Outcome-based investing – new ways of managing multi-asset portfolios

EDITION 31 – 14 OCTOBER 2011

This edition looks at new ways of managing multi-asset (or diversified) portfolios.

Key Points

• Constrained investment returns and increased volatility are likely to be with us for a while.
• As a result, we are likely to see the introduction of more funds focused on delivering predetermined outcomes for clients with a greater reliance on asset allocation and a wide range of sources of return.
• This is not to say the conventional approach to managing diversified portfolios with its focus on equities for growth funds is wrong. Shares will continue to provide superior long-term returns and are appropriate for long-term investors. But an outcome or absolute return approach may be worth considering for those with a shorter-term investment horizon or specific needs, for example, specific income requirements.

Introduction

Almost a decade ago I thought we had come into a world of lower and more volatile investment returns, after the above-average returns of the 1980s and 1990s.1 Ultimately the low return world view of earlier last decade was delayed for Australian investors by the cyclical rebound in growth assets into 2007. However, it is now clear that a much tougher environment for investors is upon us. This, combined with a number of other developments, is likely to see the growth of funds focused around delivering predetermined outcomes for investors.

Conventional investment management

The investment management industry has seen periodical changes in the way clients’ funds are managed. Prior to the 1970s investment managers focused on meeting absolute return targets, say 10% per annum (pa), over the long term. This reflected the long-term nature of insurance and defined benefit superannuation schemes.

This changed radically in the late 1970s and 1980s, with the advent of market-linked diversified funds (i.e. where fund values moved up and down with investment market values) and the shift to defined contribution superannuation funds. Heightened investor interest in the performance of their funds, increased regulation, more computing power and an expansion in the role of consultants all combined to result in the focus of investment managers becoming increasingly short term. Performance objectives were defined relative to benchmarks (such as the S&P/ASX 200 for Australian shares, or an aggregate of such benchmarks for a diversified mix of assets) and competitors via monthly performance tables.

In the 1980s, focus was on single manager diversified funds, which, in the 1990s, morphed into assembling portfolios of different managers across and within asset classes. This in turn evolved into pre-packaged multi-manager funds.

While there have been iterations along the way, over the last 30 years the conventional investment management model has involved a diversified mix of assets, the key characteristics of which have been assets categorised into growth and defensive asset classes with the proportion in each defining which age group of investors they are appropriate for, a heavy reliance on equities for growth funds as well as risk and return measurements against passive benchmarks and competitors. The focus on benchmarks and competitors has led to a relatively narrow range within which asset allocations are moved around. In fact, the 1990s saw a decline in the importance of asset allocation as all assets provided pretty good returns together and under the sector specialist or multi-manager model, in many cases, it just didn’t figure at all.

Challenges

Through the 1980s, 1990s and in Australia’s case up until 2007, the conventional model provided great returns for investors. From 1983 to 2007, traditional Australian balanced funds provided an average return of 7.8% pa after inflation (or 11.9% pa before), compared to a very long-term norm of 5.5% pa. For a number of reasons we are likely to see an increase in alternative approaches to managing diversified assets.

First and foremost is the change in the environment to one of lower and more volatile returns. The historical record tells us shares go through periods where returns are poor, such as the 1930s in the US as well as during the 1970s and the last twenty years or so in Japan. After 25 years of above-average returns between 1983 and 2007, some sort of slowdown was inevitable. The 1980s boost to asset values from falling inflation, deregulation and globalisation is long over. And now the aftermath of the global financial crisis is shown through extreme public and private debt levels in advanced countries, extreme monetary policy settings, greater government involvement in economies and markets, and more twitchy investors who seem to see negativity around every corner, all of which are resulting in lower returns and shorter, more volatile cycles.

Secondly, the role of benchmarks and competitors as performance objectives can be challenged when the benchmarks and competitors themselves are performing poorly. It’s also argued that a focus on competitors can lead to a situation where fund managers fail to see the risks they are taking because they are so busy looking across at each other.

Thirdly, pigeon-holing assets into being either growth or defensive can limit the number of managers who can invest into them and can limit them from fully utilising their investment management skills.

Finally, conventional constraints around asset weights, the move to sector specialist models and/or the focus on picking managers has meant that there is too little focus on asset allocation in many cases. However, in a world of shorter and more extreme investment cycles, and more negative correlations between equities and bonds, asset allocation is becoming critically important.

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Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591) (AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.