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Do you worry about your passive balanced fund’s asset allocation?

And should you?

Over the last few years a number of local fund managers have launched multi-asset funds that use a purely passive approach. These products take exposure to different asset classes through indices rather than picking individual securities.

As they are not actively managed, the asset allocation of these funds also tends to be fairly static. Some managers will make small tactical changes during specific market conditions, but they will not deviate significantly from their core allocation.

The rationale for this approach is that the managers will have done extensive analysis to determine what they believe is the optimal asset allocation to achieve a set target over time. As the head of core investments at Nedgroup Investments, Jannie Leach, explains: “Instead of having continuous active decisions, you have one really important decision up-front when you put the fund together.”

Given that asset allocation is the most important determinant of long-term returns, this makes sense for a long-term investor. But what about over shorter time periods?

“It may be true that a certain fixed asset allocation will give you the best chance of a certain outcome over the long term, but it doesn’t necessarily withstand different market conditions,” says Gavin Ralston, the head of official institutions and thought leadership at Schroders. “You can end up with very skewed outcomes in any particular year.”

He argues that the flexibility of active asset allocation has significant advantages.

“Active asset allocation gives you a better chance of matching the real world outcome that the client is looking for,” Ralston says.

Relative returns

This is particularly the case with passive asset allocation funds that are not well diversified. If they have exposure to only two or three different asset classes, their performance must be heavily impacted by just a few factors.

Passive asset allocation funds with high equity exposure could be most affected in a market crash since they would continue to hold that exposure and take the draw down as a result. An active manager should however be able to reduce losses by moving into other asset classes.

It is interesting that in South Africa this has not yet been thoroughly tested, since all of the local passive balanced funds were launched after 2008. They have therefore not yet shown how they would respond in a major downturn.

What they have already demonstrated, however, is that, contrary to what one might expect, their performance is very consistent when compared against active managers.

Comparing the two largest passive multi-asset high-equity funds with two of the top-performing active funds in this category over the last five years produces some very interesting results. The below figures from Morningstar show their relative performance from year to year against the category average and a benchmark composed of 25% in the Composite All Bond Index and 75% in the FTSE/JSE All Share Index.

SA multi-asset high-equity fund annual returns
  2013 2014 2015 2016 2017
PSG Balanced Fund 26.03% 11.38% 4.97% 12.56% 11.00%
+ / – category average 4.02% 1.08% -4.20% 11.12% 0.69%
+ / – benchmark 9.84% 0.65% 2.01% 6.71% -7.38%
+ / – inflation + 5% 15.73% 1.06% -5.21% 0.49% 1.50%
Allan Gray Balanced Fund 23.72% 8.99% 12.29% 6.31% 11.01%
+ / – category average 1.71% -1.31% 3.11% 4.86% 0.70%
+ / – benchmark 7.54% -1.74% 9.33% 0.46% -7.38%
+ / – inflation + 5% 13.42% -1.33% 2.11% -5.76% 1.51%
Nedgroup Investments Core Diversified Fund 19.52% 13.54% 8.47% 2.58% 12.39%
+ / – category average -2.49% 3.24% -0.70% 1.13% 2.07%
+ / – benchmark 3.34% 2.81% 5.51% -3.27% -6.00%
+ / – inflation + 5% 9.22% 3.22% -1.71% -9.49% 2.89%
Satrix Balanced Index Fund 12.19% 4.28% 4.03% 19.04%
+ / – category average 1.89% -4.90% 2.59% 8.73%
+ / – benchmark 1.46% 1.32% -1.82% 0.65%
+ / – inflation + 5% 1.87% -5.90% -8.04% 9.54%

Source: Morningstar

Note: The Satrix Balanced Index Fund was only launched in October 2013 and therefore doesn’t have a performance history for 2013.

The variance in performance by each of these four funds against both the category average and the composite benchmark is as follows:

SA multi-asset high-equity fund variance of returns
  Highest Lowest Range
PSG Balanced Fund      
+ / – category average 11.12% -4.20% 15.32%
+ / – benchmark 9.84% -7.38% 17.22%
Allan Gray Balanced Fund      
+ / – category average 4.86% -1.31% 6.17%
+ / – benchmark 7.54% -7.38% 14.92%
Nedgroup Investments Core Diversified Fund      
+ / – category average 3.24% -2.49% 5.73%
+ / – benchmark 5.51% -6.00% 11.51%
Satrix Balanced Index Fund      
+ / – category average 8.73% -4.90% 13.63%
+ / – benchmark 1.46% -1.82% 3.28%

Source: Morningstar

When compared against the category average, the most consistent performer is the Nedgroup Investments Core Diversified Fund. When compared against the benchmark, it is the Satrix Balanced Index Fund.

It’s also worth noting that in terms of largest relative underperformance, the Satrix Balanced Index Fund stands out when compared against the benchmark. Its worst year was just 1.82% lower than the benchmark return, where both active managers gave up 7.38%.

Absolute targets

Against an inflation-linked benchmark, however, the two active funds fare better. Here the range of relative returns is not so important as how regularly the fund manager is able to achieve an absolute target. When the target is missed, it’s also important that it’s not missed by too much.

The PSG Balanced Fund is the only one of the four to return better than CPI + 5% in four of the five years under review. The others all missed this target twice.

However, the underperformance of the two passive funds relative to this inflation-linked benchmark in 2016 was larger than seen by the active managers in any year. This may suggest a weakness in these strategies in a year of poor equity returns.

Finally, it’s worth asking what would happen if an investor combined two or more of these funds together.

The most consistent return would have been achieved by combining the PSG and Allan Gray funds in a 50/50 portfolio. This would have been marginally less volatile and delivered a slightly better return than a portfolio made up of the PSG, Allan Gray and Nedgroup Investment funds in equal weightings.

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COMMENTS   7

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Strangely enough, I can think of one passive balance fund (strategic asset allocation using index funds) that was launched on 1 Jan 2008 (although not as a unit trust). That fund matched the average return of large fund managers (Global BIV) over the 12 months to Dec 2008 and it slightly outperformed over the 24 months to Dec 2009. That’s before fees.

I am always intrigued by the contention that active managers can reduce losses in a market crash by moving into other asset classes. Firstly, no one knows when the market will crash, and it’s a bit late to sell after the fact. Secondly, if they are selling, who are they selling to? It can only be to other active managers (except, why would THEY be buying?). Thirdly, the evidence shows that it does not lead to better outcomes.

Active management sounds compelling on paper, and that’s why so many investors fall for it. But in practice, the high associated fees make it an illogical pursuit for the average investor.

Passive funds have to buy shares when they rebalance to their index. So they may very well be buying from active. The market consists of active and passive participants.
It is possible to invest in active funds that are cheaper than passive. Passive is not necessarily the cheaper option.

Ice, are there indeed any actively managed fund (general equities or other themes) of which the total investment cost structure is lower / cheaper than that of the Satrix Balanced Fund? Kindly provide the names.

Many people can access a good active fund via their corporate retirement scheme for less than 0.5% management fee. Some passive funds charge above 0.7% management/platform fee. I did not say that some active funds are cheaper than the satrix balanced in particular. There are SOME cases where passive can be more expensive than active.
The satrix balanced fund is a blend of active and passive anyway. (Smart beta is a particular flavour of active)
Another cheap access point for active funds is via a LISP.
My point is that one should focus on identifying a range suitable funds that fit your requirements – whether active or passive before filtering on cost.

Just because you in a passive solution, paying a lower fee, does not mean you will receive a higher return. You still need to actively pick your passive solutions. Having said that, the Nedgroup offering is fantastic – TIC 0.58%, and has a long track record.

The ETF field is becoming more and more crowded, which unfortunately leads to more confusion among investors – just look at Short Vol ETFs in the USA at the beginning of Feb.

It appears to be a race to the bottom for passive solution providers, with every advert highlighting pricing as their competitive advantage. When everyone has a passive solution, what is your real differentiation? Glossy brochures? Quirky marketing campaigns? posting bounties on criminals?

Agreed. Further in the hypothetical scenario of a market that only consists of passive vehicles who is valuing the assets that makes up the indices ETF’s track?

While it is unlikely that passive investments will ever make up the whole market, having less and less active managers is leading to worse price discovery than in the past. Passive investments just keep on replicating the current winning portfolio, hence in SA Naspers drives the market and in the US it is the FANG’s. It becomes a virtuous circle or positive feedback loop – but what will happen when things start going the other way?

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