Vanguard's approach to target-allocation funds in the UK
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Vanguard’s approach to
target-allocation funds in
the UK
Vanguard research February 2014
Executive summary. This paper explores the theory and research that
informs and underpins the design and construction of Vanguard Authors
LifeStrategy™ Funds. Peter Westaway, PhD
John Velis, PhD
Vanguard LifeStrategy™ Funds provide investors with simple, low-cost,
transparent vehicles designed to meet a wide array of needs. Built
with careful attention to Vanguard’s investment philosophy, outlined in
Vanguard’s Principles for Investment Success, they incorporate our
best thinking and practices of global strategic asset allocation with the
discipline and cost advantages of passive indexing, periodic rebalancing
and transparency. They include five funds with different allocations,
each to align with a range of investor risk tolerances, from 20% equity
and 80% bond through to 100% equities.
Important information
This document is directed at professional investors in the UK only, and should not
be distributed to or relied on by retail investors. This document is published by
Vanguard Asset Management, Limited, based on research conducted by Vanguard
Group Inc. It is for educational purposes only and is not a recommendation or
solicitation to buy or sell investments. The value of investments, and the income
from them, may rise or fall and investors may get back less than they invested.
Connect with Vanguard > vanguard.co.ukThe funds incorporate global exposure to both stock and bond markets, allowing
investors to combine exposure to equities – and the expected risk premium they
traditionally offer – while benefiting from the diversification properties of bonds. This
combination of globally focused equity and bond funds gives investors a variety of
return sources while diversifying risks beyond those present in UK markets. At the
same time, the target allocation funds allow UK investors the comfort and familiarity
of a modest overweight to local markets.
Vanguard designed the funds to act as total return investments, intended to deliver
market-like returns over long time horizons, given a desired risk level. Advantages
include a low-cost design, transparent construction and disciplined rebalancing
towards target allocations.
2Vanguard’s target-allocation funds apply a number global equity and bond allocations, all of which are
of investment best practices, including global designed to enhance the ability of investors to
asset allocation, broad diversification and a meet their goals. In short, they represent an all-in-
balance between risk, return and cost. The funds one instrument aligned with Vanguard’s Principles
offer straightforward and transparent design, low for Investment Success,1 as depicted in Figure 1.
investment costs and broad exposure across
Figure 1. Vanguard’s Principles for Investment Success
1 Goals 2 Balance
Create clear, appropriate Develop a suitable asset allocation
investment goals using broadly diversified funds
Working with a financial adviser, the investment A successful investment strategy starts with
process begins by setting measurable and an asset allocation suitable for its objective.
attainable investment goals and developing With your adviser’s help, you can then
plans for reaching those goals. establish an asset allocation using reasonable
expectations for risk and potential returns. The
use of diversified investments helps to limit
exposure to unnecessary risks.
3 Cost 4 Discipline
Minimise cost Maintain perspective and
long-term discipline
You can’t control the markets, but you can
control how much you pay to invest. Every Investing evokes emotion that can disrupt the
pound that you pay in costs and charges plans of even the most sophisticated investors.
comes directly out of your potential return. Some make rash decisions based on market
volatility.
Indeed, research suggests that lower-cost
investments have tended to outperform But, with your adviser’s help, you can counter
higher-cost alternatives. emotions with discipline and a long-term
perspective. This can help you stick to your plan.
Sources: Vanguard’s Principles for Investment Success, United Kingdom. 2013
Goals the overall plan can include different portfolio
allocations for each goal. Alternatively, they can
A sound investment plan for individuals – or an
generate a separate plan for each.
investment policy statement (IPS) for institutions
– begins with an outline of the objectives, as well
as any significant constraints. Most investors have Clear, appropriate investment goals should
rather straightforward objectives, such as saving be measurable and attainable. For example,
for retirement, saving for children’s education, given that many objectives are long term, an
preserving assets, funding retirement or meeting appropriate plan should be designed to endure
a shorter term ‘need’ or ‘dream’. If the investor through changing market environments. On the
has multiple goals, such as gathering enough for other hand, some investment time horizons could
both retirement and a child’s university expenses, be much shorter and/or include less tolerance
3
1 See Vanguard (2013) Vanguard’s Principles for Investment Successfor risk. In these cases a less aggressive costs is inverse. This is because investors see their
asset allocation would be preferred. In general, returns reduced pound for pound by the cost they
investors may have many constraints, and they incur. For example, a 2011 study 3 examined US
could be either simple or complex. Examples mutual fund performance between 2001 and 2010
of other constraints include: taxes, liquidity and concluded that the higher the fund’s expense
requirements, legal issues or the desire to avoid ratio, the worse it performed. The evidence shows
certain types of investments. Constraints can that higher costs tend not to be offset by better
also change over time. performance.4
All-in-one funds, such as Vanguard LifeStrategy™ Vanguard’s target allocation funds achieve their
Funds, offer a range of risk and return profiles mix of equity and bond exposures by employing
designed to align with different investors passive indexing. Indexing offers a competitive
according to their individual objectives, cost profile relative to active strategies thus
constraints, age, income, risk attitude, time increasing the likelihood that investors will
horizon and preferences. achieve better overall performance.
Balance Discipline
When building a portfolio to meet a specific The asset allocation decision only works if
objective, the critical first step is to choose an investors adhere to it over time and through
asset allocation: the combination of assets which varying market environments. Investors are often
offer an investor the best chance to meet their tempted to try to ‘time’ the markets, changing their
goals. A balanced plan incorporates reasonable asset allocation in response to short-term market
expectations for risk and return in a broad developments. However, academic and practitioner
and well-diversified asset allocation.2 Indeed, research has repeatedly shown that even
a portfolio’s asset allocation – the percentage professional investors persistently fail to time the
of a portfolio invested in various asset classes – market successfully 5. Similar temptations include
determines the overwhelming majority of its the impulse of investors to ‘chase’ market sectors
return variability and long-term performance. or funds that have performed well in the recent
past. In practice this can often be a losing strategy
LifeStrategy™ Funds provide the investor since the past performance of any investment can
with exposure to both the higher risk and return never be relied upon to predict future returns.
associated with investing in equities and the
diversification, volatility-reduction and downside
Another pitfall is failing to periodically rebalance
protection provided by global bonds. Given
a portfolio. As markets rise and fall, the investor’s
that asset allocation is a primary determinant
portfolio often drifts away from the original target
of investment outcomes over the long term,
asset allocation. So as not to stray too far from
we discuss this concept and its application
one’s asset allocation, periodic rebalancing can
in greater detail below.
keep the portfolio’s in line with the investor’s
goals and risk profile. Target allocation funds,
Cost which maintain a static asset allocation through
All else being equal, the lower the costs incurred periodic rebalancing, help mitigate this potential
by investors, the greater their investment hazard. LifeStrategy™ Funds can help investors
returns. Research also suggests that lower-cost avoid these common behavioural errors. They are
investments have tended to outperform higher- professionally managed, continually rebalanced
cost alternatives. Contrary to conventional back to their initial asset allocation and do not
wisdom about the relationship between price and take market bets in favour of or against any
quality, the relationship between investing and particular market or subsector.
2 See Wallick, et al (2012).
3 Wallick, et al (2011).
4 Westaway, et al (2013) discuss the cost benefits of indexed funds, including the concept of the “zero sum game,” which postulates that on average,
for every investors who outperforms the market, there will be one who underperforms the market. Deducting costs, this leaves the average fund
underperforming its benchmark.
5 For example, Becker, et al (1999) study US mutual funds and find no evidence that that these funds have significant market timing ability. See Vanguard’s
4 “Principles for Investment Success”(2013) for a more extensive discussion of the perils of market timing.Asset allocation of target funds equities are expected to generate over time with
the diversification and volatility-reducing properties
Asset allocation – the proportion of a portfolio
offered by bonds. Because equities tend to be
invested in various asset classes – determines
riskier and more volatile than bond investments,
the majority of the return variability and long-term
they are expected to offer a higher return over
performance of a portfolio. Countless academic
reasonably long periods of time. This concept is
studies and years of investment experience have
known as the ‘equity risk premium’. Financial theory
explored and confirmed this principle6.
suggests that – all else being equal – a riskier
investment on average and over the long run ought
Vanguard LifeStrategy™ Funds allocate to global to offer a higher return to the investor. If relatively
equities and global bonds, with a range of equity- riskier investments did not offer relatively higher
bond mixes as shown in Figure 2. The funds are expected returns, investors would not buy them.
intended to offer appropriate blends for different
investors with diverse risk tolerances and
Of course, their more volatile behaviour can result
investment goals.
in periods during which equities actually return less
than bonds. Because of equities’ downside risk and
Target allocation funds maintain a consistent volatility over short time periods, target allocation
exposure to stocks and bonds through time and funds maintain some exposure to bonds7, which
market events through periodic rebalancing to help mitigate, or diversify, the risk posed by holding
the initial asset allocation. This policy allows the portfolios entirely made up of equities.
investor to access both the higher return that
2.
Figure 1. Vanguard LifeStrategy
Vanguard LifeStrategy™TMFunds
Funds target
target allocations (as at 31 January 2014)
allocations
Vanguard LifeStrategyTM
Vanguard LifeStrategy TM
Vanguard LifeStrategy TM
Vanguard LifeStrategy
TM
Vanguard LifeStrategy TM
20% Equity Fund 40% Equity Fund 60% Equity Fund 80% Equity Fund 100% Equity Fund
Equities – Emerging Markets Equities – Global Developed (ex-UK) Equities – UK
Bonds – UK Government Bonds – UK Investment-grade Bonds – UK Inflation-linked Bonds – Global
Sources: Vanguard Asset Management
6 Wallick, et al 2012; Brinson, et al 1986.
7 Four of the target allocation funds include fixed income, ranging from 20% equities and 80% bonds through to 80% equities and 20% bonds. There is also a
5100% equity fund, representing the riskiest fund in the lineup.Understanding the equity-risk premium of the business), equity holders by definition
face more intrinsic risk to their investment
The equity-risk premium refers to the economic
than bond holders. In addition, while bond
relationship which states investors in equities take
holders are contractually promised a stated
on more risk and therefore expect a higher return,
payment, equity holders simply own a claim
or ‘risk premium’, than investors in cash or bonds.
on future earnings. How the company uses
those earnings (paying them out in the form
However, this expected risk premium may or may of dividends and share repurchases, or
not be realised over an investor’s time horizon. reinvesting in the operations of the firm) is
The realised risk premium can vary greatly from the normally beyond investors’ control.
expected or historical risk premium. Equity returns
can be highly volatile and long-term returns can
Again, by definition, equity ownership is
deviate from the historical ‘average’ return. But just
riskier than debt ownership. Relative to gilts,
because equities are sometimes volatile and can
where repayment of the loan is backed by
trail bond returns for substantial periods of time,
the government, ownership of uncertain future
does not mean that we should expect a negative
corporate earnings is indisputably riskier.
risk premium for equities over the long term.
Because of this risk, investors must be enticed
to pay for a claim on uncertain future earnings
Take the most recent financial crisis for example. and this ‘carrot’ is the premium or higher
In 2008, the MSCI All Country World Equity Index return that investors demand over time to
fell by 39.2% from 31 December 2007 through bear that risk.
31 December 2008, while the BarCap Global
Aggregate bond index (hedged to pounds sterling)
Another way of looking at the concept of
rose by 7.6%.8 Does that mean that the idea of the
the equity risk premium is to recognise that
equity risk premium is invalid? Not in the long run.
a firm’s shareholders are its owners. They
Using the same indices and looking at the ten years
receive a return on the firm’s capital via
ended 30 June 2013, equities rose by an average
their stake in the firm and their claim on its
of 7.3% annually, while bonds returned an average
revenues. Bonds, which are essentially loans
of 5.2%. This illustrates that the point remains: over made to the firm, require the payment of an
short periods, equities sometimes underperform interest rate that should represent the cost
bonds (they are more volatile, after all), but over of capital to the firm. If this cost of capital
sufficiently long periods, equities are expected to is higher than the return on capital, the firm
outperform bonds. Of course, historical returns will fail. Extending this to the entire market,
are never a reliable predictor of future results. it means that for investment and economic
The value of investments, and the income from growth, the return on capital should exceed
them, may fall or rise and investors may get back the cost of capital. As the owners of capital,
less than they invested. shareholders should realise a higher return
than they pay to borrow. This excess return
Because equity ownership means the investor is is the equity risk premium9.
on the front lines of business losses (bond holders
have first claim to assets in the event of the failure
Bonds typically return less than equities, but the better with lower volatility. Combining them
variability of their return profile is usually lower. with equities therefore acts as a sort of ‘shock
Indeed, they can often perform inversely to absorber’ in dampening equity market volatility. In
equities, as seen in the example given in the text some circumstances, bonds may actually increase
box on the equity risk premium. When stocks in price while equity markets fall. In these ways,
enter a bear market period, bonds usually perform they act as a diversifier of equity market risk.
8 Index performance for both equities and bonds are reported as total returns.
6 9 This relationship assumes we are comparing an equity index to a corporate bond index for similar companies.Figure 3 shows the risk/return trade-off over On the other hand, as the proportion of bonds
long periods. As the proportion of equities in increases, the variation of annual outcomes
the portfolio increases, average annual returns drops significantly, but so too does the average
increases, as does the range of annual outcomes. annual return.
Figure 3. Range of returns of UK balanced portfolios (by various bond/equity weighting schemes), 1900–2013
175%
150
125
100
Range of 1 year returns
75
50
25
5.3% 6.2% 7.1% 7.8% 8.4% 8.9%
0
-25
-50
-75
0/100 20/80 40/60 60/40 80/20 100/0
Equity/bond allocation
Notes: Reflects the maximum and minimum calendar year returns, along with the average annualised return, from 1900–2013, for various equity and bond
allocations, rebalanced annually. From 1900 through 1984, equities are represented by the Barclays Equity Gilt Study from 1900 to 1964, Thomson Reuters
Datastream UK Market Index Jan.1965 – Dec.1969; MSCI UK Jan.1970 – Dec.1985. Thereafter, equities are represented by MSCI All Country World Index.
Bonds are UK as represented by Barclays Equity Gilt Study 1900-1976; FTSE UK Government Index Jan.1977-Dec 1984, Citigroup World Global Bond Index
from 1985 through 1989, Barclays Global Aggregate Index thereafter. Returns are in sterling, with income reinvested, through 2013.
Source: Vanguard, based on Barclays UK Equity Gilt study, Thomson Reuters, FTSE, MSCI, Citigroup and Barclays.
Tactical allocation strategies: Are they Furthermore, even if some managers can add
worthwhile? value by implementing tactical tilts, the return
profile can be highly variable. For example,
A tactical asset allocation (TAA) strategy actively,
one of the most basic TAA strategies involves
or opportunistically, adjusts a portfolio’s asset
large shifts between equities and bonds
allocation based on short-term market forecasts.
or cash. When the manager feels that the
It aims to exploit perceived inefficiencies or
latter will outperform the former, they will
temporary imbalances among different asset or
re-weight towards bonds (or vice versa). If the
sub-asset classes. When considering the potential
timing is right, the investor will benefit, but
inclusion of a tactical asset allocation strategy,
at the cost of a large deviation from the initial
investors should consider the significant risks
risk exposure implied by the strategic asset
and obstacles that can overwhelm any theoretical
allocation. If the manager mis-times the move,
benefits. Some studies10 have shown that while
however, the drawdowns (short term losses)
some strategies have added value at the margins,
can be quite large and very hard to make up.
on average, most tactical strategies have failed
In addition, tactical strategies typically limit
to produce consistent, or durable, positive
transparency, increase cost and potentially
excess returns.
complicate management and oversight.11
10 S ee for example: J.L. Treynor and K. Mazuy, 1966, Can mutual funds outguess the market? Harvard Business Review 44:131–36 as well as Roy D. Henriksson
and Robert C. Merton., 1981, On Market Timing and Investment Performance. II. Statistical Procedures for Evaluating Forecasting Skills, Journal of Business
54 (4, Oct.): 513–33..
7
11 Stockton and Shtekhman, 2010.Sub-asset allocation: Diversifying within Figure 4 shows, the relative performance of sub-
asset classes asset classes can vary greatly over time. The ‘hot’
Once investors make their target asset sector(s) one year can often fall out of favour the
allocation to equities and bonds, they could look next. Chasing returns often results in the double-
at allocations across sub-asset classes. Some whammy of higher trading costs for the investor
investors use a bottom-up approach, investing with disappointing performance of the portfolio.
in those securities or sub-asset classes they
reckon will deliver superior performance. Yet On the other hand, a broadly diversified portfolio
this practice is often fraught with pitfalls. Akin provides consistent exposure across key sub-
to trying to look around corners, it is notoriously asset classes. Consequently, investors participate
difficult to predict which sub-asset classes (be in the entire market, with exposure to the
they economic sectors, geographic regions, stronger-performing sectors while mitigating
or investment styles such as small-capitalisation the negative impact of weaker-performing ones.
or value stocks) will outperform the market over This provides superior diversification across
various time horizons. market cycles.
Sometimes, investors will ‘chase’ performance Analysing past returns reveals that taking
by increasing their exposure in the forthcoming advantage of market shifts could result in
period to that market segment which performed substantial rewards. However, the opportunities
well in the most recent time period. But as that appear clear in hindsight are rarely visible in
Figure 4. Annual returns for selected equity and bond asset classes, sorted by best (top) to worst (bottom)
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
9.9% 8.3% 10.7% 38.5% 19.3% 51.1% 20.1% 37.4% 13.0% 62.5% 23.6% 20.3% 17.8% 28.3%
Top-performing asset class
8.9% 7.5% 9.4% 29.7% 13.8% 36.8% 16.8% 15.7% 7.6% 30.1% 21.3% 16.7% 15.5% 25.2%
5.9% 5.2% 8.7% 25.3% 12.8% 24.9% 16.8% 10.8% 3.6% 21.2% 19.1% 6.5% 12.8% 21.0%
1.7% 3.2% 8.0% 20.9% 11.5% 24.1% 7.2% 8.3% -10.0% 20.1% 16.7% 5.8% 12.3% 20.8%
0.6% -1.1% -15.1% 20.9% 8.5% 22.0% 3.3% 6.6% -13.2% 14.8% 14.5% 1.2% 12.0% 13.6%
-0.5% -10.8% -17.3% 16.4% 8.3% 20.2% 2.8% 5.8% -13.3% 14.7% 8.9% -3.5% 11.2% 1.6%
Bottom-performing asset class
-4.3% -13.3% -22.7% 7.1% 8.0% 9.1% 1.7% 5.6% -19.4% 13.6% 8.7% -6.6% 10.7% 0.6%
-5.9% -13.8% -26.6% 6.9% 6.7% 8.5% 0.8% 5.3% -24.0% 6.3% 7.5% -12.6% 5.9% 0.0%
-20.0% -20.0% -27.0% 5.5% 6.6% 7.9% 0.5% 5.2% -29.9% 5.3% 5.8% -14.7% 2.9% -4.2%
-27.2% -22.9% -29.5% 2.1% 4.1% 5.8% -0.2% 0.4% -34.8% -1.2% 4.8% -18.4% 0.6% -5.3%
Global equities UK government bonds (gilts)
North America equities (US/Canada) UK index-linked gilts
Emerging market equities UK investment grade corporate bonds
Developed Asia equities Hedged global bonds
Europe ex-UK equities
UK equities
Source: Vanguard calculations, using data from Barclays Capital and Thompson Reuters Datastream. UK equity is defined as the FTSE All Share Index,
Europe ex-UK equity as the FTSE All World Europe ex-UK Index, developed Asia equity as the FTSE All World Developed Asia Pacific Index, North America
equity as the FTSE World North America Index, emerging market equity as the FTSE Emerging Index, global equity as the FTSE All World Index, UK
government bonds as Barclays Sterling Gilt Index, UK index-linked gilts as Barclays Global Inflation-Linked UK Index, hedged global bonds as Barclays Global
Aggregate Index (hedged in GBP), UK investment grade corporate bonds as Barclays Sterling Corporate Index. Returns are denominated in GBP and include
8 reinvested dividends and interest.advance. The importance of full market exposure Vanguard’s target-allocation funds diversify a UK
within asset classes cannot be understated. While equity portfolio with broad-based, non-UK equities
bets on specific market segments may seem equal to approximately 75% of the total equity
appealing, these bets imply that the market is allocation. Finance theory suggests a global equity
incorrect in its assessment of the valuation of allocation that reflects the market capitalisation
a sub-asset class. of the global market. In the case of the UK, this
would imply holding 92% of the equity portfolio
Some investors use quantitative tools such as in non-UK equities. However investors in every
optimisation to periodically adjust their asset country have historically displayed a significant
allocation based on expected returns and bias towards their home markets. In the UK, for
correlations of the asset classes in the portfolio. example, a 2005 study (Chan, et al) revealed that
They aim to achieve the maximum expected UK investors, on average, constructed portfolios
return for some given level of risk. This approach, with a 5.3 times bias to domestic equities. In
while rooted in basic financial theory, can often other words, while the global market weight of
lead to significant swings in the portfolio weights UK equities is approximately 8%, the embedded
from one period to the next. At the extreme, they ‘home bias’ would suggest an allocation of
can result in portfolios that differ widely from the approximately 48% to UK equities (and 52%
strategic asset allocation. Furthermore, forecasting to non-UK equities).
expected returns and inter-asset class correlations
can be notoriously tricky. Previous Vanguard research (Schlanger, 2013)
weighed the short and long-term impacts to a
Target allocation funds maintain a static asset portfolio of investing across a wider range of
allocation over time regardless of market events markets, including the opportunity to invest in a
and cycles. This ensures a consistent exposure to larger number of securities, risks associated with
equities and their expected risk premium over the overweighting domestic markets, expected risks,
long term. Vanguard regularly reviews the asset returns and correlations. It concluded that global
allocation of LifeStrategyTM Funds, employing the diversification among the world’s equity markets
most up-to-date research on portfolio construction, should be considered a reasonable starting point
investor attitudes and always mindful of the for investors’ equity allocations.
lessons that long years of experience have taught
us. Quantitative methods, such as optimisation, However, investor preferences and bias towards
can help but do not exclusively determine the domestic markets must be weighed against
asset allocation of the funds. Instead, we use a
the relative advantages of global diversification.
number of inputs, which are aimed at meeting
Recognising this reality, the LifeStrategy™ Funds
Vanguard’s principles for investing success.
invest approximately 25% of their portfolios in
UK equities and the remaining equity portfolio in
Equity allocations in target allocation unhedged market cap-weighted equities outside
funds the UK. Vanguard believes these allocations
represent a reasonable trade-off between investor
UK equities and global ex-UK equities account
preferences and ensuring that investors gain
for about 25% and 75%, respectively, of the
exposure the potential of global investing.
equity allocation. Within the UK equity allocation,
exposure across the various segments (large,
medium and small-cap, or growth and value)
aligns to the prevailing market capitalisations.
As a result, investors benefit from exposure to
all segments of the UK equity market.
9UK and global ex-UK bond allocations grade corporate bonds. The funds do not include
LifeStrategyTM Funds offer investors a range of high-yield, or ‘junk’ bonds due to the relatively
asset allocations which include bonds. Historically, poor diversification benefits associated with the
the correlation between equity and bond returns asset class over time.
has been low, providing diversification benefits.
In extreme market conditions, an allocation to The funds allocate approximately 35% of their
government bonds (both gilts and inflation-linked bond investments to the UK, with the remainder
gilts) can provide meaningful downside protection allocated to global bonds outside the UK, with
at a time when investors most need their bond currency exposure of the latter portion hedged
allocation to react differently than their portfolio’s into pounds sterling. This represents a small
equity allocation (See Figure 5). home bias, as UK investment grade bonds only
make up 6% of global bond markets. A 35%
Although target-allocation portfolios use bonds home country bias, which represents a 6 times
as the primary diversifier to equity market risk, ‘overweight’, is still a bit lower than the home
the sectors comprising the bond allocation country bias of the average UK bond investor’s
can occasionally contribute to the portfolio’s portfolio. Data from 201212 suggest that the
overall level of risk and to its return variability, average UK bond investor holds 57%, of their
particularly over shorter time periods. For example, portfolio in UK bonds, or an overweight position
in extreme market conditions, the correlation of nearly 9 times the global market.
between equities and corporate bonds tends
to move much higher, which can diminish the At the extreme, holding all of one’s bond
diversification benefit of holding corporate bonds. allocation in the UK ignores 94% of the global
bond market. Even holding an allocation similar
To achieve diversification the bond allocations to the typical UK bond investor, at 57%, results
within the Vanguard LifeStrategy™ Funds invest in a portfolio highly exposed to UK-specific
in both UK and global bonds. This includes economic variables, including the business
allocations to government bonds (domestic and cycle, interest rates, inflation rates, etc.
global), UK inflation-linked bonds and investment
Figure 5. Bonds provide downside risk protection in variety of macro environments
Figure 5a: Distribution of monthly returns during worst Figure 5b: Distribution of monthly returns during worst
months of equity returns months of bond returns
15% 15%
10 10
Distribution of quarterly returns
Distribution of quarterly returns
5 5
0 0
-5 -5
-10 -10
-15 -15
-25 -25
-25 -25
Equities Bonds Equities Bonds
Median Top: 75th percentile Top: 95th percentile
Bottom: 25th percentile Bottom: 5th percentile
Notes: Displays the 5th/25th/median/75th/95th distribution of monthly returns for both equities and global bonds, during a 10th percentile or worse month
for either the equity market or bond market. The equity market is defined as FTSE All World Index and global bond returns are defined as the Barclays
Global Aggregate. The bond market is defined as UK bonds from Barclays Equity Gilt Study 1900–1976; FTSE UK Government Index Jan.1977-Dec. 1984;
Citigroup World Global Bond Index from 1985 through 1989; Barclays Global Aggregate Index thereafter. Figure covers Jan. 1976 to Dec. 2013. All returns are
measured with currency impact removed, with income reinvested.
10 12 See Phillips et al (2012)Increasing exposure to global bonds has UK bond market to the global equity market
the potential to offer significant long-term has offered no benefit over a hedged global
diversification benefits13. Figure 6a provides bond allocation, as demonstrated in Figure 6b.
evidence of this. Interest rate movements within Starting from a balanced portfolio of global stocks
a group of the 12 largest government bond and hedged global bonds, and adding higher
markets are not correlated with those of the UK. portions of UK bonds to the allocation would have
The benefits of this diversification can be shown increased overall portfolio risk for any particular
in a portfolio context; the low correlation of the equity/bond mix.
Figure 6a. Correlation of monthly changes in each country’s 10-year government bond yield to that of the UK,
Jan 1998–Dec 2013
1.00
0.76 0.75 0.76 0.74
0.75
0.68
0.56 0.56
0.50 0.47
0.43
0.25 0.22 0.21
0.13
0.00
lia
m
da
ce
y
ly
n
a
s
n
en
es
re
nd
an
pa
ai
Ita
iu
ra
na
an
at
ed
Sp
Ko
m
rla
Ja
lg
st
St
Ca
Fr
Sw
er
Be
he
Au
h
d
ut
G
te
et
So
ni
N
U
Notes: Shows the correlation of the monthly change in the yield of each country’s 10-year government bond to the change in the 10-year UK gilt yield.
Source: Vanguard, based on data from Thomson Reuters Datastream.
Figure 6b. Volatility change from adding UK bonds to the bond portion of a global stock/global hedged
bond portfolio
1.5%
Change in volatility from a global portfolio
1.25
1.0
0.75
0.50
0.25
0.0
5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100%
Overweight to UK bonds within the fixed income allocation
20% equity / 80% bond 40% equity / 60% bond 60% equity / 40% bond
80% equity / 20% bond
Notes: Displays the historical change in volatility from a global/stock bond allocation that results from overweighting the UK bond market within the bond allocation.
Source: Vanguard, based on the data described in the appendix.
11
13 For a more detailed discussion of the desirable properties of global bond investing for UK-based investors, see Westaway and Thomas, 2013.One reason that adding global bonds to a bond market being much more sensitive to interest
allocation improves diversification is the presence rate changes, with more volatile prices. In other
of some unique structural features of the UK words, they have a much higher duration14.
market. Relative to the global market, the UK Figure 7b shows that as of December 2013, the
market has a much higher proportion of long dated UK’s duration was close to 9, much higher than
bonds, while the global market is more evenly any other individual large bond market as well as
distributed (See Figure 7a). This leads to the UK the global average of just over 6.
Figure 7. Comparisons of UK and global bond markets
Figure 7a: Maturity band weights
16.0
14.0 13.6
12.0
10.1 9.7
10.0
8.8
8.0
8.0 7.6
7.0
6.5
6.0 5.6
4.6 4.4
4.0
2.0
0.0
t
t
t
t
l
t
t
t
t
t
t
ba
ke
ke
ke
ke
ke
ke
ke
ke
ke
ke
lo
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
G
rm
m
m
m
m
m
m
m
m
m
n
g
an
h
n
ro
s
n
h
la
lia
is
lin
is
Ye
ia
is
Eu
ol
di
Sw
an
eg
ed
ra
er
D
na
st
D
w
Sw
St
Ca
Au
or
N
Figure 7b: Average duration
10.0
8.7
8.0 7.7
7.2 7.2
6.1
6.0 5.8
5.5 5.5
4.6
4.0 3.8
4.0
2.0
0.0
t
t
t
t
l
t
t
t
t
t
t
ba
ke
ke
ke
ke
ke
ke
ke
ke
ke
ke
lo
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
G
rm
m
m
m
m
m
m
m
m
m
n
g
n
h
an
s
ro
n
h
la
lia
is
lin
Ye
is
ia
is
Eu
ol
di
Sw
an
eg
ed
ra
er
D
na
st
D
w
Sw
St
Ca
Au
or
N
Source: Vanguard analysis based on Barclay’s Capital Global Aggregate, Sterling, and Inflation linked indices, data as at 31 December 2013.
14 D
uration is a measure of the change in price of a bond (or bond index) given a change in the interest rate. Bonds or indices which have higher duration are
12 therefore much more sensitive to interest rate changes.The UK market also leans heavily towards Investors cannot manage inflation risk with any
government, government-related debt and certainty in a portfolio of nominal bonds. A bond
investment grade corporate debt and away from portfolio’s real, or inflation adjusted, value falls
securitised debt. Comparatively speaking, UK when actual inflation exceeds the expected rate of
bond investors are taking less credit risk inflation built into market interest rates at the time
(potentially forgoing higher yields) than is available the investor purchased the bond. Since inflation-
in the global market as a whole (See Figure 7c). linked gilts provide inflation-adjusted increases to
both principal value and interest payments, an
Figure 7d also illustrates a unique feature of the investor can manage the extent to which their
UK bond market with respect to inflation-linked bond portfolio is subject to short term inflation
bonds. Since 1999, inflation-linked gilts have, on risk. For this reason LifeStrategyTM Funds include
average, represented approximately 21% of the an allocation to inflation-linked UK bonds.
overall UK bond market and 30% the UK gilt
market respectively. This is much higher than the
proportions offered globally.
Figure 7c: Sector distribution of UK and global bond markets
80%
70 69
60
53
Weight in market
50
40
30
21 20
20 16
14
10 8
3
0
Government Government-related Corporate Securitised
Sector
Global aggregate Sterling aggregate
Figure 7d: Proportion of inflation-linked bonds in local markets
25%
20 19.3
15
11.2
10 9.1
4.8 4.7 4.7 4.6
5
0.5
0
K
)
PS
l
lia
da
an
en
ba
al
U
ra
ot
p
na
ed
TI
lo
Ja
st
(T
G
Ca
Sw
S
Au
U
ne
zo
ro
Eu
Source: Vanguard analysis based on Barclay’s Capital Global Aggregate, Sterling, and Inflation linked indices, data as at 31 December 2013.
13The non-UK portion of the bond allocation in Allocating approximately 35% of the bond
the LifeStrategy™ Funds is hedged into sterling. portion of the portfolio to UK bonds, spread
Currency fluctuations impart significant volatility among government (including inflation-linked),
into a global bond portfolio well above the government-related and investment grade
volatility of the underlying bonds themselves. corporate sectors, and the remainder of the
This currency-induced volatility can overwhelm allocation to global ex-UK bonds hedged back to
much of the diversification appeal of going global sterling is a reasonable strategic asset allocation.
with bonds. Hedging this currency exposure It allows the investor access to the sources of
reduces the currency volatility, and allows foreign risk and return available in the global market while
bonds in a UK portfolio actually to ‘behave like maintaining exposure to local factors. While less
bonds’, independent of the gyrations of the radical than a pure market weighting of 92% to
bond’s issued currency. non-UK bonds, a 65/35 split between non-UK and
UK bond still represents a reasonable balance.
Interest rates and bond investing reflected in the shape of the yield curve. An
Given the inverse relationship between bond upward-sloping yield curve by its very nature
prices and interest rates, combined with the indicates that the market already expects interest
higher sensitivity of long bonds to rate changes, rates to increase in the future. With longer-term
many investors might wonder about the bond yields much higher than those of short-
relationship between duration risk and the interest term bonds, by lowering duration, the investor
rate outlook. Is it a good idea to change portfolio effectively gives up income in return for lower
duration in order reduce interest rate risk, at least exposure to duration risk. But investors are
until the worst of the rate uncertainty passes? much better served by taking a ‘total return’
While any given investor might have very good approach. Over any given time horizon, both
reason to adjust their bond exposure, we believe price return and income will drive an asset’s total
that the future outlook for interest rates should return. Because of this, investors should weigh
generally not be a significant factor. their expectations for interest rate movement
against the income they give up by altering their
portfolio duration.15
Interest rates are notoriously difficult to forecast
correctly with any consistency (Davis, et al, 2010)
but, to the extent that a consensus exists on
the future path of rates, it should already be
Role of inflation-linked gilts for investors for investors to add to their portfolio using
at, or near, retirement additional earnings. As a result, investors
Inflation-linked gilts can be particularly relevant must balance their need to preserve capital,
for investors at, or near, retirement, who hold often through bond and cash-like investments,
more conservatively allocated portfolios. In the with their need to preserve their portfolio’s
accumulation stage, salaries and higher real purchasing power, or real value. Holding
returning assets, such as equities, can provide inflation-linked bonds can provide investors
effective inflation protection for investor portfolios. with a direct hedge to inflation, helping to
But, once in retirement, it becomes more difficult preserve the real value of the portfolio.
14 15 See Westaway and Thomas, Bond investing in a rising rate environment, 2013.Publically traded property securities However, it is difficult to assess the degree
to which investors can consistently rely upon
To the extent that property-based securities are
these asset classes and investment strategies
part of the global equity portfolio, the Vanguard
to deliver their potential benefits, especially for
LifeStrategy™ Funds include exposure to UK and
those strategies where investable beta is not
non-UK property at their market weights as part
available for comparison. Strategies such as long/
of the respective equity allocations. However, the
short, market-neutral and private equity depend
funds do not hold Real Estate Investment Trusts
exclusively on manager skill. This subjects
(REITs) or Real Estate Operating Companies
investors to significant manager risk, as the
(REOCs). Because property based securities
distribution of manager skill is such that investor
currently account for less than 2% of the UK
success depends on consistently accessing and
equity market capitalisation (according to FTSE
selecting top managers.17
EPRA/NAREIT as at 30 September 2013) and
2.6% of global equity market capitalisation
(according to FTSE), any additional allocation Vanguard does not include commodities,
would represent a significant sector overweight. and specifically commodities futures, in target
allocation funds based on our assessment of the
In order to justify a strategic over-weighting to risks, costs and complexities. While recognising
property-based securities, investors must be the historical diversifying benefit of commodity
comfortable with the fact that property-based futures, Vanguard cautions against making such
equities tend to perform more like equities an allocation solely based on historical commodity
than property. Property investors must also be returns. The long-term economic justification
comfortable with the possibility that the property for expecting significant, positive returns from a
portion of their investment portfolio may correlate static, long-only commodities futures exposure is
with the value of other property holdings in their subject to ongoing debate, especially in the costs.
total portfolio, such as their primary residence.16
Non-traditional asset classes and
strategies
Vanguard’s target-allocation funds do not include
non-traditional asset classes or investment
strategies. Non-traditional asset classes include
commodities, private equity, sub-investment grade
bonds and emerging market bonds. Additionally,
common alternative investment strategies may
also include equity long/short, market-neutral and
managed futures. These asset classes and
strategies may offer potential advantages
compared with investing in traditional equities,
bonds and cash, including:
• Potentially higher expected returns
• Lower expected correlation and volatility to
traditional market forces
• The opportunity to benefit from market
inefficiencies through skill-based strategies
16 For example, according to the 2011 UK census, approximately 2/3 of homes were owner occupied while 1/3 were rented. Source: Office for National
Statistics, www.ons.gov.uk.
17 For more detailed discussion on the use of alternatives, see Philips and Kinniry (2007) and for additional detail and empirical analysis of commodities as
investments, see the Vanguard publications “Understanding Alternative Investments: The Role of Commodities in a Portfolio” and “Investment Case for
15 Commodities: Myths and Reality”.The role of passive fund management Vanguard investigated the construction of
Vanguard strongly believes that any risks portfolios using actively managed funds. We
investors bear should be expected to produce a compared the average returns and volatility of
compensating relative return over time. Modern a portfolio constructed with actively managed
financial theory and years of investment practice funds to market benchmarks in both UK equity
lead us to conclude that diversified, broad- and UK bond fund categories. Figure 8 shows
based index exposures represent precisely this that, on average, most actively managed
kind of compensated risk. While some active portfolios had lower returns and/or a higher level
managers can add value at least some of the time, of volatility – the exact opposite of the desired
outperformance cannot be guaranteed. result of an efficient portfolio.
Figure 8. Annualised return and volatility
12%
10
10-year annual volatility
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18
10-year annual return
GBP diversified bond index GBP diversified bond funds
GBP government bond index GBP government bond funds
Global equity index Global equity funds
UK Equity index UK Equity funds
Notes: Active funds are represented by the median returning active fund within each broad asset class. UK equity funds are defined as those active funds
available for sale in the UK and classified by Morningstar in one of the following categories: UK Flex-Cap Equity, UK Large-Cap Blend Equity, UK Large-Cap
Growth Equity, UK Large-Cap Value Equity, UK Mid-Cap Equity, or UK Small-Cap Equity. The UK equity market is represented by the FTSE All Share Index.
UK bond funds are defined as those active funds available for sale in the UK and classified by Morningstar as GBP Diversified Bond. The UK bond market is
represented by the Barclays Sterling Aggregate Index. All returns are in GBP, income reinvested and cover the 10 years ending 31 December 2013. Active
fund returns are net of fees and include surviving funds only.
Source: The Vanguard Group, Inc., based on data from Morningstar, FTSE and Barclays.
16 While active management offers the potential As shown in Figure 9, success also tends to be
to outperform, the evidence suggests that fleeting, as even the best funds in one time period
investors do not consistently see this benefit. can rapidly fall out of favour. Vanguard found that,
According to data from Morningstar, over the of the top 20% of funds in five-year performance
5, 10 and 15 years ended 2013, 66%, 70%, ending in December 2008, over 65% of those
and 63% of actively managed UK equity funds previously top-performing funds had fallen to the
underperformed their respective benchmarks, bottom 40% in fund performance or were merged
or were merged/liquidated within the period. or closed over the following five years ending
Investors did not fare better in bond funds, in 2013. Of course, if fund managers displayed
where 66%, 92% and 80% of actively managed persistence in achieving top performance over time,
UK diversified bond funds underperformed their nearly 100% of the top performing funds would
respective benchmarks or were merged/liquidated remain at or near the top. Instead, the data reflects
over the 5, 10 and 15 periods ending in 2013.18 the daunting challenge of maintaining top-quintile
performance over the long term.
Figure 9. Subsequent ranking of former top-quintile active UK equity funds
30%
Percentage of funds remaining in the top quintile
25 24.5
23.6
20
17.3
15
12.8
11.0 10.8
10
5
0
Highest Quintile 2nd Quintile 3rd Quintile 4th Quintile Lowest Quintile Liquidated/
Merged
Notes: We ranked all active UK equity and bond funds based on their risk-adjusted returns (total return divided by volatility) during the five-year period
through 31 December 2008. We then re-ranked the fund universe as at December 2013 and identified where each fund ended that period. The columns show
the percentage of top-performing funds (top 20%) as at 31 December 2008 and the subsequent performance ranking those funds achieved over the five years
through 31 December 2013. To account for survivorship bias, we identified funds that existed at the start of the time period, but were either liquidated or
merged during the stated period. The funds included in this analysis are taken from the following Morningstar categories: UK Large-Cap Blend Equity, UK
Large-Cap Growth Equity, UK Large-Cap Value Equity, UK Mid-Cap Equity, UK Flex-Cap Equity UK Small-Cap Equity.
Source: Vanguard Group Inc. and Morningstar.
17
18 Source: Vanguard Asset Management based on data from Morningstar.Index investing and the ‘zero sum’ game • Efficient: Portfolio turnover is limited to
additions and deletions from an index, M&A
The concept of a zero-sum game starts with the
and other corporate actions. Rebalancing is
understanding that at any one time, the holdings of
continuous and costless since security weights
all investors in a particular market make up that
reflect the market weight.
market. As a result, for every invested pound that
outperforms the total market over a given period, • Transparent: Because an index fund holds
there must by definition be another pound that all or most of the securities in a given index
underperforms. Another way of stating this is that benchmark at the same weights as that of
the asset-weighted performance of all investors, the index benchmark, investors can always
both positive and negative, will equal the overall determine which securities constitute their
performance of the market. In other words, if you portfolio and how they performed.
‘sum’ the positive and negative performance
of each individual invested pound before costs, • Diversified: Index funds tracking broad
it will equal ‘zero’. benchmarks hold all or most of the securities
that comprise that benchmark. Investors
However, after accounting for costs, such benefit from the mitigation of security and
as transaction, management and other costs, sector concentration risk.
a majority of portfolios fall to the losing side • Lower cost: Index funds typically have low
of the index’s performance. The funds that do management fees and low operating costs.
successfully outperform a benchmark over a given
period often find it extremely difficult to maintain
that outperformance in subsequent periods19.
Index funds provide lower-risk, efficient,
transparent, diversified and low-cost investment
vehicles with the potential to increase shareholder
wealth through exposures in a broad range of
asset and sub-asset classes.
• Lower risk: Whether measured by the number
of security holdings, return volatility, downside
risk or likelihood of outperforming, active
management is generally riskier than passive
management.
18 19 Westaway, et al. 2013.Financial advisers and target-allocation goals. They are designed with rigourous attention
funds to our latest views on best practice and they
Vanguard believes target allocation funds provide incorporate Vanguard’s principles for investment
financial advisers with a number of ways to add success. Nevertheless, using target-allocation
value for their clients. funds within a core-satellite investment approach
gives advisers the chance to add value for their
clients in a risk-controlled way.
Target-allocation funds as a core investment
For many clients, broadly diversified, low-cost
Target-allocation funds as a source, not a use,
portfolios may serve as the core component of
of focus and time
a broader investment strategy. By using a target
Investing in the Vanguard LifeStrategy™ Funds
allocation fund as the core portfolio, a financial
can allow advisers to focus their time and
adviser achieves low costs and a high level of
resources on others aspects of their client
risk control in the investment portfolio, while also
value proposition. Here’s how. Let’s take the
having the flexibility to invest in more specialist
example of an adviser who serves as a financial
indices or actively managed funds. In addition to
planner to an individual client. Figure 10 shows
low costs and a high level of risk control, a core
a representative multi-step investment advice
investment in a Vanguard LifeStrategy™ Fund
process. The financial planner may work very
can potentially mitigate the downside risk of an
closely with an investor on steps 1 and 2,
adviser’s total portfolio when compared with the
which offer the opportunity to build credibility
broader capital markets and the adviser’s peers20.
and exercise some level of control over
But the adviser may still seek to outperform the
client outcomes, such as developing trust or
market average or index, or achieve a specific
documenting a well thought out investment plan.
investment objective, using the ‘satellite’
The adviser may then decide that a risk-graded,
component of their investment programme.
professionally-constructed target-allocation fund
ensures both prudent and suitable portfolio
Based on Vanguard’s research and experience, construction and implementation, thereby
Vanguard LifeStrategy™ Funds by themselves can fulfilling steps 3 and 4 with a straightforward,
be wholly appropriate for the majority of investors’ yet sophisticated, investment selection.
Figure 10. Sample investment advice process
1 Know your client
Review of client’s financial position
History, values, transitions goals
Goals-based planning
5 Monitor progress
2 Develop a plan
Periodic financial check ups
Categorise and evaluate
Significant life events
Statement of Determine risk/return requirements
Review progress Develop a written plan
Investment Principles
4 Implement plan 3 Construct portfolio
Best execution
Strategic asset allocation
Tax efficient trading
Sub-asset allocation
Automate rebalancing
Passive/active mix
Asset location
Manager selection
20 For more on the benefits of using index funds as a core portfolio, see Phillips and Kinniry “Enhanced practice management: The case for combining active
19
and passive strategies.”This investment selection may free up the The key point is that the decision to invest in a
time and resources traditionally spent on target-allocation fund is only as effective as the
activities such as active manager selection and suitability assessment and ‘know your client’
oversight, while helping to mitigate the risk that process that precedes it. In this way, the adviser
performance-based promises hurt the adviser’s can provide a single-fund option, such as a target
credibility. Once an adviser makes an appropriate allocation fund, with the appropriate investment
investment selection for the client, the periodic strategy and execution to help meet investors’
adviser-client review, as represented by step five, goals and objectives in accordance with their
offers opportunities for the adviser to enhance risk tolerance.
a long-term client value proposition. During this
step, financial advisers can play a central role in
periodically 21 reassessing a client’s investment
objectives, risk tolerance, changes in personal
circumstances and progress toward reaching
chosen financial goals. This should ensure the
target allocation fund selected continues to
suit the client’s current situation.
Selecting a suitable target-allocation fund
can also allow advisers to focus on building a
sustainable and valuable business by enhancing
relationships with existing clients, or prospecting
for new clients, as opposed to picking funds.
It may also help advisers shift client conversations
from the sometimes-difficult topic of investment
performance to critical financial planning areas
such as estate and family planning, areas
which entail less market risk. These services
can provide a more reliable foundation for an
enduring advice practice.
21 Based on Vanguard’s work with financial advisers, a good rule of thumb is to conduct annual adviser-client reviews. It is important to note the importance
of appropriately ‘framing’ these periodic reviews. A narrow frame may often lead to an annual review process that is overly focused on short-term
portfolio performance and, consequently, to regular, inappropriate changes to an investor’s plan. A wide frame, however, may allow a client to recognise
that short-term volatility and long-term investing success coexist. A well thought out investment plan should not change significantly year after year, but
20 it should reflect significant changes in investor circumstances, such as retirement, having children or a large unanticipated health expense.You can also read
