*This article is produced in partnership with Allan Gray

With the recent rise in the popularity of managed accounts, one would be forgiven for thinking that the diversified managed fund is a product of yesteryear. We, however, believe the role of diversified managed funds is more pressing than ever before.

In this recent article, we looked at how we believe there is a role for diversified funds in almost any multi-asset portfolio and could be held alongside or within a managed account. As discussed, this approach will not only reduce the risk of having all clients in a single investment approach, it could potentially lead to better client outcomes as well. This is because a diversified managed fund has a broader toolset available with which to manage risk and seek outperformance.

What are some of the ideal elements of a diversified managed fund that could benefit an existing managed account?

We believe there are five key elements essential to managing a successful diversified fund:

  • Flexibility, both within and across assets classes
  • Built from the bottom up, on a security-by-security basis
  • Allow the use of derivatives to manage risk
  • Active currency management, to reduce potential losses from overvalued currencies and to seek alpha from undervalued currencies
  • True alignment of interest between the portfolio manager and the end client

Let’s get into the detail:

  1. Flexibility to drive returns

If you believe an active manager has the skill to outperform, you need to allow that manager considerable flexibility and opportunities to make active investment decisions. In practice, however, diversified portfolios are often quite limited in terms of the flexibility given to decision making. Managers may also be limited in the types of assets they are allowed to allocate capital to, or restricted in terms of geographic allocations.

This inflexibility prevents the manager from taking advantage of the relative value on offer across asset classes. A traditional, rigid 60/40 split between growth and income assets leaves little room for taking advantage of opportunities when they arise, nor the capacity to increase exposure to underperforming assets with the potential for future outperformance. For example, when equity markets are high and valuations are stretched, managers should seek better value elsewhere if it is available. A rigid 60/40 split prevents this. We believe flexibility to invest across different asset classes, and at a security level within those asset classes, is key to maximising investor returns.

  1. Building a portfolio from the bottom up with individual securities

There are two primary ways to construct a diversified portfolio – own securities directly, or use a building block approach using managed funds and ETFs. Most diversified portfolios take the latter approach and outsource equity and bond research to different companies. Even if the portfolios are comprised of different investment funds offered by a single investment manager, it is likely that equity and bond teams are working separately and comprised of different people. This makes it difficult to assess the relative attractiveness of different asset classes or funds when deciding portfolio weightings. If the manager is creating a multi-asset fund from internal funds, tension can be created when changing allocations, as the manager must take money from one part of the business and give it to another. Internal political considerations can cause friction in the movement of capital.

Building a portfolio from the bottom up, using individual securities, seems to us a much better way to manage a multi-asset fund. It enables the manager to analyse the entire capital structure of a business and decide which securities (if any) might be attractive, equities, bonds or hybrid offerings. It also means every security is constantly fighting all others for capital, and every security is bought with the expectation it will be an active contributor to fund returns. This does, however, require deep expertise from the manager and a well-resourced team.

  1. Using derivatives to manage portfolio risk

Derivatives are a useful tool to manage risk at a portfolio level, without having to always buy and sell underlying portfolio holdings to adjust exposures. Derivatives are often perceived as risky, but used sensibly they can actually reduce risk in a portfolio. Say you like the prospects for a US-listed stock but think that the US market as a whole is overvalued, you can buy the individual stock then use futures to reduce your exposure to that market as a whole. This hedging allows you to control overall exposure to equities without having to reduce positions in attractive individual companies in these regions. In other words, you can reduce portfolio risk, without necessarily diluting returns.

  1. Active currency management, to enhance returns

To some extent this is an extension of our point about derivatives, but it’s worth mentioning in its own right. Currency allocations can also be actively managed using derivate overlays. This is a very powerful tool that helps manage risks within a fund and seek outperformance.

By divorcing equity research from currency research, you can still seek out attractive investment opportunities in countries where you believe the currency is overvalued.

Most managed accounts have to manage currencies by switching between hedged and unhedged managed funds and ETFs. This can become difficult if there isn’t a hedged version of your preferred investment vehicle. Even when available, it means a much less targeted and flexible approach to managing currency risk than using currency forwards.

  1. True alignment of interests between the portfolio manager and the end investor

When the interests of investors and investment managers are aligned, it creates a shared objective of maximising returns. To ensure that managers continually strive to outperform and deliver alpha for clients, we believe the right incentive structures need to be in place. As Charlie Munger once said, “show me the incentive and I will show you the outcome”.

The temptation in managing multi-asset portfolios is to deliver index-like returns, as it is unlikely that a client would ever fire a manager for minor underperformance.

As a diversified portfolio gathers assets, the temptation grows to deliver index-like returns and not stray far from the crowd. Lowering tracking error can reduce the risk of outflows, while the investment manager can continue to take active management fees from an already substantial asset base.

This is a raw deal for investors, as there is absolutely no reason to pay active management fees for index-like returns when cheap, passively-managed diversified portfolios are readily available.

Measures such as employee ownership of the firm, co-investment in the fund, and performance fees all help to ensure interests are aligned.

Performance fees are a great incentive to strive for outperformance, which is good for the client and for the business. A fair fee structure is essential though, ideally with a low base fee and a high-water mark that ensures the manager isn’t paid to recover past underperformance.

If you’ve got this far, you won’t be surprised to learn that this is exactly how we manage the Allan Gray Australia Balanced Fund. It’s a diversified fund with the flexibility to drive long term returns.

Disclaimer: Intended for advisers only and published by Allan Gray Australia Pty Limited ABN 48 112 316 168, AFSL No. 298487. Equity Trustees Limited ABN 46 004 031 298, AFSL 240975 is the responsible entity and issuer of units in the Allan Gray Australia Equity Fund (ARSN 117 746 666). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This information is of a general nature, doesn’t take into account the objectives, financial situation or needs of any individual and may not be appropriate for you or your client. Before acting on anything in this article, you should consider its appropriateness to you, having regard to your objectives, financial situation and needs. You should obtain and consider the relevant Product Disclosure Statement relating to any products mentioned, before deciding whether to acquire any products. Neither Allan Gray, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Read the relevant disclosure documents before making any investment decision. Target Market Determinations (TMDs) for the Allan Gray products can be found at allangray.com.au/PDS-TMD-documents. Each TMD sets out who an investment in the relevant Allan Gray product might be appropriate for and the circumstances that trigger a review of the TMD. Please read the Fund’s most recent Product Disclosure Statement and Information Booklet (together PDS) before deciding to invest in the Funds. A copy is available from https://www.allangray.com.au/b/forms-documents. Past performance is not a reliable indicator of future performance, and there are risks with any investment.

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