Go forth and diversify: Building resilience in multi-asset funds

Picture a forest. It’s bursting with plant and animal life. There are towering tree-trunks overhead and tangled roots underfoot.

In the 18th century, European scientists tried to tame this natural abundance. They started clearing land to create artificial forests that could be cultivated cheaply and efficiently. They chose a single species of tree and planted the seeds in orderly rows. But the result was a disaster. The trees rapidly died, and the project had to be started again at enormous cost.¹

So what went wrong? The scientists had overlooked what makes a forest resilient: its diversity. Thanks to its varied ecosystem, a wild forest contains in-built protections against disease. Lacking these natural defences, the artificial forests fell victim to parasites.

Risk and diversification

This story could be a parable for modern fund management. All else being equal, a globally diversified portfolio that encompasses a range of uncorrelated assets and strategies should prove more robust than a less-diversified alternative, especially during economic crises such as the fallout from COVID-19. 

But a successful multi-asset fund is not just a random collection of different securities; it encapsulates a set of ethical convictions and ideas about corporate and economic trends. The art of portfolio construction is to ensure these positions cohere in such a way that minimises risk and maximises opportunities. Not all multi-asset strategies are created equal.

Aviva Investors’ Multi-asset Funds (MAF) are driven by three key principles: in-built responsible investment, in-house portfolio construction and dynamic portfolio management.

1. Responsibility built-in

Start with responsible investment. Once seen as a “nice to have”, investing on the basis of environmental, social and governance (ESG) considerations has risen in prominence over recent years – and with good reason. 

A growing body of evidence shows incorporating ESG into investment decision-making not only makes the world a better place, it also enables fund managers to more effectively mitigate risk and identify new opportunities.²  

We believe focusing on a company’s short-term performance while disregarding factors such as its quality of governance, treatment of staff and record on climate change is misguided. And we don’t just simply screen out the worst offenders or run fenced-off ethical portfolios; we embed responsible investment considerations into every aspect of our multi-asset approach. 

Research and analysis

Every Aviva Investors fund manager is responsible for taking ESG factors into account when making investment decisions. They are supported by more than 20 dedicated ESG professionals, who specialise in issues such climate change, biodiversity, modern slavery and corporate governance.

We believe the basis of any ESG-focused approach is in-depth quantitative and qualitative research. We use this research to generate a proprietary ESG score that is applied to over 30,000 securities, providing a clear reference point for our investment teams. The ESG team also provides sector and industry analysis and top-down thematic research, linked to the United Nations’ Sustainable Development Goals.

Working with the Multi-asset and Macro team, the ESG analysts contribute to our quarterly House View, which sets out our collective judgement on the current economic and market environment and developing trends. This forms the basis for investment idea generation and tactical asset allocation decisions.

ESG is embedded into all the actively managed Aviva Investors funds into which the MAF range invests, with ESG factors considered alongside a range of financial metrics. Where the MAF range is invested through active funds managed externally, the provider’s ESG policies and procedures are rigorously assessed as part of the fund-selection process.

Active ownership

The process doesn’t end after we make an investment. We hold the companies we own to account. At the heart of this approach is our conviction that impactful engagement with companies is a more powerful tool than excluding them altogether – although we may decide to exit the investment if a firm refuses to improve. 

This stance is confirmed by our strong voting and engagement track record. In 2019, Aviva Investors voted at over 5,000 management resolutions and voted against management 24 per cent of the time; when it came to pay proposals, we voted against management 46 per cent of the time. 

Overall, we engaged more than 3,000 times with over 2,000 companies, helping to drive positive change on issues such as the inclusion of female executives on boards, reduction of plastics in the ocean, protection of World Heritage Sites and meeting climate change targets.

Despite these steps forward, there are still deep-rooted problems investors can’t tackle in isolation. That’s why, in addition to investment integration and active ownership, we seek to influence policymakers and regulators to create more sustainable financial markets. Aviva Investors was among the founding signatories of the UN’s Principles for Responsible Investment in 2006. We also helped to design the Sustainable Development Goals and contributed to the drafting of MiFID, European regulation to improve market transparency.

2. Strong portfolio construction

The second principle guiding our multi-asset approach is robust portfolio construction. We all know the old adage of having eggs in different baskets. Yet, we rarely recognise the possibility that eggs in separate basket can still break all at once. To mitigate this risk, we don’t follow the crowd by outsourcing our asset-allocation framework to a peer-group benchmark or third-party provider, instead we design it in-house. This frees us up to create an asset-allocation framework built on a more comprehensive set of methodologies than the average multi-asset solution. 

Growth, defensive, uncorrelated

So, what makes our approach different? Traditional asset allocation models tend to split capital between equity and fixed income: simply put, to increase risk they allocate more to equity, and to reduce risk they allocate more to fixed income. But a strategy that treats all fixed income as low risk and all equities as high risk is outdated – after all, global high-yield or emerging market debt can often behave more like equities than investment-grade bonds.

To create effective diversification and enhance risk-adjusted returns, we divide assets among three categories: Growth, Defensive and Uncorrelated. Growth assets have the potential to drive the portfolio’s growth – they include equities and riskier forms of fixed income. Defensive assets are held to protect the value of investments and manage risks: these include cash, government bonds and lower-risk corporate bonds. Uncorrelated assets have the potential to perform in all conditions, or with low correlation to traditional asset classes. We access these through a combination of esoteric investments, such as absolute-return strategies, global convertibles and real assets. 

As you move from MAF I (the lowest-risk fund in our offering) to MAF V (the highest-risk fund), the allocation to growth assets goes up and the allocation to defensive and uncorrelated assets goes down.

Truly diversified portfolios

Our asset allocation model is global in reach. This is the only way to create a truly diversified portfolio that is free from a potentially unwarranted and unhealthy home bias. A global approach should achieve a better risk-adjusted return over the longer term than a portfolio that is too concentrated in any one region. 

Many traditional asset allocation models rely heavily on historical data – but history doesn’t always repeat itself. This is why we use forward-looking metrics, combining historical data with proprietary expected-return projections to guide our decisions. This approach means we can incorporate recent market trends and forecasts and develop a framework relevant to current market conditions, as opposed to long-term historical averages.

Similarly, where many other funds use volatility as the primary measure of risk, we seek a more holistic view. While volatility can be a useful metric, it has significant limitations as a risk indicator. Volatility measures show variations around the mean; in other words, a high level of volatility will show large movements in the value of the asset from one day to the next, while low volatility will show smaller movements. But volatility doesn’t capture how much money an investor could lose in a tail-risk event, like the global financial crisis or the COVID-19 pandemic.

By incorporating tail risk into our analysis, we can glean a better understanding of the factors truly driving risk and return. For example, Japanese equities have historically been more volatile than UK and US stocks; but when tail risk is considered, Japanese equities may stack up much more favourably, due to the defensive nature of the Japanese yen.

A blend of active and passive

Implementing ideas in a cost-effective manner is key to any successful multi-asset strategy. One crucial decision is the choice between active and passive strategies. This debate is usually couched as binary; however, a blend of both strategies can work well. 

For example, we prefer to take a passive approach when allocating to large-cap US and Japanese equities. These markets are informationally efficient and liquid, making it difficult for an active fund manager to outperform. But in other, less-crowded markets, skilled fund managers can materially improve outcomes for their clients. Moreover, asset classes such as emerging market small-cap equities offer attractive expected returns but at additional risk to larger developed equity markets, so it makes sense to be more discerning when selecting companies for investment.

3. Dynamic management

The third principle of our multi-asset approach is dynamic management. The thinking here is summed up in a maxim by the writer William Arthur Ward: “The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” 

While our approach to portfolio construction is robust and sustainable, that doesn’t mean we never need to tweak the composition of the MAF range. Research shows that having the wrong asset allocation poses a threat to long-term investment performance. Taking the realist’s view, we are always prepared to adjust the sails. 

Responding when the wind changes 

Long-term asset allocations should be set to suit an investor’s goals and risk profile. In theory, maintaining these should be a simple matter of rebalancing the portfolio weights automatically on a quarterly or annual basis. However, this kind of passive, mechanical approach can be shown up by unexpected market changes. By contrast, a more dynamic approach can enable a portfolio manager to favour assets benefiting from tailwinds and withdraw from those facing headwinds.

In a trending market, like the equity rally in the first half of 2019, momentum tends to drive asset prices higher or lower for an extended period. In this environment, fixed rebalancing of a multi-asset portfolio without any discretion would see the portfolio sell the best-performing assets and buy into the weakest – effectively cutting winners and adding losers. This would result in a lower return than if these positions been left alone. 

Equally, when the tide starts to turn on an equity rally, having a process – and remit – to identify and sell over-valued assets and buy under-valued assets is clearly advantageous. In this way, proactive management of the allocation enables a manager to potentially enhance returns through market ups and downs.

Proactive rebalancing 

In essence, we understand market conditions continually evolve, and rebalancing in a considered and adaptable way is sensible, particularly when compared to arbitrary monthly or quarterly schedules. This is especially pertinent when volatility is heightened, given the fertile environment this creates for active asset allocators. 

Our Asset Allocation Committee provides the hub for our tactical views. This forum brings together MAF portfolio managers, key representatives of the investment strategy team and fund managers from across the wider Aviva Investors investment teams. The Committee puts together a positioning table that is reviewed on a weekly basis by the multi-asset team to ensure it remains relevant to current market conditions, before being applied to the MAF range. These tactical views are further refined and informed through frequent meetings among the fund managers and day-to-day portfolio monitoring.

Growth and resilience

With our in-built ESG focus, in-house asset allocation model and dynamic fund management, we believe we approach multi-asset investing differently from our peers. By challenging the status quo, we can take a broader and more active view to help us improve risk-adjusted returns for our clients.

That’s as it should be. Think back to the analogy from nature: like a flourishing forest, a good multi-asset strategy will be diversified, resilient and primed for long-term growth.