LifeStrategy: Why it's elementary
29 May 2018 | Webinars
With rates rising and equity valuations relatively high, many investors are concerned about the future. Is tactical asset allocation the key to avoiding losses? Or should investors stick with what they have?
Ankul Daga, senior investment strategist, speaks to Alice Shepherd, investment writer, about why a core holding in LifeStrategy supports investor goals in all market environments.
Alice Shepherd: LifeStrategy – why it’s elementary. In the seven years since Vanguard’s LifeStrategy range was launched, the fund has given solid support to a wide range of investors. Is this likely to continue? My name is Alice Shepherd; I have with me here Ankul Daga, senior investment strategist at Vanguard Europe; Ankul, welcome to our monthly adviser webinar and thank you very much for being here.
Ankul Daga: Thanks Alice.
Alice Shepherd: Ankul is going to help us understand how the funds are set up and why they perform as they do; if you’re having trouble with the quality of the audio, and there was a little bit of interference earlier but I hope that’s now resolved itself, there should be a window on your screen giving instructions on how to dial in directly on your phone and this should help to give you a nice, clear sound. For our live listeners you should soon see a box into which you can type questions; we have a large audience today, so if we don’t get to you personally we will definitely follow up.
The call will last approximately thirty minutes and the webinar earns participants a half hour’s worth of CPD points; you’ll need to request your certificates by contacting your usual Vanguard representative, or by writing to firstname.lastname@example.org, or by phoning 0800 917 5508.
So now we’ve covered the logistics, I have a few questions for you Ankul, but before I jump into them, I’ll just go into what we’ll be discussing today. First of all we’ll take a look at the make up of the range; we’ll then take a look at fixed income and its impact on LifeStrategy, a point of interest to many investors at the moment. We’ll then discuss indexing and how it functions in bull and bear markets, look at how the range has performed, before finishing by looking at alternatives.
So to start us off I think it would make sense if you could briefly remind us, if you will, of the core principles behind LifeStrategy.
Ankul Daga: Sure; so LifeStrategy is our range of multi-asset funds, going all the way from 20% equity mix on the left hand side of the screen, to a 100% equity mix. What we’ve tried to do is offer the clients a range of choice between equity and bond mixed, to align to their investors, their clients’ risk profiles.
In this range we have five different options and each of those options are pretty well diversified; we’d like to think that these funds are outwardly simple, but inwardly sophisticated. They have thousands of holdings inside each of these funds; they provide investors global diversification, and we also take deliberate decisions around how we expose investors to currency risk.
For instance in these funds, the equity portion is left unhedged, whereas the fixed income portion is entirely hedged back into the investors’ base currency, which is sterling; these funds are automatically rebalanced and are relatively easy for investors to understand.
So the key idea behind LifeStrategy is to provide investors with a diversified vehicle to get access to markets and at the same time provide them transparency in terms of what they hold in those vehicles, and while doing that we go back to our core principle at Vanguard, which is to provide them investment options at the lowest possible cost.
Alice Shepherd: And so that’s an enduring solution because we aren’t chopping and changing the allocations.
Ankul Daga: Absolutely, these are target allocation funds, which stick to their mandate firmly. We keep rebalancing back to the mandate and we don’t try to do any form of tactical allocation with these funds.
Alice Shepherd: If we just go back to the previous slide, I notice there is a large amount of fixed income, especially in the more conservative portfolios, and there are a lot of headlines about rising interest rates at the moment; so one question I’d like to ask is what kind of impact will this have on these allocations for fixed income? Is this something that investors should be worried about?
Ankul Daga: So let’s look at what happens to bonds when interest rates go up; so I’m going to move two slides down and here’s the actual outcome for a bond investor. What you see here is the impact on the sterling bond market of rising interest rates over the last 30 years. We’ve taken five specific scenarios where interest rates have gone up and you can see the amount interest rates have gone up by the green numbers right in the middle of the screen.
If I start from the number on the left hand side, in 1994 to 1995 interest rates went up by 150 basis points, and during that period the sterling bond market, or the Sterling Aggregate Bond Index went up by about 5%.
Alice Shepherd: But doesn’t that seem counterintuitive? Isn’t it the case that when interest rates go up, bonds go down?
Ankul Daga: Yes, but I think what investors should really focus on is not interest rates, but rather yields. Let me try and do the same experiment, but looking at the impact on bond prices and the total return from bonds when yields go up.
So when yields go up, of course bond prices come down, right, and that has a significant impact on the total return from bonds, so again the bonds we’re looking at in blue are again very similar to what we saw in the last slide; the sterling bonds are in blue, global bonds are in green, and what investors can clearly see is that every time yields go up, bonds do lose their value.
The first point I’d make is investors shouldn’t worry about interest rates – they should think more about yields. When they think about yields, it’s important to think about what is priced into the market, what is the market expectation, and what subsequently happened; or what we call what is realised?
So investors need to think about what is implied and what is realised, and when there is a surprise, at that point, there is an impact on the asset that that investor is holding.
I’d remind investors to think about yields and then think about surprises, and the final point I’d make around this is the reason we put on these green bars all along this chart, is to highlight to investors that if they’re concerned about their local market, they can go global with bonds. They can use global bonds to reduce some of the price impact, or some of the price action on the security, on the asset that they are holding.
Alice Shepherd: Okay, so it’s more about whether rates rise more quickly or to a greater extent than expected.
Ankul Daga: Absolutely; it’s all about the surprise factor.
Alice Shepherd: I think a few people will respond to the suggestion of higher interest rates by considering short-duration bonds; if I was worried about interest rates, would it make sense to go short duration?
Ankul Daga: I think this is a very common fallacy; a lot of investors are worried about the duration exposure of their portfolio rather than what the asset is providing them with in the first place. So if I can just step back and think about what is the fundamental reason for investors to hold bonds, I can typically think of two reasons; the first one is risk reduction; bonds provide diversification to investors against equity market action, or in adverse equity markets, bonds tend to provide some cushion to investors.
As you can see on the next slide, what we’ve tried to do is we’ve just tried to put some numbers around that, and kind of express it in terms of what kind of cushions are different bonds providing in an equity market downturn?
We’re showing here a bad equity quarter, on average when equities go down by around 8.8%, and the reaction function of bonds that are maturing in one to three years, three to five years, the overall aggregate bond market, five to seven years and so on. You can see that as you go from left to right, the response is more and more positive. Going back to first principles, the primary rule of bonds in a portfolio is to reduce the risk of the overall portfolio, and as you reduce the duration of your bond allocation, the cushion that the bond allocation is providing your portfolio is significantly reduced.
The second reason it makes sense to have bonds is to get a source of stable income. A short-duration one will offer investors much lower yields and much lower income as compared to a longer-duration bond, and there again reducing the duration of the portfolio is going to come back to bite the investor; it’s a price they’re paying as they reduce the duration, for as long as they hold a shorter duration.
Now why do I say all of this? I want to remind the audience that to predict interest rates and to predict yields is extremely difficult. The entire market has been expecting, and particularly the professional segment in the market, the fund management segment, has been expecting interest rates and yields to rise all the way from 2011.
If you look at the forecast of professional investors, they’ve been expecting yields to rise in 2011, 2012, 2013, 2014 and that has continued. And the reality is they haven’t actually moved that much; in fact yields have started moving much more significantly in the US in the last twelve months after a very long period of hiatus.
So forecasting how yields will move is extremely difficult and given that, it would be sensible for investors to stay with a diversified exposure to bonds, with a portfolio, which has bonds which are both short duration and longer duration, and keep that overall balance for the overall equity bond mix of the portfolio.
Alice Shepherd: And in LifeStrategy we would have short-duration bonds as well?
Ankul Daga: Yes, so in LifeStrategy the bond allocation is an aggregate bond market representation; it has short-dated bonds, medium-dated bonds, and long-dated bonds.
Alice Shepherd: So that’s interest rates, but another cause of concern for bond investors is the slowing down of quantitative easing; is this something investors should be worried about?
Ankul Daga: So when you look at quantitative easing, essentially what central banks are doing, or have been doing is buying a lot of the bonds from the free market, from the open market, and as a consequence their balance sheet has been expanding over time.
So what you see in the slide in front of you is the balance sheet of the four major central banks, and the US is in grey, followed very closely by the Eurozone or the European Central Bank, and then the Japanese Central Bank and finally the Bank of England.
And what we’ve tried to illustrate with this is over the last ten years central banks have been building up their balance sheet to support markets, and as a consequence they have suppressed the yields in the bond market. This is a technique used to essentially stimulate the overall market; capital markets on the whole, not just bonds but also equities.
And the first point I’d like to highlight is if you look at the overall balance of all the global central banks’ balance sheets, they’re actually fairly stable in the near term; so from now, so if you look at the shaded area on the right hand side you can see that the total value is actually pretty stable over the next three to four years.
So even though we hear a lot of market news around specific central banks, you know, the Federal Reserve for instance reducing quantitative easing, the Eurozone is still doing more quantitative easing and the same goes for the Japanese Central Bank.
So I think the first point I’d highlight is quantitative easing is actually stabilising rather than reducing dramatically, and second, quantitative easing is an artificial measure, which was put in place by central banks to stabilise capital markets; the last thing they will want to do is surprise markets and create adverse action.
Alice Shepherd: Absolutely, and you can see there’s also still a vast amount on the balance sheet there. Moving away from fixed incomes now, critics of indexing often say that it works when the market’s performing well, but a bear market is when active management comes into its own; is there truth in that?
Ankul Daga: So we’ve been hearing this argument from a lot of our investors, and what this has led us to, is to do lots of different experiments to see if this actually works. So what we did was we looked at equities; we looked at fixed income and we tried to find some kind of a pattern.
So what we were almost thinking was if a fund manager does well in a bull market, will they do better in the next bull market, or contrarily if I turn it around, if a fund manager did well in a bear market, will they continue to do better in a bear market?
So what I’ve got here on the chart is the performance of US equity funds in the first bear market, which is the tech bubble, that is on the horizontal axis, and then the performance of the same fund managers in the Global Financial Crisis on the vertical axis.
There were some managers who did really well in the tech bubble, and those are the managers on the right hand side; but the same managers actually ended up underperforming quite significantly in the Global Financial Crisis, and equally there were some managers who did really badly, or who really suffered during the tech bubble, who then subsequently did really well in the Global Financial Crisis.
So you can see that on the top left of this chart where on the left hand side it’s underperformers in the tech bubble, but on the top part of this chart are managers who outperformed during the Financial Crisis. And the reason I’m trying to kind of go through that is to highlight that we find this in the snowball effect where there isn’t a particular pattern; the performance is absolutely random whether we look at equities, whether we look at fixed income, whether we look between a bull market and then a subsequent bear market, or we compare the performance of managers from one bear market to another bear market.
And my point here is quite simply that it’s very difficult to find persistence within active fund management from one part of a cycle to another cycle, and again this is where, you know, as we all know outperformance is not a good guide; if anything it leads to certain biases, which can hurt investors.
Alice Shepherd: And so if it were true that active management did perform well in a bear market, then we would expect to see all those results clustered at the top right, wouldn’t we? Is that correct?
Ankul Daga: Yes, and so if on the contrary, if there was a link between past performance and then future outcomes, what you would expect is to see a lot of clustering on the diagonal, the 45 degree diagonal where you’d find a lot of managers on the top right, so the managers who did well in the first crisis, which is the tech bubble, continued to do well in the Global Financial Crisis, and similarly you would want to see a clustering on the bottom left, where managers who underperformed continued to underperform; so you’re almost looking for a diagonal kind of zone going across this page rather than seeing a completely randomly scattered snowball effect.
Alice Shepherd: And this is equity funds; is the picture similar for fixed income?
Ankul Daga: So we’ve done this for fixed income; we’ve done this for different cycles as well over the last 25, 30 years, and the pattern’s pretty much the same. I could have easily put six charts here rather than just one, but I think they looked so similar that the end conclusion that we are drawing from them is exactly the same.
Advisers and investors need to look at each fund manager in a lot of detail and do a thorough due diligence before selecting an active fund manager; one of the variables we did find of value was around the cost that these fund managers charge and we found that the probability of a lower cost fund to outperform the benchmark was higher than the higher cost fund.
So when we look at the first quartile, we find more lower-cost funds outperforming than higher cost, and then if you look at the bottom quartile, so the underperforming funds, we find more higher-cost funds are a proportion of underperformers than lower cost funds.
Alice Shepherd: And so I imagine the picture is similar when we look at multi-asset performance. Is there any persistence when it comes to that?
Ankul Daga: So what we have done is we’ve looked at the performance of multi-asset funds available to UK investors and compared it to LifeStrategy; again the idea of using LifeStrategy there was quite simply to use a passive investable alternative; we could have easily used a benchmark there, but then the criticism of the benchmark is that the benchmark isn’t investable in itself.
Also a lot of the fund managers tend to use different benchmarks, which makes it even more confusing to investors; to simplify the picture, what we’ve done in this chart here is we’ve compared each of the multi-asset segments to a respective LifeStrategy fund. For aggressive we’ve taken the 80% equity, 20% bond LifeStrategy; for the moderate segment we’ve taken the 60% equity, 40% bonds, for the cautious we’ve taken 20% equities, 80% bonds, and then finally for the tactical or the flexible segment of the market we’ve taken our balanced LifeStrategy, which is the 60/40 again.
And these categories are defined by Morningstar; so we’ve taken the funds in each segment based on what Morningstar defines these funds’ mandate to be, and these fund managers would have access both to active and passive investment vehicles, and also the ability to be more dynamic for their strategy.
Whereas if you compare that to LifeStrategy, LifeStrategy is very transparent; the mandate is very clearly set out and all we’re doing is rebalancing it back to the mandate. And you know, when you look at the significant contrast between the two and you think of the opportunities that are available to LifeStrategy and to a lot of the multi-asset active managers, there is a significant difference; there is more opportunity in the latter compared to the former with the LifeStrategy.
But even despite the significant difference in opportunity, when you look at the performance, it’s actually quite telling; so what this chart is actually showing, is if I specifically focus on the moderate segment of the market, which is where we have the bulk of the assets and the largest number of multi-asset funds, what we find is LifeStrategy is performing better than ninety-five percent of the multi-asset funds available in that segment.
So the way to read this chart would be the red dots show the performance of the median fund, which has underperformed by -2.9%, underperformed by almost 3$ on annualised [data].
Then along with that you’ve got the 25th and the 75th percentiles; so the bulk, the closest 50% to the median performers, the average performer in green and in grey, and then the 95th and the 5th percentile is what you see in the risk curves; going straight down all the way to the top and the bottom.
And in the moderate segment you can see that the entire chart is just below the zero line, which is the LifeStrategy performance; now again I admit that this performance is only comparable from the point we launched LifeStrategy, which was about seven years back, in July 2011, but even so you’d expect that there’ll be a significant dispersion and a lot of active managers would be able to outperform a relatively straightforward mandate, which is entirely transparent and giving access to markets in a relatively simplified format.
Alice Shepherd: There’s certainly a strong dispersion of returns when you look at the tactical category.
Ankul Daga: Yes, yes and when you specifically look at the tactical category, the tactical category is also called the flexible multi asset segment and in that segment the fund manager would have a lot of discretion in changing the risk allocation, and as we’ve kept reminding our audience time and time again, asset allocation is the biggest driver of overall returns for a portfolio, and if that asset allocation isn’t firmly fixed and it’s constantly changing, the variability of returns can actually be very dramatic, and that’s what you see in the tactical segment.
But even in that kind of tactical segment, you can see that more than 80% of funds are underperforming a simple balance strategy of a 60/40.
Alice Shepherd: Thank you; and so you referred to the fact that you know, often another way in which these active funds will differ from LifeStrategy is that they are able to access other parts of the market like alternative investments; this isn’t something that we include in LifeStrategy. Why is that?
Ankul Daga: So when we were building LifeStrategy we looked at a whole range of alternatives going from non-traditional fixed income, like high-yield bonds, to property, commodities, and even the more kind of specialised segments of the market like private equity, hedge funds.
And the first thing we noticed was for non-traditional fixed income, specifically high-yield bonds and emerging market debt, their characteristics are highly correlated to equity, which the portfolio already has to some extent.
Again I think our argument isn’t that those categories don’t have any benefit for investors, but that a lot of the benefits can be extracted by having exposure to equities in the first place.
Now when I move across to property, investors can get exposure to property in two ways; one through REITs within the equity market, and second through investment in commercial property funds, which are again very popular in the UK.
Now if you were to get exposure to property through REITs, that is essentially getting, doubling up our exposure to the equity market, or a specific sector in the equity market. Now LifeStrategy funds already have exposure to REITs and if investors wanted to have a specific exposure to a specific sector, that would make sense but we didn’t necessarily see a reason for having that sector overweighted in the portfolio.
If you come to commercial property, commercial property suffers from very, very high costs, which make it really prohibitive for investors to first access them, and second get the performance of the asset class on the whole, and we’ve done a lot of work to highlight some of that.
And finally moving on to the specialised asset classes, like private equity or hedge funds, those asset classes suffer from liquidity constraints, which are inherent in the way those asset classes function.
So again this is not meant to be a criticism, but rather an acknowledgement of a certain fundamental characteristic of the asset class, and LifeStrategy is built to provide a stable solution to a wide range of investors, and given that we don’t know the exact needs of each of the investors, we have taken the approach of designing something which is simple, is accessible, and which is well-diversified.
Alice Shepherd: Thank you; so we’ve come to the end of the presentation part of the webinar; I think we have some questions from the audience. We may not get to all of them, but one question I have is: we know Vanguard is always strong on the importance of cost, but isn’t performance more important?
Ankul Daga: I think at the end of the day it really matters what the investor is looking for, and of course the investor would care - investors should and would care about performance - but whatever performance the asset class gives is not necessarily what the investor receives.
The performance of the asset class is delivered to the investor through a particular fund, it could be an active or passive fund, and the cost of those funds will be deducted from the investor, so I would say actually performance matters, but equally cost matters as well, and in fact the performance of the asset class is something we don’t know before the fact, and it’s something we kind of have to live with, we realise what we realise, but the cost is practically guaranteed before the fact, and we already know what we are paying for that exposure.
Alice Shepherd: Okay, thank you, so the LifeStrategy funds are designed to be simple, low cost solutions that work for most people most of the time; as circumstances evolve performance may be better or worse in the short term, but now at the seventh anniversary of the funds, we can see that they are doing what they were designed to do; Ankul, thank you very much; it’s been a really interesting discussion and great to hear more about how the funds work and delve into some of the issues that affect them.
If you would like to know more about LifeStrategy, or if you’d like to sign up for one of our CPD accredited workshops on fixed income, please do get in touch with your Vanguard Representative, either directly or by calling 0800 175508, or write to email@example.com, and use the same contact details for claiming your CPD credits for this webinar.
We’ll be back next month as always on the third Tuesday at 2pm; that will be Tuesday 17 July. Our topic will be Europe and the future of the Euro; a timely webinar given recent events in Italy and changes in ECB monetary policy. We’ll be looking at some research from our Investment Strategy Group, and our guests will be Alexis Gray and Peter Westaway. We won’t have a webinar in August but we will be back in September, so make sure you sign up for July’s webinar; that’s us for today – thank you very much Ankul, and thank you to all of our listeners.
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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.
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