David Wright takes a close look at the changing landscape of portfolio construction.
The post-GFC era has brought about some material changes in the way portfolios are being constructed and managed. While some of these changes are common and somewhat cyclical, others have more permanent implications for the types of products and investment styles both financial advisers and investors are likely to support going forward.
One of the most obvious trends post GFC has been the enormous flow and/or switch from active management to passively managed (index) investment products. To be fair, money flows from actively managed funds to passively managed funds is a common trend after significant market “corrections” as investors and advisers lose faith in active managers in a negative return environment. This time, however, this flow has been further exacerbated by the regulatory focus on adviser remuneration practices. This, combined with investor pressure to reduce fees in a low to negative absolute return environment, has resulted in some advisers seeking to reduce fees to the client by using passive funds within client portfolios.
The interest in ETFs (exchange traded funds) and the potential to build a low-cost portfolio off an IDPS (investor directed portfolio service) platform and therefore reduce costs for investors has also driven interest in ASX-listed passive investment products. While growth in ETFs has been rapid in percentage terms in the Australian market, the level of actual funds invested remains at only a very small fraction of the overall managed investments industry. But based on the experience in the US and Europe, this is likely to grow substantially.
One of the major concerns that investors have had post the GFC has been the protection and preservation of their invested capital. This is clearly evidenced by the massive flow of investors’ money into government-guaranteed cash accounts and term deposits. However, it is very interesting to note that some of the managers that have been enjoying stronger funds flow than others are those with a strong focus on downside protection. This is particularly interesting because these managers tend to be much less benchmark aware in their approach, which is completely opposite to the trend to passive management.
‘It is also not safe to assume that all truly active managers will outperform. The won’t’
Similarly, while the vast majority of portfolios’ fixed interest allocations have been invested in cash accounts and term deposits post the GFC, there is a growing recognition that investment in fixed interest index funds is sub-optimal from a capital protection perspective. That is, the highest weights in fixed interest benchmarks are the largest issuers of bonds, which in turn are the most indebted countries from a sovereign bond perspective, and often more highly geared companies from a corporate bond perspective.
As an example, the heaviest weights in the Barclays Global Aggregate Index include the US, Japan and a number of the troubled European countries. Do advisers really want their clients’ fixed interest allocations invested in the most indebted countries and companies – one thinks not. As a result, in the rare instances where advisers are allocating money to fixed interest funds in the current climate, the more active, less benchmark-aware managers are the ones receiving the flows.
In the 20 years I have been involved in the investment industry, another common trend following equity market downturns is the move from actively managed Australian equities funds to investment in direct equities. Following a market downturn and negative returns from managed funds, some advisers and investors take the view that they can do a better job of managing Australian equities exposures by investing in a portfolio of direct stocks. This approach tends to be used in two ways. Firstly, investing in a portfolio of blue chip, large companies and blending the portfolio with an actively managed small companies manager; and secondly, investing in a large cap fund and investing in a number of small companies directly in an attempt to provide outperformance.
Alternatively, this “core and satellite” investment approach can also be achieved by blending index funds or ETFs as the core, with highly active managed funds or LICs (listed investment companies) as the satellite exposures within portfolios. This approach is also currently popular and assists in keeping overall portfolio management fees down while also providing potential for outperformance of the underlying index through the use of actively managed funds.
Finally, while the use of alternative asset classes and alternative investment strategies has reduced dramatically since the GFC – largely due to a misguided belief that all alternative products are illiquid – the more highly knowledgeable practitioners and sophisticated investors have continued to use alternative products as a source of generating returns within the current low-return environment. Australian and international long/short funds, CTA (Commodity Trading Advisor) funds and some global macro funds have generated attractive absolute returns both during and post the GFC.
So what implications do these portfolio construction practices have for the types of products and kinds of investment styles that are likely to be supported by financial advisers and investors going forward? The current portfolio construction practices have resulted in support for the different types of products and investment styles becoming very polarised. That is, on the one hand there is strong support for cheap beta (that is, index tracking funds) and on the other there is also attraction and support for truly actively managed, downside risk focused investment products and managers.
