Volatility a wake-up call for multi-asset
Thomas Nehring, head of Institutional & Wholesale Distribution UK & US at Nordea, comments on the impact of recent volatility and drawdowns on multi-asset funds.
There are many commonalities between the countless diversified multi-asset funds available for investors. The stated aim of most of these solutions is to provide equity-like returns at less than half the volatility of the stock market, while also targeting capital preservation over a three to five-year period. This is normally achieved by broad diversification across different asset classes.
However, while the goals of these strategies can be quite similar, the investment philosophies and processes can vary widely. Ever since the financial crisis, there has largely been no opportunity – with the exception of 2011 – for investors to test the advertised diversification benefits and the differentiators between processes powering the multi-asset funds available in the market. Almost all asset classes have performed positively in unison during recent years.
But this all changed in 2015. Last year saw a turning point in markets, with almost all asset classes witnessing heightened volatility compared to recent history. There were few safe havens on offer for investors. The summer of 2015 in particular was a wake-up call for investors in this space, with philosophies and processes claiming to offer true diversification facing acute stress, leading some multi-asset managers to post significant drawdowns in the harsh market environment. Many diversified funds wilted in the summer heat.
Between July and August, coinciding with the Grexit and China hard landing scares, the Morningstar EAA OE Moderate Allocation sector (GBP) – which houses some of the largest strategies in the multi-asset space – returned -2.3%, which was roughly half the 4.4% decline for the MSCI World. While the universe was able to dampen down losses compared to equity markets, these solutions could not provide the much-needed and often-promised true diversification for capital protection.
This was not an anomalous occurrence. Similarly poor capital preservation characteristics were on display during the highly volatile month of January this year. The Morningstar EAA OE Moderate Allocation sector declined -2.5% in sterling terms, while the MSCI World fell 5.6%.
The universe’s poor downside protection over these volatile periods can be attributed to two main reasons. Firstly, many managers overestimated the potential of asset class diversification. In addition, many managers still make macro calls, which are extremely difficult to do in volatile conditions, and then allocate to assets to reflect these particular views.
But the good news for investors is not all multi-asset solutions are created equal.
We took a decision almost 10 years ago to shift our investment focus away from asset class investing – such as top down or directional/beta investments – to focus on risk/return drivers, or risk premia. One of the primary reasons for this important distinction is that most asset classes include several risk/return drivers exhibiting significantly different characteristics over time, and by separating these we are able to run a much more robust correlation analysis.
For example, by splitting the risk-adjusted return characteristics of investment grade bonds into sub-components – duration and credit spreads – it is possible to see the potential diversification benefits due to the fundamentally different individual return drivers that may have been missed otherwise.
By focusing on carefully selected risk/return drivers that complement each other in recessionary and recovery periods, an investment strategy does not necessarily need to make the correct macroeconomic call in order to achieve a positive total return over time and in different periods of the economic cycles.
Clearly not all multi-asset strategies are the same. If there is a positive to come out of the elevated market volatility we have experienced during the summer of last year and at the beginning of 2016, it is that investors will be forced to take a closer look at the universe to determine what solutions can truly deliver on their much-vaunted promises.