The new breed of asset allocation solutions

Nick Blake, head of retail sales at Vanguard Investments, gives an overview of the different asset allocation solutions available to advisers.

With roller coaster markets over the past two years, who knows whether double dips or Nike ticks are the shape of things to come in 2010.

Perhaps this is why we have seen an increase in the rise of asset allocation solutions starting to come forward, often with a mission to reduce the erosion of alpha through excessive costs. An increasing number of IFAs are turning their back on manager selection, having spent too long on the phone to disappointed clients. Instead, a focus on sound financial goal planning and efficient asset location through tax wrappers is now at the core of many adviser propositions. But who does the investment?

Sounding the purest instruments

This is where approaches vary. Many advisers understand the critical importance of asset allocation over the long run. They understand good asset allocation can make a significant contribution to a client’s alpha in its own right. As such, they will advise down to the level of portfolio construction, either by using their own insight or a number of the tools available on the market.

Having decided on the best asset classes to buy, they will fill the asset buckets with the purest, most cost-effective instrument, usually a passive index fund. This gives the client the lowest cost (therefore the lowest drag on performance) and the closest return to the index performance of that asset class.

Other advisers are following a broad asset construction philosophy, but then providing a tactical overlay to give the portfolio a ‘kicker’, by timing asset class performance in the economic cycle.
However, many advisers are questioning their own chances of getting asset allocation right, at any level. Some interesting questions are now debated at seminars. For example, how many assets classes are there? Is it two: equities and bonds? Or is it 32, by the time you have broken each asset class into regions and issuer? How about home bias? Even if I knew how much equity exposure I wanted, should it be biased toward the client’s domestic market or should it be more global?

The new solutions

Such questioning has seen the emergence of the new asset allocation solutions. These appeal to those advisers wishing to focus solely on financial planning and tax wrapper optimisation.

The asset allocation provider may be providing the solution either through a model portfolio (perhaps run on the adviser’s wrap), or through a fund of funds vehicle. Either way, this introduces another player into the supply chain who needs to be paid for and, therefore, a further potential drag on performance. How does an adviser ensure that this additional component does not create an unacceptable client cost?

There is a common theme among the emerging suppliers: the use of low-cost vehicles to execute the strategy.  Low costs look set to be the theme for 2010.

Some argue low-cost solutions, such as passive index funds or ETFs, are used to help create room for the asset allocators’ margin, but this is doing them a considerable disservice. This is a group of people who understand the extent of what anyone in their position can realistically provide. They are no more able to pick the next decade’s best performing managers than the next person. So they do not want to waste time and energy trying.

These are investment professionals who know their role, who know that even good, persistent alpha generators get dragged back below the index performance because of costs. They know the frictional costs of portfolio turnover create costs way beyond what is declared in the Total Expense Ratio. In fact, the very phrase “Total Expense Ratio” is itself a misnomer given the level of fees and charges which are not included in its calculation.

Of course, there are fund of fund solutions seeking to do the same job using more active components. The asset allocation of such funds will be equally professionally considered, but they will always face the challenges of overcoming manager selection risk and alpha-consuming costs.

It is no surprise, therefore, that the new breed of asset allocation solutions have low cost at the centre of their proposition. Not only is this providing an investment component cost that is acceptable (or even cheaper than before), it is the best way of keeping the asset class performance you have strived to achieve in the first place.