Acknowledging risk and the multi-asset dilemma
On the other side, one must acknowledge the role of uncertainty, especially given future returns are probabilistic.
For example, while a passive strategy may have a higher probability of success – if for no other reason than the fee advantage – it is not certain that the most likely outcome will occur.
Somewhat awkwardly, in this way investing can be likened to a horse race – while the favourite has the best chance of winning, they often do not, which is what makes the sport exciting.
Furthermore, while we must all appreciate the advantages for the passive investor, it is by no means certain that passive funds will perform better than active funds over the planned investment period.
It may be probable, but it is a mistake to think it is a deterministic inevitability.
This is further complicated when we add a multi-asset context.
In this world, the key driver of returns is decoupled from the price discovery mechanism that characterises single asset class funds.
While the impact of portfolio design is most obvious at a broad asset class level, it is also true within asset classes, as passive multi-asset funds will often exhibit a ‘home bias’ in their underlying exposures – we see this regularly across equity, bond and currency exposures, reflecting the liabilities and preferences of the local investor.
This again distorts the price discovery that is exhibited in single asset class funds and as a result, the features of a passive multi-asset funds differ significantly from their single asset class brethren.
It is important to highlight these differences because it can alter the risk profile of the portfolio through the impact of valuation and correlation.
This can be seen in the performance of passive multi-asset class funds over the past few years.
These funds have typically benefited from higher relative exposure to the largest capital markets – such as US equities or UK gilts – despite the fact that many investors consider these assets expensive.
As both returns and risk are linked with starting valuations, this raises a dilemma.
That is, the high price of these assets reduces the prospective returns and increase the prospective risk.
While this is true of any passive fund, it is less relevant for a single asset fund as these are judged by their ability to deliver returns compared to the benchmark. The overall risk and return characteristics of this benchmark are therefore of little importance.
However, the situation is different for multi-asset funds as these are primarily designed to deliver returns within a given risk boundary, which may include many different assets and portfolio constructions.
