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.uk
The 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. 2
Vanguard’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 Success
for 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. 9
UK 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. 13
The 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.
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