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LifeStrategy: the benefits of endurance

29 April 2019 | Topical insights

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Commentary by Edoardo Cilla, Investment Strategist

Endurance isn’t a particularly fashionable concept. These days we’re all about change; our bank, our insurance, our utilities, our jobs – there’s always a more attractive deal or opportunity. Why endure something if you can change it?

The problem is that changing something doesn’t necessarily make it better.

Endurance is one of the key features of our LifeStrategy funds. The LifeStrategy range consists of five funds, each with specific risk characteristics and strategic asset allocations.

The asset allocation relates to the amount of money that investors allocate to various asset classes like stocks and bonds. A strategic asset allocation is one that doesn’t shift, that endures. The LifeStrategy 60% Equity Fund, for example, maintains its asset allocation to 60% equities and 40% bonds, periodically rebalancing back to the target, ensuring at the same time a strategic globally diversified exposure within equities and bonds.

The alternative approach is tactical asset allocation. A fund that has a tactical asset allocation can change its asset allocation depending on where the manager sees opportunities in the short term. For example, if the fund manager feels that UK equities are likely to underperform in the following weeks, she may switch some of the fund’s assets out of UK equities and into another asset class, such as US equities, or even into fixed income or alternatives. Of course this comes with risk: the risk that the market does not move as the manager predicted.

We believe LifeStrategy’s strategic approach is one of the keys to its success. Here’s why.

Portfolio returns are primarily driven by strategic asset allocation

Possibly one of the most influential analyses into the sources of investment returns was a study in the US entitled Determinants of Portfolio Performance, often known by the names of its authors, Brinson, Hood and Beebower. What it showed was that over a ten-year period 94% of the variation in returns in a group of balanced pension plans was due to their strategic asset allocation. Only 6% was attributable to market timing or security selection.

Since then, different studies, using a variety of fund types and time horizons, have come up with similar results – somewhere around 80%-90% of the return variability of balanced funds is determined by the long-term mix of equities, bonds and cash – in other words, by the strategic asset allocation.

Tactical asset allocation is difficult to do successfully and efficiently

The ability to switch into different asset classes or sectors may be tempting, but market timing decisions are complex. Securities are priced off expectations: for a manager to outperform, they need to correctly predict a market event, such as a rise in interest rates, before the rest of the market does. They then need to foresee how the market will respond, which is not always immediately obvious.

Let’s imagine that a manager decides they have found an opportunity for outperformance.  This is merely the first of a number of decisions that must be made correctly and with extreme accuracy. For each asset class a manager moves out of, they need to work out when to move out and when to come back in. And what should they buy instead? How muchshould they sell? Can they get the right price? Should they reverse their original position or move into another one? If a fund manager can get all of these decisions right, then they have a chance at outperformance. But it is clearly never easy.

Tactical activity also costs money. Not only will a tactical manager be spending a lot of time trying to predict the market over the short term, the trades that they make will incur implementation costs. To compensate for these costs, a tactically managed fund will potentially need to take on more risk to try and achieve a greater return.

Tactical funds are often more expensive. Research shows that the more expensive a fund is, the less likely it is to outperform. A high-cost investment makes net outperformance, relative both to the market and to a lower-cost investment, much less likely.

A strategic, transparent and diversified approach

Strategic asset allocation is clearly powerful. So how can investors implement it and how does a strategic approach work in practice?

The Vanguard LifeStrategy range is an efficient and effective solution. It comprises five funds, each with a different strategic asset allocation so that it can serve investors with different preferences. What is important here is that these asset allocations are enduring, which means that they do not change over time; investors can be sure that the fund they choose will consistently maintain the equity and bond mix that they selected it for.

Moreover, the LifeStrategy funds are truly strategic solutions, implemented with Vanguard’s diversified low-cost index funds. In fact, not one of the asset allocation decisions made in the LifeStrategy funds is tactical. We focused on asset classes that are liquid and can be accessed at low cost: equities and bonds. We have not included alternatives in order to preserve important characteristics of the funds: liquidity, low cost, transparency and absence of unnecessary active risk.

Our strategic approach does not end at the asset allocation level. At sub-asset allocation level (within equity and within fixed income) we follow a passive market capitalisation approach that allows our funds to achieve globally diversified exposure. For example, the LifeStrategy 60% Equity fund has around 22,000 securities across some 25 countries.

However, a passive market capitalisation allocation does not mean adopting a passive approach. In fact, we achieve market capitalisation exposure after removing segments of the market that we believe do not benefit the diversification of our funds, like high yield bonds for example.

Also, following a strategic approach does not mean ‘set and forget’. We constantly challenge ourselves on previous asset allocation decisions and closely monitor the funds to help investors maximise their chances of investment success.

So, does a strategic approach work in practice?

How to measure success

Below we compare LifeStrategy’s risk and performance against multi asset solutions available to UK investors. In both the 3-and 5-year periods measured, the LifeStrategy funds almost represent an efficient frontier for all the other funds. In fact, for each level of risk, LifeStrategy products delivered top return characteristics.

Past performance is not a reliable indicator of future results.
Source: Factset / Morningstar as at 31 December 2018. Performance figures include the reinvestment of all dividends and any capital gains distributions. The performance data does not take account of the commissions and costs incurred in the issue and redemption of shares. Basis of fund performance NAV to NAV with gross income  reinvested. Competitors shown are UK domiciled funds in the following Morningstar categories: EAA Fund Global Large-Cap Blend Equity, EAA Fund GBP Moderately Adventurous Allocation, EAA Fund GBP Moderate Allocation; EAA Fund GBP Cautious Allocation and EAA Fund GBP Moderately Cautious Allocation.

The most compelling case for strategic asset allocation? It works. Aided by a low-cost, diversified approach, strategic asset allocation drives the majority of LifeStrategy’s returns, without forcing it to take on unnecessary risk.

It is possible for active management to succeed, especially if costs are low, the manager is particularly talented and investors can accept the inevitable periods of underperformance. But for many investors, a strategic asset allocation in line with their long term goals and implemented with low-cost diversified funds is likely to represent an effective strategy.

Performance: rolling 12 months

12-month periods to 31 March 2019

12 months to end Mar 2015 Mar 2016 Mar 2017 Mar 2018 Mar 2019
LifeStrategy 20% Equity Fund 10.98 1.42 8.28 1.45 4.76
LifeStrategy 40% Equity Fund 12.39 0.89 13.53 1.56 5.76
LifeStrategy 60% Equity Fund 13.77 0.11 18.97 1.89 6.99
LifeStrategy 80% Equity Fund 15.05 -0.73 24.55 2.14 8.17
LifeStrategy 100% Equity Fund 16.41 -1.60 30.29 2.38 9.30

Past performance is not a reliable indicator of future results.
Source: Factset / Morningstar. Performance figures include the reinvestment of all dividends and any capital gains distributions. The performance data does not take account of the commissions and costs incurred in the issue and redemption of shares. Basis of fund performance NAV to NAV with gross income reinvested. Performance is net of fees.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.                                                    

Investments in smaller companies may be more volatile than investments in well-established blue chip companies.

The fund(s) may invest in financial derivative instruments that could increase or reduce exposure to underlying assets and result in greater fluctuations of the fund's Net Asset Value. Some derivatives give rise to increased potential for loss where the fund's counterparty defaults in meeting its payment obligations.

The Vanguard LifeStrategy® Funds may invest in Exchange Traded Fund (ETF) shares. ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.

Some funds invest in securities which are denominated in different currencies. Movements in currency exchange rates can affect the return of investments

Alternative investments are subject to less regulation, may be illiquid and can involve significant use of leverage, making them substantially riskier than other investments.

Important information

This document is directed at professional investors and should not be distributed to, or relied upon by retail investors.
This document is designed for use by, and is directed only at persons resident in the UK.

The opinions expressed in this presentation are those of individual speakers and may not be representative of Vanguard Asset Management, Limited.

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document is general in nature and does not constitute legal, tax, or investment advice. Potential investors are urged to consult their professional advisers on the implications of making an investment in, holding or disposing of [units/shares] of, and the receipt of distribution from any investment.

The Authorised Corporate Director for Vanguard LifeStrategy® Funds ICVC is Vanguard Investments UK, Limited. Vanguard Asset Management, Limited is a distributor of Vanguard LifeStrategy® Funds ICVC.

For further information on the fund’s investment policy, please refer to the key investor information document (“KIID”). The KIID and the Prospectus for this fund are available from Vanguard Asset Management, Limited via our website https://global.vanguard.com/.

Issued by Vanguard Asset Management, Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.

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