John Husselbee

Multi-Asset: why the past five years is not a guide to the future

John Husselbee

New research from Morningstar on the UK fund of funds (Fofs) market shows strategies investing in passive vehicles have produced the best performance over the last five years. But I suggest the argument that fees are a major factor behind this admittedly made more forcefully in press articles than the research itself requires further examination.


First of all, let’s look at a few of Morningstar’s findings. In terms of performance across its GBP Moderate category (50-70% in equities and the rest in bonds and cash), Fofs investing in passive funds returned 4.3% in annualised terms over five years to the end of May 2020 compared to 3% from unrestricted peers with full investment freedom. As for fees within this category, passive Fofs charged less than half: an average of 52 basis points versus 110bps from unfettered peers. But more context is required to tell the full story; to Morningstar’s credit, some of this is acknowledged in the report and I quote a couple of key passages:


Our analysis suggests the performance on a risk-adjusted basis of fund-of-funds comes out in a far better light… many are outperforming the broader market when overall risks are considered. This can be explained by the fact that risk targeting, and protection of capital, are common features of the fund-of-funds universe.’


‘While there are significant cost savings to be had in buying an index only/fettered fund, their outperformance in recent years has been helped by the fact the market dynamics have favoured passives, leading them to outperform their active counterparts. If conditions are right, this could flip and the performance of active fund-of-funds would show a more positive picture. Still, the fee drag would remain.’

That first point is a key one for the Fof universe and us at Liontrust as a provider of target-risk multi-asset portfolios with the concept of winning by not losing at the core. The second is more fundamental and highlights exactly why comparing these vehicles remains such a challenging task.


SAA, not active or passive

For us, the story over the last five years is not active versus passive, whether you selected actively managed funds or trackers, but rather one of strategic asset allocation (SAA) and how a portfolio’s approach has influenced this.


To make our position clear, we are an active multi-asset manager and ultimately believe choosing active funds is the way to outperform over the long term. Saying this, we do use passives and also offer largely passive-only portfolios, albeit run with the same SAA and tactical asset allocation (TAA) as for our whole range. As evidence of our argument, our active Growth portfolios have outperformed the passive Dynamic Beta vehicles over five years: to the end of August 2020, our Growth 4 has produced annualised returns (since launch) of 6.0% versus 5.5% from our Dynamic Beta 4. What this shows is that deeper drivers, such as asset allocation, remain greater determinants of overall performance.


Given the spread of approaches available in multi-asset/Fofs, not just active versus passive but also target risk versus target return, falling back on higher fees for ‘active’ underperformance seems overly simplistic. This is particularly the case over the last five years when equity performance has become increasingly driven by a handful of US large-cap growth stocks and a few giant tech names are effectively able to move the market by themselves.


Compare and contrast – and how we do it

To explain this in more detail, the following is a compare and contrast between our mid-range target risk portfolio at Liontrust (Risk Grade 4) against a passive lifestyle offering with a traditional balanced asset allocation of 60% equities/40% bonds. By examining the process behind these, we can see why each has performed as it has in recent years and, more importantly, why this can reverse as we look forward (the flip teased by Morningstar).

First, we need to go back to the motivating factor behind any Fof or multi-asset portfolio to meet the goals, risk tolerance and time horizon of investors. There are many ways to achieve this, but we see four key elements as standard: SAA, TAA, fund selection and stock selection. At Liontrust, our process includes all four; in contrast, the majority of passive lifestyle offerings have SAA and (passive) stock section but remove the active decisions involved in TAA and fund selection.

Ultimately, the contrast between active and passive is founded on a fundamental divergence in opinion on market efficiency:

  • Passive managers believe markets are efficient so there is no point choosing between stocks
  • Active managers believe markets are inefficient – at least in the short to medium term – so they can make excess returns through active decisions.

What is key to understand is that over the last five years, the make-up of the market and type of companies in the ascendancy has meant removing active decisions, for the most part, has produced better performance – but there is nothing to suggest this will remain the case forever.

Approach to strategic asset allocation

Approach to market allocation

Source: Liontrust, as at 31.05.20

If we focus on SAA, it appears initially that a good proportion of ‘balanced’ portfolios have a similar asset allocation in the 60% equities/40% bond region, as the first set of charts above shows. When you dig deeper, however, as per the second set, this split in a passive offering will typically be done on a market cap weighted basis, so if the MSCI All Country World Index has around 60% in the US, for example, around 40% of an entire portfolio (60% of that 60% in equities) will be invested in one market – and all in larger companies.

SAA is the scientific part of our process, where we analyse the historical returns and volatilities of a range of asset classes to determine the best allocation for each of our model portfolios to meet their respective volatility targets. As a contrast to market-cap weighted exposure, our equity allocation is more diversified and also includes smaller companies, for example, which a range of studies have shown are a vital component of long-term outperformance. For bonds, we also include exposure to high yield and emerging market debt.

Broader exposure to these core asset classes versus passive multi-asset peers as well as including categories such as alternatives gives not just additional sources of return but also more balanced and diversified portfolios. While a passive approach to SAA has been enough to secure outperformance over recent years given underlying conditions, this does not diminish those other advantages over the longer term.

If SAA is the science, TAA and fund selection are the art – and both are absent from passive lifestyle products. As an active manager, we believe we can add value through both but whenever any kind of decision is involved, there is potential to be right or wrong and our calls on areas such as value and small caps have negatively impacted performance in recent years relative to passive portfolios automatically pushed into surging US large-cap growth companies.

Finally, stock selection is the end point for all Fof and multi-asset portfolios and, once again, ultimately rests on that efficient/non-efficient question. As we have shown, for the passive 60/40, the make-up of the MSCI World Index means close to 40% is automatically invested in US large-cap equities at present, however expensive this market may be. To give an indication of the nature of this index, at the end of August 2020, the top five stocks were Microsoft, Apple, Amazon, Facebook and Alphabet – and most investors would struggle to argue they constitute diversified ‘global’ equity exposure.

With active portfolios, underlying managers select stocks based on their particular investment styles, and some are happy to own these more expensive growth names. The difference is that this is the result of an active decision about the companies’ prospects rather than just because they are the largest stocks in a benchmark.

Right place, right time? The tech effect

Given the different approaches for active versus passive, what can we conclude about recent and potential future performance?

Over the last five years, any investor with a meaningful position in large US growth companies would have outperformed, and the standard passive Fof, with its market cap weighted exposure to the MSCI World Index, has clearly been in that camp. Purely by nature of its construction, with no active decisions, such a portfolio is the very definition of being in the right place at the right time.

What we can also say, however, is that this now means these portfolios have heavy exposure to expensive, momentum equities. A detailed debate about whether tech performance can continue is beyond the scope of this piece but, to summarise, we believe nothing can go up forever and the sell-off in recent weeks has to give advocates of these stocks pause. Wherever people stand on this, the tech effect’ is surely worthy of analysis in this context given how much this single factor has driven passive outperformance.

In contrast, our portfolios alongside many active peers continue to be well diversified, with a tilt towards cheaper parts of the market and a blend of managers with a record of long-term outperformance. With the market becoming increasingly narrow in its leadership, we feel the best option for a multi-asset portfolio is to be even more diversified and would question the capacity of passive vehicles to do this with trackers few and far between in areas such as small-cap equities or non-core bonds, for example.

Looking forward, we highlight comments from renowned US investor Howard Marks of Oaktree, who recently wrote about what being a truly active fund manager means. For Marks, it is about being different of course, but also about confidence without hubris and what he calls intellectual humility. In essence, this is about having strong beliefs while recognising fallibility and dealing intelligently with the uncertainty that goes hand in hand with markets we continue to believe are inefficient.

He ends by quoting Voltaire ‘Doubt is not a pleasant condition, but certainty is absurd’ a notion that might be applied to continuing to plough money into expensive stocks. Again, we would suggest evidence that very few active managers are currently buying these companies on hugely inflated valuations, even among tech specialists, is a clear red flag. Passive funds are filling the role of greater fools at present (someone has to be willing to pay the asking price)  and will have already been hit by recent selloffs.

We continue to believe the skill of active decisions should outperform the luck of right place, right time over the long term. To finish with an analogy, if you are walking along a muddy path, any kind of wellingtons will do; if you get onto a decent footway, you want to make a call on changing into walking boots or trainers to get yourself moving –  and so it goes with passive and active. The cost of the shoes, while an important factor, is not the be all and end all.

For a comprehensive list of common financial words and terms, see our glossary here.

Liontrust Insights


Key Risks & Disclaimer

Please remember that past performance is not a guide to future performance and the value of an investment and any income generated from them can fall as well as rise and is not guaranteed, therefore you may not get back the amount originally invested and potentially risk total loss of capital.

This content should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust.


Tuesday, September 29, 2020, 10:22 AM