For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Following on from Anthony’s note last week which referenced the poor recent performance of index funds within the multi asset space, this week we take a deeper dive into some of the misunderstandings surrounding indexation, particularly with regard to mixed asset and long term asset allocation.
Advisers have been sold the concept that indexation is a low-risk low-cost approach to fund selection. On its surface this may be true. If a client is seeking exposure to UK equities, then clearly a UK equity index fund is a very low cost approach to achieving that with no risk versus the index. This however, is the fundamental problem. The single most important decision, in the long run, is what asset class (index) the client should be exposed to.
The approach taken by most advisers, at least in the accumulation phase, is to risk profile a client and then select a portfolio of funds that meet that risk profile. The asset allocation mix that comprises that portfolio will be the main determinant of the outcome for clients. While there is an almost unlimited range of portfolios that meet a particular volatility profile, there will generally be a consensus around normal allocations, which itself will be a function of recent returns.
For this reason, many advisers decided to delegate that portfolio construction role to mixed asset managers, who have the expertise in building portfolios for the prevailing conditions. Some would be active within the asset classes some would be passive, ultimately this matters much less than the chosen asset allocation.
When index funds moved into this space, to the largest degree, they decided to fix the asset allocation as well as the stock selection. Many advisers misunderstand that in those circumstances they are taking responsibility for allocation role as well as the risk profiling. With active managers, the fund manager decides the appropriate asset allocation for the risk profile. With a passive it is the IFA who has decided the asset allocation by selecting the index fund, although he may believe he has delegated it to the index manager. This is starkly demonstrated by Anthony’s example last week, where in the IA Mixed Investment 0-35% shares sector funds have performed dismally compared to the active funds in the last few years, but the managers of these funds bear no blame, they have followed their indices perfectly.
So indexation in the mixed asset space is not a low risk approach, as is widely believed, it simply shifts the asset allocation risk from the fund manager to the adviser, hence the lower fees.
There is another important point with fixed asset allocations and that is the impact that fixing allocations can have on total returns over time. Most indexed asset allocation approaches rebalance to a target allocation at a set frequency. The impact of this depends on the degree to which you believe markets are either mean reverting or trending. In a mean reverting world, rebalancing can have a positive impact, for example if bonds have performed poorly compared to equities when the rebalance happens, bonds will be bought and equities sold. If the market mean reverts bonds should do well in the next period and the client benefit.
However, if asset classes are trending this approach will be very damaging. A regular rebalancing to a target approach would have led to consistent rebalancing to the worst performing asset class, which if it were trending lower would have harmed clients. This is the issue with bonds recently, that Anthony highlighted last week. If this trend continues, even a do nothing ‘active’ manager, will outperform indexation as his bond exposure will become smaller simply because of falls in value.
I am reminded here, of one experience from earlier in my career, during the bursting of the tech bubble. One of my colleagues was a fan of Enron, but thankfully he had a self-imposed upper limit on individual stocks weights of 8%. Unfortunately, as it fell relentlessly towards zero he continued to rebuild his position back to his target of 8%. Although he realised his error before the company eventually went bust, he still managed to lose 20% of his clients money in a position that was never more than 8% of his fund. This is the situation index managers face in asset allocation space, if markets mean revert, they will do fine. If they trend, they will be destroying value. Evidence suggests that trends can persist for long periods of time.
Our view is that we are in an inflationary period where bonds will trend lower over time. This is being proven right as time goes on. Many index funds are buying bonds every month as they fall in order to bring their weights back to target. Simply doing nothing would have been a better plan.
We feel it is important advisers understand these two risks. They are taking an active asset allocation decision by selecting index funds, not delegating asset allocation to a specialist, and fixing a target allocation can be beneficial if markets mean revert, but can be highly damaging if they trend.
Premier Miton Macro Thematic Multi Asset Team