Weighing up the benefits and risks of multi-manager funds

As advisers become increasingly time-poor, multi-manager funds seem to have emerged as an ‘all-in-one’ solution they need for their clients. But as Benjamin Levy reports, planners need to be careful because there is a wide range of approaches out there – both good and bad.

As advisers search for ways to lower risks across their businesses, multi-manager funds are becoming increasingly important for their diversification, lower volatility, and more consistent returns.  

Advisers are adopting them as a convenient tool to provide broad exposure for low value clients and yet still make a business profit. 

At the same time, asset managers have undertaken a complete rebuild of their multi-manager funds from the top down, focusing on more consistent returns, reducing the number of managers available, and establishing the outcome they want to achieve before even moving onto the design phase of the fund itself. 

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But this rebuilding has raised questions about how many managers you can use before they grow too many to handle. 

A rift has also developed between the asset management companies, based on which stock selection and asset allocation is best suited to beat the current market conditions. 

Lowering risk for advisers 

Inflows into multi-manager funds are rising as advisers try to lower risks across their businesses and guarantee consistent returns. 

Colonial First State’s FirstChoice platform is at the forefront of this trend. A majority of funds under management (FUM) has flowed into multi-manager products this year, according FirstChoice Investments head Scott Tully. 

Fund manager selection is a compliance and risk issue for advisers, and they don’t want to have to worry about it in their business, Tully says. 

Leaving the management selection to another company with a team and a process in place to handle it mitigates some of the risk that advisers are facing, he says. 

One of the benefits of multi-manager over direct funds is that the planner knows what they’re getting in terms of the manager.

It avoids some uncertainty around fund selection and it reduces the risk of investing in a fund that may close or freeze, says AMP head of product and APL management Brad Matthews. 

The increasing amount of regulatory compliance that advisers are facing is pushing many of them to get fund managers to take on the load, leaving them to focus on engaging with clients.

One of the most important compliance risks that fund managers assume will be handled by a multi-manager fund is due diligence. 

The most important thing for Colonial is that investors and planners can rely on the wealth manager to ensure that the managers are still appropriate for the client, rather than advisers trying to pick managers themselves, Tully says. 

Multi-manager funds aren’t right for everyone, but they are the right business solution for many planners, he adds.  

According to Perpetual head of multi-manager Damien Webb, investors and advisers are more interested in mitigating market risk than compliance risk. Multi-manager funds offer consistent returns that help investors sleep at night, he says. 

The inherent diversification in a multi-manager fund is a big drawcard for these investors. The diversity of assets balances out a range of risk sources, provides lower volatility, and while it won’t shoot the lights out in performance, it can still reach the upper second quartile of returns. 

“Most investors are still smarting over the GFC, and generally just the poor returns of virtually everything post-GFC,” Webb says. 

The multi-manager approach can also help advisers strengthen their business model. If an adviser’s investment approach is too concentrated, it can be costly to their business model if it materially underperforms the market. 

A multi-manager approach with a strong research element should avoid that scenario, Webb says. 

Multi-manager funds are even being spruiked for their ability to reduce Future of Financial Advice risks to advisers, according to some managers. 

Russell Investments head of advice capability John Nolan said last year that multi-manager funds were a good low-cost, low-risk product for advisers to avoid complaints around the best interest duty. 

Although they wouldn’t produce exceptionally high returns, planners can be confident they won’t blow up, freeze or stress the client, he said. 

Advisers with low-value clients should not go out on a limb to recommend an exotic product in case it fell apart, he said. 

Low net worths 

That’s not the only reason that multi-manager funds are more suited to the low-net worth market. Advisers appear to be using them as a cheap product solution.  

“They’re a good way for clients who might have smaller than average balances to get access to a wide range of strategies,” Matthews says. 

Clients with low balances are unfairly discriminated against in the battle for fund managers. 

Size matters in this industry, and it can be very difficult for a client with a low wealth balance to access the same amount of funds covering all the wealth creation strategies that are more readily available to a larger balance client. 

Multi-manager funds solve that problem quite neatly by widening the range of investment solutions. 

They also provide access to diversified portfolios at a relatively low advice cost. They give the benefit of diversification without the cost of the planner having to research, advise and switch between fund managers all the time. 

“There are smaller clients that have a lot of faith in their financial adviser, and use them really for the strategic element of the plans, but they don’t want to get involved on the investment side,” Webb says.  

A multi-manager balanced fund –which has diversified manager access and active asset allocation – can be the perfect solution for that, Webb says. 

But that doesn’t mean that high net wealth clients can’t benefit as well. Many of the managers included in a multi-manager fund may not even be available to retail investors. 

Some of Colonial’s offshore global managers have no presence in the Australian market, and a multi-manager portfolio gives access to those managers for all investors. 

“Some of our fund managers are managers who are purely institutional only, so that means that the pool of managers is greater,” Tully says. 

A reappraisal – bottom up or top-down? 

This surge in interest from advisers in multi-manager funds comes at the same time as asset management companies reconsider their approach to multi-manager funds and the way they are developed and run. 

Traditionally, multi-managers built their funds through a bottom-up approach, in which companies would research good managers and their funds, group them into their different asset classes, and then allocate percentages of FUM accordingly to create a diversified fund. 

But this approach has been criticised by managers such as Tyndall AM, who accused fund managers of failing to put enough emphasis on a rigorous and disciplined portfolio construction process. 

The way asset management companies blended their managers together in this approach also resulted in a bland outcome for investors. 

Head of multi-manager funds at Tyndall Ken Ostergaard wrote in Money Management last month that some multi-managers blended so many managers together that the resulting portfolio behaved like the index they were supposed to beat. 

“Instead of performance being largely a result of stock and asset allocation, it becomes merely a random function of so-called factor risks,” Ostergaard wrote. 

Tyndall Asset Management reassessed the approach of its multi-manager funds a few years ago, dropping an external consultant and building a new internal team. 

It is clear to Russell Investments’ director of client investment strategies Scott Fletcher that the bottom-up approach led to some bad outcomes for investors. 

“Whether you achieved the outcome you were actually after, like CPI plus 2 per cent, was more by accident than good management,” Fletcher says. 

The strategy also lacked real diversification, which made itself felt during the GFC. The deal that investors were sold on multi-manager funds was not the experience that they went through.  

The promise of multi-asset investing has always been founded in modern portfolio theory, in which the investor would achieve the returns they targeted on a more consistent return basis by diversifying across different asset classes. 

Over five years, investors would indeed reach the return numbers they expected, but the volatility over that five years was significantly higher than they expected, especially during the GFC. 

It raised issues about whether investors were comfortable with the up-down, up-down style of returns over longer periods of time, according to Fletcher. 

“The whole reason that companies like Russell are moving beyond just pure multi-manager to more of an outcome-focused multi-asset type of approach is the fact that the GFC raised the question as to whether retail investors could survive the experience along the way to achieving a long-term investment outcome that was promised to them,” Fletcher says. 

Managers are now starting to implement a top-down approach, in which asset management companies first start with the outcome they want to achieve, and then go into the design phase. 

Multi-manager funds should be more about the role of an asset class in achieving an outcome rather than the percentage of an asset class that investors are exposed to, Fletcher says. 

Active management – and taking every asset on its own merits – is a key component of the new approach.  

Fletcher uses credit exposure as a case in point. 

In the bottom-up approach, credit exposures would be lumped into a traditional fixed income allocation. Now, credit exposures are understood to act more like equity exposures, so they can play more of a growth role in a portfolio, he says. 

That means that companies need to spend less time and research money on picking managers that correlate well, and more time on making sure that asset allocation is properly placed, and focused on value and opportunities. 

“You have to work really hard to add value in this environment,” Webb says. 

How to manage the managers 

Rebuilding multi-manager funds from the top down has raised questions about whether there is a limit to the number of managers asset companies can use to generate outperformance before they start getting too numerous to handle.  

Most asset managers have been guilty of spending far too much time and money from their research budget on manager selection and blending, Webb says. 

They were also too diversified, with too many managers doing largely similar things, which led to an expensive quasi-index portfolio, he adds. 

Managers would be better off choosing only three to five high-quality traditional managers in each sector, which is the amount that Perpetual has settled on, Webb says. 

“Don’t go too crazy with your traditional managers,” he says. 

According to Ostergaard, on average, there are eight underlying managers in most funds, and outperformance suffers as a result.  

“When it comes to blending and selecting managers, we believe in a philosophy of less is more: ie, fewer rather than more managers,” he stated. 

Tyndall has only five managers in global equities and four in domestic equities, approximately half the industry standard, Ostergaard wrote. 

A smaller number of mangers can also ensure that their different investment approaches are complementary, a critical component when generating outperformance. 

It also makes it easier for the over-arching asset company to analyse their different correlations in detail across different time horizons and in different market environments. 

However, according to Fletcher, trying to come up with a number of managers to use in a multi-manager fund is the wrong place to start.

That question was often asked within the multi-manager approach, but it was only a valid question in a bottom-up approach, he said. 

All that bottom-up managers are really worried about is how many managers they can put together to outperform a benchmark, and there is a limit to the number they can use. 

In the modern multi-asset approach, the outcome is much more important, and therefore risk factors are much more important. 

You start with the outcome that you want, not the amount of managers that you need, Fletcher says.  

Another factor to take into account is the difficulty of achieving active management in the current market. 

Correlations are rising in asset classes and even within the equity markets, making it difficult for managers to differentiate themselves.

Both value and growth managers are ending up outperforming at the same time, when the role of a multi-manager fund is achieve outperformance at different times.  

Asset management companies have to take that into account when they consider how many managers they need to gain the exposure necessary to reach a desired outcome.  

Colonial seems to have no limit on the number of managers they can use. There are nine or 10 different sectors in their multi-sector fund, with a number of managers in each to manage them separately. 

Tully admits that it results in a lot of managers in aggregate for one fund, but they are well in hand, he says. 

“These are very big funds, and the scale is there for us to be able to do that,” he says. 

The number of managers you can use is only constrained by your resources and organisational ability, Tully believes. 

He leads a team of eight people whose job is to select managers. 

“The advantage is that we have the team and the resources committed to managing the portfolios,” he says. 

The over-arching manager selection team must keep their role separate from the managers inside the fund in order to make it work. 

“We’re not trying to get involved in anything to do with stock selection. Our role is to review and analyse whether their investment process and investment portfolios make sense for our needs,” Tully says. 

But asset managers also have to know their managers better than the managers know themselves. 

“We need to know why they make decisions, what their process is, how does that translate through to the portfolios, and we ask them why they made that stock selection,” he says. 

Asset managers must develop a deep understanding of what their managers do, Tully says. 

Research critical

As managers rebuild their funds to make them more attractive to investors, deeper research has become critical to their approach. 

The industry’s concern with growing capital at a reasonable rate over inflation has driven greater investment in research teams since the GFC, Webb says. 

“Investors switched off between the debate over the virtues of a multi-manager fund versus a direct fund. Both gave them declining capital values, and that’s what they care about,” he says. 

Growing capital has spurred the focus on portfolio management since then, Webb says. 

Capital market insights is one of the core necessary capabilities to achieve success with a multi-manager fund, according to Fletcher. 

But that doesn’t just mean a tactical investment strategy, but also deeper research into demographic trends, retirement trends, changing capital markets, which investment styles are in favour or not, and research into return assumptions in portfolios. 

“Research is always critically important,” Fletcher says. 

Webb warns that advisers should not rely on any multi-manager approach to diversify their client’s investments. 

“It’s not a panacea, you can still get multi-manager wrong if you’re not investing in the research, and having good intelligent accountable portfolio managers managing that money,” he says. 

How to beat the market? 

As active management and achieving outperformance has become more difficult, different approaches have developed between the different asset managers on how to beat the market in the current conditions. 

Perpetual’s approach, and one it applies across all of its funds, is to search for value above all else. 

“The anchor point must be the asset allocation. Focus on value, focus on being contrarian. Value is the number one driver of long-term returns,” Webb says. 

Perpetual also uses a short-term measure based on price momentum to offset the early-buy, early-sell character of value. 

Colonial rejects this approach. 

“We don’t want a portfolio full of value managers,” Tully says. 

Value managers have periods where they all perform very similarly, and there needs to be a good mix of managers in there to get good diversification, he says. 

Colonial has just two good quality value managers in its equity portfolio, he says. 

Whatever approach they take, investors shouldn’t put too much emphasis on short-term performance when selecting managers. They need to look instead at future trends, Ostergaard warns. 

In the past, some managers lined up what they thought were the best value, growth, small cap managers and so on, based on their recent performance, and back-tested their returns over a short period. 

But those allocations were static, and rebalancing back to strategic weights happened as though recent history would repeat itself indefinitely, with no dynamic asset allocation, Ostergaard wrote. 

Asset managers were also outsourcing all outperformance to the underlying managers, implying that all alpha should come from shares only. But alpha comes from a range of sources, including asset allocation, stock selection, and currency in global equities, he wrote. 

Colonial is firmly in the strategic asset allocation camp. 

“We believe that it is more important to set your overall risk profile and then incrementally change that from time to time as markets change,” Tully says. 

Dynamic asset allocation is too much like trying to time markets, and that tends to lead to decisions that don’t add value to the portfolio, he says. 

However, Webb also believes in the dynamic approach. 

Perpetual focuses on how it’s going to build a long-term strategic asset allocation, but also has a very active program in how it manages its allocations to the shorter-term ebb and flow of markets. 

Both the strategic and tactical approaches look for a good mix of uncorrelated assets as building blocks for their portfolio, and they constantly adjust that through the cycle, Webb says. 

Fletcher is critical of using tactical approaches to solve problems with multi-manager funds. 

“Some asset managers try to address issues that were brought to prominence by the GFC by grabbing a traditional bottom-up multi-manager approach and adding more tactical market timing to it. But that still won’t address the end result of ‘What outcome am I after and am I even on track?’. 

“That is what investors are desiring. Just increasing a range and whacking around your allocations a lot more is no guarantee you’re going to get any closer to that outcome,” Fletcher says. 

Whatever the arguments, it is clear that asset managers are settling in for multi-manager funds to play a more important role for years to come. 

Matthews believes that multi-manager funds are going to remain important to advisers because fundamentally it makes sense for their business. 

Advisers are still going to have the pressures of compliance and making sure their businesses are economically sound, Tully says.  

And for many advisers, their desire to try and select managers by themselves will stay where it is – nowhere.