Why clever multi-asset funds ‘keep it simple stupid’
For intermediaries only. Not to be distributed to, or relied on by, customers.
Tim Orton, Managing Director of Investment Solutions at Aegon, discusses how to measure value for money when assessing multi-asset strategies, and explores a few fundamentals that we can learn from the US navy.
Until recently I believed that the term, KISS (Keep It Simple Stupid), was just an overused acronym dreamt up by some clever management consultant in the 1990s, but in actual fact, its origins go back further than that. KISS is a design principle attributed to Lockheed Martin’s Chief Engineer, Kelly Johnson, who told the team working on the SR-71 BlackBird spy plane in the 1960s that whatever they made had to be simple enough for a man in the field to repair with basic mechanics training and tools. It’s a principle that’s been used extensively, and with significant success, in the years since.
This is good practice, in my view, for portfolio builders too. Complexity can add cost, so it should only be added where it offers demonstrable benefits. Complexity also has a tendency to put people off investing altogether. Here I explore a few potential drivers of investment performance and assess which design features have – and crucially those that haven’t – historically added value. But first it’s important to look at why cost is so critical.
Cost - the one input we can control.
Cost can have a significant impact on the eventual pay out for investors. Our example shows that, over 25 years, a £100,000 investment in the FTSE All-World with a charge of 0.25% would have returned over £90,000 more than the same investment with a charge of 0.80%.
With such an impact on the outcome, providers should be able to justify every extra basis point. If it doesn’t have a real prospect of adding value, it shouldn’t be added. The following design strategies are therefore examined on the basis of both cost and value-add.
1. Asset allocation strategy
The philosophy of keeping it simple, doesn’t necessarily mean always opting for the most basic approach. Rather, it means adding complexity only where it adds real value. And one area where we believe value can be added is through active asset allocation, provided the balance is right.
Most multi-asset strategies fall into three categories:
- Static – set split between asset classes, usually based on market cap.
- Strategic – long-term strategic asset allocation with periodic reviews to make adjustments for prevailing market conditions.
- Tactical – frequent asset allocation changes based on near-term factors.
Each of these options is progressively more expensive and complex, with static being the least expensive and tactical necessarily incurring higher transaction and monitoring costs. But which offers investors the best value for money?
Arguably, tactical funds merit higher costs as they can react more quickly to market changes and therefore aim to avoid pitfalls or profit from opportunities that less active portfolios miss. It can, however, be difficult for tactical funds to consistently get these sorts of decisions right, and there are trading costs involved with making frequent changes. In reality, it has been hard for them to perform well relative to cheaper options in recent years.
In contrast, static funds have lower operating costs, but are at the mercy of market cycles. In the example of a market cap approach to static asset allocation, if larger markets fare well then these funds will outperform. But if the tide turns in favour of smaller markets then the strategy isn’t able to adapt and will start to struggle.
A strategic approach aims to strike a balance between tactical and static approaches by focussing on how markets are valued relative to long-term future expectations. So while the asset mix is regularly reviewed, changes are typically only made when there are fundamental shifts in the markets, or when rebalancing is required. We favour this approach as it allows funds to take advantage of market gains while crucially keeping costs low.
2. Stock selection – active or passive?
One longstanding area of debate is whether actively managed portfolios add more value than passive. To examine this, we looked at the risk return profile of funds from the two largest Investment Association (IA) Mixed Investment sectors and compared those using mainly passive components to those using mainly active ones over five years.
We found that those using passive components generally delivered better returns for the level of risk taken. This was partly because active funds found it harder to outperform passive in mature markets like the US and UK.
Of course, these results only give us a snapshot. Performance could vary over different timeframes, or in the future, and some active funds will fare better than others. The strategies looked at will also use a variety of other techniques to add value, which will impact returns.
3. Do complex assets add value?
Another key decision is whether to use more complex assets, like those used by absolute return strategies. These strategies typically use a wide range of alternative investments, such as commodities and derivatives, which tend to be more expensive. They aim to improve diversification, dampening volatility and enhancing returns, but the chart below suggests that this doesn’t always justify the higher risks and costs involved, especially for those with a long-term investment horizon where growth is key. These types of funds are also inevitably harder for clients to understand.
Complexity can put investors off investing altogether
It’s also worth remembering that 57% of UK investors choose not to invest in stocks and shares at all[i], preferring to keep their money in a bank account currently offering near-negative returns in real terms. In many cases the complexity involved in making a decision (there are over 700 multi-asset funds in the UK market alone[ii]) may be a contributing factor. With state provision dwindling and mortality rates rising, this is a toxic situation.
As such, there is a softer benefit in offering investment strategies that can be easily explained to a client, and where they can feel comfortable that they know what to expect.
Keep It Simple Stupid
Today, KISS is used in many engineering professions, but it has a lot to teach anyone whose job it is to build multi-asset portfolios too, namely:
- A product should be as simple as possible – but crucially without compromising functionality.
- You should only add complexity (and therefore cost) where you can demonstrate value.
- If a user can’t understand a product, it will impact their experience and outcome.
Keeping these principles in mind will, in my view, lead to better investment strategy design, and ultimately better outcomes for customers. It’s easy to forget that products are designed for people – pilots, teachers, doctors, dockworkers and yes, the odd management consultant. If we forget that, we risk killing our products before they get off the ground.
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The value of investments can go down as well as up and investors may get back less than the amount invested.
[i] BlackRock Investor Pulse Survey 2019, based on 27,000 respondents over 13 nations in July and August 2018.
[ii] Source: Investment Association Mixed Investment (0-35%, 20-60%, 40-85%), Volatility Managed, and Flexible Investment sectors as at August 2020.