Adrian Gaspar, Multi-Asset Investment Specialist at M&GPrudential Treasury and Investment Office (T&IO), looks at areas to be assessed for robust due diligence.
Advisers who recommend risk managed funds to their clients will often do so on the premise that the chosen solution may be held for several years.
Whilst they are generally designed and mandated to consistently deliver returns within certain risk budgets this does not excuse an adviser from carrying out robust due diligence, particularly as the market continues to evolve. The relaunch of Prudential’s risk managed active and passive fund range being evidence of this,
Among the areas that should be assessed as part of the due diligence process are:
Group strength and depth of resource / operational scale
Advisers should understand the strength, heritage and depth of team and process behind each fund, and their exposure to key decision makers.
Many risk managed fund ranges leverage off the skills and resource of large existing teams and use portfolio construction and risk management processes that have been in place for many years.
Sustainability of team and process
Although past performance is not always a guide to the future, a team that has steered multi-asset portfolios through periods of volatility and over a long timeframe cannot be ignored. A feature of many of the successful multi-asset teams is longevity of process, people and resource. Many also believe that a team-driven approach is more effective as this does not leave them exposed to key individuals leaving.
It is also worth understanding how teams are incentivised and if they invest in their own funds, to gauge alignment with the interest of investors.
Relatively small teams of skilful individuals are very capable of generating strong returns for their investors but understanding what succession plans are in place in the event of a key individual leaving is important.
Asset allocation – strategic / tactical
When researching multi-manager or other outsourced investment solutions, readers will invariably come across the terms ‘strategic asset allocation’ and ‘tactical asset allocation’.
Strategic asset allocation is the core combination of asset classes in a fund – generally established based on expected returns – which the manager/team feels will deliver on investment objectives over the medium to
longer term. The value of assets can change given market conditions, so for a fund to meet its objectives the strategic asset allocation may need to be re-adjusted accordingly.
Tactical asset allocation is a strategy that fund managers will use to take advantage of certain situations or opportunities in the markets to add extra performance to a portfolio. Many managers may be very flexible about how they employ tactical asset allocation and if profits have been achieved or no opportunities exist they may employ the core original strategic asset mix.
Asset allocation – modelled, unconstrained, dynamic, team driven
The strategic asset allocation for risk managed funds is generally based on the views of an investment committee or the output from a stochastic model with the aim is to have a long-term view on the potential returns from assets.
If a team is making these decisions within each portfolio, do they have a demonstrable track record in making sound strategic asset allocation decisions? While a team or manager will input into the key decisions, this is usually informed by huge amounts of statistical analysis and projections, so does each team have a clear rationale for the data they use?
If the asset allocation is based on a stochastic model, how does the fund manager cater for new asset classes or those with very attractive valuations? How have the models reacted in challenging investment conditions and do they ever trigger significant changes to the strategic asset allocation?
How often is asset allocation reviewed? Some risk managed solutions may dynamically review asset allocation whilst other funds review asset allocation quarterly. Market movements could have quite an effect on the actual shape of a risk managed fund ‘intra quarter’ and it is feasible that the relative risk of a fund could change in the short term, unless action is taken. This would have to be assessed against the cost of rebalancing and the longer-term assumptions against which many risk managed funds are run. Many fund managers would be reluctant to react to short-term market movements if they felt this changed the longer-term expectations for investors.
If a fund group use a static strategic asset allocation benchmark does this make it difficult to generate returns within the prescribed risk budget? For instance, a fund may have been structurally overweight in gilts last year and provided stellar returns. However, what happens if confidence returns or gilts are no longer one of the ‘safe havens’ of choice? Will the fund group be able to react to this or will they be constrained by outputs from their models?
Most funds have some flexibility through tactical asset allocation but there will often be permitted ranges which provide control over the positions that a manager/team can take. Asset allocation may also be constrained by those aligned to a risk profile tool or output. This does bring real discipline with it but also means that the fund manager must abide by the asset allocation bands set by the risk profiler.
Some companies have taken an unconstrained approach to asset allocation giving themselves more freedom to adjust weightings and invest in less mainstream (for retails investors) asset classes like commodities and alternatives. These funds will still have clear objectives and internal risk controls to which they must adhere.
There is no right or wrong way but an understanding of how any of these funds decides on asset allocation strategy is important as:
a) Numerous academic reports suggest it is a key influence on providing returns in line with investor expectations.
b) An understanding of fund aims, and objectives helps manage client expectations.
While managers of risk managed funds will always have to be mindful of the risks they are taking other multi-asset/managed funds can also be run in variety of different ways.
Some may take a more ‘core’ approach where asset allocation may not deviate significantly from peers and the
manager and team will seek to add incremental value through good fund selection. Others operating with fewer portfolio constraints or risk tolerances see decisions on asset allocations as a hugely important. These managers will make their own assessment of the global economic environment and if they are strongly positive on a market they may take significant overweight positions in favoured asset classes.
Look past the headlines and understanding the constituent assets of a risk managed fund is important.
The balance of active and passive vehicles is one consideration but if an adviser analyses and understands what asset classes they are exposing their clients to then they will understand not only the investment risk of a fund but also any liquidity (property and bond funds) and counterparty risk (derivatives for currency hedging, structured products, absolute return funds).
It may be worth advisers understanding the relevant legislation under which each fund falls – for instance some will have UCITS status meaning they can be sold in Europe, whereas other groups with no aspirations of passporting in to Europe will have registered their funds as NURS, which also allows greater investment freedom than UCITS.
The volatility of funds is usually calculated using standard deviation. As the name suggests standard deviation is a measure of the difference in movement in prices of an asset and a representative average. Large standard deviations suggest high volatility and potentially higher risk, whilst low standard deviations indicate less variation in prices and hence lower volatility.
When designing and building risk managed funds, a volatility measure for each fund may be agreed after a thorough assessment of the risk/return that can realistically be achieved over the longer term. Most companies take a long-term (10 year) strategic view with a process in place for shorter term tactical decisions.
Some managers may stray outside of their volatility measure in the short term but will not automatically reduce or increase positions if they do not feel this is in the investor’s best interest and ultimately the aim is to maximise returns and keep costs down.
Risk managed funds generally aim to generate moderate returns over their composite benchmarks (when investing in active funds) but within a very controlled process driven by the requirement to produce increasing gradations of risk/return.
When assessing risk managed funds advisers should also seek to understand if all funds within the range have consistent/linear performance characteristics and whether they have adhered to the performance objectives.
Another way to assess the efficiency of any range of risk managed funds is to plot the risk and returns on a scatter graph to see how consistently they remain within a relevant range on the ‘efficient frontier’ over time.
A concern would be if some risk managed funds provided similar levels of return for different funds or generated similar levels of risk. Advisers and their clients would rightfully expect funds with higher volatility parameters to generate higher returns over the longer term.
Fund diversification/direct investment
An assessment of the underlying holdings in a risk managed fund can provide an interesting insight in to how they are being run and can help advisers explain to clients what they are investing in.
For instance, some fund ranges will have a high weighting to an individual fund or they may be more fettered
with heavy exposure to existing funds within the group’s range. Some may use derivative based funds to manage risk, diversify, add performance or gain exposure to a market or asset type. Others may gain some (indirect) hedging using absolute return funds or structured products.
Passive funds, Exchange Traded Funds (ETFs) and direct investments will also feature, often to reduce costs and help manage volatility.
Advisers should understand how the manager rebalances due to cash flow or market movements. It is likely that clients would prefer dynamically rebalanced funds but the benefits of this must be assessed against possible increased trading costs.
Advisers should understand how much is invested in active funds and how much is in passive vehicles and whether this is reflected in the costs and performance. A fund manager should be clear on whether passive vehicles are being used to reduce cost and/or volatility or to gain efficient access to an asset class.
Cost – share classes/correlation with underlying assets
Disproportionately high charges can affect returns to investors so should be considered in the context of what each fund is trying to achieve and its success in doing so. Clearly passive funds will generally appear cheaper.
However, some managers of predominantly passive funds will also buy assets that are expensive to trade, which may increase fund expenses because they feel the investment and diversification benefits outweigh the extra costs. The aspect of traditional assets versus alternative assets also comes into play here.
Governance and risk controls
Due to the nature of risk managed funds it is clearly very important that underlying holdings in the funds that make up the portfolio are continuously monitored so that the characteristics of each fund stay broadly the same.
Risk and oversight teams are often be able to access fund holdings data more frequently than most. This means their analysts can closely monitor exposure to stocks or markets – often using sophisticated systems – very proactively, to ensure each fund continually adheres to its aims and risk parameters.
The introduction of one or more independent party on to Governance Committees is a feature of some funds. These independent parties are unencumbered by any conflicts of interest and are there to constructively challenge the investment decisions made.
Learn more about Prudential’s latest risk managed range underpinned by robust governance.