Education

CFA UK is the professional body for investment managers – your scribe was awarded one of its qualifications in his younger life. It recently expressed some concerns about the impact on portfolio diversification of a long period of negative interest rates. It suggested advisers might want to look through the following checklist. If we take out the references to clients, it would be a good one for do-it-yourself investors to work through on their own account.

Are my client’s return expectations reasonable given the low expected future returns offered on many assets?

In light of the above, are my client’s current contributions (or savings) sufficient to meet their objectives?

Conversely, are some clients assuming too much risk in order to hunt for yield in a low return world? For example, are risks now higher than they were for traditional portfolios with high government bond weightings (my emphasis)?

When considering risk, what are the limitations of my risk model(s) in relation to the assets in which the portfolio is invested? Do they, for example, rely completely on historic correlation, volatility and drawdown data which may not hold in the future? How have I addressed those limitations, even if only qualitatively?

How long would it take to liquidate the client’s entire portfolio? How much would it cost do so? How do those figures compare with the past and is the level of exposure to illiquid assets still appropriate for the client’s needs?

As the hunt for yield continues, are my client advice and investment decisions accounting equally as much for the risk characteristics of a product/asset as its return potential?

I think the third paragraph is particularly relevant to those investors with passive multi-asset portfolios that are biased to fixed income stocks, like a Vanguard Lifestrategy 20% or 40% equity fund. The conventional risk control offered by owning long dated government bonds may well not hold good in the next few years

Introduction

I thought it was time I posted something for my subscribers who are invested in passive multi-asset funds, most likely via the very successful Vanguard Lifestrategy range.

Readers may know that if one picks these funds, one is accepting the well established (but arguable – See Multi Asset Academy) idea that equities add volatility to a portfolio and fixed income investments add a stabiliser. With a well thought out asset allocation to various parts of these high level asset classes, one can build funds with more or less equities and therefore more of less volatility. Volatility is one way of looking at the risk of capital loss.

So Vanguard market funds with anything from 20% to 100% invested in equity index trackers. The non equity element is invested in a range of fixed income trackers. One would expect the funds to all perform about the same in terms of market direction (because although the asset allocations are different, they invest in the same indices), but not degree. Over the long term, the 100% equity fund ought to make you more money, but the ride will have been a lot bumpier.

However, the relative directional movements of equity and fixed income markets may not be what the textbook would have you believe in the short term.

The fact that Vanguard, for sensible marketing reasons, offer funds differentiated by 20% changes in equity content can result in the sort of strange results that any fixed algorithm will output when several variable inputs change at the same time.

A coming together of returns over 3 years

Here is what I am working up to:

If you look at current data from Morningstar for 3 year annualised returns from the Vanguard Lifestrategy 20%, 40%, 60% and 80% equity funds, the results for all 4 are within a few basis points of 4.7%.

More recent returns favour the funds with more fixed income (because of the Covid pandemic) and the 3 year average volatility is reported as increasing with the equity exposure.

The interesting point, applicable now and maybe rarely in the future, is that one cannot buy investments and expect that a given asset mix will always deliver a predictable return and perhaps more relevant for portfolio builders, at times the inverse relationship between equites and fixed income assets breaks down.

Over the last 3 years, a wholly unpredictable event has meant that cautious investors have made as much money as adventurous investors.

Knowing what we do about recent events, we might think that is intuitively what should have happened. But it is not what mechanistic risk modelling software tools would have predicted.

Implications

Does that probably rare coming together of fund returns mean we ought to change our portfolio design methodology.? I think not – for me it just confirms that in building portfolios we should be allowing for as many unforeseen possibilities as possible and undertake reviews based on what we actually know at the moment.

So, taking that to its logical conclusion, fixed income investments have recently performed as well as equities for less volatility. That implies central banks are predicting a recession. At current ultra low interest rate levels, it also makes fixed income assets look super expensive.

Bearing in mind that we have drawn this data from passive asset allocated funds with no bias to US tech (where there have been big jumps in equity valuations) , it also suggests that ordinary global equities in general are cheap. That brings us back to my suggestion that looking for value might be a rewarding use of research time.