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Inflexible friends

Fully flexible asset allocation funds fared badly when compared with their multi-asset peers. By Randal Goldsmith

Randal Goldsmith

In 2012, fully flexible asset allocation funds might have been expected to perform better due to a trend for controlling risk exposure in the first six months and taking more risk in the last six months. In fact, fully flexible asset allocation funds generally underperformed compared with multi-asset funds, whose asset allocation is constrained by their mandate.

The median fund within the S&P Capital IQ global neutral in euro peer group, for example, returned 8.9 per cent in 2012 while the flexible peer group returned 6.7 per cent. The median fund return in the global neutral US dollar peer group also outperformed the median flexible fund. Annualised median returns in these peer groups over the past three and five years reveal a similar pattern.

Within S&P Capital IQ’s sterling-denominated peer groups, medium-risk multi-asset funds (balanced and neutral peer groups) generally outperformed defensive and aggressive funds. Asset allocation balanced was the best-performing peer group in 2012, with 11 per cent, compared with 10.9 per cent for the sterling aggressive peer group and 7.5 per cent for the sterling defensive peer group. Over three years and five years, the sterling neutral peer group outperformed all the other sterling peer groups, returning 5.8 per cent and 3.5 per cent respectively on an annualised basis.

The medium-risk peer groups tend to have a lot of exposure to fixed-income credit, defensive funds have more government bonds and cash, and aggressive funds have more equities. This is particularly true of distribution funds that are generally in the asset allocation neutral sterling peer group.

The reason they have this exposure is they aim to provide income as well as total return, and that income is treated as a fixed-income distribution with an Isa tax shelter so long as equities are never more than 40 per cent of the total portfolio.

The more ways there are to make money, the more ways there are to lose money, and the generally weak performance of flexible multi-asset funds – defined as funds that can invest their portfolios anywhere from zero to 100 per cent in risk assets – compared with their more restricted competitors, demonstrates this over the past five years. This is in large part due to the influence of political news reducing the reliability of both fundamental and technical asset allocation tools.

Technical tools in particular are notoriously unreliable in politically driven markets, although they helped flexible fund managers outperform in 2008 and also in 2001 and 2002, when market trends persisted long enough to make money from them. However, in 2012, many flexible funds had cash and derivative hedges that hurt relative performance in the second half of the year. Many flexible and defensive funds also held gold as a protection against inflation risk, which dragged on performance.

During our annual review of graded multi-asset funds, we noted overwhelming caution on interest rate duration risk associated with low-yield Western sovereign debt. Many funds have exited this asset class after running it down over the past couple of years. While it is still possible to find multi-asset fund managers who hold gilts, treasuries or bunds, we found no graded fund managers who like interest rate duration exposure. However, the flip side is a forced buyer in the form of central banks engaging in quantitative easing and institutions complying with capital ratio regulations. Without enthusiasm, managers generally favour equities, having decided they are the ‘least bad’. However, there are segments within equities where managers have more conviction. In general, quality multinationals that pay dividends are liked.

For the first time in many years, multi-asset managers have developed a liking for Japanese equities and, within the equity portion of funds, the exposure to this market has been selectively raised to complement the continued preferred area of Asia.

Caution following the eurozone crisis remains and has prompted huge reticence in investing aggressively into this region. Few believe that Europe’s problems are over, and although exposure to this area remains underweight relative to indices, some managers have made selective new purchases. Views on the US and UK markets are mixed, with some managers holding no US equity exposure, believing it to be expensive on valuation grounds, while others are positive on the market “due to its stable growth backdrop”.

Randal Goldsmith is director of S&P Capital IQ Fund Research

MA Table 040413

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