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Class conscious

In my last couple of articles, I have discussed the importance to investors and advisers of the asset allocation used by different with-profits funds. In particular, I have highlighted the truism that, over any period of time, bonuses paid out of with-profits funds cannot exceed the investment returns the fund receives.

Knowing the rates of return enjoyed on different asset classes and combining this with the known asset allocation of a with-profits fund, it is possible with a large degree of accuracy to ascertain the maximum level of bonuses that fund will be able to pay out in the immediate future and, in many cases, over the forthcoming years.

Here, I will be extending these principles to look at managed funds to enable advisers to assess volatility and investment returns. This will enable us to identify the reasons why most managed funds have historically been only marginally less volatile than equity funds and why even many defensive managed funds have been more volatile than every other asset class apart from equities.

A convenient starting point for this discussion is the 1980s, when a managed fund from Target Life (remember them, fellow old-timers?) came consistently top – not just top quartile or decile – of the managed fund performance tables, usually by a big margin. How did they do it?

Quite simply, this fund was managed aggressively, with the asset allocation almost entirely directed towards UK equities. Other managed funds included a proportion of other asset classes, with the strategy being to offset to some extent the expected high volatility of the equity market.

Unsurprisingly, Target Life&#39s strategy paid handsome dividends in the decade up to 1989, when the FTSE All-Share index rose every year for 10 years, increasing by more than 400 per cent over that period as well as producing dividend yields averaging only a little under 5 per cent a year.

Indeed, the FTSE All-Share reinvested index (which takes into account these dividends as well as the increase in the underlying share prices) rose by over 750 per cent. Put simply, even an index tracker without the benefit (if that is the correct word, bearing in mind the performance of index trackers against active fund managers) of specialist fund management should have produced returns to investors of 750 per cent before charges.

During this same decade, the other major asset classes performed less well, with the reinvested index of long-dated fixed-interest gilts showing a 300 per cent gain (good, obviously, but nowhere near as good as equities), cash accumulated returns showing a 230 per cent gain and property reinvested returns showing a 240 per cent gain.

Thus, managed funds with holdings in any one or more of these other asset classes could never hope to complete with the returns enjoyed by Target Life&#39s investors. Many of its competitors and detractors at the time, including myself, cried foul as we were not comparing like with like, we were comparing an equity fund in a bull market to truly managed and diversified funds. But Target did enough to ensure that its fund was categorised as managed and its investors could not give a stuff how the outperformance had been achieved – all they cared about was that they were quickly being made rich by their lucky or shrewd choice of fund.

Before highlighting the relevance of these issues to the current day, it is perhaps worth noting that Target&#39s fund – although later reinvested after being taken over – continued to perform well while equities did well but lost its top billing, not least because other managed funds followed its lead.

We are now up to date with the core topic of this article -the fact that, nowadays, most managed funds have very few holdings (or none, in some cases) in any asset class other than equities.

I recently had cause to reassess a number of leading providers of managed funds and found – to randomly select just three – that one is invested 83 per cent in equities, 4 per cent in cash and 13 per cent in fixed interest, another is invested 95 per cent in equities and 5 per cent in cash while the other (bizarrely, in my view, called a balanced managed fund) is invested 83 per cent in equities, 13 per cent in fixed interest and 4 per cent in cash. These massive weightings towards equities are even more pronounced for managed funds with titles such as aggressive.

I am not for one second suggesting that these are sub-standard funds or are likely to be poor performers, nor am I suggesting that the providers are deliberately trying to mislead investors but, bearing in mind that many full-blown equity funds typically have cash holdings of around 5 per cent, it can be seen that there is very little difference between many managed funds and equity funds.

When I have from time to time discussed this issue – not in an aggressive way but only over a few beers – with some of these providers, I have been told that the terms managed and balanced managed refer mostly to the spread of holdings to overseas equity markets as well as UK equities. The overseas equity sector generally excludes UK equities, they confirm. Fine, but should not some better terminology be found for these managed funds to make it clear that the investor is, in fact, almost entirely investing in equities?

To look briefly at other implications of this issue, it is noticeable that the performance of the average managed fund is consistently very little difference from the performance of the average equity fund. Moreover, there is very little difference in the respective average volatility of these two sectors.

In summary, before moving on to look at the application of these issues on defensive managed funds, I would strongly recommend advisers to ensure that they are aware of the asset allocations of their preferred managed funds and are under no illusions that many of these funds will not produce markedly different performance – both in terms of returns and volatility – than equity funds.

Please note that I do not in any way mean to decry managed funds but merely to make sure that we all know what we are getting.

So, what about cautious or defensive managed funds? It is here that the perception of many advisers and their clients of managed fund asset allocation achieves reality although with a couple of words of caution. True, these funds invariably do hold significant amounts of asset classes other than equities, with the typical split being up to 5 per cent in cash, with the balance split roughly equally between equities and fixed-interest gilts.

The first word of caution relates back to a series of articles I wrote in Money Marketing a few months ago, in which I noted that the prices of equities and gilts have tended in recent years to move in opposite directions (they are negatively correlated). This means that the gains in one have regularly been offset by losses in the other.

This not only indicates a significant reduction in risk, which is what the funds correctly aim and profess to achieve, but also a significant reduction in potential returns.

The second word of caution relates to the fact that few defensive managed funds have any holdings in property, an asset class which has shown very low volatility for quite a few years, has produced good returns and shows little or no correlation with either equities or fixed interest. If these factors continue, managed funds could significantly increase returns and reduce risk by higher investment in this asset class.

Anyhow, we reach the end of this discussion but, in the last of my articles in this series, I will bring these factors together and discuss the roles, if any, of with-profits and the different types of managed funds in a properly structured investment portfolio.


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