Active Asset Allocation – the answer to Active v Passive investment debate?

The debate around the merits of active v passive investing was re-ignited by the regulator’s reports on its Asset Management Market Study (AMMS). But our Asset Allocation Director, Gavin Stewart, believes it has brought to the forefront the importance of a well governed asset allocation approach.

The Financial Conduct Authority’s (FCA’s) reports on its study of the asset management market had relatively little to say about asset allocation. Not directly, anyway.

Among the more noteworthy issues raised in relation to advisers were:

  • how paying more in charges for active management didn’t always correlate to better outcomes for the customer; and
  • how advice costs are claimed to be one of the largest portions of the asset management value chain.

But while asset allocation was referenced largely in relation to investment consultants, the regulator’s study re-opened the debate over the merits of active and passive investment management. At Scottish Widows we believe this debate is too narrow. We believe the question should not be whether you take an active or a passive approach, but why you wouldn’t take the best features of each?

This is where asset allocation comes in. Because we believe effective asset allocation means that it is possible to provide investors with the best of both worlds, by combining active allocation decisions with elements of passive or quantitative underlying management.

 

Are investors getting their money's worth?

One of the more striking sections of an interim report that wasn’t short of eye-catching statements pointed to evidence suggesting that both actively and passively managed investments “do not outperform their benchmark after costs”. Indeed, the report suggested there was “a negative relationship between net returns and charges”.

Both these statements appear to have only considered equity funds in their analysis. But the vast majority of customers have exposure to multiple asset classes – either through multi asset funds or through a range of funds in different asset classes.

The report appears to take the view that in many instances, stock picking – in the form of active management – doesn’t necessarily generate long-term value for investors. Conversely, a passive fund which closely tracks the index will likely generate gross returns close to the benchmark. So in what appears to be a position somewhere between a rock and a hard place, what can advisers do to influence investment outcomes and long-term value? We believe the answer lies in effective asset allocation.

 

A disciplined approach to asset allocation

The FCA remarked in the interim report that “asset allocation is one of the most important elements of an investors’ investment strategy that can impact returns over time”. Indeed, a 1986 report on the performance of 91 US institutional pension funds by Gary Brinson, L. Randolph Hood and Gilbert Beebower found that 93% of the variation in portfolio performance was determined by asset allocation. The remaining percentage was attributed to stock selection and market timing.[i]

And while subsequent research papers have both reinforced and disputed their findings, what is not in doubt is the importance of asset allocation, especially for long-term investors.

The fundamental basis of asset allocation is a simple one. It refers to the principle that different assets perform differently in different economic and market conditions.

Scottish Widows takes a largely quantitative approach to equity investments in multi asset funds, with a mix of factor based strategies (also referred to as quantitative investment), employment of smart beta strategies and pure passive equities.  Other asset classes such as fixed interest or property will have an approach that fits their particular market and the fund target. 

But overlaying all of it is an active approach to asset allocation. The advantage of this blend is that we have the flexibility that comes from being able to review, rebalance and rotate among asset classes (as opposed to taking a static approach). Adjusting these over time recognises the reality that relative valuations move and change and are subject to market fashions and preferences.  If you are able to stand back and take a longer term considered view then this gives real opportunities to improve fund and customer outcomes.

Asset allocation in Scottish Widows recognises the importance of diversification in multi-asset funds in particular, with improvements in risk metrics through investing in several asset classes rather than just one, and recognises the essential need to adjust to reflect changing markets.

We undertake active asset allocation at two levels in Scottish Widows funds – long-term strategic and medium-term ‘house view’. The former relates to the optimal long term mix of asset classes for the fund’s risk profile, based on the modelled returns of those assets over the long term. The long-term strategic view also considers the range of asset classes in which a fund can invest in and our view of customer expectations.

A review of the long-term strategic asset allocation is undertaken regularly, with the aim of refining the asset allocation and improving projected returns while ensuring the funds remain aligned with their intended risk profile.

The medium term ‘house view’ refers to the adjustments made to individual asset class or sub asset class weightings on the basis of their expected performance over the next 18 months to five years. The aim here is to add value by reflecting our current views of the relative value and attractiveness of different asset classes. The ‘house view’ is set out by our Insurance Investment Strategy Committee, taking on board the medium-term positioning recommendations made by our Asset Allocation team.

Ultimately, the aim of our multi-asset proposition is to generate outperformance by taking an active approach to asset allocation, rather than relying primarily on fund managers to deliver outperformance through stock selection.  

This is where we think the key added value comes for investors – it is an issue apparently missed by the FCA and which we believe is much more important than whether the underlying components of a fund are managed actively or passively.

By taking an active approach within a structured framework, we believe we offer investors and advisers the best of both worlds.

 

PLEASE REMEMBER PAST PERFORMANCE IS NOT AN INDICATOR FOR FUTURE RESULTS. INVESTMENT MARKETS AND CONDITIONS CAN CHANGE RAPIDLY AND, AS SUCH, ANY VIEWS EXPRESSED SHOULD NOT BE TAKEN AS STATEMENT OF FACT, NOR SHOULD RELIANCE BE PLACED ON THESE VIEWS WHEN MAKING INVESTMENT DECISIONS.

(i) https://www.jstor.org/stable/4478947?seq=1#page_scan_tab_contents

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Scottish Widows Limited. Registered in England and Wales No. 3196171. Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number 181655.

Scottish Widows Unit Trust Managers Limited. Registered in England and Wales No. 1629925. Registered Office in the United Kingdom at Charlton Place, Andover, Hampshire SP10 1RE. Tel: 0345 300 2244. Authorised and regulated by the Financial Conduct Authority. Financial Services Register number 122129.

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