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Is asset allocation the key to returns?

Asset allocation is a major driver of returns, but sometimes picking a good fund will earn you even more
August 24, 2017

A crucial consideration for investors constructing portfolios is whether their overall asset allocation or individual investments contribute more to their returns. With the increasing availability of passive funds that track broad indices it is possible to construct a portfolio with broad asset, regional and sectoral exposures, rather than pitting your luck on a small selection of individual securities such as shares or funds.  

This question is proving to be a particular dilemma for one Investors Chronicle reader, who asks: "My independent financial adviser (IFA) is a great advocate of asset allocation and suggests that this factor – and not the selection of individual funds – will drive the bulk of my returns. Is this the case? And if it is should I just put together a passive portfolio of exchange traded funds (ETFs)?”

Asset allocation is about working out how much risk you can take on, and what balance of bonds, equities and other assets will best achieve that risk. And it helps you define a long-term strategic plan from which you might make shorter-term moves.

Although for some investors much of the excitement of investing comes from stockpicking, research has shown that asset allocation, rather than the selection of individual securities such as shares or funds, is the primary driver of portfolio performance.

>The right asset allocation could mean the difference between your portfolio rising 10 per cent and one with a different allocation falling 10 per cent

Many studies on this question have been published, and notable examples include 'Determinants of Portfolio Performance' in 1986 by Gary Brinson, Randolph Hood and Gilbert Beebower and 'Does Asset Allocation Policy Explain 40, 90 or 100 per cent of performance', in 2000 by Roger Ibbotson and Paul Kaplan. The former found that choosing stocks and funds and market timing played a minor role in influencing a portfolio's total return and volatility over time compared with asset allocation. Ibbotson and Kaplan also found that asset allocation was responsible for about 90 per cent of the variability of a fund's returns over time, although the explanation for the differences between funds and their performance was less clear cut.

"There is a lot of research to say that asset allocation is the prime driver of portfolios and responsible for 90 per cent of the variation in returns," says Ben Kumar, investment manager at Seven Investment Management. "And the other 10 per cent is down to fund selection. The idea is that even if you pick the best active managers, if you are in the wrong area you will not earn the same returns as someone who was invested in a better performing market or asset class."

For example, in 2016 the US market outperformed the European stock market significantly and most European active funds did not return as much as a US passive fund. In 2016 MSCI Europe returned 18.8 per cent cent in sterling terms, compared with 32.7 per cent for the S&P 500 index, and the only active fund in the Investment Association (IA) Europe ex UK sector that beat this was Marlborough European Multi-Cap (GB00B90VHJ34) with a return of 34.4 per cent.

 

When active can do better

Asset allocation is responsible for a large chunk of investment returns, but it does not account for all of them. And over time you are unlikely to earn as much in the best-performing passive fund in a given asset class as the best-performing active fund in that area. The right asset allocation could mean the difference between your portfolio rising 10 per cent and one with a different allocation falling 10 per cent. But to get the best possible returns you are likely to need a mixture of active and passive funds.

"The bulk of return might come from asset allocation, but don't confuse the majority of return with the entirety of return," says Ben Seager-Scott, chief investment strategist at Tilney Group. "You need to think about adding layers of value at every stage of your portfolio. After you have decided on the right asset allocation model [for you] you need to work out which are the best [shares and funds] to put that model into action."

Rob Morgan, pensions and investments analyst at Charles Stanley, adds: "You can't solve all questions through asset allocation. Your asset allocation model will be a product of how much risk you are willing to take for potential returns. But when you are putting together your portfolio, you need to ask how to maximise your returns from each of the asset classes you have chosen, and that may mean going passive or it may mean going active." 

Even if active funds only add a small increment of extra performance over the short term, over the long term those increments could make a big difference to your returns. 

"If you take the FTSE 100 over the past 15 years, the annualised total return has been 7.5 per cent, which is not an unreasonable return to expect over the long term, with highs and lows along the way," says Mr Seager-Scott. "But it is reasonable to expect that a good active fund manager could add another 2.5 per cent on top of that on an annualised basis. So assuming that is correct, you are taking 7.5 per cent annualised returns from asset allocation and 2.5 per cent from stock selection. That doesn't sound like a lot, but over time small differences compound."

For example, if you had invested £100,000 in the FTSE 100 15 years ago, forgoing any costs you would now have £295,000. If you had invested with an active manager who'd given you 2.5 per cent of alpha on top of that, you would have earned £418,000 over the same period.

"So on an annualised basis, although the majority of your returns are coming from the market, small additional pockets of added value dramatically scale up the returns you earn over time," explains Mr Seager-Scott.

£400 split between the top-performing active open-ended funds over five years within the IA Global, UK All Companies, Global Emerging Markets and UK Gilts sectors would have generated almost £300 more over five years than the same amount invested in a sample of five ETFs in those areas over the same time period, according to FE Trustnet data.

However, active funds do not always outperform, for example when the style of an active fund manager falls out of favour, and they tend to be more expensive. For example, in 2016 when the S&P 500 index returned 32.7 per cent, only 48 out of 116 IA North America sector funds beat this.

 

When to go active and when to go passive

The best option is likely to be a mixture of active and passive funds, as active managers have a better chance of outperforming in some markets than others.

Mr Kumar says: "The first decision to get right is knowing which asset classes or regions of the world you like or don't like, and after that you need to decide what kind of fund you want to use. Consider whether there are any active managers who stand a good chance of adding significant value – generally the riskier an asset class is, the more potential there is for an active manager to outperform."

Under-researched, high-risk or less liquid areas offer the greatest potential for active fund managers to outperform the indices that cover them. So, for example, emerging market small-cap stocks, which are covered by fewer analysts and less well-known, offer the potential for active managers to glean an edge on their competitors through knowledge and research.

BlackRock Frontiers Investment Trust (BRFI), meanwhile, which invests in stocks from frontier markets such as Argentina, Romania and Kuwait, has made a net asset value (NAV) return of 118 per cent over five years, in contrast to 88 per cent for MSCI Frontier Markets index, according to Winterflood data. The trust's manager, Sam Vecht, has proved he can generate market-beating returns in under-researched markets. 

"The places where active managers tend to be able to add value are places where not many analysts and investors are looking," says Mr Kumar. "You need an edge, so areas such as emerging markets, which are less well observed and efficient than developed markets, are a good place to opt for active management." 

Mr Seager-Scott adds: "It is very difficult for active fund managers to add value in areas such as gilts, treasuries or mega-cap stocks in the UK or US."

The first thing you need to consider after deciding on your asset allocation is whether an active fund is going to be better than an equivalent passive fund in a certain area. "If I do not have high enough conviction in a particular asset class or sector then my default position is to go for a passive fund to minimise cost," says Mr Morgan. "But in a lot of cases, and certainly in more specialist areas, there is a good case for active management. With passive funds you are getting the good, the bad and the ugly and I would hope that over time an active manager would give me more exposure to the good than the bad and ugly."

There are also areas where you might increase your risk by opting for a passive fund, for example a highly valued market where large stocks account for an increasingly large proportion of an index, such as US equities. Although ETFs tracking the main US benchmarks have earned high returns over the past 10 years, it could be time to shift some of your US allocation into value-orientated, lower-cost stocks.

One approach to building a mixed active and passive portfolio is to select a range of active fund managers to invest with for the long term, and use passive funds as short and medium-term positions. You should generally not invest with an active manager for less than five years as they may experience periods of underperformance or have long-term investment strategies. However ETFs can be useful to make the most of shorter-term market shifts, such as the performance of cyclical banking stocks.

One example of this would be to opt for a value-focused US equity fund such as UBS ETF MSCI USA Value UCITS ETF (UC07). Seven Investment Management is currently using a passive value strategy in the US for its clients' portfolios, and is not using any active managers in that region.

 

Total cash returns from ETF-only portfolio (on £400 invested)

AssetFund1-yr total return (on £100 lump sum) 3-yr total return (on £100 lump sum) 5-yr total return (on £100 lump sum) 
Global equitiesVanguard FTSE All World UCITS ETF (VUKE) 115.8153.6196.3
UK equities iShares Core FTSE 100 UCITs ETF (ISF) 112.7124.3151.4
Emerging market equities iShares MSCI Emerging Markets 119.9135.1143.8
UK gilts iShares UK Gilts 0-5yr UCITS ETF 99.9105.1105.2
Total 448.2518.2596.7

Source: FE Trustnet, as at 18.08.17

 

Total cash returns from active fund-only portfolio (best performing funds over five years - £400 invested)

SectorFund1yr total return (on £100 lump sum) 3yr total return (on £100 lump sum) 5yr total return (on £100 lump sum) 
IA Global Fundsmith Equity 118.7202.0269.3
IA UK All Companies Old Mutual UK Dynamic 137.3184.1287.7
IA Emerging Markets Hermes Global Emerging Markets 129.2166.8199.7
IA UK Gilts Aberdeen Sterling long dated government bond94.3135.4142.8
Total 479.4688.3899.4

 

Source: FE Trustnet, as at 18.08.17