17 October 2017 | Webinars
What are the core attributes of a successful investment fund? How can investors avoid the lure of a good story and focus on the essentials?
Neil Cowell is head of intermediary distribution at Vanguard Europe and Alexis Gray is an economist in our Investment Strategy Group. Leo Schulz, senior investment writer, speaks to Neil and Alexis about what makes a diversified multi-asset strategy really successful. This is an edited transcript of their conversation.
Past performance is not a reliable indicator of future results.
Leo Schulz: Diversification: the magic ingredient. Diversified multi-asset funds have become enormously popular in recent years. Vanguard of course with its LifeStrategy® funds has been a key player in that expansion. But what we want to do today is dig below the surface and look at the features that make a diversified multi-asset strategy really successful.
My name is Leo Schulz. I have with me Neil Cowell, head of intermediary distribution, and Alexis Gray, an economist in our Investment Strategy Group, and a member of our working group on single fund solutions. Neil, Alexis, welcome to you both. To all our live listeners, you should now see a box appearing on your screen, in which you can submit questions for Neil and Alexis. We'll work them into the discussion as we go along. Anything we don't have time for, we'll follow up on individually.
The agenda for today is very simple; we're going to look at four key areas that make a difference to a multi-asset fund: its strategic positioning, diversification, its balance, and its cost. Okay, let's start with the strategic. Neil, we all know that strategic asset allocation is the key to long-term investment returns, but surely there's a layer of activity - tactical asset allocation - where investors can add further value?
Neil Cowell: I'm not so sure, Leo. I think seeing around corners can be hard. It's not just about predicting events, but it's about getting the right weighting, how long to hold, what the right trade is at the right cost - there are lots of decisions that need to be right in order to get a positive result. Don't forget of course, I mean you've already made the point that eighty percent of the variance of returns comes from the strategic asset allocation, or the beta.
This is borne out actually by some recent analysis of the market that we did, looking at propositions in the multi-asset space, and we compared about five or six of these, and all the time it was the beta that was dominating the return. So I guess our message here is be careful what you're paying, and certainly be careful what you're paying for.
Leo Schulz: We talk about the eighty percent of the variance of returns as being due to a strategic asset allocation, but people tend to think, I'm not part of that eighty percent, you know, I'm part of the twenty percent. But I guess what you're saying, Neil, is that's not really possible, everybody is subject to the beta.
Neil Cowell: I think so, I mean evidence bears that out, and we always stress that while as much as eighty percent of the variance of a return comes from that beta, twenty percent is around the alpha, but that's not always a positive contribution, so that shouldn't be overlooked.
Leo Schulz: So on that point, if we look at the next slide, Alexis, could you just explain what it is that we're looking at on this chart?
Alexis Gray: So we took a look at evidence from the market, we took a look back over the last six years at the performance of tactical managers versus a strategic benchmark, which in this case is our LifeStrategy® fund, with a buy and hold strategic asset allocation. We look across four different categories here, so in anything from aggressive down to moderate, cautious and then tactical. So you're looking at different risk profiles and comparing those versus this strategic benchmark.
Now what you can see on average here is that the net return per year after accounting for that market year is negative. In other words, tactical managers underperformed strategic on average – that’s not to say that every manager underperformed, but on average by anywhere from one to three and a half percent, so it’s not so easy to see around corners.
Leo Schulz: And each of those boxes that we can see there, the four boxes, Alexis, that represents a degree of risk, as it were, in the portfolio, so from aggressive through to cautious and then to tactical, so you're looking right across the risk spectrum with that.
Alexis Gray: Right, so we're looking at different levels of alpha giving you different performance relative to a strategic benchmark. So in some cases there are funds that have outperformed, but on average you're seeing them underperform.
Leo Schulz: And what's the strategic benchmark that you're looking at there, Alexis?
Alexis Gray: It's the LifeStrategy® funds.
Leo Schulz: So for each of our LifeStrategy® funds, twenty, forty, sixty, eighty etc, we're looking at how the rest of the market performed against those funds.
Alexis Gray: Exactly, we're thinking about categorising them according to what Morningstar tells us - they're a similar group with a similar asset allocation, a similar level of risk.
Leo Schulz: So you're using LifeStrategy® as a proxy for the market as a whole. Alexis, something which is thought about and studied to some extent, is why is it that fund managers find it so difficult to get these decisions right?
Alexis Gray: I mean I think there are a few things going on. One is that the market is quite sophisticated now, you've got a lot of professionals competing for the same pool of money, and it's hard to get right. You have to be beating the consensus really. If you think about last year as an example, we had these big political surprises with the Brexit vote, with the election of Donald Trump in the US. Now at the start of the year, if you had assumed that both of those two things would happen, you would probably think the equity markets would crash, right, they were potential risky events?
After the fact though, the equity market was actually very strong for the year. If you were not in the market for the full year, at full weight, you missed out on some amazing returns. So timing events and knowing where to be in the market is very difficult to get right, and so that's what we're seeing here. I think the other point is that the more that you try to time the market, the more cost you generate because you're trading more frequently, a strategic fund is not trading anywhere near as much, so that higher cost is a big hurdle.
Leo Schulz: Thank you for that, Alexis. Shall we move to the next point, to the diversification of a multi-asset fund? We've got actually two slides to look at here, and I think if we just look at this one, which is showing the global equity market breakdown and if we just look at the next one, and that's showing the global bond market breakdown. Neil, we kind of know what these charts are, most of us will have seen these charts or something very similar in the past, but why is it important, what's the point that we want to take away from this?
Neil Cowell: Well I think both charts are really showing us the same thing, so with modern indexing techniques with electronic markets now, it's possible to bring an enormous number of stocks or holdings together in one place, and to give investors this very powerful exposure to world markets, to do so accurately, and also consistently, and very importantly to do it at very low cost.
Leo Schulz: I think that is an interesting point there that you make about the cost, and the fact that you can access this great variety of assets in a very efficient and effective way, but Alexis, we talked about the equity rally as a result of events in 2016. If we think back further to when gilts rallied, for example, we can think of the volatility of the Eurozone sovereign debt crisis, wouldn't it be better to extract value from those events, from that volatility rather than having a static allocation that kind of cancels itself out?
Alexis Gray: I think what history shows us is that buying and holding the market can give you a very good return. I mean if you think about what you're holding, on the equity side you're buying an investment in a company, you're buying a stake in Twitter or Facebook, HSBC, a big banking company, of BHP, a mining company, and as those companies grow and provide earnings, you're getting a piece of that action. On the bond side, what are you doing? You're lending money to a company like a government or a corporate, and they're giving you some sort of interest on that.
So you're buying something that's real and in the long run there has tended to be a positive return for both of those investments. So having access to that is beneficial to you in the long run, the diversification is about minimising volatility, it's about not putting all of your eggs in one basket, but spreading yourself so that if one pocket of the market does badly, you don't lose a lot of your money at once.
Leo Schulz: So in a way, a tactical asset allocation is playing the volatility of the market, but a strategic asset allocation is benefiting from organic growth within the economy, from real life activity?
Alexis Gray: Exactly, so the types of companies I'm talking about, whether it's technology, whether it's mining, whether it's pharmaceuticals, you're benefiting from the growth overall of the economy, rather than trying to time, and like I said, you know, maybe some managers can do well at timing, but it generates cost and it's hard.
Leo Schulz: If we look at the next component on our list, we look at the balance of a multi-asset fund, Alexis, could you just, to start again with you, could you just explain what it is that we're looking at with this chart?
Alexis Gray: What we're looking at, Leo, is the critical components of any investors' portfolios, so two major asset classes are equities and bonds. I have explained broadly what the characteristics are, equities being an investment in a company, whereas bonds being basically a loan to a government or a corporation. Now this is the historical return for those two asset classes over roughly twenty years, so what do you notice?
Well first of all, if you look at equities, which is dark blue, the returns year-to-year have tended to swing around, anything from plus thirty percent down to minus twenty percent. So whatever's happening in the world, you might get a big swing year-to-year, if you compile all of those, equities have tended to provide better returns, so there's some risk involved, but a stronger return, so you're holding it for growth.
On the bond side, the grey bar, shows you that year-to-year, you tend to get a more stable, but generally lower return out of a bond portfolio. So there's more certainty, but because there's that more certainty and lower risk, the net return tends to be lower over the long run.
Leo Schulz: And Neil, if you were explaining to a client why to have a balanced portfolio, why to have both equities and bonds in a portfolio, how would you put that argument?
Neil Cowell: I think Alexis has touched on many of the key points, but I think it's important to emphasise that in a balanced portfolio, whilst you may occasionally miss some of the peaks of performance, you're also indemnified against the errors and the losses to a degree. Total returns in the fixed income space are rarely negative, very long, and equities of course, you know, whilst they may be more volatile in the short-term, to Alexis' point, tend to grow in the longer-term.
Alexis Gray: I think this comes to an important point about why do you hold bonds, which tends to be for diversification, so on average you can expect better returns out of equities, but you're minimising volatility by holding that more stable asset class, which is bonds.
Now more recently I think there has been some controversy about whether you should continue to hold bonds, if interest rates and yield are so low, you know, people ask whether there's some sort of bubble in this market, and if rates rise that maybe there'll be some sort of crash. I think those fears are really overdone, and as I already mentioned, I think holding bonds is not so much about growth, because the outlook, let's face it, for bond returns, given low rates, is more muted, maybe say two percent in the UK for a global or a UK fund over the next decade, on average per year.
You're holding it for diversification, that idea that when the equity markets rock, that bonds tend to rise or hold their value. But that property remains true, whether yields are low or high.
Leo Schulz: But as interest rates go up, Alexis, government bonds particularly are going to lose their value, and yet you would advocate keeping them in the portfolio?
Alexis Gray: Yeah, I mean as rates rise, this is beneficial for long-term investors. You're right that in the short run, a rise in yield represents a fall in price, there's an inverse relationship there. So there's a sort of capital loss, that can be, in a given year, it can be negative, but by a very small margin. But if you think about it, as yields are rising, the new bonds that are issued that are coming into a mutual fund or a portfolio, have a higher yield, so your income stream's growing.
So once let's say, for example, you hold a bond portfolio that has a five-year duration, after five years there's a net benefit to higher yield. So in the long run I would say if rates rise because the economy's doing well, your income stream's getting bigger, you're no longer searching for yield, that's good news.
Leo Schulz: We had a question, which I think is a very good question and one that's very relevant. We’ll just step aside from the formal agenda as it were, just for a few moments, I think, to think about the point that's being raised here. The question is, is there an argument that with markets at record highs, and potential for some form of pull back increasing, that a static strategic strategy could expose new money, money coming into a fund, to losses before it had a chance to benefit from the longer-term growth that we've been discussing in the slides here?
Alexis Gray: Can I make a few points here? I think the market is frequently at record highs because the market trends up, the level tends to get higher. What we have to think about is whether we are being compensated for the risk that we're taking on. So if we look at price-to-earnings ratios, which is one way of thinking about value - what's the value of what I'm buying - both have tended to drift upwards since the crisis. I would say immediately after the crash in 2008, the market was probably undervalued in most parts of the world because asset prices fell so much and they've been gradually recovering to a point where yes, there are pockets of the world where the market may very well be overvalued, we may be seeing a bubble.
It's always hard to know in advance whether you're in a bubble. So I say the risk of a correction in some pockets is definitely there, and that's not to say you should be completely out of the market. Going a hundred percent into cash, those types of things, that on its own is very risky because we don't know how far into the cycle we are. You know, are we at stretch points where we were in 2007? Not necessarily, I don't know that we're quite at those extremes.
When you consider that interest rates are so low now, you can justify having higher asset prices because people are looking for somewhere to find yields. So it's really hard to know when the corrections can come, and I would say having a balanced approach, not fully coming out of the market and still maintaining some investment is important, maybe just gradually dipping into the market rather than going in on one day is one way to protect yourself.
Leo Schulz: I think it's a fair point isn't it, that markets are high, certainly in headline terms as it were, but are there any obvious triggers for a major correction? I mean, interest rates might be an example.
Alexis Gray: I mean there are many different things, you are looking at what can really shift sentiment, what can cause people to re-evaluate asset prices. Maybe it's a sharp increase in interest rates that we didn't see coming, maybe it's some geo-political tensions, something happening between North Korea and the US, I mean who knows, it's something that breaks into them. It's funny that of some of the events over recent times, none of those have, you know, the election of Donald Trump potentially could have done it, but it didn't happen.
So we've had quite a few things that could have caused markets to shift, the Federal Reserve raising interest rates, it hasn't happened yet. So I would agree to be somewhat guarded, but I would not say that we're overly bearish.
Leo Schulz: And of course in absolute terms, interest rates are still very low, aren't they?
Alexis Gray: That's right, the interest rate in the UK is still near zero.
Leo Schulz: Neil, what would you say to an investor coming into the market who might now be concerned about just this issue, that markets have been very strong and that suspicion, the fear and anxiety that they might fall back for a period?
Neil Cowell: I think our messaging stays the same, Leo, irrespective of market conditions. You know, we talk regularly about our investing principles, that investors should understand why they're investing and have a clearly articulated goal and understand the nature of what they're seeking to achieve. Very importantly, they should make sure that the risk is right for them, that the balance we talked about is right for them, the portfolio has that accurate blend of bonds and equities that supports their risk strategy.
It's critical that the component parts of that portfolio are at low cost, we can't stress that enough, and we'll talk about that in a minute, and then finally, to Alexis' point, tune out the noise. Having got that component part of the strategy in place, let time do the heavy lifting.
Leo Schulz: So it's partly about your goals and getting the right sort of balance of risk and required return, but there's a kind of a risk tolerance, isn't there? There's kind of an emotional engagement with the market, isn't there, where people just, but rightly or wrongly, just don't want to see their money going down. But does that just mean that you lose, does that mean that you stay out of the market, does it mean that you overweight a certain type of asset? What's the response there?
Neil Cowell: I think that's, I mean that's one of the things that we have been talking about for quite some time now, I mean I think that's where the adviser has a huge role to play. The phrase we use a lot here is the adviser's role is that emotional circuit breaker - markets will be volatile, prices will go down, there's no question about that - Alexis has articulated that well.
But it's important if we are clear about the goal, if we are clear about the ambition, if we're confident the asset allocation is right, then that's where the adviser really adds value, that behavioural coach, that emotional circuit breaker, to ensure that the investor doesn't do something quite foolish.
Alexis Gray: Yeah, and I think also that setting expectations is another role for the adviser to say look, interest rates are low, bond portfolio returns are likely to be lower than where they were historically, even after adjusting for inflation. And equity markets are, you know, the valuation is higher than where it was a few years ago, so once again return expectations are a little bit lower. So as long as the client understands that, if you set that expectation early, that can help with some of the issues of them getting upset later on.
Leo Schulz: So there's a coaching role, isn't there, this is, when we talk about behavioural coaching, this is a prime example, would that seem fair?
Neil Cowell: Yeah, very fair indeed.
Leo Schulz: So if we go back onto as it were the formal agenda and start to think about costs, if we look at this slightly complicated chart I think, in my humble opinion, Alexis, perhaps you could illuminate our listeners on what we're looking at here?
Alexis Gray: We're looking here at a chart of various funds offered in the market, we're looking at first of all the expense ratio along the horizontal axis, and then the net return, on average over ten years on the vertical. So we've looked at a whole set of funds in the market, basically everything over the last decade, and tried to consider is there any relationship between how much money I pay, my expense ratio, to a manager, and what my return is after paying those fees?
And across these different segments of the equity market, from global to UK all the way down to emerging markets, we find an inverse relationship. That means that the more costs I pay, the lower my net return tends to be.
Leo Schulz: So just to be quite clear, if for nothing else than my own sake and my own sanity looking at this chart, so to the right is more expensive funds?
Alexis Gray: That's right.
Leo Schulz: To the left therefore are cheaper funds, and the red line that we see sloping in all cases from downwards from left to right, so downwards from the more expensive to the cheaper funds, so that essentially is telling us that the cheaper funds have better returns?
Alexis Gray: On average.
Leo Schulz: On average, and the more expensive funds have lower returns, on average. And as you pointed out, this is over, what in this case, six different, and quite different, types of equity asset?
Alexis Gray: Right, and we've looked at this, the funds domiciled in the UK, Europe, Asia, Australia, North America, over different time frames, this relationship forms wherever you look. So it's a strange concept, when you think about buying anything else, if you buy a new car or a new house, the more you pay, the better quality you expect, right? Now in the investing world, the more you pay, the less that ends up in your pocket on average.
So it's the reverse thinking to anywhere else that you spend money, so I think it's a bit of an adjustment in mindset. That's not to say that paying a lot to an active manager is automatically making you worse off, but they have to work harder to earn back that fee. The amount of alpha that they need, you know, if they're charging you one percent in fees but they're only giving you seventy-five basis points of alpha, you're worse off.
Leo Schulz: And Alexis, we were talking earlier about interest rates, and although rates are going up, we don't expect them to go up very far or very fast, and I think your projections, if I understand correctly, are that investment returns looking ahead are likely to be lower in the future than they have been in the past, does that put pressure on costs?
Alexis Gray: It does, I think if you have both in the bond and equities space a lower expected return over the next decade than what we've seen over say the last thirty years, that means your manager is now getting a greater share of your return. So let's say you get two percent from a bond fund, but you're paying half a percent in fees, that's a quarter, so having a very close eye on costs matters more as we move now into a lower return environment.
Leo Schulz: Neil, costs are a subject close to your heart, what's your interpretation here?
Neil Cowell: Yeah, again, Leo, I think Alexis has summed it up well, I mean costs create an inevitable gap between the performance from a particular market and what an investor will actually get back, and investors need to remember that yes, returns may rise and they may fall, but costs remain constant. And with the impact and the effect of compounding over time, they can make a serious difference to long-term returns.
And I mean when you look at that chart, we do see, as Alexis has said, that lower cost funds do tend to outperform, nothing magic about that, it's just that if you're paying less to the fund manager, then automatically you're keeping more for yourself. We always use the phrase at Vanguard, in the world of investment you get what you don't pay for.
Leo Schulz: If we can just come to bring these various thoughts and ideas to a conclusion, and just look at this last chart, again, Alexis, would you mind if I call upon you to just explain what these two great splashes of dots are telling us?
Alexis Gray: Sure, so Leo, we're looking here at the pool of different funds available in the multi-asset world, and we're looking firstly at their return, which is the vertical axis, and then their risk, which is the horizontal axis. So over the last three years and the last five years, how have multi-asset funds performed, how have the LifeStrategy® Vanguard funds performed?
Leo Schulz: So each of those blue dots is a multi-asset fund, is that it?
Alexis Gray: That's right, this is the full market.
Leo Schulz: And you spoke earlier on in the discussion about using LifeStrategy® as a proxy for the market as a proxy benchmark, and the LifeStrategy® funds then are the coloured squares.
Alexis Gray: That's right, and so what we've tended to see with the LifeStrategy® funds compared with the market, is that they've had a lower risk and for that given level of risk, a higher return. So I think the ideal place you want to be is towards the top left, so whatever level of risk I'm taking on, I want the highest possible return. So they have been, I would say, quite difficult to pick - not impossible - some managers have performed very well, but the vast majority have struggled to beat this strategic type of asset allocation fund.
Leo Schulz: And that's going to be for the reasons that we have discussed: the costs of trading, higher fees, taking taxable positions that are difficult to work out.
Alexis Gray: Exactly, and difficulty in timing the market while keeping costs down.
Leo Schulz: Neil, when you think about the LifeStrategy® funds and it's been certainly a very successful product in the UK and among our advisers, for which we are very grateful - when you look at these results, is that about where you want to see LifeStrategy®?
Neil Cowell: I think there are two points there, Leo. I mean it's tempting to talk about performance, and although that's very pleasing, I think the picture also needs to embrace the symmetry that we're seeing there, the relationship between risk and return brought to you through that strategic asset allocation.
I think the reason that we have been very successful in the UK with LifeStrategy® is because advisers are realising that it does exactly what you would expect it to do, you know, time and time again strategic asset allocation delivers.
Leo Schulz: Alexis and Neil, thank you both very much. I think it's been a really interesting discussion. I apologise that we haven't been able to deal with all the questions that have come in, but we will get back individually to those whose questions were unanswered. Unfortunately we have come to the end of our time for today, I am sure you are all very eager to be getting back to your day jobs.
This document is directed at professional investors and should not be distributed to, or relied upon by, retail investors. It is designed for use by, and is directed only at, persons resident in the UK.
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 does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
The opinions expressed in this material are those of the individual speakers and may not be representative of Vanguard Asset Management, Limited.
This material was produced by Vanguard Asset Management, Limited. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.
Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
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 is available in local languages from Vanguard 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.