In this article I take us a step further and show how to choose a multi-asset fund, explain the importance of asset allocation, and look at why some multi-asset funds are particularly useful in retirement.
Who should consider multi-asset funds?
Broadly, multi-asset funds are best suited to investors, or advisers, who are looking for a single-fund solution for their own, or their clients’ savings. For whatever reason, they may prefer to have a fund manager decide how to spread their investments across different asset classes, rather than make that decision themselves.
"It’s essential to assess your risk tolerance"
All multi-asset funds are defined differently and are managed according to their own set of investment objectives and strategies. There are many different types of multi-asset funds available and management techniques vary.
Multi-asset funds fall into one of two groups based on performance targets. The first group aims to outperform a benchmark or index; the second group aims to produce a particular return (for example, a return above inflation over a given period). Multi-asset funds are suitable for a wide range of investors.
What is the first step in choosing a multi-asset fund?
Which type you choose depends largely on two things: your investment timeframe and your tolerance for short-term volatility. Preferably, if you have a long investment timeframe, you shouldn’t be too worried about short-term volatility. But some people are unable to tolerate high short-term volatility, even if their investment timeframe is long, and this should be taken into account.
If you are in your 30s, with a long investment timeframe and unlikely to need to draw on your savings for the next 30 years or so, then you can afford to have a high allocation to equities. Equities tend to be quite volatile from month to month, but this is offset by the higher returns that they are expected to generate over the longer term.
As you approach retirement, your investment timeframe shortens and you will need to shift into funds with a lower risk, such as those with a higher allocation to bonds and cash.
After identifying my investment timeframe and tolerance for volatility, what’s my next step?
It’s essential to assess your risk tolerance. Multi-asset funds come with different levels of risk, so assessing and setting your personal risk profile will enable you to create a shortlist of suitable funds. Generally, high reward comes with high risk, but high risk will not suit all investors. Many would prefer to take on less risk and, in turn, sacrifice some reward.
Everyone is different; you need to find your individual balance between risk and reward. It’s also important to consider your investment objectives. As multi-asset funds all have their own investment objectives, it’s important you choose a fund with objectives that match your own. For example, if you are in the accumulation phase of life, working and investing to grow your portfolio, it is unlikely that you need to invest in an income-producing fund. On the other hand, an income-producing fund may be essential for a retired investor.
Something else you may need to consider is where a multi-asset fund will fit into your wider portfolio, assuming you intend it to be one of a number of investments. One option is to have a multi-asset fund, or funds, as the core of your portfolio and build other investments around the periphery. Another option is to use a number of multi-asset fund managers in a portfolio. Not only could this provide diversity among portfolio holdings, but it also provides diversity among fund managers and therefore a mixture of investment styles and ideas.
Why should I use a fund manager to make asset allocation decisions?
Quite simply, because of the resources available to a fund manager. Compared to the average investor, fund managers have extensive research resources at their disposal, are highly trained and experienced, and generally have a better investment capability. That said, there are no guarantees that a fund manager will outperform. A multi-asset fund that uses a flexible asset allocation policy to produce a particular return relies heavily on fund manager skill for performance. Having the flexibility to reallocate the portfolio from
equities to bonds is only beneficial if bonds subsequently outperform. The risk of making the wrong call is similar to the risk of any other active (non-multi-asset) fund managers selecting the wrong security for their portfolios.
From the end investor’s perspective, the best way of managing this risk is to ensure that your fund is managed by an experienced, well-resourced team.
Having made the decision to invest in a multi-asset fund, investors should select a manager who they believe is best placed to make decisions for them and choose a fund that matches their objectives and risk profile. This relieves the burden from the investor, who may not have the tools or the skills at their disposal to allocate assets effectively.
How important is asset allocation to a fund’s performance?
Undoubtedly, asset allocation plays a major part in determining fund performance, but it is not the only element. Security selection is the other main driver. Security selection is the process of deciding which individual securities will be held in a portfolio. In other words, once the decision has been made to allocate, for example, 70% of a portfolio to equities, the manager then needs to decide which individual equities they will buy to make up that 70%.
The manager will need to consider the risks and potential rewards affecting individual securities and how these will affect the portfolio as a whole. Again, it is essential that investors choose a fund manager who they believe has the ability to select the right securities.
What do I need to consider when investing in a multi-asset fund in relation to risk?
There’s always a risk in taking money out from under your mattress and investing it, but it’s important to understand that the basic premise of multi-asset funds is that they reduce or spread risk. A professional fund manager will not only understand how to allocate a fund’s assets across different asset classes, but will also be aiming to select good securities within each asset class.
As we discussed in the previous issue of Investment Fundamentals - Everything you wanted to know about multi-asset investing - a multi-asset fund’s diversification can help mitigate risk. But in addition to this, multi-asset funds that aim to produce a particular return (rather than outperform an index) are much more likely to target volatility than most managed funds; they may look to smooth returns through reallocating the portfolio to different asset classes to remove peaks and troughs in returns.
Additionally, these funds are able to quickly adapt to changing market conditions. They can reduce exposure to riskier asset classes when the outlook is poor. Controls are in place to try to minimise losses as well as maximise gains, and this can mitigate the overall risk of the fund.
That said, the risk inherent in any investment is that it fails to generate the return expected of it. In the case of multi-asset funds, this would mean the fund either failing to beat its benchmark, or not delivering its particular return objective. Such failure could be due to poor fund management, or worse-than-expected market performance.
Poor fund management could relate to the fund being poorly structured in terms of matching its investment strategy to its investment objective. Or it could relate to poor decisions regarding asset allocation or security selection. These are risks that thorough fund analysis, either by you or your adviser, should aim to avoid.
As for risks relating to market performance, the global financial crisis (GFC) is a good example of something that was not generally expected to happen. Funds that had a high and static allocation to equities were badly affected. Even if a fund outperformed its index, its absolute return would still have been much worse than an investor would have expected it to be.
The GFC was the worst financial crisis for perhaps eighty years, so in an historical context another crisis should not be expected for many years. However, there is always the possibility, even if remote, that markets will experience another shock. Rather than allow fear of such a repeat to drive you and your money back under the mattress – and in so doing, miss out on good returns – I would suggest you focus not only on choosing a good fund manager who may be able to anticipate such turbulence, but also on learning how you can respond to such turbulence. The worst mistake that any investor can make is to sell after markets have fallen sharply. Training yourself to do the opposite would be time well spent.
Are most multi-asset funds growth-oriented? What if I need income?
There are income-producing multi-asset funds, whose objective is to deliver a certain level of income while maintaining or growing the capital value. Such funds can be particularly useful for retired investors, for whom income and inflation are a focus.
Multi-asset funds can provide an alternative income source for people who rely on annuities, term deposits, or pure fixed income investments. They also provide another level of diversification.
Why does a retiree need to focus on inflation?
It is important to understand that inflation is a concern and consideration for all investors, not just retirees. Inflation will gradually erode the value of money and therefore deplete the value of savings and investments. Simply put, a dollar today is worth more than a dollar next year.
Bear in mind that the Reserve Bank of Australia has a target inflation rate of 2-3%. When inflation is 2.5%, the value of your money halves in around 28 years. In other words, in 28 years you will only be able to buy half the amount of goods and services you were able to buy today. Put another way, you will need $100 to buy goods worth $50. If inflation is 4%, the purchasing power of money halves in just 18 years. Inflation is a real danger that must be recognised and accounted for when investing.
It is therefore essential that your investments grow at least in line with, and preferably more than, the rate of inflation over the long term in order to ensure you can maintain your quality of life in the future. With respect to retirees, many people today are living 20 or even 30 years into retirement. Healthcare costs are rising, and it looks likely that we will at some point face an environment of high inflation and high interest rates. While high interest rates will aid income generation, high inflation will erode purchasing power unless your portfolio generates some capital growth. So it is essential that savings maintain their purchasing power throughout a person’s retirement. Traditionally, investors have tended to switch from growth-producing assets to income-producing assets at retirement. But this is no longer an option for many investors. For the years following retirement, people are likely to need to continue to build their savings pot, as well as take an income, to ensure that they have enough capital to last the duration of retirement.
Otherwise they could be drawing an income from their savings with little growth in the savings pot, thus running the risk of outliving their savings – an unwelcome scenario, as most retirees are unable to return to work to replenish their coffers. It is therefore essential to select investments that can beat inflation.
How does a multi-asset fund protect against inflation?
‘Protection’ is an often-misused term. Some investments can keep pace with inflation; for example, inflation linked bonds are one of the only investments that do offer ‘protection’ against unexpected inflation. Other investments – such as equities, commodities and infrastructure – have the potential to outperform inflation. In an environment of falling inflation (and therefore likely falling interest rates), fixed income is also likely to outperform. But these investments do not offer guaranteed protection against inflation.
A multi-asset fund that invests in a variety of asset classes can aim to outperform inflation by reallocating assets into potentially inflation-beating securities. A flexible asset allocation policy ensures the manager has the maximum opportunities available to meet this target. They can grow the fund when market conditions are accommodating and reallocate the portfolio to more defensive assets to minimise losses when market returns are poor. Over the long term, this strategy should be able to provide a return in excess of inflation and therefore maintain purchasing power for investors in future years.
Published in Aberdeen marketing
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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