Ghosts of 2008 hang over panellists

Uncertainty over the global economic recovery stalling and the possibility of more quantitative easing could see the panellists continue to take a defensive stance at the next rebalancing.

With the November rebalancing only a week away Adviser Fund Index (AFI) panellists are looking to the future.

It is interesting, however, to spend a portion of this contemplative period looking at the recent past to see how the decisions made at the last rebalancing have impacted the performance of the benchmark AFI portfolios.

In the six months between the November 2009 rebalancing and May this year, the divergence between the returns of the Aggressive and Cautious indices was 5.5%. This reflected the sustained rally in equity markets that benefited the traditionally equity heavy Aggressive index, while causing the more defensive Cautious index to lag.

Looking at the rebalancing in May, it could be expected that if this rally were to continue the Aggressive index should have continued to outperform over 2010, or if volatility unwound investors’ risk appetites the reverse could have happened. (article continues below)

What is remarkable about the last six months of the indices performances is the correlation between them. The divergence between the Aggressive and Cautious indices has shrunk from 5.5% to 0.44% from May 1 to October 19. The Balanced index sits almost perfectly between the two returning 0.22% less than the Aggressive portfolio and 0.22% above the Cautious.

So what has been driving this correlation of returns? James Davies, the head of fund research at Chartwell Investment Management and AFI panellist, says there could be several explanations. “We’ve noticed a similar trend in our own portfolios in recent months,” he says. “It’s partly the product of fluke when you pick arbitrary valuation points. When you’re in a market that is rewarding different asset classes at different times there are bound to be points of cross-over.”

The performance graphs suggest this is a factor in what has been happening. Up until July, the Aggressive index appeared to be struggling, falling over 8% from May, while the Cautious index had fallen less than 5% over the same period. This spread, however, began shrinking from this point suggesting that equity markets had begun to outperform.

Were this a complete explanation, the Aggressive index should have continued its speedy recovery and easily outpaced the Balanced and Cautious portfolios, but instead after regaining lost ground in early September it has subsequently lost pace.

Ben Willis, the head of research at Whitechurch Securities, says another possible factor was the growing caution present at the last rebalancing that meant some panellists chose to move wholesale down the risk spectrum.

“Looking at the last rebalancing there was an element of moving more defensive across our portfolios,” he says. “We added an absolute return fund to our Aggressive portfolio because we felt it should help limit some of the downside.”

By adding defensive positions to a traditionally riskier portfolio panellists reflected their concerns over the resilience of the rally that had carried them into 2010. While funds like absolute return products can help to dampen some of the downside, they can also limit the upside gains helping perhaps to explain some of the recent performance.

This is not to say that signs of an equity market recovery will drive the panellists back up the risk scale in November’s rebalancing. There are still uncertainties over the global economic recovery stalling and the possible effects of another round of quantitative easing suggested by the Federal Reserve.

“Many people have been defensive and are hugging a defensive benchmark,” says Davies. “The ghost of 2008 looms large over portfolio construction, but I think we’re approaching an inflection point. Which way that will go will depend on the outcome of the inflation/deflation debate.”

The problem with this debate is that it ignores the purpose of having segregated mandates in the AFI. The reason why there are Aggressive, Balanced and Cautious portfolios is, in part, to see how these differently constructed funds perform under various market conditions.

If panellists are trying to reflect the pessimism on particular markets in the Aggressive portfolio, they have a wealth of global equity products in which to invest. Judging by the recent performance of the index it appears that some panellists have brought in products for the purpose of defending past performance without paying attention to the mandate.

“We feel it would be disingenuous to change the mandate of the portfolio to suit short-term sentiment,” Willis says. “The move into the absolute return fund was a small measure and we’re looking to exit it at the next rebalancing.”

Despite these worries, all of the AFI panellists’ indices beat their Investment Management Association (IMA) sector benchmarks since the last rebalancing. The AFI Aggressive index returned 4.23% against an IMA Active Managed sector average of 1.84%, the AFI Balanced index beat the IMA Balanced Managed sector average by 1.06% and the AFI Cautious outperfor­med its benchmark by 1.14%.

The figures appear to show that, even in a period of high volatility in markets, value can still be gained through manager selection. The fact the IMA Active Managed sector was the worst performing IMA benchmark sector, while the AFI Aggressive index outperformed its peers, suggests that if it was caution that drove panellists at the last rebalancing, their instincts may well have been right.