Five keys to managing a balanced fund

With the recent rise in the popularity of managed accounts, you would be forgiven for thinking that the diversified managed fund is a product of yesteryear. We, however, believe the role of diversified managed funds is more pressing than ever before and there is a role for them in almost any multi-asset portfolio – even to be held alongside or within a managed account. This is because this approach will not only reduce the risk of having all clients in a single investment approach, but it could also potentially lead to better client outcomes as well.

We believe a diversified managed fund has a broader toolset available with which to manage risk and seek outperformance and outline below our view to the five key elements essential to managing a successful diversified fund:

1. Flexibility, both within and across assets classes

   Diversified portfolios are often quite limited in terms of the flexibility given to decision making in terms of where to allocate capital or in terms of geographic allocations. This inflexibility prevents the manager from taking advantage of the relative value on offer across asset classes. We believe flexibility to invest across different asset classes, and at a security level within those asset classes, is key to maximising investor returns.

2. Built from the bottom up, on a security-by-security basis

   There are two primary ways to construct a diversified portfolio – own securities directly, or use a building block approach using managed funds and ETFs. Most diversified portfolios take the latter approach and outsource equity and bond research to different companies making it likely that equity and bond teams are working separately which makes it difficult to assess the relative attractiveness of different asset classes or funds when deciding portfolio weightings. In addition, internal political considerations can cause friction in the movement of capital.

   Building a portfolio from the bottom up, using individual securities, seems to us a much better way to manage a multi-asset fund. It enables the manager to analyse the entire capital structure of a business and decide which securities (if any) might be attractive, equities, bonds or hybrid offerings. It also means every security is constantly fighting all others for capital, and every security is bought with the expectation it will be an active contributor to fund returns.

3. Allow the use of derivatives to manage risk

   Derivatives are a useful tool to manage risk at a portfolio level, without having to always buy and sell underlying portfolio holdings to adjust exposures. Derivatives are often perceived as risky, but used sensibly they can actually reduce risk in a portfolio. Hedging allows you to control overall exposure to equities without having to reduce positions in attractive individual companies in these regions. In other words, you can reduce portfolio risk, without necessarily diluting returns.

4. Active currency management, to reduce potential losses from overvalued currencies and to seek alpha from undervalued currencies

   To some extent this is an extension of our point above, but it’s worth mentioning in its own right as it’s a very powerful tool that helps manage risks within a Fund and seek outperformance. By divorcing equity research from currency research, you can still seek out attractive investment opportunities in countries where you believe the currency is overvalued. Most managed accounts have to manage currencies by switching between hedged and unhedged managed funds and ETFs. This can become difficult if there isn’t a hedged version of your preferred investment vehicle. Even when available, it means a much less targeted and flexible approach to managing currency risk than using currency forwards.

5. True alignment of interests between the portfolio manager and the end investor

   When the interests of investors and investment managers are aligned, it creates a shared objective of maximising returns. To ensure that managers continually strive to outperform and deliver alpha for clients, we believe the right incentive structures need to be in place. As Charlie Munger once said, “show me the incentive and I will show you the outcome”.

As a diversified portfolio gathers assets, the temptation grows to deliver index-like returns and not stray far from the crowd. Lowering tracking error can reduce the risk of outflows, while the investment manager can continue to take active management fees from an already substantial asset base. This is a raw deal for investors, as there is absolutely no reason to pay active management fees for index-like returns when cheap, passively-managed diversified portfolios are readily available. Measures such as employee ownership of the firm, co-investment in the fund, and performance fees all help to ensure interests are aligned.

If you’ve got this far, you won’t be surprised to learn that this is exactly how we manage the Allan Gray Australia Balanced Fund. It’s a diversified fund with the flexibility to drive long term returns. To find out more visit our Fund page or contact your local BDM.

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