Elston Consulting has launched a published 60/40 Index for UK investors. The Elston 60/40 GBP Index represents a 60% strategic allocation to Global & UK equities and a 40% allocation to predominantly UK bonds. A “60/40” equity/bonds composite benchmark is a traditional comparator for multi-asset funds and portfolios. However, there are no standardised views of what a 60/40 portfolio looks like. For global investors this could mean 60% Global Equities, 40% Global Bonds. For US investors, 60/40 could mean 60% US Equities, 40% US Bonds. Elston’s 60/40 Index for UK investors provides a standardised comparator for multi-asset portfolio managers and multi-asset fund providers looking for a straightforward multi-asset benchmark. The index is constructed using large liquid and low cost ETFs as the underlying securities so the benchmark is replicable and investable. Its performance broadly represents the returns after fees of an index portfolio invested in the strategy. The index values are available on Bloomberg (ticker 6040GBP Index), Morningstar and other leading data vendors. The weightings scheme is available to licensees. Henry Cobbe, Head of Research at Elston Consulting, which created the index says: “At the moment each multi-asset manager, portfolio manager or research firm creates their own internal composite for their version of 60/40. By having a publicly available benchmark for UK investors, we are enabling decision-makers make comparisons, insights and analysis in a way that is consistent, straightforward and accessible.” In 1q20 Risk Parity and Min Variance multi-asset strategies offered best downside cushioning relative to a 60/40 Equity/Bond portfolio for GBP investors.
Risk-based strategies: 1. Offer a systematic approach 2. Are designed to be differentiated 3. Have potential to enhance returns, mitigate risk or improve diversification Get the full report here http://www.elstonetf.com/store/p12/Multi-asset_strategies%3A_1q20_update.html
Diversification: the only free lunch for investors Portfolio theory holds, and experience affirms, that true diversification means that the overall risk of a portfolio can be less than the risk of its constituent parts. The diversification effect is determined by correlation. Broadly speaking, the lower the correlation between asset classes, the greater the diversification effect when combined in a portfolio. This in the underlying principle behind combining equities and bonds to create a multi-asset approach. Whilst this traditional “asset-based” approach holds for the long-term. It fails to consider that correlations are not static but are dynamic. This means that diversification effect is also dynamic and changes with market conditions. The limits of asset-based diversification In stressed market conditions, the relationship (correlation) between asset classes tends to increase. This means that the diversification effect created by mixing asset classes is reduced. In order to introduce true diversification effect into a portfolio investors can use a risk-based approach to constructing portfolios. Asset-based or risk-based approach? The bulk of multi-asset portfolios in the UK market use what’s called a traditional “asset based” approach. This means that the target asset allocation drives the level of portfolio risk. The asset allocation for each portfolio is broadly fixed, and volatility therefore fluctuates. An alternative approach is called a “risk-based” approach. This means that a target risk characteristic for a portfolio – for example a minimum variance portfolio, or a risk parity approach – drives the asset allocation. Risk-based approaches explained We analyse three risk-based multi-asset strategies for GBP investors:
Differentiation impact Relative to global equities, whilst a 60/40 approach, represented by the Elston 60/40 GBP Index [6040GBP Index], reduces beta by 40.6%, it only reduces correlation by 3.0%. Put differently, there is very low diversification effect. By contrast, a risk parity approach, represented by the Elston Dynamic Risk Parity Index [ESBDRP Index], offer the greatest diversification effect as it reduces beta by 78.0% and correlation by 48.1%. 5 year data to 31st March 2020, GBP terms YTD performance Year to date, risk parity has provided greatest capital preservation relative to asset-based and other risk-based strategies. What next?
For investors looking at introduce true diversification into a multi-asset portfolio, incorporating an allocation to a dynamic multi-asset risk-based strategy, such as Max Deconcentration, Min Variance or Risk Parity makes sense. These systematic strategies can be delivered using portfolios of ETFs for liquidity, transparency and efficiency. For full report, see http://www.elstonetf.com/store/p12/Multi-asset_strategies%3A_1q20_update.htm The impact of Coronavirus on multi-asset strategies is summarised below. This chart shows the peak-to-trough and YTD performance of Global Equities and Elston's multi-asset indices for GBP investors. Asset-based diversification has its limits Whilst a traditional asset-based approach to diversification can help reduce equity market beta, but it doesn't necessarily help reduce correlation. Why does (de)correlation matter The maths of diversification means that the less correlated an asset within a portoflio, the greater the diversification effect. Comparing multi-asset approach A 60/40 equity/bond portfolio (represented by 6040GBP Index), reflects a traditional multi-asset approach. Year-to-date this strategy has a beta of 0.60x but a correlation of 98.9%. By contrast, a risk-based approach to diversification not only reduces beta, but also reduces correlation. A Minimum Variance multi-asset strategy (represented by ESBGMV Index) has a beta of 0.35x and a correlation of 88.0%. A Risk Parity multi-asset strategy (represented by ESBDRP Index) has a beta of 0.18x and a correlation of 58.7%. Summary
For effective risk-based diversification, whilst maintaining exposure to risk assets with returns potential, a risk-based approach to portfolio construction makes sense. A local problem? In January, when the Coronavirus story broke in China, the global response was that this was a localised issue. Like other viral outbreaks such as SARS (2003) and H1N1 (2009), the issue look localised to China and Asian Emerging Markets. Going global In February, as the virus spread aggressively in South Korea and Italy, markets woke up to the fact that this was a global issue. The questions being how far would it spread; how fast would it spread; and how long would it last? All of these questions were to ascertain how materially the outbreak would impact global growth, as demand falls, businesses' cash flow struggles and supply chains are disrupted. A false sense of security What was deceptive is that the time from the first infection in a country to the virus "j-curving" has been quite long 20-30 days. This gave Europeans a false sense of security that the outbreak was containtable. The J-Curve The chart below shows the J-curve as to how long it has taken for some key countries to reach 1,000 cases. The reality is that once it gets going, containment is difficult without some of the extreme measures introduced quite promptly in Wuhan (wide area quarantines or "lockdowns"), and more recently in Italy. Tracking the J-curve gives helpful cues as to when the UK government might move through the different phases of its response plan to Contain, Delay, and Mitigate the virus' impact undperpinned by Research. On this basis, whilst we are still in the Contain stage, we can expect to move into the Delay stage (closing schools, cancelling large scale gatherings, encouraging working from home) in coming weeks. Economic impact and policy response The economic impact of self-isolation, travel restrictions and lock-down are in addition to the human cost of the virus. That is why we have seen, and expect to continue to see, a co-ordinated economic policy response that supports business, monetary policy and markets. China plateau Meanwhile, in China, where the outbreak started, case numbers have plateaued suggesting that the drastic measures taken have worked, and that it is in aggregate a 2-3 month disruption. What next?
The next 4-6 weeks will see an acceleration in cases in key European and potentially US markets. So we may not be at "peak panic" yet at a social level, but the key question for markets is will this be a short run (3-6) month impact on otherwise resilient trend growth, or a trigger to a global recession. Our view is the former, but there's more fear to come first. Investors often seek out differentiated risk-return assets for inclusion within a portfolio for diversification purposes.
This is often the rationale used for inclusion of hedge funds, absolute return funds, diversified growth funds, and real assets in a portfolio. An alternative approach But is there an alternative way of achieving differentiation? We believe so. Risk-based strategies are multi-asset strategies that are designed to be differentiated. Examples of multi-asset risk-based strategies include: Minimum Variance, Risk Parity, Maximum Deconcentration, Maximum Sharpe and Maximum Decorrelation. These strategies target a particular risk objective and that risk objective drives the underlying asset weightings. Has it worked? On a rolling 5 year basis to end 2019, both multi-asset Min Volatility and Risk Parity delivered in providing both lower beta to, and reduced correlation with Global Equities, relative to a 60/40 portfolio, as well as delivering on their stated objectives. Relative to global equities with a Beta of 1, a 60/40 strategy, a multi-asset Min Variance strategy and Risk Parity provide a -40.4%, -68.8% and -75.3% reduction in beta respectively. Relative to global equities (correlation = 100%), a 60/40 strategy, a multi-asset Min Variance and Risk Parity provide -5.7%, -32.2% and -45.3% reduction in correlation respectively. This highlights that although a 60/40 approach reduces beta, it doesn't much reduce correlation. For an effective decorrelation approach to achieve true diversification, a risk-based approach to multi-asset investing provides a helpful diversifier. Risk-based strategies are a portfolio construction approach and can be delivered using liquid ETFs with no leverage and no shorting. We expect to see a growing role for multi-asset risk-based strategies within portfolios given their transparency, liquidty, and cost advantage relative to hedge funds and absolute return funds. We believe that systematic strategies that are designed to be different are more likely to be different than strategies that are hoped to be different. After all, portfolio construction is just maths. Get the full report For the analysis: Global Equities proxy: iShares MSCI ACWI UCITS ETF [Ticker: SSAC LN Equity] 60/40 strategy: Elston 60/40 Index (GBP) [Ticker GBP6040 Index] Multi-asset Min Variance strategy: Elston Min Variance Index (GBP) [Ticker ESBGMV Index] Multi-asset Risk Parity strategy: Elston Risk Parity Index (GBP) [Ticker ESBDRP Index]
What actually delivers performance? A portfolio’s asset allocation is the key determinant of portfolio outcomes and the main driver of portfolio risk and return. Ensuring the asset allocation is aligned to an appropriate objective is therefore key. Getting and keeping the asset allocation on track for the given objectives and constraints is how portfolio managers can add most value for their clients. What differentiates portfolio managers? There are no “secrets” to asset allocation in portfolio management. It is perhaps one of the most well-studied and researched fields of finance. Perhaps unusually for a competitive service industry, core know-how is not a barrier to entry. Anyone completing their Chartered Financial Analyst exam will have a comprehensive grounding in the principles of portfolio management. There are, in my view, three differentiating factors for discretionary fund managers.
Quality of Process To create a quality investment process, managers need a robust set of capital market assumptions for each asset class and the relationship between asset classes. Ideally these should be term-dependent, to align to an appropriate term-dependent investment objective. To create an appropriate asset allocation, managers need to consider what their objective is: is it risk-adjusted returns in which an asset-optimised approach makes sense (the bulk of retail multi-asset strategies take this approach); is it to match future liabilities, in which case a liability-relative approach makes sense (more akin to how a defined benefit pension scheme is managed); is to target a volatility level or band; or is to target a level of income distribution. Managers also need to design a set of constraints – risk budget, fee budget, minimum and maximum position sizes, portfolio turnover constraints and counterparty considerations. Managers need to make implementation decisions as regards how they access particular asset classes or exposures – with direct securities, higher cost active/non-index funds, or lower cost passive/index funds and ETFs. Fund level due diligence as regards underlying holdings, concentrations, round-trip dealing costs and internal and external fund liquidity profiles are key in this respect. Quality of People Whilst we believe strongly in the deployment of technology to assist managers in designing, building and managing portfolios, that doesn’t mean that people aren’t core to a business. Investment managers must invest in their people to build on both quantitative skills that are necessary to finance as well as communication skills that are necessary to communicate with advisers and their clients. It’s people that make up a brand, and clients measure performance as much on client service as on returns. Quality of Proposition There are few firms, if any, that can build an end-to-end proposition entirely in-house. Part of a manager’s skillset is to understand where their expertise lies. We believe that there is little value in reinventing the various wheels of a proposition. But there is tremendous value in bringing together best in class components that create a proposition in a way that is robust, repeatable and proprietary. It’s the quality of choices around proposition that differentiate portfolio managers, and in this respect it is important to remain agile and adaptive, to a rapidly changing landscape in asset management and technology. Bringing it all together The objective for investment managers is no longer about “pushing” one product or another. It should be about providing solutions that help address a specific need. Managers should ask themselves: what problem is the investment strategy trying to solve for their client? How can they do that in a way that is robust, repeatable and evidence-based, so that everyone can sleep well at night? The secret is, there are no secrets. Good portfolio management is about focusing on what matters, using informed common sense.
Conservative majority Conservatives are on track for a winning a clear majority in the UK general election. The campaign has centred on a core message of Get Brexit Done which has appealed to traditional Tories and disgruntled Labour voters in Leave-oriented constituencies. Furthermore, a distrust of Labour’s leadership under a hard-left Corbyn has led to a significant reduction in Labour seats despite his popularity with youth activists. A Brexit election Each party’s position on Brexit has been the key driver for voting intentions, despite efforts by all parties to also focus on domestic policy and leadership personalities. The Conservatives message was to get Brexit done. The Liberal Democrats was to Revoke Article 50, ignore the Referendum result and remain. Labour’s stance was to hold another referendum. Voters, like markets, wanted clarity over “dither and delay”. With a clear majority, and an unambiguous mandate to deliver Brexit, some say that ironically, the bigger the majority, the softer the Brexit as Johnson will not be held hostage by hard-Brexit supporting “ultras” from the European Research Group. Meanwhile, Conservative MPs that have become independents or defected to the Liberal Democrats will vanish into obscurity. Breaking through the “Red Wall” The changing composition of the Conservative win is radical. Whilst some remain-leaning Conservatives voters (and MPs) have shifted allegiance to the Liberal Democrats, constituencies in Labour’s northern heartlands known as the “Red Wall” because they have not had a Conservative MP since the 1930s or 1950s. As predominantly Leave constituencies, voters have “lent” the Conservatives their vote as more trusted to deliver on Brexit after the shambles of a hung Parliament. Strategist vindicated Love him or hate him, the result is a vindication of Johnson’s chief strategist Dominic Cummings who developed Johnson’s core strategy on becoming Prime Minister in July 2019 as “D.U.D.” standing for Deliver Brexit, Unite the Country, Defeat Labour. With the two D’s on track, it will then be for the U and a pivot to a domestic agenda once UK has left the EU on or before 31st January. The Election in 3 Charts 1. Poll tracker Based on an analysis of polling data by the BBC, average voting intentions on 11th December, the day before the election, pointed to 43% support for Conservative, 33% for Labour, and 12% for the Liberal Democrats. Source: BBC 2. Cable Sterling has rallied on exit polls that pointed to a clear Conservative win, with markets encouraged at the prospect at the end of political deadlock, the end of any risk of a hard left Labour government, and the beginning of constructive engagement with the EU to get a comprehensive trade deal in place by December 2020. On becoming PM, Johnson forewarned that “people are going to lose their shirts” by betting against Brexit, using the language of investment managers. For anyone short sterling over the past few weeks, that’s proven absolutely true. 3. ETF Flows focus on UK Small Caps In the three weeks in the run up to the UK election, investors have been positioning for a Conservative win, with a record £151m flowing into the iShares MSCI UK Small Cap UCITS ETF (Ticker: CUKS) that focuses on domestically oriented smaller capitalisation companies. Bottom line
The bottom line is like him or loathe him, Boris Johnson has through force of personality and message discipline won a majority by reaching across tribal party loyalties to secure a clear mandate. We can expect a break-neck parliamentary agenda to deliver Brexit by 31st January 2020, before pivoting to domestic policy issues. At last there will be clarity and focus over the next 5 years, and reduced risk of a hard left Labour. This is good news for the markets, but more importantly good news for the country. [ENDS] Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) or “LON:” (London Stock Exchange). For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.uk Photo credit: as per specified source; Chart credit: as per specified source; Table credit: as per specified source. All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement.
What just happened? The UK’s financial services watchdog, the Financial Conduct Authority (FCA) has fined Henderson Investment Funds Limited, the fund provider that is now part of Janus Henderson, £1.9m ($2.5m) for “failing to treat fairly more than 4,500 retail investors in two of its funds.” The funds named are the Henderson Japan Enhanced Equity Fund and the Henderson North American Enhanced Equity Fund, which had been originally set up and marketed as actively managed funds. In November 2011, the funds’ appointed manager Henderson Global Investors Limited decided to reduce the level of active management of these funds – effectively making them more similar to a passively-managed tracker fund. Who was affected? While this change of strategy was communicated to institutional investors, who were also offered fees to be reduced to zero, there was no such communication or fee adjustment for the 4,713 direct retail investors (who represented 5% of fund value by AUM), and 75 intermediary companies (for example, financial advisers) who remained invested in those funds. How long did this go on for? This discrepancy continued between November 2011 and August 2016, Henderson allowed this discrepancy to continue with retail investors seeing no change in prospectus, objectives or fee levels while the fund was deliberately reposition to a more passive-style strategy: effectively Henderson wilfully converted two of its funds into closet index funds, but just didn’t tell its retail clients. What was performance like during this period? The charts below show the performance of each fund between November 2011 and August 2016. The charts show the funds underperforming the index owing to active fees which creates heavier and heavier drag. Henderson Japan Enhanced Equity (old name) Source: Bloomberg, GBP terms, monthly data, vs selected index Henderson North American Enhanced Equity (old name) Source: Bloomberg, GBP terms, monthly data, vs selected index What happened after 2016? Based on our research, in 2016, the two offending funds were renamed. The Henderson Japan Enhanced Equity became the Henderson Institutional Japan Index Opportunities fund. The Henderson North American Enhanced Equity became the Henderson Institutional North American Index Opportunities. The retail AMC on these funds was reduced from 1.50% to 0.50%. Information on the two funds is presented in the table below. Fund particulars Note: Old name and old retail AMC is pre 2016 changes. New name, new retail AMC and new OCF is as at April 2019. AUM as at November 2019. Source: See fund provider data for each fund here and here Fined for being a closet index fund? The fine is for not treating customers fairly, because for retail clients the change in strategy was not communicated and fees were left unchanged. This contrasts to the treatment of institutional clients, where changes were communicated and fees were offered to be waived. The fine is therefore for leaving retail investors thinking they were invested in active fund even though it had – deliberately – become a closet tracker. Is the first fine for closet indexing in the UK? No, the FCA led the way in 2018 and issued the first fine in Europe for closet index funds, fining a number of unnamed fund houses £34m to compensate clients invested in closet index funds. What’s different this time is that both the manager and the specific funds have been “named and shamed”. How can you tell if an active fund is a closet tracker There are a number of metrics used such as active share, tracking error and R-squared that have been set out by ESMA. On that basis, between 5-15% of all funds offered in Europe could be deemed closet index funds. How was the fine worked out? The total fine was £2.7m, based on £5.8m revenues during the period, but a 30% discount was applied based on Henderson’s cooperation resulting in a £1.9m fine. £1.8m of this fine represents compensation to affected clients, based on the difference in fees paid by retail investor between the two Henderson funds and similar passive products. How can we evaluate a “closet index” fund? There is no defined formula for evaluating a closet index fund. Some measures look at active share, others at a combination of active share, tracking error and correlation. In our view, a closet index fund will have zero or negative alpha, a beta to its index that is close to 1.0x and a high correlation between the fund and the index. Negative alpha means the fund underperforms the index. Beta close to 1.0x means that the fund moves in tandem with the index. Correlation close to 100% means the behaviour of the fund is similar to the index. In terms of similarity to the index, we can see the following metrics for the period under review: Henderson Japan Enhanced Equity (old name) Alpha: -0.198% Beta: 1.033 Correlation: 95.6% Source: Elston research, Bloomberg data, 1-Nov-11 to 31-Aug-16, monthly data Henderson North American Enhanced Equity (old name) Alpha: -0.137% Beta: 1.052 Correlation: 90.0% Source: Elston research, Bloomberg data, 30-Nov-11 to 31-Aug-16, monthly data Investor awareness The fines are helping to increase investor awareness of the closet indexing issue, and we expect long-only retail active managers to remain under scrutiny. Find out more Read the FCA’s final notice Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) or “LON:” (London Stock Exchange). For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.uk Photo credit: as per specified source; Chart credit: as per specified source; Table credit: as per specified source. All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement.
Political context There is certainly going to be continued uncertainty in the run up to the Brexit Hallowe’en. We outline three political scenarios. Hard Brexit: whilst Parliament has successfully passed a law to ensure the Government must apply for an extension if they cannot reach a deal by 31st October, there is still a risk of a Hard Brexit as there is an outside chance that the EU would not win unanimity from the EU27 to agree to grant an extension. 31st October 2019 exit from the EU therefore remains the legal default. Extension: if there is no deal by 31st October, and the UK Government seeks an extension from the EU and it is granted (for example 31st March 2020), then the can has been kicked down the road further, and there will likely be a General Election that will serve as a bitter and contested rerun of the Referendum campaign. That General Election will either result in one of 1) a “Leave” mandate led by a fractured Conservative/Brexit Party, or 2) a “Remain” mandate from a Remain Alliance led by Lib Dems, or 3) a Labour government and second referendum. Last-minute deal: there is an outside chance that the Prime Minister secures a Last-minute deal, that would be largely based on the existing Withdrawal Agreement, but with a Northern-Ireland only backstop. Whilst this would be the ultimate in “government by essay crisis”, it would at least provide resolution to this 3½ year saga, tragedy, comedy or farce (depending on theatrical preference). What about the economy? To gauge the UK economic outlook, we look at three key indicators: Growth, Inflation and Interest Rates. Growth: Despite low levels of unemployment, Brexit uncertainty is weighing on the UK economy with GDP contracting -0.2% in the second quarter. Both manufacturing and service sectors have already shown signs of entering a downturn. The uncertainty around Brexit could slow the growth down even more. The GDP growth for 2019 is still projected at 1.2% by the Bank of England. Inflation: Inflation is close to the Bank of England’s 2% target rate. Although the UK inflation is currently subdued, the expected rate of inflation remained at 3.2% . We estimate expected inflation using the 5 year breakeven rate, the difference between nominal and inflation-linked gilts yields. Put simply, this means that the market is expecting a higher level of inflation over the next five years than at present. Interest Rates: The UK yield curve continued to be flat at the end of 2q19. The spread between 2Y and 10Y bonds decreased further from 27bps to 21bps when compared with last quarter, the smallest gap since 2008. BoE’s chief Mark Carney’s recent speech warning an intensifying global risks added more concerns of a near-term recession. In our view, there is no change to the “lower for longer” outlook for UK interest rates. Asset class positioning In the context of political and economic outlook, what are our views on asset classes? Equities: Within an equity context, our portfolios do not have a domestic bias and are globally diversified, meaning that Brexit has limited impact on global equity risk compared to the bigger issues of the day, namely US-China trade disputes and US interest rate path. For reference, the UK is only about 6% of global equities (when counting both developed and emerging markets). So for globally diversified equity portfolios, Brexit has limited direct impact. Equities are long run return drivers and are exposed to a broad range of currencies in terms of the revenues of the global companies that make up each market. We do not believe that attempting to time the market for short run currency fluctuations, with regards to equity exposure, is worthwhile, and creates additional cost drag. Key question: to hedge or not to hedge However, for UK investors, currency positioning is key. In 2016, advisers that allocated to unhedged global equity exposure, and/or focused on large cap UK equities (e.g. the FTSE100) which have a high proportion of dollar revenues protected their clients from sterling devaluation. Fig.1. World Equity Returns in GBP terms: unhedged vs hedged Source: Elston research, Bloomberg data, total returns for respective ETFs. YTD 2019 is to 31-Aug-2019. iShares MSCI World (IWRD) and iShares MSCI World GBP Hedged (IGWD). All performance data in GBP terms. In the event of a no-deal Brexit (legal default), we expect further GBP weakness in which case an unhedged approach continues to make sense. In the event of an extension or a last-minute agreement, we expect GBP to recover towards 1.30 to 1.40 level respectively, in which case a tactical allocation to GBP-hedged global equity exposures would ensure global equity returns are delivered in sterling terms. Fig.2. GBP/USD Spot and potential levels under different scenarios Source: Elston research, Bloomberg data
Bonds: For bonds, most advisers rightly have a bias to domestic bonds for their clients to ensure alignment of client’s income and spending needs, as well as for protection in economic downturns (put simply: typically bond values are higher, when growth and interest rates are lower). We expect UK interest rates to remain lower for longer under all 3 scenarios, whilst inflation remains contained. If we saw risk of higher UK interest rates, we would look at allocating client assets to shorter duration (e.g. <5 year) UK bonds that are less sensitive to changes in interest rates. Alternatives: Property: We like property as a real asset that offers inflation protection. However, we see property as a potentially exposed asset class in the event of a no-deal Brexit. We would be concerned by the risk of reduced economic activity, business relocations and higher vacancies. For this reason our preference is for globally diversified funds that invest in shares of property companies, rather than for UK focused funds that invest in direct assets. Alternatives: Commodities: We like commodities as a diversifier owing to their less correlated relationship with equities and bonds. However as we are late in the cycle, we are cautious commodities. However we see Gold as a traditional defensive asset in uncertain times, and note the risk of sustained upward pressure on oil prices amidst geopolitical tensions in the Middle East. In the fallout from the Woodford debacle, there are a several questions that the FCA should be asking over coming weeks. Some technical, some compliance-related, and some propositional.
Here’s my checklist: Start with the KIID. The stated objective of the Woodford Equity Income Fund (“WEIF”) is “to provide a level of income together with capital growth.” The stated policy is “to seek to invest at least 70% in shares of UK listed companies. It may also invest in unlisted companies, overseas entities and derivatives. It is not anticipated that the use of derivatives will have a significant adverse effect on the risk profile of the fund.” So investors who read the KIID (which is meant to be all investors) understood that the fund would invest in unlisted companies. Look at the factsheet: the stated objective on the factsheet of the WEIF is “To provide a reasonable level of income together with capital growth. This will be achieved by investing primarily in UK listed companies.” Given most investors check factsheets, not KIIDs, why was there no reference to unlisted assets on the factsheet. A small point, but, in my view, the objectives as stated on a factsheet and KIID should be identical verbatim. Was there mis-selling? Arguably not. The reference to unquoted assets is right there in the KIID, and implicitly in the word “primarily” on the factsheet. And Woodford published all his holdings. So caveat emptor. But the trade-press and some brokerages focused much more on his large cap investment style than his unquoted investments, until they started turning sour that is. So any mis-selling discussion would need to focus on the nature of the financial promotions issued by Woodford and to what extent they outlined the extent of the allocation, and associated risks, with illiquid assets and how the fund’s strategy was presented to potential investors. Promotional materials: brokers offering the Woodford fund articulated his style (presumably based on Woodford’s own promotional materials) as investing in big solid companies with stable dividends. There’s little or no reference to unquoted assets, so is it possible that investors (who rely more on buy lists and trade press) were unaware of the risks associated with illiquid assets. So investors were possibly exposed to more risk than they were expecting. Are there any similarities between the issues that arose for WEIF and the issues that arose with Invesco Perpetual? The FCA published a damning 29 page verdict on the breach of limits by Invesco in relation to funds (including two flagship funds managed by Woodford), shortly before he left the firm. You can read the full report here. But to summarise, the issues in 2014 focused around “1) investing some of its funds in breach of investment limits; 2) introducing leverage into certain funds without providing investors with and 3) failing to put adequate controls in place to ensure that all funds were valued accurately and that all trades were allocated fairly between funds. As a result of these failings, Invesco Perpetual’s investors were exposed to greater levels of risk than they had been led to expect.” Were similar issues arising at Woodford, and if so, who was responsible – any or all of the management firm, fund administrator, or the fund manager? Limits for illiquid assets: to what extent did Woodford breach either in letter or spirit the rules around maximum holdings in illiquid assets for a daily dealing fund? In early March, the holdings in illiquid assets hit 18%. The two steps that will come under increased scrutiny were 1) the asset transfer of unquoted shares to WPT (where such investments are more appropriate) which, amazingly the manager, claimed after taking legal advice that “the shares-for-assets deal was not a related party transaction”, and 2) the attempt to list assets on TISE to get round the letter of the rules. Compliance turnover: there has been a high turnover of compliance officers (those with the controlled function CF10 (Compliance Oversight)) at Woodford Investment Management and its predecessor firm Woodford Investment Management LLP. Having three compliance officers in five years, according to the FCA register for those firm, raises its own set of questions. Role of buy lists: in the non-advised sector, buy lists are helpful for investors who feel overwhelmed by choice and want help in selecting funds for each asset class. Some brokerages offer their own buy list, like the HL50, others offer their own buy list alongside third party research from fund rating firms like Morningstar. Buy lists provide an important resource, but will come under scrutiny. Screening methodology, impartiality and oversight should be clearly defined and implemented. Nor should buy lists be restricted to active funds. Investor behaviour: ironically, behavioural research points to investors often being their own worst enemy. Chasing star managers, or star asset classes (before a fall), not cutting losses early enough, over-relying on brands and personalities and not managing a broader asset allocation are all well documented failures. Looking at behaviourally-adapted investment propositions, such as target-risk or target-date multi-asset funds, is one potential remedy. Need for kitemarking: there is an overwhelming level of choice of funds for retail investors, both for single-asset strategies and multi-asset strategies. Investing an entire portfolio into a single asset class – like UK Equity Income – is rarely likely to be appropriate. And the biggest detriment to customer outcomes will be those investors who have all their wealth held within a single asset class and within a single fund. There needs to be a discussion around the potential role for investment pathways (not crossing into advice) that use kitemarked multi-asset funds that are outcome-oriented and evaluated against stakeholder-style metrics including good customer outcomes and value for money. In the US pensions market, safe harbour criteria give providers comfort that they are not giving advice when selecting a default strategy for less engaged, less confident investors. Kitemarking would be a possible first step in this direction. The views expressed are the author’s own and do not necessarily reflect the views of Elston Consulting Limited, its clients or suppliers.
In this report, we analyse the data around a selected opportunity set of bond indices as represented by London-listed ETFs. The report covers global, USD, EUR, GBP and Emerging Market bond markets, for aggregate, government, corporate, high yield and emerging market exposures. Whilst the bond market dwarfs the equity market, the majority of ETFs are focused on equity exposures. That is gradually changing with growing acceptance of bond ETFs as a convenient and liquid way of accessing targeted bond exposures by geography, issuer type, credit quality, or maturity profile. In this report, we:
For more information and important notices, view the full report. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: This article references research by Elston Consulting that is sponsored by State Street Global Advisors Limited. I wrote this article myself, and it expresses my own opinions. Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs and may be prefixed by the relevant exchange code, e.g. “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.ElstonETF.com All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement. Image credit: Elston; Chart credit: n.a.; Table credit: n.a.
What’s new? A bond ETF is not brand new: the first bond ETF launched back in 2002. But they are gaining traction, and as adoption increases the breadth and depth of bond ETFs have also broadened. In my first DIY multi-asset ETF portfolio back in 2008, the main bond ETFs available back then were for broad exposures like Gilts, Index-Linked Gilts and Corporate Bonds. Fast forward over ten years and there’s the ability to access much more targeted exposures. Investors can access both corporate and government bonds for GBP issuers as well as for major currency issuers such as USD and EUR, both unhedged and hedged to GBP. Furthermore, within these opportunity sets investors can select from a range of investment term options, whether short-term (e.g. <5 years), medium term (e.g. 5-10 years), or long-term (>10 years). As well as high yield bonds, more specialised bond exposures are also increasingly available. So whatever the exposure, there is an investable index to express it, and increasingly an ETF to track it. But what is a bond ETF and what are the benefits? A bond ETF is simply a bond fund that can be bought or sold on an exchange, like a share. This has three benefits: it enables access, provides diversification and creates liquidity. According to a recent survey of UK managers, while the access and diversification points are readily understood, there are concerns about liquidity.
Understanding bond ETF liquidity Ultimately the liquidity of a bond fund, whether a traditional fund or an ETF is only as good as the underlying asset. We can term this “internal liquidity”. But if liquidity of a fund itself is a concern then you are probably better off in a bond ETF than a traditional bond funds. Why is that? Simply put the stock exchange creates a secondary market for ETFs (buyers and sellers of bond ETFs trading with each other without necessarily requiring a creation or redemption of units of the bond ETF that would impact underlying bond liquidity). We can term this “external liquidity”. If liquidity of the underlying asset class was a concern and you wished to exit a traditional bond fund, your redemption would be at the discretion of the fund provider and in extremis, you may find yourself gated. So if bond liquidity is a concern, avoid traditional funds and stick to ETFs: there’s a secondary market for them other than the fund issuer. Additional liquidity of bond ETFs By way of example, 2017 provided a stress test for the bond market – in particular high yield bonds. The findings are reassuring. When high yield bond yields spiked in March 2017 and high yield bond values came under pressure, we can see how high yield bond ETFs actually fared in these challenging conditions. The volumes of the secondary market trading between investors buying/selling on exchange (which requires no trading of the fund’s underlying securities) eclipsed net share redemptions (which does require trading of the underlying securities) by a significant factor. The volumes on secondary markets increased to an average of $12.7bn in the first two weeks of March (versus a previous nine-week average of $6.7bn), whilst the net redemptions of high yield bond ETFs was only $3.5bn (representing 6.1% of total assets). A similar resilience was exhibited in November 2017. So far from triggering a liquidity stampede in the underlying holdings, the presence of secondary market enabled investors to trade the ETF holding those bonds amongst themselves. This is why secondary market liquidity is seen as an advantage, rather than a disadvantage. Secondary Market Trading of High-Yield Bond ETFs Increased When Yields Rose in 2017, 29-Dec-16 to 29-Dec-17* Source: ICI 2018 Factbook. Figure 4.6
The ratio of secondary market volume to net share issuance is therefore one measure of bond ETF liquidity, but the most indicative measure of bond ETF liquidity is bid-ask spread. Conclusion Innovation for bond ETF investing is focused on more nuanced index design and construction of bond ETFs which provide the tools managers need to reflect their views as regards issuer type, term and credit quality when allocating to bonds. The adoption of bond ETFs is demand-led as it enables access, provides diversification and creates liquidity. This is and should be welcome to investors large and small. For more information and important notices, view the full report. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: The article includes references to research by Elston Consulting that was sponsored by State Street Global Advisors Limited. I wrote this article myself, and it expresses my own opinions. Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs and may be prefixed by the relevant exchange code, e.g. “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.ElstonETF.com All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement. Image credit: n.a.; Chart credit: ICI; Table credit: n.a.
We conducted a Survey of senior portfolio managers and decision makers from firms whose combined assets under management is in excess of £500bn. The survey was designed to get a better understanding on how those managers approach bond investing. Our key findings based on the survey are summarised below:
For more information and important notices, view the full report. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Additional disclosure: The data in this article comes from an Elston ETF Research report “Bond ETF Investing Survey” that was sponsored by State Street Global Advisors Limited. We warrant that the information in this article is presented objectively. For further information, please refer to important Notices and Disclosures in that Report which is available on our website www.ElstonETF.com This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This article reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.ElstonETF.com Image credit: Elston Consulting; Chart credit: Elston Consulting; Table credit: Elston Consulting
Multi-asset risk-based strategies offer an alternative approach to portfolios construction.
Examples of multi-asset risk-based strategies include: Minimum Variance, Risk Parity, Maximum Deconcentration, Maximum Sharpe and Maximum Decorrelation. These strategies target a particular risk objective and that risk objective drives the underlying asset weightings. We see a growing role for multi-asset risk-based strategies as more informed comparator to traditional asset-based multi-asset comparators such as a 60/40 equity/bond portfolio. Potential application for risk-based strategies Potential applications include: Portfolio diversifier: Investors traditionally use hedge funds and/or absolute return strategies as diversifiers within a portfolio context owing to their differentiated risk-return characteristics. Similarly, risk-based strategies offer a systematic approach to delivering differentiated strategies for diversification purposes. More specifically, the objectives of a Max Deconcentration and Max Decorrelation are to deliver a differentiated approach (for a given opportunity set subject to parameter constraints). Return enhancement: Risk-based strategies have the potential to enhance portfolio returns. More specifically, the objective of a Max Sharpe strategy is to deliver maximum risk-adjusted returns (for a given opportunity set subject to parameter constraints). Risk mitigation: Risk-based strategies have the potential to mitigate portfolio risk. More specifically, a Min Variance strategy is optimised to deliver a risk-return characteristic close to the theoretical Minimum Variance Portfolio (for a given opportunity set subject to parameter constraints). Benchmarking purposes: Using risk-based strategies as comparators to Hedge Funds, Diversified Growth Funds and Target Absolute Return Funds provides additional performance insight without the problems that are inherent in peer group type measures. Get the full report Factor-based investing – an alternative approach to cap-weighted indices
Factor-based investing focuses on identifying broad persistent characteristics for securities within a single asset class. Factor-based indices ascribe weights to securities within an index based on those factor characteristics. Factor-based indices are therefore typically single asset in nature, and represent an alternative approach to capitalisation weighted indices. For example, Minimum Volatility equity index is typically constructed with a single asset class, e.g. equities whose constituents exhibit the lowest volatility characteristics. Risk-based strategies – an alternative approach to multi-asset When looking at multi-asset strategies, there are two approaches. For asset-based investing, asset weights determine portfolio risk characteristics. For risk-based investing, portfolio risk characteristics determine asset weights. Risk-based indices are therefore typically multi-asset in nature, and represent an alternative approach to asset-based (e.g. 60/40) multi-asset indices. For exanoke, a Minimum Variance index strategy targets the minimum variance multi-asset portfolio. Risk-based multi-asset strategies therefore reflect a portfolio construction approach, rather than a factor screen. It is the set of rules by which a multi-asset portfolio is optimised. What are the advantages of a risk-based strategy? The advantages of long-only risk-based index strategies are that they: 1. Provide a systematic approach to risk management 2. Can be constructed with liquid underlying ETFs 3. Do not use leverage or shorting Get the full report here http://www.elstonetf.com/store/p3/Multi-Asset_Indices%3A_risk-based_strategies.html Risk-based strategies are an alternative approach to multi-asset investing.
For traditional asset-based strategies, such as a 60/40 equity/bond portfolio, asset weights drive risk characteristics. For risk-based multi-asset strategies, risk characteristics drive asset weights. The objectives of multi-asset risk-based strategies are derived from different branches of portfolio theory can be defined as follows Minimum Variance: Aims to minimise the overall strategy volatility by using pairwise correlations and volatilities of stocks to provide a good proxy for the least risky portfolio in the Modern Portfolio Theory framework. Risk Parity: Aims to achieve equal risk contribution from asset classes under the assumption of identical pair-wise correlations structures. The same as inverse volatility weighting. Maximum Deconcentration: A naïve diversification strategy that aims at maximising the effective number of holdings, equivalent to minimising concentration. Maximum Sharpe: Aims to combine assets to achieve a strategy with the highest risk-adjusted return in excess of the risk-free rate. Maximum Decorrelation: Aims to minimise the volatility of a strategy assuming that individual volatilities are identical, thereby constructing the strategy based on correlation structure alone (solving for the least correlated strategy). Get the full report here http://www.elstonetf.com/store/p3/Multi-Asset_Indices%3A_risk-based_strategies.htm
Positioning for a GBP recovery? With Brexit doom and gloom mostly priced in, all eyes are on sterling which has become the Brexit barometer. So which way for sterling? Stating the obvious:
In the event of a relief rally in GBP, how can investors position portfolios accordingly? Translation effect Recall that the GBP currency impact on portfolios in 2016 was massive. As GBP depreciated, investors whose global equity portfolios were unhedged enjoyed strong performance thanks to the translation effect of foreign earnings. The same applied to FTSE 100 which looked stronger against a weakening GBP. The reverse would also therefore be true. Any significant appreciation in GBP would see (foreign) global equity returns offset by GBP strength and would weigh on the FTSE 100. So for those who were lucky enough to be unhedged as sterling fell can’t rely on luck if sterling rises. Toolkit for GBP recovery Like everyone else, we have no crystal ball as to how Brexit could play out, but we can identify some of the tools that investors may want to have in their armoury to implement their views, whatever their risk posture, in case of a GBP recovery. We look a selection of exchange traded products to access currency pairs, ultrashort bonds, shorter duration bond and GBP hedged equities to implement a tactical position for different risk levels. 1. Short-term currency exposure On the approach to and in the event of any deal, for very short term exposure (<1 month), investors could consider gaining rapid currency exposure by using a currency pair ETC and if seeking additional risk could use a leveraged exposure. Leveraged exposures should be short-term in nature and investors should ensure they understand the risks. Currency pairs GBPP: ETFS Long GBP Short USD LGB3: ETFS 3x Long GBP Short USD 2. Volatility dampener Investors can tactically allocate to ultrashort GBP bonds if they are looking for a cash-like volatility buffer with more yield than cash with a GBP return profile. Ultrashort duration Bonds ERNS: iShares GBP Ultrashort Bond ETF JGST: JP Morgan GBP Ultra-Short Income UCITS ETF 3. Short duration bond exposure Tactical allocations to short duration GBP bond exposures is available both for UK gilts and GBP corporate bonds for investors seeking GBP bond exposure without being over-exposed to interest rate risk from the longer-duration nature of the main indices. Short duration Gilts IGSL: iShares UK Gilts 0-5yr UCITS ETF GLTS: SPDR® Bloomberg Barclays 0-5 Year Sterling Corporate Bond UCITS ETF Short duration GBP Corporate Bonds IS15: iShares £ Corp Bond 0-5yr UCITS ETF SUKC: SPDR® Bloomberg Barclays 0-5 Year Sterling Corporate Bond UCITS ETF 4. Equities hedged to GBP To access equities hedged to GBP, rather than running a currency overlay, investors can access GBP hedged versions of mainstream ETFs. At 29-30bp TER, these are slightly more expensive than their conventional versions, but the cost difference represents the cost and convenience of running the currency overlay. Most regional equity ETF exposures offer GBP hedged versions, or investors can use ETFs tracking MSCI World (GBP hedged) as a proxy for risk assets. For example: Global equities (GBP hedged) IWDG: iShares Core MSCI World UCITS ETF GBP Hedged XDWG: Xtrackers MSCI World UCITS ETF 2D – GBP Hedged Conclusion Whilst no deal is supposedly ruled out, there is no certainty as to what any deal would look like. Whatever the politics, if you believe there is potential for a recovery in sterling, ETPs provide tactical ways of positioning portfolios accordingly. In 2018 Risk Parity and Min Volatility multi-asset strategies offered some downside cushioning and lower volatility relative to a 60/40 Equity/Bond portfolio for GBP investors.
Risk-based strategies: 1. Offer a systematic approach 2. Are designed to be differentiated 3. Have potential to enhance returns, mitigate risk or improve diversification Get the full report
What is risk-based multi-asset? Risk-based strategies are an alternative approach to multi-asset investing. For traditional asset-based strategies, such as a 60/40 equity/bond portfolio, asset weights drive risk characteristics. For risk-based multi-asset strategies, risk characteristics drive asset weights. How does this compare to factor investing? Factor-based index strategies typically look at screening single asset class securities for a particular factor. For example, Minimum Volatility equity index is typically constructed with a single asset class, e.g. equities whose constituents exhibit the lowest volatility characteristics. By contrast, For multi-asset strategies a Minimum Variance strategy targets the minimum variance multi-asset portfolio. Risk-based multi-asset strategies reflect a portfolio construction approach, rather than a factor screen. It is the set of rules by which a multi-asset portfolio is optimised. What risk-based multi-asset strategies are available? We focus on five well researched risk-based multi-asset strategies:
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