02 November 2020
By John Husselbee, Head of the Liontrust Multi-Asset team
New research from Morningstar on the UK fund of funds (Fofs) market shows strategies investing in passive vehicles have produced the best performance over the last five years. But I suggest the argument that fees are a major factor behind this – admittedly made more forcefully in press articles than the research itself – requires further examination.
First of all, let’s look at a few of Morningstar’s findings. In terms of performance across its GBP Moderate category (50-70% in equities and the rest in bonds and cash), Fofs investing in index or smart beta funds returned 4.3% in annualised terms over five years to the end of May 2020 compared to 3% from unfettered peers with full investment freedom. As for fees within this category, passive Fofs charged an average of 52 basis points versus 110bps by unfetted. But more context is required to tell the full story.
For us, the story over the last five years is not active versus passive, whether you selected actively managed funds or trackers, but rather one of strategic asset allocation (SAA) and how a portfolio’s approach has influenced this.
To explain this in more detail, the following is a compare and contrast between our mid-range target risk Verbatim portfolio against a passive lifestyle offering with a traditional balanced allocation of 60% equities/40% bonds. By examining the process behind these, we can see why each has performed as it has in recent years and, more importantly, why this can reverse.
First off, we need to go back to the motivating factor behind any Fof or multi-asset portfolio, to meet the goals, risk tolerance and time horizon of its investors. There are many ways to achieve this, but we see four key elements of a standard approach: strategic asset allocation (SAA) at one end and stock selection at other across the board, and potentially tactical asset allocation (TAA) and fund selection in the middle.
Our process includes all four elements; in contrast, the majority of passive lifestyle offerings will have SAA and (passive) stock section but remove the active decisions involved in TAA and fund selection. What is key to understand is that over the last five years, the make-up of the market and type of companies in the ascendancy has meant removing active decisions, for the most part, has produced better performance – but there is nothing to suggest that will remain the case forever. Either way, deeper drivers of performance, asset allocation primarily, are far greater determinants of overall returns than fees.
If we focus on SAA, at surface level, a good proportion of ‘balanced’ portfolios have a similar asset allocation in that 60% equities/40% bond region. Under the surface, however, this split in a passively managed offering will typically be done on a market cap weighted basis, so if the MSCI World Index has around 65% in the US for example, 40% of an entire portfolio will be invested in that market – and all in larger companies.
SAA is the scientific part of our process, where we analyse the historical returns and volatilities of a range of asset classes to determine the best allocation for each of our portfolios to meet their respective volatility targets. As a contrast to market-cap weighted exposure, our equity allocation also includes smaller companies for example, which a range of studies have shown are a vital component of long-term outperformance.
More diversified exposure to core asset classes – as well as including extra categories such as alternatives – gives not just additional sources of return but also a more balanced overall portfolio. While a passive approach to SAA has been enough to secure outperformance over recent years, given underlying conditions, that does not diminish these other advantages over the longer-term.
If SAA is the science, tactical asset allocation and fund selection are the art – and both are entirely absent from passive lifestyle products. As an active manager, we believe we can add value through both tactical asset allocation and fund selection. But whenever any kind of decision is involved, there is potential to be right or wrong and our calls on areas such as value and small caps have affected performance in recent years relative to passive peers automatically pushed into surging US large-cap growth companies.
Given the different approaches for active versus passive, what can we conclude about both recent and potential future performance? Over the last five years, any investor with meaningful exposure to large US growth companies would have outperformed, and the standard passive Fof, with its 60% market cap weighted exposure to the MSCI World Index, has clearly been in that camp. Purely by nature of its construction, with no active decisions, this portfolio is the definition of being in the right place at the right time.
What we can also say, however, is that this means these portfolios have heavy exposure to expensive, momentum equities. In contrast, our portfolios – alongside many active peers – continue to be well diversified, with a tilt towards cheaper parts of the market and a blend of managers who have generated long-term outperformance.
Ultimately, we continue to believe the skill of active decisions should outperform the luck of right place, right time over the long term. To finish with an analogy, if you are walking along a muddy path, any kind of wellingtons will do; if you get onto a decent footway, you want to make a call on changing into walking boots or trainers to get yourself moving – and so it goes with passive and active. The cost of the shoes, while an important factor, is not the be all and end all.
Key Risks & Disclaimer:
Liontrust Fund Partners LLP (2 Savoy Court, London WC2R 0EZ), authorised and regulated in the UK by the Financial Conduct Authority (FRN 518165) to undertake regulated investment business.
Please remember that past performance is not a guide to future performance and the value of an investment, and any income generated from them can fall as well as rise and is not guaranteed, therefore you may not get back the amount originally invested and potentially risk total loss of capital. Investments should always be considered as long term. This document should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy. It contains information and analysis that is believed to be accurate at the time of publication but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust.
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