Short-term volatility is nothing to fear

With all three Adviser Fund Indices having significant equity holdings, it was no surprise that last week’s stockmarket falls led to similar drops in the AFIs – but it may not be cause for concern.

Since the inception of the Adviser Fund Indices in November 2004, global equity markets have generally seen a prolonged period of solid growth. However, last week’s market jitters caused a relatively abrupt correction in global share prices, with most major bourses suffering modest losses (see news analysis).

The FTSE 100 index fell by 4% from May 10 to May 15, with other major stockmarkets suffering similar reductions, ranging from a 2.1% drop in the S&P 500 index to a 4.3% fall in the German Dax. Commodity prices were also subject to marked decreases and the value of the dollar fell against the euro, sterling and yen.

The three Adviser Fund Indices all have significant exposure to equities and were not immune to share price falls. On a total return basis, the Aggressive AFI fared worst, with a 4.5% drop in value, while the Balanced index (down 3.2%) and Cautious AFI (down 2.1%) saw smaller losses from May 10 to May 15, according to Financial Express. The equivalent loss for the FTSE All-Share index was 4.2%.

Funds investing in global emerging market equities and those with exposure to commodities suffered the heaviest losses. The Investment Management Association Global Emerging Markets sector average was down 6.5% over the period. Eight funds in the Aggressive AFI are in the IMA Global Emerging Markets sector, and Jupiter Emerging European Opportunities (down 8.8%) and Dimensional Emerging Markets (down 7.5%) saw the biggest losses.

Of those AFI constituents in the IMA Specialist sector, JPMorgan Natural Resources (down 8.3%), Threadneedle Latin America (down 7.4%) and Merrill Lynch Gold & General (down 7.1%) fared poorly.

To date, the aggregate asset allocation decisions of the 18 panellists have generally been successful, with the three AFIs outperforming both their respective Association of Private Client Investment Managers and Stockbrokers indices and IMA Managed sector averages.

However, the recent reversal in fortunes of global equity markets has hurt the three AFIs more than their equivalent Apcims and IMA Managed benchmarks. For example, the Apcims Growth index (down 3.5%) and average IMA Active Managed sector fund (down 2.7%) were more resilient than the Aggressive AFI (down 4.5%).

This relative underperformance from the AFIs also occurred on the two previous occasions since November 2004 when share prices saw modest corrections.

The first minor setback in markets took place in April 2005, with the FTSE All-Share index falling 4%, in total return terms, between April 4 and April 29. The Aggressive AFI dropped 4.7%, while the average IMA Active Managed fund fell 3.8% and the Apcims Growth index was down 3.3%. The Balanced AFI (down 3.6%) and Cautious AFI (down 2.1%) also performed worse than their respective IMA Managed sectors and Apcims indices.

October 2005 saw the second retrenchment in share prices, with the FTSE All-Share index dropping 6.4% and the Aggressive, Balanced and Cautious AFIs down 5.8%, 4.6% and 3.3%, respectively. Again the pattern was the same, with the AFIs suffering more than the IMA Managed and Apcims benchmarks, with the exception of the Cautious AFI (down 3.3%), slightly outperforming the Apcims Income index (down 3.4%).

The relative fluctuations of the three AFIs have behaved in line with expectations, with the riskiest Aggressive index exhibiting the most volatility and the Cautious AFI producing more stable returns. While the three AFIs have to date outperformed their respective Apcims and IMA Managed benchmarks, they have all done so with greater volatility, with the exception of the Balanced AFI, which has a smaller annualised volatility than the IMA Balanced Managed sector (see table).

The overweight position of all three AFIs to global emerging markets and the tendency for the panellists to pick actively managed funds that do not hug benchmarks may have contributed to this increased level of volatility.

Jake Moeller, investment services manager at Towry Law, says: “There were no changes made to our strategy on the back of the market corrections. We anticipated this sort of correction and have factored it into our underlying asset allocation models.

“Overall, we have not done too badly. We have chosen some high alpha funds that have not performed well during the correction, but a week’s worth of volatility is par for the course for an aggressive portfolio, and growth investors should respect that volatility is Total AnnualisedIndexreturn (%) volatility (%)driving returns.”

If markets continue to go through a significant correction, the AFIs may not be positioned well to cope with such a downturn. It should, however, be noted that abrupt changes in equity market performance over such short-term periods may not be indicative of any long-term trend. In addition, the relatively high levels of volatility of the AFIs may not persist in future.

However, if the long-term asset allocation positions of the AFIs prove to produce superior returns, then higher short-term fluctuations should theoretically not be a concern. While the makeup of the AFIs changed significantly at the May 1 rebalancing, the underlying asset allocations of the three indices were broadly unchanged. The risk-adjusted performance figures for the AFIs to date may not make such good reading.

The Adviser Fund Index Series – A Summary
The Adviser Fund Index series comprises an Aggressive, Balanced and Cautious index each tracking the performance of portfolio recommendations from a panel of 18 investment advisers. For each risk profile, all panellists specify a weighted portfolio of up to 10 funds from the authorised UK unit trust and Oeic universe that, when aggregated, define the constituents and weightings of the three AFIs (see