Senior Investment Analyst Deanne Fuller commented, “Lonsec has traditionally reviewed Diversified and Multi-Manager Funds as separate sectors. As well as bringing both fund types under one ‘Multi-Asset Class’ sector, we have expanded the review to include new products – Multi-Asset Real Return Funds and Multi-Asset Income Funds.”

“Many traditional Multi-Asset Class Funds disappointed during and after the GFC. They experienced significant drawdowns brought about by being structurally required to hold as much as 70% in equities.”

Most traditional Multi-Asset Class Funds have been managed with reference to a strategic asset allocation (SAA) framework, with some tactical asset allocation (TAA) tilts. Following the GFC, a number of managers, including Mercer, MLC and Russell, widened their asset allocation ranges to opt for a more dynamic approach to asset allocation.

“While SAA is typically long term and TAA shorter-term, Dynamic Asset Allocation (DAA) aims to take positions over the medium term when markets are extremely over or undervalued,” said Fuller.

“We see this approach to be particularly beneficial when used as a risk management tool, used to protect on the downside when markets are extremely overvalued, rather than used to generate alpha from the process (market timing bets).”

Does DAA go far enough?
While useful in providing some additional flexibility, DAA doesn’t go far enough for a small group of managers, including AMP, MLC, Schroder and Select. They argue that markets have entered a period of heightened volatility and the need for flexibility in asset allocation is essential in delivering portfolio risk and return objectives.

“This includes the ability to ‘go anywhere’ – meaning the fund may be completely divested from a particular asset class in periods of sever market stress,” commented Fuller.

“It allows for more opportunistic investing in new asset classes as and when opportunities arise.”

“These funds aim to limit the extent and severity of drawdowns and deliver a ‘real rate’ of return above cash or inflation, hence the name ‘Multi-Asset Real Return Funds.”

What sets these funds apart from their more traditional counterparts is the absence of the structural impediments usually associated with SAA.
In a similar vein, Multi-Asset Income Funds allow for flexible asset allocation in order to deliver a more reliable income stream to investors.

“These funds are designed for those investors who have a need for stable and consistent yield, for example retirees,” said Fuller.

“They are designed to be liquid, invest across a range of income producing assets, provide a regular, stable income, a level of capital growth to keep pace with inflation and to provide some downside protection.”

While in their infancy, these new style funds are designed to overcome some of the issues raised post GFC and are considered to be an exciting development within the space. That said, Lonsec recognises that no one investment style will outperform in all market conditions. Multi-Asset Real Return Funds are likely to underperform their more traditional counterparts in strong bull equity markets, but as a trade-off, will potentially provide a smoother ride for investors.

While traditional SAA does have its limitations, providing the underlying assumptions (risk, returns, correlations) are regularly revisited and risk is considered in its broadest sense, the traditional SAA approach can still be an appropriate way to invest for those with long-term investment horizons.

The review
Lonsec’s Multi-Asset Class Sector Review covered 27 fund managers across 37 fund ranges and assigned ratings on over 120 individual funds across the four sub-categories:

• Diversified (14 fund ranges)
• Multi-Asset/Multi-Manager (16 fund ranges)
• Multi-Asset Income (two funds)
• Multi-Asset Real Return (five funds).

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Senior Investment Analyst Deanne Fuller commented, “We reviewed over 40 managers in the lead up to the 2011 review, conducting on-site due diligence on managers located across the major hedge fund centres of Zurich, London, New York, Princeton, Greenwich and San Francisco, as well as Melbourne and Sydney.”

“As well as meeting with incumbent managers, it’s important for us to meet with ‘prospect managers’ and identify any potential managers that would enhance Lonsec’s recommended list. Not all managers we meet with are rated.”

Sector themes and observations

Sector flows
After the significant outflows experienced by the hedge fund industry during the GFC, 2010-2011 saw assets under management in the sector return close to 2007 levels according to BarclayHedge, a provider of alternative investment databases; total hedge fund assets were estimated at US$1.77 trillion at 30 March 2011.

“The managed futures, global macro and event driven sectors received the largest inflows,” observed Fuller.

“As many investors still have the effects of the GFC fresh in their mind, larger funds with longer track records attracted the majority of inflows due to their lower perceived risk.”

“Most flows came from pension funds and institutional investors driven by a desire to find attractive risk adjusted returns uncorrelated to the stock and bond markets,” continued Fuller.

One of the trends noted by Lonsec is the rapid growth in the managed futures space since the end of 2009. Assets under management in this sector globally have grown 36% to US$291 billion at 30 March 2011, making managed futures the largest hedge fund strategy in the market.

“The weight of money and high correlation among managers in this strategy leads Lonsec to believe that risks have generally increased, specifically the potential for signal decay and the inefficiencies and negative performance impact that can be attributed to the unwinding of crowded trades,” said Fuller.

“While we do not see this as an immediate concern, should growth continue at this pace, Lonsec believes there may be cause for a re-rating of funds across the sector.”

Active versus passive
“The active versus passive debate has now entered the alternatives arena,” said Fuller.

“While investors have been attracted to the low correlation with traditional asset classes, higher fees have made the sector less attractive.”
In an effort to reduce hedge fund fees, reduce trading costs, lower financing costs and increase transparency, a number of approaches have been put forward by managers, including investible hedge fund indices, hedge index tracker funds, hedge fund replication strategies and hedge fund beta strategies.

“Lonsec regards the hedge fund beta concept as being superior to hedge fund replication and investing in hedge fund indices,” commented Fuller.

“Essentially hedge fund beta examines a number of hedge fund strategies and identifies and implements the ‘bread and butter’ trades that underpin each strategy.”

“While the underlying strategies are less likely to perform as well as a dedicated manager specialising in a particular strategy, the trade-off to investors is that this strategy is substantially cheaper.”

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