Financial advisers who rely on passive multi-asset funds for their clients' portfolios may be exposing them to unnecessary risks, according to Premier Miton’s David Jane.
Passive multi-asset funds have become an increasingly popular option over the past decade, thanks to their low fees, easy-to-understand approach and strong performance.
There are several passive multi-asset ranges with the best-known being Vanguard LifeStrategy. BlackRock, Legal & General Investment Management, abrdn and HSBC Global Asset Management are some of the other fund houses with offerings in this space.
A look at the IA Mixed Investment 40-85% Shares sector – which is the fourth biggest in the Investment Association universe – highlights the popularity of the passive approach: around one-quarter of the money in this peer group is split between just two funds – the £13.6bn Vanguard LifeStrategy 60% Equity and £9.4bn Vanguard LifeStrategy 80% Equity funds.
However, Jane – a member of Premier Miton’s macro thematic multi-asset team and co-manager of funds such as Premier Miton Cautious Multi Asset – warned that advisers building their portfolios around indexed multi-asset funds may be taking on unexpected risks.
Firstly, he highlighted that some passive multi-asset funds follow a fixed allocation to different asset classes based on a benchmark index or a risk profile.
But this means the adviser is effectively making an active decision to stick with the same allocation regardless of the market conditions or the client’s objectives.
“With active managers, the fund manager decides the appropriate asset allocation for the risk profile,” Jane said. “With a passive [strategy] it is the IFA who has decided the asset allocation by selecting the index fund, although he may believe he has delegated it to the index manager.”
He pointed to the example of the IA Mixed Investment 0-35% Shares sector, where passive multi-asset funds have significantly underperformed their active peers in recent years.
This is down to the weak performance of bonds; IA Mixed Investment 0-35% Shares funds tend to have a bias to bonds given the 35% cap on stocks. Active funds were able to move away from long-duration bonds as rising interest rates upended the investment environment, while passive multi-asset funds were unable to do this.
“So, indexation in the mixed-asset space is not a low-risk approach, as is widely believed, it simply shifts the asset allocation risk from the fund manager to the adviser, hence the lower fees,” Jane argued.
The second risk flagged by the Premier Miton manager is that the passive multi-asset approach assumes asset classes will revert to their historical averages over time and therefore periodically rebalance their portfolios to maintain target weights.
However, this can be detrimental if the asset classes enter a persistent trend and this reversion does not take place, as it would mean persistently buying more of falling assets and selling more rising assets.
Jane cited the example of the tech bubble in the early 2000s, when he witnessed one of his colleagues lose 20% of his clients' money by repeatedly buying more Enron shares as they fell to keep his target weight of 8% in the doomed company.
He argued that a similar – but not as extreme – situation could happen to passive multi-asset funds as they continue to buy bonds to maintain their target allocations.
“This is the situation index managers face in asset allocation space: if markets mean revert, they will do fine. If they trend, they will be destroying value. Evidence suggests that trends can persist for long periods of time,” the manager said.
“Our view is that we are in an inflationary period where bonds will trend lower over time. This is being proven right as time goes on.
“Many index funds are buying bonds every month as they fall in order to bring their weights back to target. Simply doing nothing would have been a better plan.”