Blowback: Another unintended consequence of passive investing?
In the last week Perspectives Series, Morphic released the second and final part of our look at the changes taking place with the funds management industry. (Click here for the Part I and Part II if you haven’t read it).
So what part does this blog relate to?
One area that was discussed briefly was our view that dynamic asset allocation or real return portfolio building would see increased interest from investors. Strategic Asset Allocation (SAA) or Tactical Asset Allocation (TAA) are terms used to describe the decision of which asset class to allocate funds to and in what size, along with when to move up or down those allocations, with tactical being the shorter term focus (e.g. should we go to cash in the short term?) and strategic (do we think emerging markets are a good investment on a 5 year view?), the longer term.
The first part of the Perspectives Series was all about how consultants had boxed in managers to force them to focus on one sub-area. Now of course this is fantastic for the consultants: they gain control over the allocation at that point rather than the client, and advising the client on where to allocate is another profitable fee source.
Why should I care about this?
The question we would raise is: who is more likely to be able to dynamically run a portfolio to emerging risks in the world – a consultant not plugged into markets, or portfolio managers at the frontline every day?
And of course not every investor has access to a consultant or even a financial planner. Many who could have access don’t want it. Australia now has $500bn of Self-Managed Superannuation Funds. Many members of these funds enjoy managing their own money. But we believe that as these savers retire, at some stage they will realize that trading stocks or tinkering with allocations is less fun and adds no value.
We would suggest that a portion of money should go to managers who can provide “holistic management “ – i.e. the manager decides whether they should carry more cash or be risk adverse; or alternatively the manager takes more risk on. Conversely the manager can also decide what regions or factors to focus on.
We are seeing the emergence of some of these funds. Former “bond king” Bill Gross runs a fund at Janus which is unconstrained and Schroders has a “real return fund”. We are not convinced the Schroders fund is set-up right yet (too much allocation to vanilla assets), but it’s a step in the right direction. Variations of absolute return funds with the right risk controls and liquidity measures are probably best placed to offer up a dynamic mixture of assets according to future needs of retirees.
And where is the blowback?
Finally, there is potentially a great irony in the move to passive in our opinion. Markets and the world in general have a way of delivering “unintended consequences” back to those who start something, but end up with a whole lot of adverse outcomes they hadn’t considered.
Financial advisors have led the push to get away from paying high fees to fund managers, but have ended up taking onboard all these asset allocation and factor “calls” themselves. Knowing that low volatility or momentum have outperformed is one thing. Being able to invest in it – great. But knowing what the future risk and return profile from that factor is and how does it interact with the other factors you are running  is another challenge altogether.
The irony is that consultants and advisors could find a large number of smart, unemployed, ex-long only buyside managers, squeezing them out of their jobs or putting pressure on salaries in the long run.
Now clearly for society as a whole, this a more efficient allocation of human capital away from active asset management into other fields, but “You try to do the best by your clients and you end up being made redundant”.
 As an example, the ishares Minimum Vol fund (USMV) has the second highest level of absolute flows in the USA in 2016, with $6.7bn YTD. This is part of the chase into low volatility funds and relies on the backward looking outperformance of low-vol anomalies. Rob Arnott at Research Affiliates shows that most of this performance is simply by people just paying more for the same factor – i.e it’s self-fulfilling! There is no concept of valuation in here. Will this factor perform as well on a forward looking basis? I’m skeptical.
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