Risk in equity markets in terms of volatility is at a quarter-of-a-century low, according to the widely-consulted CBOE Volatility Index (VIX). Given the various macro risks that face us (Brexit, disarray in the Trump administration, nuclear threats from North Korea), this may seem highly counterintuitive. But the U.S. administration’s market liberalization stance, ultra-low interest rates and share price momentum fed by growing numbers of passive investors have continued to drive stock prices up.
Yet, anyone who thinks risk is off the table does so at their peril. Ironically, the apparent lack of fear in markets has left lots of investors pretty fearful: a recent survey showed that 44% of fund managers worldwide felt that global equities are now overvalued – the highest proportion since 1998. Such widespread concern leaves markets highly vulnerable to a sell-off.
But with interest rates close to zero, what alternatives are there for investors? Where is the safe haven at a time when asset prices seem to have become so separated from fundamental value? The answer may be that the safest place to be isn’t one place but many. A multi-asset fund that intelligently diversifies capital across a range of very different and (ideally) lowly correlated asset classes can reduce exposure to declines in any single asset class while optimizing opportunities to capture return.
But not all multi-asset funds are built the same. Some important questions need to be asked to ensure that a multi-asset fund is built to cope with whatever challenges markets present in these unusual times. For anyone concerned about risk, here are questions to ask before choosing a multi-asset fund:
How diversified is the fund?
Some funds claim to be diversified – but look beneath the surface and you can often find a traditional “balanced” fund that’s simply offering a blend of equities, bonds and cash. To be sufficiently diversified to weather market volatility, a fund needs to be looking at the full universe of traditional and alternative asset classes, ranging from equities to property to infrastructure to emerging-market debt. A portfolio of 12 or more different asset classes shouldn’t be unusual.
By blending multiple return drivers that are largely independent of each other, a fund is far less vulnerable to external shocks wherever they arise.
It’s also important to see where returns will come from. Some asset classes will be chosen for their growth potential, others for their steady income yield, and others for a return with very low economic sensitivity. By blending multiple return drivers that are largely independent of each other, a fund is far less vulnerable to external shocks wherever they arise.
How equity heavy is it?
Following on from the point above, some multi-asset funds also find it hard to shake off their reliance on listed equity. Publicly traded shares have a valuable role in a portfolio – not least for their liquidity. But it’s important to check the breakdown of a portfolio, and the minimum that can be held in equities, just in case exposure to any correction in equity markets is higher than you assume.
Is it reliant on market timing?
There are a number of ways that multi-asset funds seek to generate excess return. One philosophy involves actively moving between asset classes depending on which assets are seen to be on the rise and which seem to be in decline – often using exchange-traded funds (ETFs) to aid easy trading. This can sound like a smart idea, but it leaves investors heavily exposed to the fund manager’s market-timing skill, which is a high-risk move, especially when markets are volatile.
The major impact on long-term returns of missing out on the 10 best days in markets (which often occur just after a market correction) is well-documented. Additionally, you need to be confident that the fund’s performance can compensate for the additional cost of frequent trading. A fund that looks for a wide range of compelling asset classes, combines them to get an optimal blend of correlation and function, and then regularly rebalances back to the fund’s target exposure could be more cost-effective in the long run.
Is it forward-looking?
Multi-asset funds can easily be viewed as a convenient way to spread risk to avoid losses in the short term. But their value also lies in their ability to include emergent asset classes that may generate strong returns in the longer term. Opportunities such as insurance-linked securities, social infrastructure and healthcare royalties have only become available in the last five years or so. But being able to include them as part of a highly diversified portfolio offers the opportunity to tap into their potential at an early stage without having to take on the risks of, for example, a sector-specialized healthcare or infrastructure fund.
Is it built to manage the risks that really matter to investors?
It’s easy to get caught up in the idea that managing risk is only about managing market volatility. But the key investment risk is whether or not a fund will meet an investor’s own financial objectives. In this regard, it’s important to know what returns a multi-asset fund is aiming for. An outcome-oriented approach that’s benchmarked against an explicit return objective (a specific return over cash, for example) offers the reassurance of a disciplined approach to both risk and return and makes it easier to match a fund against an investor’s own expectations.
How much manager risk does it involve?
Finally, a multi-asset fund may be diversified across asset classes, markets and investment strategies. But if it’s led by just one star manager, your risks are still heavily concentrated in the hands of one individual. The solution? Look for a fund that’s driven by a clear, disciplined and team-based process – and where both the management team, as well as the portfolio, are properly diversified.
Multi-asset funds can be an effective way to create diversification and generate income, but it is up to investors to determine whether their selected fund can meet their specific objectives while offering comprehensive risk management.
Diversification does not ensure a profit or protect against a loss in a declining market.
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.
1 Bank of America Merrill Lynch Global Fund Manager Survey, June 2017.
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