A new and viable breed of funds is emerging: those that combine the benefits of active asset allocation with low-cost, index-tracking products, writes HSBC's Andy Clark.
In a world where charges are being increasingly scrutinised, a new and viable breed of fund is combining the benefits of asset allocation in a cost effective way by holding beta products such as ETFs and index trackers as the underlying investment.
These asset allocated passive funds are interesting because, amid the debate over active versus passive funds, these combine the benefits of both. These new funds therefore bring two key advantages to the table: asset allocation and diversity, combined with good value underlying products.
Benefits of diversification and asset allocation
For investors, it is important to have exposure to a mix of assets in order to achieve potentially good long-term performance. As the graph demonstrates, the performance of asset classes varies each year and these can swing quite drastically.
For example, within our categorisation of asset classes, this graph shows the worst performing asset class in 2008 was UK equities, posting a loss of 29.3%. In 2009, there was quite a turn of fortunes with UK equities being the best performing asset class, posting a return of 30.12%, as measured by the FTSE All Share index.
Indeed, it is often said successful investment performance is driven by good diversification and asset allocation. Even the most astute investor could not consistently predict the best asset class to outperform in each year – therefore it makes sense to hold a mix of assets and invest for the longer term. Ultimately this should deliver smooth performance as a variety of asset classes should have low correlation to each other. Advisers should be encouraging their clients to spread their eggs more widely than holding, for example, just one or more UK equity funds.
In constructing such a fund it is important not just to hold global geographic exposure, but also to ensure the portfolio contains assets outside the traditional realm of equities and bonds.
With innovative ETFs on the market today, it is possible to also hold asset classes such as hedge funds, commodities and property.
Incorporating these modern assets into a portfolio will provide a highly diversified multi-asset portfolio and potentially contribute toward the desirable goal of achieving smooth returns over the long term.
Achieving good value through passive investments
Index tracking funds are normally lower cost than their active counterparts as there are less overheads. By selecting passive funds with low costs, this should help to achieve a closer tracking error to the relevant index, and also return the maximum possible investment growth to the investor.
Actively managed equity funds can cost the investor 1.5% per annum or even more. Of course, fund of fund managers can gain cheaper access to these as they negotiate bulk deals, and commission is not calculated into the equation.
Even so, fund buyers can expect to pay around 0.75 per annum for an actively managed fund. By the time they levy their own charges, the TER on the fund of funds product that combines an underlying portfolio of actively managed funds can be close to 2%-2.25%.
In an environment where low cost, high quality index tracking funds are becoming increasingly prolific, and competition in the ETF market is heating up, it is possible to find index tracking funds and ETFs with an annual charge of closer to 0.25-0.30%. Combined with the fund manager’s fees to actively asset allocate the portfolio, it is possible to build such a fund of funds, where passive funds are the underlying investment, for closer to 1%.
Indeed, advisers who have traditionally favoured actively managed funds consider fund of funds a good solution for investors because they offer expert fund selection, while delivering the benefits of active asset allocation. Certainly this remains the case and these funds should offer a viable investment proposition for investors.
A good fund of funds manager should more than cover the costs of the so-called double layer of charging. However, for investors seeking a lower cost solution, funds of passive funds, at around half the cost of their traditional multi-manager counterparts, offers a highly attractive alternative.
In an RDR world, a fund that can offer the attributes of active asset allocation combined with low cost underlying investments, seems increasingly attractive and is bound to grow in popularity.
A new world?
We would argue there is room for both active and passive funds within an investment portfolio.
Now stepping into the limelight is the new breed of active funds of passive investments, combining both concepts working in a complementary manner. By introducing this new breed of funds, investors are offered additional choice. This new type of fund is most likely to appeal to investors wanting a low cost route into an actively asset allocated portfolio, but it will not replace active and passive management as viable forms of investment in their own right.
Andy Clark is managing director, wholesale at HSBC Global Asset Management
