper.

 

In terms of allocation, while most managers of diversified growth funds expect allocations of around 10%, others are making larger allocations; "We have been surprised - some clients have been replacing their whole strategies with this," says Miller.

 

However, since Boots pension fund's foray into the swaps market, the thinking on risk immunisation has evolved. Consultants are now advising pension funds to place assets freed from the swaps programme into alpha generating strategies, including alternatives.

 

Schroders put its money where its mouth is in that its own staff pension fund decided at the end of 2005 to invest according similar lines., as the return component of an LDI strategy. Other managers are also targeting their diversified growth funds as the alpha generating component of a portfolio using interest rate and inflation swaps to hedge out risk and to match cash inflows with expected cash outflows. Collins at Watson Wyatt says diversified growth funds are also suitable for defined contribution pension schemes. DC pensions account for a tiny proportion if total pension assets, but are the predominant scheme structure for open schemes and for new members.

 

Interestingly, Michel Bernard, director of institutional funds at F&C, which has £101bn (almost €150bn) in assets under management, says that his firm has recruited both a small UK scheme and a large one to its diversified growth fund, which was due for launch in August this year.

 

"This product appeals both to funds with sophisticated governance and also to small schemes that do not have the knowledge that is commensurate the risk that they want to undertake," says Bernard. Others agree: "We spoke to a number of consultants who saw the need for diversifying assets to give equity type returns with lower volatility," says Miller at Fidelity. "Some of the larger pension funds were doing that themselves as they had the capability in house to seek [those managers] out. But we have since found that a number of mid to larger sized funds are looking to what these assets can do."

 

Here providers are up against another trend in asset management. BlackRock created a customised portfolio of alternatives for the 's Cumbria County Council in July for a 10% allocation that amounted to total assets of £120m. The alternative assets in the portfolio will include hedge funds, global tactical asset allocation, commodities, infrastructure, emerging market debt and high yield debt.

 

Managers of managers are also getting active in this area. Although Russell does not see demand for a full diversified growth strategy, it is investigating the possibility of introducing a diversified alternatives fund, combining a range of underlying alternative investment capabilities into a single structure. "We will not include equity and bonds in this fund," says Mark Barry, director at  Russell. "Having this alternatives fund as well as the underlying building blocks of both alternatives and conventionals will allow us to offer bespoke diversifed growth portfolios. These will use best of breed managers in each asset class across equity, bonds and alternatives with flexibility to tailor to clients risk and return objectives, irrespective of asset size."

 

Russell's manager of managers rival SEI also says it will not package up equities, bonds and alternatives into single fund. "The whole idea of liability driven investment means that each client has different liabilities and we have always provided bespoke asset allocation. I know that as soon we wrapped that up with a single NAV, the next client would come along and say it was not for them," says Mark McCarron, managing director and client portfolio manager at SEI.

 

Collins of Watson Wyatt sees funds of alternatives as an interesting area for clients, pointing out that in this area conventional managers and multi managers will be in competition with other providers, such as specialist alternative investment groups now offering expertise in more than one area of alternative investment.

 

 

 

How much to charge?

 

An important area in the area of diversified growth  is the alignment of interests between the investment manager and the investor - and investors should  consider how and whether internal managers are being  incentivised.

 

John Collins, senior investment consultant at Watson  Wyatt, has identified that fees in diversified growth  funds range from 40 basis points to 150 basis points plus  a 20% performance component. "You do see the full  spectrum in terms of pricing structures," he comments.

 

Fidelity says the fee for its product will be 95 basis  points; JPMorgan Asset Management charges a 1% clean  fee, while CSAM charges a 25 basis point management  fee for its fund, which has a target total expense ratio of  70-130 basis points.

 

 

"The key areas we are thinking about include alignment  with clients," says Kitts, who points out that it is crucial for  managers to be remunerated fairly within a multi asset  structure, where some asset classes are more expensive  than others and different levels of alpha are being generated. "We are really looking carefully at this to ensure that  our interests are aligned with those of our clients," he comments.

 

Kitts says fees can be tailored to the asset mix in a segregated portfolio - beta only, alpha only and a mix. "I do  not think there is an easy consensus and I think that some  clients will opt for more beta than others if they are fee sensitive and one our product development issues has to be to  cater to different clients."

 

It also goes without saying that euro denominated diversified growth funds will be attractive to continental European  investors, which is already the next port of call for investment managers like JPMorgan Asset Management.