Portfolio Adviser • Portfolio Adviser February 2019 v2 • Fund Trends

Risk-targeted funds are growing in popularity among investors who covet volatility over return but as each fund in the IA Volatility Managed sector interprets risk objectives differently, be aware that no two funds are the same

Fifty-six per cent of advisers use risk-targeted funds, comprising one-third of their assets under management, according to research by Invesco in September 2018. Given the large number of advisers who use these type of funds, it is surprising that the IA Volatility Managed sector was only launched in April ’17.

At launch, the sector held 83 funds with a combined AUM of £19.3bn. Seventeen months later, to the end of November 2018, the sector comprised 124 different funds and the AUM had grown to £28.6bn, according to the Investment Association.

However, a large number of fund ranges managed by firms such as Architas, Premier and SEI remain outside this sector, with most placed in IA Mixed Investment. As a result, the actual AUM of risk-targeted funds is much bigger, in excess of £50bn.

The five Aberdeen Standard Investments MyFolio ranges, Managed, Managed Income, Market, Multi Manager and Multi Manager Income, comprise 25 funds and represent nearly half of the total IA Volatility Managed sector with around £13.8bn under management (see chart 1).

Instead of having a specific return objective, the funds in the sector target a volatility range over the longer term. Therefore, it is completely feasible that a fund may have performed poorly but can still meet its primary objective by remaining within its specified volatility parameters.

A big criticism of the sector is that it contains different funds with differing volatility objectives. But even though its median performance is meaningless it’s a good starting place for investors wishing to find funds that target volatility instead of return.

A common misconception about these funds is that they will protect investors’ capital during market turbulence as they have a volatility objective. This is incorrect and we would expect many funds to lose ground during difficult economic conditions.

The majority of the highest-risk funds target a volatility that is similar to global equities, meaning they should perform in line with that asset class over the long term.

IA Volatility Managed consists primarily of funds ranging from low to high risk but with a similar investment approach. One of the problems with this is that each range will determine risk differently depending on the long-term market assumptions driving the respective asset allocation.

Therefore, while two funds may have almost identical absolute volatility targets, how ‘fund A’ determines what a volatility of 10% means could be completely different to how ‘fund B’ does.

This is evident when comparing the HSBC Global Strategy Balanced Portfolio against the Cornelian Managed Growth Fund, which is also expected to be a balanced portfolio. The HSBC fund has a longterm volatility target of 9.5% per annum, while the Cornelian fund targets a volatility of 8.4-10.5% per annum. You would expect both funds to have broadly similar asset allocation and short-term volatility.

Interestingly, during the past five years to 31 December 2018, the HSBC fund had a volatility of 7.2% per annum while Cornelian’s was 5.9% over the same period, according to FE Analytics. The HSBC fund also has a larger allocation to riskier assets, with 65% in equities, while only about 50% of the Cornelian fund is held in equities.

Overall, investors should be aware that just because two funds have similar targets, their volatilities may not be the same over the short and medium term.

The IA Volatility Managed sector consists of many funds with extremely different objectives. Generally, the only similarity between them is that they manage returns within a specified volatility parameter.

The aim of some funds is to preserve investors’ capital, while others target a similar volatility and return to global equities. Simply looking at the sector’s return and determining a fund’s quartile ranking is futile and would be more of an assessment of market conditions than fund performance.

Since the global financial crisis (GFC), volatility in markets has been subdued though it has increased during the past six months. During the past five years to 31 December 2018, the MSCI World had a volatility of 9.8% per annum in sterling terms.

Compare this with the previous 15 years (31 December 1998 - 31 December 2013), when the volatility of the index was 15.3% per annum, according to FE Analytics.

Due to market conditions since the GFC, the majority of funds in the sector have not provided volatility anywhere near their long-term target. We are not disappointed in the performance of these funds and believe most have been investing in a prudent way.

The HSBC Global Strategy Balanced Portfolio has a long-term volatility target of 9.5%. If it had achieved this over the past five years it would have been fully invested in global equities, which is not what investors would expect from a balanced portfolio.

Most funds in the sector have long-term volatility targets of 10-15 years, occasionally longer, to take account of periods of above- or below-average volatility. Assessing whether a fund has hit its volatility target over a five-year period is not that useful.

Over shorter-term periods, comparing a fund’s volatility relative to the equity markets is a more productive exercise. For every risk-targeted fund recommended by Square Mile, we state its long-term volatility objective and estimate the expected volatility relative to UK equities. We believe this is a better measure for UK retail investors.

For example, the SEI Balanced Sterling Wealth Fund targets an expected annualised volatility of close to 15% over the long term. However, we believe in practice it will deliver a level of volatility similar to 65-85% of UK equities.

Chart 2 reveals how the fund has remained broadly within its UK equity bands, even though its volatility has been considerably below its long-term target set at 15%. This means it has been delivering in line with our expectations.

Fund ranges within the IA Volatility Managed sector can be classified under three headings: passive funds; fettered fund of funds, invested in internally managed active funds; and unfettered fund of funds, invested in externally managed active funds.

The L&G Multi Index invests predominantly in passive funds managed by the wider group but it is not purely passive in nature.

All five funds within the range benefit from L&G’s proprietary tools and assumptions, and these help build the long-term asset allocation that is used as a starting point for portfolio construction.

Justin Onuekwusi, the lead fund manager, and the asset allocation team then make tactical short-term adjustments of one to five years to the long-term asset allocation in order to build the final five portfolios. As a result, even though the funds may invest in passive funds, the final portfolio is certainly not passively managed.

One of the fettered fund of funds ranges we like is the Aberdeen Standard Investments MyFolio Managed offering, which consists of five funds all managed by Bambos Hambi and his team. This is the largest fund range in the sector by AUM.

The range will predominantly invest in Aberdeen Standard Investment funds, which limits the investible universe for Hambi. However, we believe the breadth of funds available is large enough to build suitably diverse portfolios.

Given the use of internal funds, this fund range will typically be 40-50 basis points cheaper than a fund range that uses external active funds. And one of the reasons we like this range is the breadth of funds that Hambi can invest in, made possible by the size and scale of the Aberdeen Standard Investment business. This type of fund structure may not be suitable if it is managed by a smaller asset manager with a limited number of funds.

The final type of fund range available to investors is one that predominantly invests in active funds. The Premier Liberation range follows this approach and consists of four risk-targeted funds. The starting point for each is the long-term asset allocation determined by distribution technology.

The team responsible for the funds, led by the experienced David Hambidge, will then look to add value through both tactical asset allocation as well as fund selection.

They invest across a broad range of asset classes and vehicles, including both openand closed-ended companies. This gives the team the widest universe of funds to select from and provides them with the best alpha opportunities compared with other funds in the sector. This type of approach is the most expensive in the sector, however, meaning the team must generate more alpha to provide the same net returns as their peers.

Over the long term, we would expect the Premier Liberation range to outperform Aberdeen Standard Investment MyFolio Managed, which in turn we would expect to outperform the L&G Multi Index range, due to the greater alpha opportunities available to each manager.

However, since the L&G Multi Index range was launched in August 2013, this has not been the case. The L&G and Premier ranges have provided broadly similar risk and return outcomes, and this trend has been reflected across the sector.

The reason is that passive funds have largely outperformed active funds in UK equities as mid-cap bias active funds have been hurt by the Brexit fallout, even though alpha has been generated through international equities in the unfettered approach.

Additionally, the majority of fixed income managers have underperformed their benchmarks as they have been surprised by the prolonged low-yield environment.

One of the reasons why the Aberdeen Standard Investments MyFolio Managed range has a lower risk and return profile than its peers is due to the structure of the funds. All five have a 10-20% allocation to absolute return strategies.

Returns from many absolute return funds have been disappointing in recent times, particularly when compared with equities (see charts 3 and 4).

The IA Volatility Managed sector was only launched in April 2017 and there are still adjustments needed to make it more useful for investors. While it is a good starting point for investors looking for risk-targeted funds, the sheer range of volatility objectives leads to limitations.

In future we would like to see sub-sectors created so that a better comparison can be made for low-, medium- and high-risk funds. This would be a difficult task, however.

It is feasible that sub-sectors could be based on a fund’s historical volatility, its risk rating from an external provider or longterm volatility expectations relative to UK or global equities.

None of these suggestions may provide the perfect solution for every fund range or investor but it would provide some progress from the current arrangement.

A current trend within this sector and others is pressure on fund groups to reduce their fees. During the past 12-18 months, both Aberdeen Standard Life Investments and Architas have cut their fees by 20 basis points or more. This will adversely affect their revenue but it also means they should remain competitive.

BMO recently launched three risk-targeted funds that utilise internal active funds and all have an ongoing charges figure (OCF) of under 30 basis points. This move means all funds within the IA Volatility Managed sector, and especially active funds with high OCFs, are under mounting pressure to justify their fees.

If they are unable to do so, they will either have to reduce them or face the prospect of investors going elsewhere.