Multi-asset managers have faced extraordinary market conditions this year, but the challenges go further than that. We are witnessing far-reaching structural changes in the financial markets. Forces that defined the investment world for a generation are now fading out, or becoming less predictable.
The Baby Boomers, for example, are aging. The 30-year downward trend in developed-market interest rates, and the era of low inflation, is coming to an end. Meanwhile, quantitative easing (QE) – that phenomenal rising tide that caused all boats to float over the past decade – is giving way to quantitative tightening (QT).
Opportunities are still out there, but the demands on multi-asset managers are becoming greater, and we are entering a less forgiving era where it’s going to be a case of “adapt or die”.
Investors will need to ask their managers tougher questions about how they are meeting the challenges of structural change.
Asking the right questions
If Fund A is allowed to hold a maximum of 40% in equities and Fund B has a maximum of 50%, which will protect clients better in a market selloff? The answer is that we don’t have enough information to say.
A better question to ask is how flexible the managers are in moving around their permitted ranges. For example, if Manager A is not very dynamic and hovers around the 30% mark, they may be exposing clients to too much risk during market crises and not enough in bull markets.
In the past 12 months, where we saw extremes of bull and bear conditions, the degree of flexibility afforded to a manager would have been a highly relevant criterion to look at.
Is your multi-asset fund a bond fund in disguise?
Government bonds have been a powerful part of multi-asset managers’ toolkit for many decades, acting as a reliable diversifier and safe haven.
After the 2008/09 Global Financial Crisis, quantitative easing brought a flood of liquidity, and the artificial support of central bank buying of investment-grade bonds. At times of market stress, the simple tactic of dialling down equity exposure and increasing bond weightings frequently worked.
How many poor asset allocation decisions have been masked by the success of the long duration trade (which benefits from falling interest rates) over the past decade? For that matter, how many of the successful multi-asset funds of recent years are actually bond strategies in disguise? We may be about to find out.
How top-down is your manager?
Going forward, investors will need to ask their managers tougher questions about how much analysis they are doing within and across asset classes, as opposed to just between asset classes. We are entering a world where the value added by portfolio managers is not just about getting the “bonds vs. equities” decision right. The asset class-level decision will always be important, but success increasingly depends on allocation within and across asset class buckets.
The broad toolkit of a global multi-sector investment universe gives managers multiple ways to express their top-down views by exploiting relative value opportunities. For example, looking ahead to a potential inflation – or indeed stagflation – scenario, relative value positioning within asset classes has a valuable role to play. In fixed income, for example, this could mean exploiting instances where countries are at different stages in their monetary cycles. In equities, for example, relative value positioning can pinpoint companies that are best able to defend their profit margins, playing them off against those that are most vulnerable.
What is the “sell discipline”?
Behavioural theory tells us that humans show a bias towards selling winners too early and holding on to losers for too long. And professional fund managers are only human. Acres of shelf space have been filled with books on how to get into the market at the right time, but much less about the optimal time to get out. But this can make a very significant difference. Managers can have a stellar hit rate (i.e. percentage of correct calls) but still make no money if they don’t have a rigorous system for when to take profits or close out a losing trade. For reasons we’ve discussed, tomorrow’s markets may be less forgiving of mistakes, so risk controls like these will be more crucial than ever.
Adapt or die?
Under the new rules of the game, what survival characteristics will single out the successful managers from the laggards? One key, as I’ve argued, is flexibility; when none of the safe havens are working and there’s nowhere to hide, the best defence is to be agile. Second, successful managers will need the resources and the willingness to do the hard work of sifting through the whole available opportunity set, extracting the multiple smaller pockets of value within asset classes. The environment we face is in many ways more challenging and volatility may be higher, but this means the opportunities for active managers to outperform are potentially greater.