Outsourcing focus | Making outsourced investment management work for your clients

Outsourcing focus Making outsourced investment management work for your clients

In association with IFA Magazine.

How can you analyse market performance in your sleep?

Outsource to Schroders and add our global resources to yours through our Multi-Asset and Multi-Manager fund ranges or the Model Portfolio Service and Discretionary Fund Management from Cazenove Capital.

We’ll put our 70 years of multi-asset investing experience to work for you.

Work smarter An IFA Magazine special supplement in financial advisers Many created of today’s

association with Schroders and choose Cazenove toCapital focus on the planning

aspect of their role by outsourcing their investment decisions.

Contents

Put our team on your side to give your clients the full benefit of Schroders’ Making outsourced investment management global multi-asset capabilities.

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work for your clients

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- 100+ people globally with local presence in the US, UK, Europe and across the Asia Pacific region

Discretionary Fund Management Is it right for your client?

- £70bn* in AUM across a diverse,

global client base

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- Leveraging the comprehensive investment resources of Schroders Why model portfolios needn't be boringand Cazenove Capital

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The importance of risk profiling in portfolio management

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Rebalancing does it really matter?

IFA Magazine is published by IFA Magazine Publications Ltd, Arcade Chambers, 8 Kings Road, Bristol BS8 4AB Tel: +44 (0) 1173 258328 © 2018. All rights reserved ‘IFA Magazine’ is a trademark of IFA Magazine Publications Limited. No part of this publication may be reproduced or stored in any printed or electronic retrieval system without prior permission. All material has been carefully checked for accuracy, but no responsibility can be accepted for inaccuracies. Wherever appropriate, independent research and where necessary legal advice should be sought before acting on any information contained in this publication.

The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested.

IFA Magazine is for professional advisers only. Full details and eligibility at: www.ifamagazine.com

Source: Schroders as at 30 September 2018

Schroders has expressed its own views and these may change. The data contained in this document has been sourced by Schroders and should be independently verified before further publication or use. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Any data has been sourced by us and is provided without any warranties of any kind. It should be independently verified before further publication or use. Third party data is owned or licenced by the data provider and may not be reproduced, extracted or used for any other purpose without the data provider’s consent. Neither we, nor the data provider, will have any liability in connection with the third party data. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice. Reliance should not be placed on any views or information in the material when taking individual investment and/or strategic decisions. No responsibility can be accepted for error of fact or opinion. Any references to securities, sectors, regions and/or countries are for illustrative purposes only. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Issued in October 2018 by Schroder Investment Management Ltd, 1 London Wall Place, London EC2Y 5AU. Registration No 1893220 England. Authorised and regulated by the Financial Conduct Authority.

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Making outsourced investment management work for your clients Financial Planners have never been so busy. As well as delivering excellence in client service, the pressures of keeping up with the weight of changes to regulation and legislation is placing an increasing burden on the resources of financial planning firms.

Due diligence is so important because it’s about doing everything you can with the information available at the time to make decisions that will help you to achieve the best possible outcome for clients

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So, you’ve made the decision to outsource the investment management aspect of your financial planning business to a specialist, third-party provider.

You may even be already using an outsourced service – or combination of approaches - but considering some changes or adding to the list of providers you use. More and more financial planning firms are seeing the benefits of doing just this. Working in partnership with a specialist provider (or providers) means that you can focus on your strengths in delivering excellence in financial planning and client service whilst also reducing the compliance burden, improving portfolio reporting and reducing costs.

For clients too, there’s the benefit of having the greater peace of mind which comes from knowing that their portfolio is being constantly and actively managed by expert investment managers who have significant research and analysis resources to back up their judgements.

Doing your due diligence But how do you collect all the relevant information that is needed to check out a particular product, fund or service? How do you conduct effective due diligence to get under the skin of providers’ services in order to see if there is genuine compatibility with your business and the needs of your clients? The importance to your business of getting this right can’t be overstated. Some might argue that due diligence is just good practice, and in many ways that’s true.

I FAmagazine.com November 18

Any proposition needs to be well researched and assessed so as to ensure that its use can be justified both in the present and in the future. Yes, you need to do proper checks at the start, with information gathered, verified and stored, and crucially, fact separated from opinion. These things should happen because it’s in clients’ interests, not simply to tick a box for compliance purposes. And therein lies the rub: due diligence is so important because it’s about doing everything you can with the information available at the time to make decisions that will help you to achieve the best possible outcome for clients.

of what they do and how they do it - how they actually manage your clients’ money. You’re looking for a strong cultural fit of course, which means entering two-way discussions to ensure that they have a strong grasp of your business and its needs in just the same way as you do of theirs.

Good practice in this area includes a healthy degree of professional scepticism. It isn’t enough to gather all the information available and accept it at face value. Marketing literature needs particular care.

When extending it to any independent validation of the information, this too needs to be considered thoroughly. Any third party endorsement is helpful, but it is important to understand the basis on which the endorsement was given and the credentials of anyone making judgements.

This supplement gives just a snapshot of some of the services that are available to you and your clients from Schroders and Cazenove Capital. It is designed to give you a flavour of the considerable resources and global reach which the organisations have – and why it’s their approach of working closely with financial planners and their clients which ensures that partnership is built to last.

Getting this right from the very beginning can make the difference between having an acceptable approach and an excellent one which stands the test of time – that makes sense not just for your clients but also for your business too.

Working together with an outsourced investment manager - the right fit

To find out more about all the outsourcing options available from Schroders and Cazenove Capital visit www.schroders.co.uk/outsourcing

This is where understanding the complete resources of the third-party manager really come into play.

Once you start to dig deep, you’ll discover the detail

Sue Whitbread Editor IFA Magazine

I FAmagazine.com November 18

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Discretionary Fund Management - Is it right for your client?

Sue Whitbread talks to Simon Cooper, Business Development Director and Steven Rooke, Portfolio Director of Cazenove Capital about discretionary management and why it is all about providing advisers with what they - and their clients – want

and their clients, combined with our access to the global expertise of the Schroder Group.

SW: How does the Cazenove Capital DFM service operate? Do you work in partnership with the adviser or is it more “off the peg”?

SW: Simon, how can you help advisers who are looking to outsource the portfolio management function for their clients?

SC: As an adviser, when you are considering the outsourcing of portfolio management, in some cases a model portfolio service can be just what is needed. In other cases, a bespoke service is more appropriate. Our job is to ensure that whatever the client’s requirements, advisers can find the right solution with us. We offer both of these approaches within a robust framework that really does utilise all the strengths of Schroders and Cazenove Capital.

SW: In your experience, why do advisers use a Discretionary Fund Manager (DFM)?

SC: As advisers know, working with a DFM can be an ideal solution where they are looking to outsource the day-to-day asset allocation and fund selection decisions, allowing them more time to focus on clients’ financial planning requirements.

Cazenove Capital is the wealth management business of Schroders in the UK and Channel Islands. We have a dedicated DFM team whose strength is founded on the lasting relationships that they build with advisers

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SC: Our discretionary fund management team works very much in partnership with the adviser. Everyone is different and has different needs so we are focused on each adviser’s individual requirements and on delivering a high level of service to the adviser and the client. Both the adviser and client will have direct access to a portfolio manager and dedicated support team. Following a well-established central investment approach, we develop and implement the most suitable portfolios whilst aiming to deliver superior risk-adjusted returns in line with clients’ risk profiles and financial requirements.

SW: Steven, can you talk us through the investment process?

SR: Our investment philosophy for the bespoke portfolios, as with the Model Portfolio Service (MPS) which we can also offer as an attractive alternative, is underpinned by two key factors: an understanding of the business cycle (see Chart 1) and its impact on different asset classes and underlying investments, as well as a strong belief in the merits of diversification.

Chart 1 shows the business cycle as we currently see it. Around the world different markets will almost always be in different phases of the cycle at different times. This assessment strategy is embedded right across our investment process. Being able to select those assets in those areas where we see strong growth potential is crucial.

I FAmagazine.com November 18

Chart 1 – The business cycle Showdown: Output above trend Growth decelerating Inflation rising

Overweight

Market

Underweight

Recession: Output below trend Growth decelerating Inflation falling

Recession: Output above trend Growth accelerating Inflation rising

Recovery: Output below trend Growth accelerating Inflation falling

Absolute return

Government bonds

Developed market equities

Developing market equities

Corporate bonds

Cash

Developing market equities

Commercial property

Government bonds

Absolute return

Commercial property

Commodities

Cash

Corporate bonds

Commodities

Developing marketing equities

Commercial property

Developing marketing equities

Corporate bonds

Absolute return

Developing market equities

Commercial property

Absolute return

Corporate bonds

Developing market equities

Developing market equities

Cash

Cash

Commodities

Commodities

Government bonds

Government bonds Source: Cazenove Capital September 2018

We are fortunate to have huge resources for research and analysis behind us. That’s not just at Cazenove Capital but also within the Schroders network too.

There are many fund managers who we can tap into for insight for example, plus economists for views and opinions. Our investment process is specifically designed to ensure a robust, repeatable approach to delivering on our core investment beliefs and is comprised of the following components:

Investment Research We have a disciplined manager research process alongside a strong and deep capability involving all members of the investment team as well as portfolio managers. This structure allows us to invest with the very best managers as well as being able to evaluate the evolving investment opportunity set.

Investment Policy

SW: How does your DFM service differ from other managers?

The house investment policy is set by the Wealth Management Investment Committee (WMIC), chaired by the Chief Investment Officer. The WMIC sets guidance as to the expected outlook for different asset classes, sub asset classes and regions.

The remit of this committee is:

SC: We use a broad range of asset classes when it comes to investment, on the DFM side we use a lot of wider products such as structured products and alternatives which we believe is a strong value add for investors. It really differentiates us from our peers.

• To determine a central macro overview for the world’s major economies, with a particular emphasis on current and anticipated changes in the business cycle

There are three elements which differentiate our offering from competitors. When it comes to investment, on the DFM side we use a lot of wider products and invest in alternative areas such as structured products, targeted absolute return, property and other specialist vehicles. All of which can be used to deliver strong risk-adjusted returns.

• To consider the implications of recent and prospective changes in monetary policy, fiscal policy and government regulation and geo-political developments Our approach to investing focuses on the business cycle and explicitly evaluates current and future economic and investment environments in order to take calculated views from a top- down asset allocation perspective.

I FAmagazine.com November 18

Secondly our exposure to the wider Schroders' investment engine puts us in a unique position.

Given, the huge scope for research we have internally, there isn't any investment or asset class that we can't use within the portfolios for investors.

Within the group we have access to specialists in almost every area of investment. This gives us

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incredible strength through having the resources to build portfolios which are underpinned by strong research and analysis as well as robust processes.

Finally as well as different fund management styles we can blend the management approaches.

When constructing the portfolios, we look at how assets work together with each other. We look at different fund managers, how they work and the different strategies they use so that we can blend those management styles. Combining these complementary approaches, boosts portfolio diversification and reduces volatility, whilst helping to deliver strong long term returns which investors want.

SW: How does the DFM service proposition work?

What does it cost and what can advisers expect?

SC: The DFM team is set up purely to work with advisers and their clients. It works on a partnership basis with the adviser, the client and the portfolio manager to create a bespoke portfolio which is based on the clients’ aims, objectives and risk profile. It ensures a highly personalised service for the client.

This service means that you are getting face to face portfolio management and a more bespoke portfolio.

It is something which is built specifically for the individual client.

We deliver full online reporting and there’s also an app to make it even easier to view the details. There has been lots of investment made by us into these areas recently which is great. Both the client and the adviser have access to clients’ information through that same portal. It really is efficient for the adviser.

Our standard fees for bespoke portfolios for clients investing from £200,000 up to multi million pound portfolios are 0.85% on the first £1million (which includes all custody fees) then 0.5% over that.

SC: Yes indeed. The breadth of services we can provide is huge. Aside from the DFM and MPS portfolio services, we can run AIM portfolios, charity portfolios, corporate pensions, banking and treasury – you name it we can handle it. We are here to provide the services which advisers want. We’re just not about forcing a solution upon them in any way.

It’s about being adaptable and providing effective solutions for advisers and their clients that really work for them.

By working together with the adviser we can make sure that the client really does get access to the very best opportunities for strong, long-term investment returns as well as peace of mind from knowing that their assets are in safe hands.

To find out more, please visit our website www.cazenovecapital.com/adviser

Around the world, different markets will almost always be in different phases of the cycle at different times

We have a varied client base ranging from pension pots through to multi-million pound portfolios across the world. One thing we’ve focused on over the years is busting the myth of feelings like “we’re too small for Cazenove Capital”. That simply doesn’t apply at all.

SW: Are there any other services which are of interest to advisers and their clients?

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I FAmagazine.com November 18

Why model portfolios needn’t be boring Steven Rooke, Portfolio Director and Simon Cooper, Business Development Director of Cazenove Capital, talk to Sue Whitbread about the Model Portfolio Service and how it is helping advisers to provide effective investment solutions to a broader range of clients SW: Steven, could you explain exactly what the Model Portfolio Service (MPS) is about and how you run it?

SR: The MPS is a discretionary investment management service that consists of a suite of six risk-profiled portfolios which are independently risk-rated by Distribution Technology.

It is aimed at advisers who are looking to outsource investment management in a platform environment, and to help them provide a service for clients who may not need a bespoke service as it would not be cost-effective.

We launched the MPS at the start of July 2016, literally straight after the EU vote. It was certainly an interesting time for markets back then. Since then, I’m pleased to say that the performance of the portfolios has been good. The reason we launched the MPS was to provide an extension of our Discretionary Fund Management (DFM) service offering bespoke portfolios for advisers’ clients. As time has gone by, with more and more advisers using wraps and platforms for much their investment business, adding MPS to the range was a natural progression for us. It has meant that we can extend our help and services to advisers for their entire book of business.

SW: How does the MPS differ from the bespoke portfolio service?

SC: The MPS portfolios are easily accessible via platforms and for clients with a minimum of £1,000 to invest. It takes advantage of the platform’s ability to administer assets in a cost-efficient manner and is also available in a range of tax-efficient wrappers, such as Individual Savings Accounts (ISAs), self-invested personal pensions (SIPPs) and General Investment Accounts (GIAs) SW: Steven is there a difference in your investment approach to the MPS compared to the bespoke Discretionary portfolios?

I FAmagazine.com November 18

SR: When it comes to management, what we wanted to do was to keep the MPS in line with our investment process as we possibly could, given the requirements of platform usage. Advisers will see the same investment ethos streaming through both services.

Our investment philosophy, as with the DFM service, is underpinned by two key factors: an understanding of the business cycle and its impact on different asset classes and underlying investments, as well as a strong belief in the merits of diversification.

The investment approach we take within the MPS is very much a multi-asset one– a specialist area for us. Through this, we cover the full range of asset classes across equities, bonds and other alternatives (property, gold, infrastructure etc.) to ensure that we can deliver strong risk-adjusted returns for investors over time.

Our approach feeds through our centralised investment process. We benefit from having many in-house specialists at Cazenove Capital as well as being able to lean on the wider Schroders group.

There’s a huge amount of resource there for us too.

Our combined heritage, created by bringing together Schroders and Cazenove Capital, is quite unique in the investment world.

What this means for clients is that even those investing smaller amounts into the MPS, are getting the benefits of Cazenove Capital investment experience. Whilst using their platform of choice.

MPS provides exposure to the Cazenove Capital house view on platform.

The portfolios use a whole of market approach, which also gives an extra layer of independence. There is no obligation on us whatsoever to buy Schroders’ funds.

SW: Which platforms can advisers use to access the MPS?

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SC: The portfolios are available and administered by third-party platform providers and structured to fully support the client/adviser relationship. At present, advisers can access the MPS via platforms from Aegon, Standard Life, Novia, James Hay and Fusion.

Aviva is following and being launched in Q4 2018.

This is an important aspect as it is all entirely IFA demand driven. It helps them to broaden the investment options they have within those platforms and helps with switching options too. We realise that ideally, we need to make the MPS available through all platforms in due course.

SW: What models are available?

SC: We have the ‘Core Models’ and ‘Active/Passive’ Models. The core models are unconstrained and utilising open ended funds, ETF’s and Investment trusts. On the back of adviser demand we launched the cost effective active/passive range.

SW: How do you go about risk monitoring within the portfolios?

SR: We construct optimal asset allocations for the models based on our in-house strategic asset allocation aligned to the six risk categories. These are independently risk rated by Distribution Technology and Defaqto.

SW: What about rebalancing? What’s your process there?

SR: We like to maintain a pragmatic approach within our models – as we do with private client portfolios.

Rather than being forced into a static asset allocation, with quarterly rebalancing tied to specific dates on a calendar, we prefer to take a different route.

Instead, we rebalance at a time when we feel it most appropriate. It gives us the scope to run our winners and rebalance when opportunities arise in markets.

We keep a keen eye to ensure that the portfolios stay within Distribution Technology’s risk profiles.

SW: How do you see the MPS as helping advisers to meet clients’ needs and build an effective business?

SC: Because the MPS is available through third party platforms, access is simple. We prefer not to pigeon-hole it at particular client segments and that is borne out by the way in which advisers have been using it to date. Some advisers use it for investments as large as £5m so it is by no means limited to those investing relatively small amounts. Of course, some will use the DFM service for those clients investing larger amounts, where they feel that a bespoke service may be appropriate.

way, instead it’s up to us to work around them and their requirements – and that’s what we do.

Our approach really underpins the advisers’ business.

It frees up time for advisers and their teams so that they can concentrate on their client service model and deliver the most effective service for their clients. In a way, it’s like us putting 4,700 Schroders’ employees on their doorstep, helping to support the business and the service the client receives.

Put simply, using services like the MPS or the DFM helps advisers to demonstrate quite clearly to their clients that they are sitting on the same side of the table as them. It shows that it is the client’s best interests which are driving decisions and really helps maintain advisers’ impartiality. Because of the power of technology it’s so easy to do now.

Overall, it represents a very cost efficient solution for advisers’ clients. Basically, they’re getting the full Cazenove Capital experience and service for just 30 basis points ex VAT. It’s ideal for clients who don’t need or want a bespoke service.

SW: How can advisers keep up to date with what’s going on within the portfolios?

SC: Advisers and their clients can view the underlying assets through the platform. Also, we produce quarterly fact sheets for all eleven model portfolios (6 core and 5 active/passive models) as well as monthly communications, video updates and a quarterly magazine.

All of these are available through our website www.cazenovecapital.com

Overall, it’s our job to provide a flexible approach for advisers.

It’s not for us to force advisers to work our way, instead it’s up to us to work around them and their requirements – and that’s what we do

Overall, it’s our job to provide a flexible approach for advisers. It’s not for us to force advisers to work our

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I FAmagazine.com November 18

The importance of risk profiling in portfolio management Marcus Brookes, Head of Multi-Manager at Schroders, talks to Sue Whitbread about how the combination of their fund management expertise and Dynamic Planner's risk targeting and asset allocation model has led to greater choice for advisers

SW: Marcus, could you start us off by talking us through your approach to managing the portfolios for the relatively new Dynamic Planner range?

MB: The approach that we use for the Schroder Dynamic Planner range of five portfolios utilises the same philosophy and process that we use on the Diversity Range. This is to formulate a market view and then invest with the very best fund managers that are positioned to benefit from those market conditions. Put simply, where we find assets that we are bullish on, we seek out the best managers in that area that are bullishly positioned. For the Schroder Dynamic Planner funds we can implement these views whilst ensuring that the funds remain within the volatility parameters as set by Distribution Technology’s Dynamic Planner, which is an important feature of these funds. The existing Schroder Multi-Manager Diversity range of funds is risk rated, which means they are assigned a rating that reflects their expected volatility due to the risks they are currently taking. Importantly though, this range of funds is not targeting a certain level of risk rather they target outperformance of their benchmarks which could see a 4 rated fund become 3 or 5 depending upon the market conditions.

The new Schroder Dynamic Planner range has been designed to enable advisers who use Dynamic Planner, the market leading provider of digital risk profiling and financial planning services, to risk profile their clients to select investment solutions that are suitable for their clients’ requirements. The funds target Dynamic Planner risk profiles from level 3 to level 7. The range commits to being risk managed, so for instance the Schroder Dynamic Planner 4 fund

I FAmagazine.com November 18

will always be managed to achieve a risk outcome that stays within the boundaries of the Dynamic Planner risk level 4. This is where our partnership with Dynamic Planner has proved to be so important, as we can use their data to model the fund’s potential transactions before we implement them.

We also chose to cap the cost of the Schroder Dynamic Planner range at 0.99% OCF to offer a lower cost solution for advisers. This means we use some passive funds alongside active funds, to enable the costs to be reasonably low for a multi-manager fund.

We have always been able to select from the whole of the market, which has meant using some internal funds which we have also done for this new range.

Schroders has a policy of no “double dipping” which means there is no annual management charge (AMC) made these funds. The remainder of the Schroder Dynamic Planner funds are invested in third party funds and there is a huge overlap with the Diversity range in the names that are used, with funds from Jupiter, Morgan Stanley, GLG, Hermes and Invesco for instance.

SW: What are you doing with the portfolios at the moment? Looking ahead to 2019, where do you see the best opportunities for growth and how are you looking to access those?

The U.S. equity market is an area that we are strongly underweight in. In fact we even have zero weighting in some of the funds that are allowed to do that as the market looks pretty expensive to us. We’re not forecasting any sort of disaster in the U.S. equity market. We’re just saying from a fundamental perspective it looks quite late in the day for that trade, which has been going on for a while, and the valuation is just incredibly high.

On the flip side, Japan has done nothing wrong. Its economy is going really, really well. The only thing it is missing is inflation, really, but when you look at the tightness of the labour market there, America

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is doing really well with 3.7% unemployment; Japan is even lower at 2.8%. So, for us, you have got a world class set of companies trading on a much bigger discount against U.S. equities than they really deserve to. I think it is good news that Shinzō Abe, who has been one of the more successful prime ministers since WW2, has just been reappointed by his party. He is giving clear direction to the Japanese economy and trying to instil good corporate governance at companies. We’re confident that Japan still looks like a really great place to be. It is relatively cheap and, as I say, world-class companies trading on a discount, it is great.

As advisers know, gold is attractive as an inflation hedge. In September, inflation worries started coming through, on the back of some pretty strong economic data. Gold has been a bit weak of late, but I think as a diversifier in a portfolio, particularly if you share our view that inflation is the likely outcome of too many tax breaks and a tightening labour market, I think gold could be a fantastic asset to hold.

SW: Your relationship with Dynamic Planner is an interesting one. How does that work? How does the technology help you to deliver benefits for advisers and their clients?

MB: The partnership with Dynamic Planner was very much a case of ‘right place right time’, for them and us when we launched the fund range nearly a year ago. We had been discussing the idea of launching a risk-targeted range of funds for some time, as we had watched this part of the industry grow and it seemed the natural step.

Distribution Technology bring an awful lot of expertise and technology to the table, having established themselves as the market leader in fund risk-profiling. One of the greatest benefits to using this fund range is the enhanced reporting tool that investors will receive. It’s of a very high standard and can have each adviser’s logo on it, meaning it really feels like a private client experience. This is not something that Schroders could provide, and really helps the fund range to stand out from the crowd.

To find out more about the Schroder Dynamic Planner fund range visit www.schroders.co.uk/outsourcing

Distribution Technology bring an awful lot of expertise and technology to the table, having established themselves as the market leader in fund risk-profiling

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I FAmagazine.com November 18

Rebalancing – does it really matter?

Clement Yong, Analyst, Schroders' Multi-Asset team sets out the case as to why an active rebalancing policy is essential to achieve and retain healthy long-term returns for your clients Why an active rebalancing policy is essential to achieve and retain healthy long-term returns for your clients As an adviser, it can be hard to hold your nerve when making investment decisions on behalf of your clients. Share price gyrations, sudden market drops and fear of missing out can unsettle the steeliest investor. Whether or not you outsource the investment management process, such tribulations can undermine the discipline needed for long-term gain and to retain the returns your clients need to enable them to meet their goals in life.

Of course, diversification is key. By ensuring that your clients have a portfolio consisting of a range of different asset classes and sectors, you can increase the odds that at least one of them will be working hard when the others aren’t. But maintaining the necessary diversity of assets is not something that can be left to chance. Our research at Schroders suggests that keeping the right balance between the different assets over time is an important factor often overlooked when it comes to investment management.

Why is balance so important?

Risk is as important as return or, as billionaire investor Warren Buffett put it, “Rule number 1: never lose money. Rule number 2: never forget rule number 1.” Getting the right balance between risk and reward is not easy. Attaining good “risk-adjusted” returns means maintaining the right proportion of those assets that provide growth, balanced against the right proportion that will provide security. Asset allocation is the biggest influence on a portfolio’s risk and return.

What happens when there is no rebalancing?

An essential part of maintaining a diversified portfolio is to carry out regular rebalancing – ie the regular adjustment of a portfolio so that it keeps returning to the original asset allocation. Say equities make up 75% of a portfolio but then have a good run

I FAmagazine.com November 18

while other assets languish. That equities portion may end up making up 80% of the portfolio. By rebalancing, you sell until the equities are back to a 75% portion.

You end up selling assets that have performed well and buying ones that haven’t – a prudent move in itself – which helps guard against portfolio drift.

We decided to run some scenarios to find out how rebalancing, and not rebalancing, would have affected outcomes – the returns achieved versus the risks taken. We used one of the simplest of diversified portfolios split 60% in shares – to provide the growth – and 40% in bonds – to provide the security.

While an investment portfolio might start with this division, stockmarket movements mean that it will almost certainly move away from the original “60/40” allocation. We looked at how it would have fared in two 10-year periods,1990-2000 and 2000-2010, with no intervention. We found that a 60/40 portfolio in 1990 would have ended up divided 75/25 by 2000. On the other hand, a 60/40 allocation in 2000 would have become 45% equities and 55% bonds by the end of the decade. In both cases, the better-performing asset class came to dominate the portfolio. That may well have worked well in terms of returns, but it would have shifted the risks drastically compared to the original asset allocation.

Why is an unbalanced portfolio more risky?

Seduced by high returns, an investment manager might be tempted to leave a portfolio of high-performing shares or equity funds to grow.

The problem is that they may also end up dangerously exposed. The results can be both painful and swift.

Perhaps the most traumatic illustration was in 1974, when the FTSE All-Share Index fell by more than 70% - very bad news for anyone holding a UK share portfolio. Black Monday in October 1987 wasn’t that great either: by the end of the month, the US Dow Jones Industrial Average was down by 22% and the UK market was off by 26%. In 2008, the year when

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There is a "rebalancing premium", at least in risk-adjusted terms Return

Volatility

Return/Risk Ratio

Drift

10.18%

12.88%

0.79

Monthly rebalance

8.83%

8.91%

0.99

Quarterly rebalance

8.92%

8.89%

1.00

Annual rebalance

8.99%

8.91%

1.01

2 - year rebalance

8.95%

8.87%

1.01

3% band rebalance

8.89%

8.93%

0.99

5% band rebalance

8.95%

8.97%

1.00

10% band rebalance

9.04%

9.10%

0.99

20% band rebalance

9.42%

9.54%

0.99

Past performance is not a guide to future performance and may not be repeated

Equity returns are based on those of the S&P 500 Index TR; bond returns on 10-year US government bonds. Period covered is January 1940 to March 2018. Where relevant, portfolios are rebalanced back to a 60/40 allocation target. Source: Schroders, Robert Shiller, Global Financial Data and Thomson Reuters Datastream.

the credit crunch kicked in, the FTSE 100 index fell by 31%. And bonds can suffer too: in 1994 unexpected interest rate rises by the US Federal Reserve helped to wipe a cool $1.5 trillion from world bond markets.

It is true that markets do come back from such losses, but it often requires a strong stomach to last the journey. For an investor, not having all your eggs in one basket can both protect wealth and give the confidence to stay aboard.

For the purposes of our illustration, we have ignored such costs, but we acknowledge that they can be substantial enough to outweigh the benefits of rebalancing. Choosing the optimum rebalancing strategy therefore involves a trade-off between the best risk-adjusted returns and the lowest level of costs consistent with achieving those returns.

How does rebalancing work?

In short, no. Our research shows clearly that, while a rebalancing strategy should follow set rules, it also necessarily requires judgement. Not only do investment managers have to decide whether to rebalance or not, but also how frequently, the target allocation and the way the strategy should be implemented, among other things. Having the expertise to time rebalancing strategies based on economic environments can be difficult, but our experience suggests that having such a policy in place should help greatly during times of market stress.

The main rebalancing approaches are either “periodic”, based on set time intervals such as every quarter, or when differences in performance cause the asset allocation to drift away from its target by more than a certain percentage. This is known as “band” or “range” rebalancing. To see how these strategies affect long-term returns, we tested our 60/40 portfolio over the nearly 80-year period since 1940 using different rebalancing strategies and none at all. (This was the longest set of reliable data we could find.)

We tested nine rebalancing portfolios and one with none, our “drift” portfolio. In terms of absolute returns, the drift portfolio performed best, with a 10% annual return. However in risk-adjusted terms, which we defined as annualised returns divided by annualised volatility, it performed the worst. Indeed, every portfolio which used a rebalancing policy, be it periodic or range based, outperformed the drift portfolio in risk-adjusted terms (see chart).

Doesn’t regular rebalancing incur costs?

Is rebalancing just an automatic process?

We conclude that, even when markets are doing well, rebalancing produces superior risk-adjusted returns compared with doing nothing. As an integral part of the investment process, rebalancing should therefore bring rigour and discipline to the construction of the portfolio, while providing free long-run risk management. This is a combination that should commend itself to all advisers, allowing them and their clients to sleep that bit easier at night.

For more information about multi-asset investing visit www.schroders.co.uk/outsourcing

It is true that regularly buying and selling assets is a more costly strategy than leaving a portfolio alone.

As well as commissions paid to brokers, the typical spread between selling and buying prices also works against the frequent trader.

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I FAmagazine.com November 18

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