Behind the Numbers: Evaluating outcome-orientated funds

UK multi-asset funds have seen growing inflows relative to other categories in recent years. This may be due to their popularity with individuals and advisers who want to hand over most investment decisions to a manager. Important changes in the UK have supported this growth in multi-asset funds based on their suitability as complete investment solutions, including the Retail Distribution Review and the increased choice given to individuals at retirement.

The RDR helps ensure only investments that are suitable are recommended, taking account of clients’ circumstances. As a result advisers have to spend more time understanding their clients’ needs and objectives, which leaves less time for investment management. The emphasis on client objectives has therefore driven growth in multi-asset funds that are managed to pre-defined targets and have been labelled “outcome orientated”. This is in contrast with traditional multi-asset funds that are defined by the structure of their portfolios. So we have considered whether outcome-orientated funds require a different evaluation approach. Our key findings are:

  • The underlying portfolios of most outcome-orientated funds are similar to those of traditional multi-asset funds
  • Most outcome-orientated funds meet their pre-defined objectives. However, risk adjusted performance is very similar to traditional multi-asset funds, and both groups typically underperform representative indices over the long term
  • Since portfolio positioning and risk ad- justed return profiles of outcome orientated multi-asset funds are similar to their traditional peers we don’t think they need to be categorised separately.

Traditional versus outcome-orientated

There is at least as much variation among outcome-orientated multi-asset funds as there is across their traditional counterparts, but the different objectives broadly fall under the three headings of target return, target risk and target income.

Target return funds

Target return funds generally aim to provide a cash or inflation plus rate of return over a pre-defined period. Rates of cash or CPI +4-5 per cent are typical, and have been set by investment managers as an “equity-like” target return, pointing to historical studies of average risk premiums over cash and real rates return over several decades of time. They typically aim to achieve this with lower risk than equities, often indicating an upper limit for volatility.

Managers should be accountable, in the first instance, for delivering on the stated return target. However, we should also consider whether the investment objective has given investors any more than they could have got from similar funds. That is an important question to ask because the portfolios of most target return multi-asset funds (as distinct from the more complex multi-strategy funds) look similar to traditional flexible and moderate allocation multi-asset funds. Investment managers typically express their return targets over three or five-year rolling periods or the medium/long-term.

Performance statistics for target return funds that have at least five years’ history are not that different from traditional funds, particularly when adjusted for volatility differences. They have an average Sharpe ratio that is slightly lower than the traditional category averages, but not significantly different. As with traditional multi-asset categories, target return funds underperform representative composite indices. However, the majority of target return funds have met their objectives.

Risk-targeted funds

Risk-targeted funds are managed to a risk target (typically a volatility band), re-positioning the portfolio as required. So if a fund starts to breach the upper band the manager may have to sell “risky” assets and either hold more cash or reinvest in “safer” assets. This is in contrast with traditional multi-asset funds that are managed within asset allocation boundaries defined by the peer group and aim to outperform other funds in the same group or a representative blended index. Risk targeting should also be distinguished from risk ratings. The latter are applied externally by a ratings agency, and can be given to both risk-targeted and traditional multi-asset funds.

Risk-targeted multi-asset funds are normally launched as fund ranges with volatility bands that run consecutively from low to high, typically without gaps or overlap.

Management within a risk bank is influenced by how volatility is measured. Measurement can be based on actual historic returns or predicted volatility from a portfolio allocation model. In the former case, the length of the interval readings and period of measurement matter. Lengthening the period of measurement and using weekly or even monthly intervals instead of daily reduces sensitivity to what is actually happening in the market.

Although investors may feel misled by a volatility calculation that is insensitive to market conditions, they may be served better in the long run because re-positioning the portfolio away from higher risk assets during a period of market stress and reinvesting in “safer” assets or accumulating cash will generally be at the expense of long term returns.

Whatever the effect on manager re-positioning of the measurement approach, the underlying portfolios of risk-targeted funds do not look very different from those of traditional funds at any given moment in time.

How have risk-targeted funds done so far? Take a look at three-year returns (to end September 2016), standard deviations and Sharpe ratios of the main mid-range risk targeted funds versus the Morningstar GBP Moderate Allocation category average and a composite 50:50 equities and bonds index.

The average mid-range risk-targeted fund has delivered better three-year annualised returns than the GBP Moderate Allocation category average, and all except two have better volatility adjusted returns. However, differences in the latter are not significant, and the performance histories of risk-targeted funds are relatively short. On the other hand, annualised returns, and Sharpe ratios, are consistently lower than the 50:50 global equities-GBP aggregate bonds index, in common with other actively managed multi-asset funds.

Multi-asset income funds

Multi-asset income funds should have an important role following the increased choice given to individuals at retirement over their pension investments. The greater need for capital and income stability in retirement adds to the appeal of multi-asset income funds, which are less volatile than single asset categories such as equity income and high yield bond funds. Of course, investors could create their own income by regular top-slice selling, but it’s more convenient for them to receive a regular payout. However, is there a price for this convenience? To answer this, we have looked at whether any return is given up by pursuing income versus a total return approach.

Consider a comparison of those multi-asset income funds’ portfolio allocations and then their performance compared with the broader Morningstar GBP Moderate Allocation category.

The broad asset allocation positioning of multi-asset income funds is very similar to the Morningstar GBP Moderate Allocation category, reflecting the broadly similar approach other than they typically have higher allocations to sub-asset classes such as equity income and high yield. Performance of the average multi-asset income fund is marginally stronger than the GBP Moderate Allocation category, but not on a risk-adjusted basis.

Randal Goldsmith is a manager research analyst at Morningstar