Lucas Financial Consulting Ltd

For the average Irish balanced managed and consensus fund investor the year 2008 was a pretty horrendous. According to the Mercer Managed Fund survey, the average Balanced Managed Fund delivered performance for that year of -34.6% and the average Consensus Managed Fund delivered a very similar and also painful -35%.

Managed funds – A brief history

Managed funds became popular investments during the 1980s as they offered investors diversification over 4 main asset classes, i.e. equities, property, bonds and cash. Equities were invested globally but there was a high exposure to Irish equities as a natural consequence of currency considerations for the Punt at the time and the level of local investment management expertise (or perhaps the lack of global expertise). The property element was mainly invested in Irish commercial property and bonds initially consisted of investments in Irish Government bonds but in later years gained exposure to Euro sovereign bonds following the introduction of the Euro.

These funds would generally have a greater proportion of their funds under management invested in equities as this asset class is generally the leading performer at the head of the risk return spectrum over the long term and offers high liquidity. Property and bonds provided alternative asset classes that could be considered to act somewhat differently to equities during rises and falls in stock markets providing a level of protection to investors.

Reward can’t have a downside… can it?

The balanced managed fund sector was defined as medium risk by consensus of the industry as a whole. However, what does “medium risk” really mean to an investor? What level of return can be considered “medium”? – A return of plus 10% or minus 10% for example? – Or plus 15% or minus 5%?

The mere mention of “minus” in my experience can magically transform a happily enthusiastic and adventurous investor to a “keep my capital intact” investor in an instant. I can recall when one of the now iconic first customer warnings was introduced, it began its life as “Warning: the value of your investment can rise or fall”, which soon was amended to a more cautious, “Warning: the value of your investment can fall or rise” Did you spot the difference? This was on the basis that the original statement might mislead investors to expect an increase in their investment before any subsequent fall (ouch!).

The average investor in a balanced managed fund since 1987 (according to the Mercer surveys of returns) has experienced a variety returns from +34% in 1997, to -34% in 2008. “Now Mr.and Mrs Client, tell me, was that the kind of investment journey you expected from your “medium risk” fund?” A swing in returns of some 68%, somehow, I don’t think so!

So where did it all go wrong?

Over time a number of factors contributed to the dramatic negative fund performance in 2008 and in our view here are four of the central characters in that tragedy:

1. Fund managers monitored each other’s asset allocations and performance very closely through the available industry surveys and began taking additional risk by investing more in equities over time in a bid to outperform their peers. This led to “herding” around the benchmark and to a vicious cycle of ever increasing equity exposures to aggressive levels (of circa 80% in 2007 (source: Mercer) which were amongst the very highest, if not the highest in international pension terms at the time. Ireland may have been extreme in this respect but it was not alone as there were similarly high average equity allocations in the UK balanced managed fund sector during 2007.

2. There were very high allocations to Irish equities and Irish assets in these funds which, while justified by the performance of the Irish economy pre-crash, reduced the overall protective benefits that wider global diversification would have provided. They were also effectively big bets on a very small economy and stock market in global terms.

3. Fund managers were also constrained by investment mandates set for them by their life companies which required them always to have a certain percentage allocation to equities, say 55%-75%. This was irrespective of the actual market conditions. For example, in this instance, if equity markets were in free fall the fund managers were still mandated to hold at 55% of the fund in equities.

4. Also a “one size fits all” approach to finding a suitable investment solution for an “average” investor led to these being most popular fund recommendations for clients.

The story for Consensus Funds is different though, right?

 Wrong! Consensus funds are designed to deliver the average balanced managed fund return from the Irish fund manager market. They effectively remove the risk of the fund underperforming the average fund manager’s performance…by… yes you’ve guessed it, delivering approximately the average performance of the Balanced Managed fund sector. All of the above mentioned flaws were immediately also inherent in Consensus funds as they evolved, and this led to a very similar looking performance of -35% for the investors in these funds for 2008.

Thus performance in 2008 demonstrates that existing Managed and Consensus funds have fundamental issues which directly impact on investors. It is strikingly apparent that there was and continues to be a real dis-connect between the level of risk being taken in these funds and the client’s comfort level /return expectations.
 So, what’s the solution then?

As Albert Einstein said, “We can’t solve problems by using the same kind of thinking we used when we created them. “Funds in Ireland have been around for the best part of two to three decades. The investment industry has evolved and developed significantly during this period with access to an ever increasing number of asset classes.  A number of developing economies around the globe are also offering increasing investment opportunities. Innovations in modern portfolio modelling and the use of better, together with more technologically advanced methods of risk management are enhancing the risk adjusted outcomes for investors.

A next generation solution…

We believe there is a fresh solution available to the problems exhibited by both managed and consensus funds and to the performance experienced by their investors – Multi Asset Portfolio / Funds. These types of funds are growing in popularity in both Ireland and the UK and are seeing increasing investment flows into them since 2008. They are being welcomed in both markets as a next generation or a “state of the art” solution to the weaknesses of the “old” balanced managed fund model.

These funds are genuinely different from the past, or at least they should be if they truly have access to global capabilities with experts in the field of asset allocation together with a very wide and increasing number of asset classes to invest in. The best of these Multi Asset Funds will usually include:

Robust portfolios built from a much wider choice of asset classes from an increasing number of regions of the world.

The expertise and insight of specialist asset allocation experts who analyse the long-term forecasts for the valuations, correlation and volatility of various assets.

A specialist short-term tactical team who assess the threats and opportunities offered by the economic environment over the next 6-12 months and how the portfolio can be adjusted to take advantage of these.

Utilise different styles of investment e.g. Passive/active, value/growth etc., at times in the economic cycle that are most advantageous for the portfolio

The ability to include an external manager’s fund, as rarely does one asset management house have access to all of the available solutions

Access to a diverse range of the latest developments in asset classes such as commodities, absolute returns, emerging market debt and convertibles.

Targeting investment risk.

One of the critically important lessons arising from the last few years is that clients ‘perspectives have changed from a return to a risk focus.

A lot of investors targeting a return of say 7%-8%, have discovered that they certainly don’t like the experience of a potential fall in their investment by 30%-40% (unsurprisingly) at some stage during their investment term. To address this, what if fund managers could use modern techniques and a greater variety of investment assets to control and target risk within certain levels to deliver a more consistent level of return for investors?

A return that would be consistent with a client’s risk profile? Too futuristic?…too optimistic? Certainly not – a select few Multi Asset funds in the market have now very successfully addressed this by designing funds which manage and control the risk of their funds over the client’s investment horizon thus providing more clarity around return expectations.

It is important to point out that all of this extra fire power for generating a better risk reward outcome for you needn’t come at an extra premium. Global asset managers can generate economies of scale which can nicely translate into an affordable annual management charge.

This modern approach is a welcome and significant development, because now, probably for the first time, the objectives of investors, brokers, fund managers and pension trustees are aligned together in managing or targeting specific risk levels to provide a better return outcome for investors.

Finally, a few words of caution – beware of poor quality and expensive imitations which have more of a resemblance to the old managed funds of yesteryear!