Vanguard s approach to target-allocation funds Vanguard research February 2013 Executive summary. This paper provides an overview of Vanguard s approach to constructing target-allocation funds. 1 Vanguard LifeStrategy Funds seek to maintain a defined, static asset allocation for the life of the investment. The funds cover a range of five target asset allocations to meet a variety of investor risk tolerances ranging from 20% equity / 80% fixed income to 100% equity. See Figure 1 on page 2. Authors Randy J. Lee, CFA Christopher Philips, CFA David J. Walker, CFA Francis M. Kinniry Jr., CFA/ Principal For Professional Advisers only. Not to be given to retail investors. The value of investments, and the income from them, may rise or fall and investors may get back less than they invested. This document is published by Vanguard Asset Management, Limited, based on research conducted by the Vanguard Group Inc.
Figure 1. Vanguard LifeStrategy Funds target allocations Vanguard LifeStrategy TM 20% Equity Fund Vanguard LifeStrategy TM 40% Equity Fund Vanguard LifeStrategy TM 60% Equity Fund Vanguard LifeStrategy TM 80% Equity Fund Vanguard LifeStrategy TM 100% Equity Fund UK equities Developed world ex-uk equities Emerging markets equities UK government bonds UK investment grade bonds UK inflation-linked bonds Source: Vanguard Asset Management, Limited. Vanguard s target-allocation funds apply a number of investment best practices, including top-down asset allocation, broad diversification, and a balance between risk, return and cost. The funds offer a straightforward design, low investment costs and broad exposure to across the equity and fixed income allocations all of which help to maximise the usefulness of these funds for investors. Vanguard believes investors, often assisted by a financial adviser, are responsible for determining the appropriate fund for their circumstances, with specific attention to their investment goals, along with their ability and willingness to take market risk to achieve those goals. This paper discusses the key benefits of targetallocation funds for investors, including: Predetermined asset allocation: Ensures constant exposure to a mix of equity and fixed income investments. Constant exposure helps to limit market timing and return-chasing behaviours, while enabling investors to participate in the long-term equity risk premium. 2 Once an investor selects the asset allocation that best matches their goals and risk profile, the required level of investor engagement is minimised until the next scheduled assessment of their personal financial situation. Automatic rebalancing: Anchors investors exposure to equity and fixed income investments to their desired asset allocation. This removes the risk of drifting significantly from a target asset allocation, which can lead to portfolio risk exposures that are not aligned with an investor s risk and return objectives. Broad diversification: Maintains investors exposure across the key sub-asset classes, allowing the investor to participate in strongerperforming sectors while mitigating the impact of weaker-performing ones. This helps to manage overall portfolio risk. Convenience and simplicity: Ensures that experts handle the complex, but critically important, decisions involved in constructing portfolios and rebalancing assets. This allows the investor, often assisted by a financial adviser, to focus on defining their investment goals and developing an investment plan designed to meet those goals in accordance with their risk and return objectives and personal financial situation. 1 The Key Investor Information Document (KIID) is a short and clear document containing key information for retail investors to help them understand the nature and the risks of investment products. A synthetic risk and reward indicator, as recommended by the European Securities and Market Authority (ESMA), formerly Committee of European Securities Regulators (CESR), is included in the KIID. This indicator is based on historical data and may not be a reliable indication of the future risk profile of a fund. 2 For insight regarding the equity risk premium, see the text box on page 4. 2
The paper also provides the rationale for the investment strategy that underpins the Vanguard LifeStrategy Funds. This includes our view of appropriate asset class diversification and the benefits of using index funds to construct these risk-graded portfolios. Finally, the paper examines how financial advisers might use target-allocation funds to add value for their clients, such as: Constructing a core/satellite portfolio: Broadly diversified, low-cost portfolios may serve as a suitable, core component in their clients bespoke investment programmes. Ensuring product suitability: Well-constructed and implemented portfolios may provide advisers with additional time and resources. This can allow them to focus on the know your client process and ensure investment portfolios align well with their clients financial situation, return objectives and risk tolerance. Enhancing role as behavioural coach: Simple, packaged portfolios may help investors and their advisers avoid common behaviours, such as market timing and performance chasing, that tend to reduce returns or increase risk. All-in-one funds All-in-one funds provide a comprehensive investment approach delivered in a simple package. These funds help to address a particular challenge facing many investors: how to invest in a suitable, professionally constructed and riskcontrolled, broadly diversified portfolio. As both external academic and Vanguard research indicate, many investors lack time or interest when it comes to investment or retirement planning. Even motivated savers may make investing errors or fail to manage the portfolio s strategy effectively over time. Left alone, investors tend to be too aggressive, too conservative or fail to diversify. For example, a 2008 study 3 of UK defined contribution plans reported that over 70% (32 of the 45 pension plans surveyed) provided 100% equity allocations as the default investment strategy. While these 100% equity default strategies were typically coupled with an age-related switch to lower-risk investments, often 5 or 10 years out from a planned retirement date, the study nonetheless suggests many savers are inappropriately invested in high-risk portfolios. In another example, a study by Vanguard on US defined contribution plan members found that a total of 37% hold extreme allocations (16% with no equities, 21% with only equities). Nearly half have equity exposure above 90% or below 10%. 4 All-in-one funds simplify the asset allocation decision by offering broad diversification across asset classes. They also typically offer diversification within asset classes, using criteria such as market capitalisation, investment style or credit quality. These features, coupled with automatic asset class rebalancing, can help mitigate the risk that investors may hold extreme asset allocations. 3 Source: PensionDCisions 2009 DC Default Provider Survey. 4 Pagliaro and Young, 2010. 3
Common single-fund investment options include: Target-allocation funds: Maintain a defined asset allocation for the life of the investment. Offered as sets of funds with target allocations, investors determine which portfolio(s) best fits their circumstances. If investors, with their advisers help, assess their willingness and ability 5 to take risk and revisit that assessment periodically, a target-allocation fund may offer a compelling solution. Their portfolio stays aligned with their investment objectives and personal risk tolerance. Target-allocation funds require some investor engagement, because the asset allocations do not change. Balanced funds that hold a static mix of asset classes, such as equities, bonds and cash, as well as Diversified Growth Funds, 6 may also fall into this category of funds. Target-date funds: Set their initial asset allocations based on a projected retirement year and gradually shift to a more conservative allocation as that date approaches. The final allocation guides investors to or through their retirement date, depending on whether they expect to purchase an annuity at retirement or intend to continue to invest indefinitely. Targetdate funds require the fewest decisions and least investor engagement. This type of fund offers investors simplicity, but in a portfolio that reflects only one variable: their intended retirement date. Vanguard does not offer target date funds in the UK at this time, but may do so in the future. Understanding the equity-risk premium The equity-risk premium refers to the economic relationship that states investors in equities take on more risk and expect a higher return, or risk premium, than investors in cash or fixed income. However, it is important to note that this expected risk premium may or may not be realised over an investor s time horizon. The realised risk premium can vary greatly from the expected or historical risk premium. Equity returns can be highly volatile and long-term returns can deviate from the historical average return. But just because equities are sometimes volatile and can trail bond returns for substantial periods of time, does not mean that we should expect a negative risk premium for equities over the long term. Because equity ownership means the investor is on the front lines of business losses (bond holders have first claim to assets in the event of default), equity holders by definition face more intrinsic risk to their investment than bond holders. In addition, while bond holders are contractually promised a stated payment, equity holders simply own a claim on future earnings. How the company uses those earnings (paying them out in the form of dividends and share repurchases, or reinvesting in the operations of the firm) is normally beyond investors control. Again, by definition, equity ownership is riskier than debt ownership. Relative to gilts, where repayment of the loan is backed by the government, ownership of uncertain future corporate earnings is indisputably riskier. Because of this risk, investors must be enticed to pay for a claim on uncertain future earnings and this carrot is the premium or higher return that investors demand over time to bear that risk. 5 Investors willingness to take financial market risk is an emotional, or psychological, measure and is sometimes gauged through the use of a predefined investor questionnaire. Investors ability to take financial market risk is based on an assessment of many factors, including their financial wealth, current income and future income potential, time horizon, spending requirements and family situation. 6 Some Diversified Growth Funds in the UK are distinctly different from target-allocation funds in that they tactically allocate across asset classes at the discretion of the investment manager. The risks and drawbacks of these tactical asset allocation funds to an investor are briefly discussed in the text box on page 6. 4
The importance of asset allocation A portfolio s asset allocation the percentage of a portfolio invested in various asset classes is one of the most important determinants of the return variability and long-term performance of a broadly diversified portfolio engaging in limited market-timing. 7 Figure 2 shows the long-term relationship between return and risk. For example, a portfolio of 80% equities/20% bonds has historically experienced a wider range of returns using rolling 12-month windows). It also shows a greater risk of loss than a portfolio of 20% equities/80% bonds. Alternatively, higher equity allocations have historically led to higher average annualised returns since 1976. 8 Target allocation funds maintain a static asset allocation over time and market events. This ensures a consistent exposure to equities and their expected risk premium over the long term. However, investors should not assume that the equity risk premium received in the past will be received in the future or that equity risk premiums will be realised in every future time period. As a recent example, bonds outperformed equities over the first decade of this century. Figure 2. A portfolio s asset allocation largely determines the expected risks and returns Range of returns for various equity/bond allocations: Rolling 12-month total returns 1976 2012 100% 75% 50% 25% 0% 10.6% 11.2% 11.6% 12.0% 12.3% 25% 50% 20% equities / 80% bonds 40% equities / 60% bonds 60% equities / 40% bonds 80% equities / 20% bonds 100% equities Max Min Average Annualised return Source: Thompson Reuters DataStream. The global equity ex-uk portion (65%) is represented by MSCI World ex-uk from 1976 to 1987 and MSCI AC World ex-uk thereafter. The UK equities proportion (35%) is represented by the FTSE All Share Index. Bonds are represented by the FTSE British Government Fixed Interest All Stocks Index. 7 Wallick et. al. 2012; Brinson and Hood, 2006. 8 Note that with yields on the Barclays Sterling Aggregate Bond Index hovering around 2.3% as of 31 December 2012, investors should not expect a repeat of the 9.9% annualised returns experienced historically in the UK bond market as shown in Figure 2. This is because current yields can be considered the best proxy for future return expectations. As a result, investors in fixed income investments should be primarily focused on the ability of high quality bonds to diversify the volatility and downside risk of equities in their portfolio. 9 Human capital is the sum of a person s current and expected future knowledge, experience and skills. It is directly related to potential future work earnings. 5
Tactical allocation strategies are they worthwhile? A tactical asset allocation strategy actively, or opportunistically, adjusts a portfolio s asset allocation based on short-term market forecasts. It aims to exploit inefficiencies or temporary imbalances in market values among different asset or sub-asset classes. When considering the potential inclusion of a tactical asset allocation strategy, investors should consider the significant risks and obstacles that can overwhelm any theoretical benefits. Many studies 10 have shown that while some strategies have added value at the margins, on average, most tactical strategies have failed to produce consistent, or durable, positive excess returns. In addition, tactical strategies typically limit transparency, increase cost and potentially complicate management and oversight. 11 If an investor expects the risk-reward relationships of the past to prevail in the future, then higher allocations to equities should lead to greater wealth accumulation and retirement income over an investor s life cycle. So if maximisation of wealth is the primary goal, then a higher equity allocation might be an appropriate strategy, as shown using historical data in Figure 3. However, this does not account for the downside risk and volatility that investors would need to withstand over short time periods to realise the potential for greater wealth accumulation over their entire life cycle. One only needs to contemplate the range of final portfolio balances and drawdown values in Figure 3 for investors who allocated 100% of their portfolio to UK equities. Conversely, if minimising risk is the goal, investors may lean toward much more conservative allocations, but in doing so, investors often risk not accumulating enough assets to meet their financial goals. This risk is commonly known as shortfall risk. In addition to market and shortfall risk, investors may consider their current and future employment when determining an appropriate asset allocation The historical return and risk characteristics of the range of equity allocations in Figure 2 supports the theory that equity exposure should decline with age to help manage risk. Younger investors are generally better able to withstand market risk than older investors because a larger percentage of their total expected wealth is in their human capital 9 versus their financial holdings. Investors nearing retirement are less able to tolerate significant volatility, specifically the risk of downside loss, and may wish for a more moderate allocation to equities. An investor s personal situation also helps to determine an appropriate risk level. For example, an investor with variable job income may not tolerate significant portfolio volatility or capital loss. These investors may therefore opt for a lower equity-allocation than their age or time horizon might otherwise suggest. 10 See for example: J.L. Treynor and K. Mazuy, 1966, Can mutual funds outguess the market? Harvard Business Review 44:131 36 as well as: 4 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. 11 Stockton and Shtekhman, 2010 6
Figure 3. Wealth maximisation versus drawdown risk 100% UK equity portfolio 100% UK bond portfolio 1.2 M 1.0 0.8 Best 15-year period: 1,062,000 1979 1993 Worst 15-year period: 246,000 1994 2008 1.2 M 1.0 0.8 Best 15-year period: 624,000 1979 1993 Worst 15-year period: 303,000 1996 2010 Portfolio value 0.6 Portfolio value 0.6 0.4 0.4 0.2 0.2 0.0 0.0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Years 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Years Source: Thomson Reuters Datastream. Equities represented by the MSCI UK index from 1976 through 1984 and the FTSE All Share Index thereafter. Bonds represented by the FTSE British Government Fixed Interest All Stocks Index. Note: This example assumes that the investor started with a 10,000 investment at the start of the 15-year window. We assume the investor added 1,000 per month, and held their target asset allocation constant through the end of the 15-year investment window. Each line represents one possible investment path on an annual frequency. There are 22 possible 15-year paths. The hypothetical portfolios above are rebalanced monthly and do not include investment costs. Influence of investor behaviour Knowing the theory and benefits of asset allocation and risk premiums does not necessarily ensure that investors effectively set and adhere to an appropriate asset allocation, particularly in times of volatile markets. Indeed, volatile markets often influence investors to abandon their carefully considered asset allocations. For example, in Figure 3, investors allocated entirely to equities would have experienced a significant decline in their portfolio values during the global financial crisis in 2008, with the risk that they abandoned their target asset allocation at the equity market s bottom. For example, retail fund cash flow data from the Investment Management Association (IMA), indicate that investors withdrew 1.2 billion from equity funds and invested 2.8 billion in bond funds in 2008. UK and global equity markets then proceeded to strongly outperform UK and global bond markets over 2009 2010. Single-fund, target-allocation portfolios automatically adhere to a static asset allocation, thus helping investors to guard against the tendency to chase returns by moving into and out of market segments based upon recent past performance. Balancing inflation risk with market risk in setting asset allocation The prior discussion focused on the historical volatility and risk of loss for different asset allocations in nominal terms. However, inflation negatively impacts a portfolio s real value, and many investors target their longer-term financial goals in real terms. Investors should weigh shortfall risk the possibility that their portfolio will not meet longer-term financial goals against market risk, or the risk that their portfolio returns will be negative. 7
Vanguard s target-allocation funds have been explicitly designed for investors with longer-term time horizons who seek to outperform inflation over their investing lives. Long-term investment portfolios, allocated completely in cash-like investments, carry significant risks in terms of their ability to meet many investors long-term financial goals. A large majority of investors in the UK will need to accept some market risk in order to adequately save for their retirement. On the other hand, investors with shorter-term financial goals or highly averse risk tolerances may find cash to be the suitable investment for their entire portfolio. The benefit of automatic rebalancing Various asset classes produce different returns over time. If left alone, the allocation weights of higher-returning assets increase and cause a portfolio s asset allocation to drift from the target allocation. This drift may subject investors to more (or less) risk than they originally intended. To ensure the portfolio aligns with its target risk and return characteristics, it must be periodically rebalanced to its intended asset allocation. 12 Historically, significant rebalancing opportunities have come after extreme market events. However, some investors find it difficult to rebalance their portfolios during or after a period of poor investment performance, especially when coupled with a high degree of market uncertainty. The thought of selling their best-performing asset classes and committing those resources to the worst performing asset classes seems counterintuitive, despite the proven benefits of this approach. All-in-one funds can help investors adhere to a targeted asset allocation without having to continuously monitor and manually rebalance the portfolio. Sub-asset allocation: Diversifying within the major asset classes Once investors determine their target allocation across major asset classes, the focus turns to sub-asset allocation the allocation across types of equities and bonds. Without guidance or the benefit of a single fund solution, investors often construct portfolios using a bottom up approach, chasing high-performing sub-asset classes and/or collecting hot-performing funds. The challenge with chasing performance is that consistently picking winning asset classes is hard to do, as suggested by Figure 4. Constructing a portfolio by picking each market segment in isolation often leads to transactions based on near-term relative performance and can thus lead to an endless cycle of chasing past winners. 12 Jaconetti and Kinniry, 2009. 8
Figure 4. Sector performance is random and difficult to accurately predict Annual returns for selected equity and bond categories, ranked best to worst 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 71.77% 9.57% 6.72% 9.39% 40.48% 17.46% 50.48% 16.75% 37.40% 13.02% 59.38% 22.95% 20.31% 13.44% 30.64% 8.87% 3.17% 9.06% 20.86% 12.84% 23.49% 16.30% 8.31% 3.51% 30.12% 16.20% 16.68% 13.15% 24.20% 4.24% 0.27% 8.38% 20.21% 8.27% 22.04% 5.38% 8.30% -3.78% 15.85% 14.51% 7.22% 12.30% 4.35% -3.47% -0.88% -14.99% 6.80% 7.20% 9.86% 2.56% 5.32% -16.03% 10.32% 8.75% -3.46% 12.04% -0.78% -5.90% -13.29% -22.68% 5.23% 6.83% 8.71% 0.65% 5.18% -29.93% 6.36% 8.32% -5.09% 2.91% -1.06% -25.17% -14.44% -27.54% 2.08% 6.58% 7.93% 0.53% 1.88% -35.16% -1.19% 7.54% -17.15% 0.56% Investment Grade Bonds UK Inflation Linked Bonds UK Equities UK Government Bonds Developed World Equities Emerging Market Equities Source: Thomson Reuters Datastream, Barclays Capital, MSCI and FTSE 1999-2012. Indices are: Investment grade bonds. Barclays Sterling Non-Gilt Index; UK government bonds, Barclays Sterling Gilt Index; UK inflation linked bonds, Barclays UK Inflation Linked Bond Index; Global equities, FTSE All World Developed ex-uk Equities; UK equities, FTSE All Share Index; Emerging markets, MSCI Emerging Market Index. On the other hand, a broadly diversified singlefund portfolio provides consistent exposure across key sub-asset classes. Consequently, investors participate in stronger-performing sectors while mitigating the negative impact of weakerperforming ones. This gives them a better chance of adhering to a diversified strategy across market cycles. Investors should also consider the relative proportions of each sub-asset class and how they may differ from the broader market. 13 In other words, they should know whether a fund employs a significant bet on any market segment, such as corporate bonds or emerging market equities. Such bets could be the result of expectations of outperformance for a particular market segment or could be the result of using some form of portfolio optimiser. An optimiser might use correlation statistics in conjunction with return and volatility statistics to suggest an allocation that provides the best return in exchange for a desired level of volatility. In many instances the recommended weights may differ widely from those reflected in the capital markets. The importance of full market exposure within asset classes cannot be understated. While bets on specific market segments, such as small-cap equities or corporate bonds, may seem appealing, these bets implicitly suggest that the market is incorrect in its assessment of a sub-asset class. As a result, Vanguard cautions against managing a portfolio solely on the basis of quantitative modelling. Instead, Vanguard views quantitative modelling as a useful tool that can complement a broader array of investment analysis processes. 13 Cole, Kinniry, and Donaldson, 2009. 9
The Vanguard approach to sub-asset allocation UK and global ex-uk equity allocations UK equities account for 35% of the equity allocation within the Vanguard target-allocation portfolios. Within the UK equity allocation, exposure across the various segments (large, medium, small-cap, growth and value) aligns to the prevailing market capitalisations. The investor subsequently maintains exposure to all segments of the UK stock market. Vanguard s target-allocation funds diversify a UK stock portfolio with broad-based, non-uk equities equal to 65% of the total equity allocation. While finance theory suggests that an upper limit should be based on the global market capitalisation for non-uk equities (currently approximately 92%), several factors combine to result in a weighting that differs from market proportions. First, investors in every country have historically displayed a significant bias towards their domestic equity markets. In the UK for example, a 2005 study (Chan et al) revealed that UK investors, on average, constructed portfolios with a 5.3 times bias to domestic equities. In other words, while the global market weight of UK equities is approximately 8%, the embedded home bias would suggest an allocation of approximately 48% to UK equities (and 52% to non-uk equities). Second, Vanguard research reveals that for UK investors, portfolio allocations to non-uk equities approaching market proportions have provided less diversification, on average, since 1970 (Figure 5). Data from 1970 through 2012 indicate the volatility of an equity portfolio would have been minimised at allocations of 20% to 30% in UK equities, or alternatively, 70% to 80% in broadbased, non-uk equities. For these reasons, Vanguard does not focus solely on optimisation to construct portfolios. Instead, we evaluate the investment trade-offs, as well as factors such as costs and behavioural realities. While no optimal allocation exists for every investor or every time period, allocating 35% of the total equity portfolio to UK equities and 65% to broad-based, non-uk equities, within the equity portion of each of the funds, reasonably balances market capitalisation awareness, home bias and diversification opportunities. Figure 2. Figure 5. Combining UK and non-uk equities historically led to lower average portfolio volatility Change in portfolio volatlity when combining UK and non-uk equities: 1970 2012 Change in Volatility 0.0% -0.5% -1.0% -1.5% -2.0% 35% UK equities, -2.5% near the bottom of -3.0% the historical volatility curve. -3.5% -4.0% -4.5% -5.0% 0 10 20 30 40 50 60 70 80 90 100 Percent global ex-uk equities Source: Thomson Reuters Datastream and MSCI. UK equities are represented by the MSCI UK Index. Non-UK equities are represented by the MSCI World Ex UK Index from 1970 through 1987 and the MSCI All Country World Ex UK Index thereafter. While quantitative optimisation can serve as a reference point, it only looks backward and depends on the time period examined. For example, at different observation dates, the optimal allocation to non-uk equities has been as low as 20% or as high as 70%. Further, when evaluating portfolios diversified across multiple asset classes, the results may also change. 10
Figure 6. Home bias can lead to sector imbalances relative to the global equity market Sector weights for UK and Non-UK indices 25 20 15 10 5 0 Oil & Gas Basic materials Industrial Consumer goods Health Care Consumer services Telecom Utilities Financial Technology UK sector weights World ex-uk sector weights Source: Thomson Reuters Datastream. Sector weights of the FTSE All Share Index and the FTSE All World ex-uk Index as at 31 December 2012. Over recent periods, the performance of UK and non-uk equities might suggest a higher allocation to UK equities, but specific risk exposures inherent to allocating to a single country may override this. For example, Figure 6 shows the sector weights of the FTSE All Share Index and the FTSE All World ex-uk Index as at 31 December 2012. A portfolio dominated by UK equities overweights the oil & gas and basic materials sectors and underweights the industrial and technology sectors. A global equity portfolio would mitigate these sector imbalances and further diversify away the concentrated exposures and omissions that exist in the UK equity market. UK and global ex-uk fixed income allocations The fixed income allocations within the Vanguard LifeStrategy Funds are broadly diversified according to the prevailing market weights for UK government bonds, UK inflation-linked government bonds and UK investment-grade corporate bonds. The funds allocate to investment-grade corporate bonds, but do not allocate to high-yield, or junk bonds. The funds also do not invest in global bond markets outside the UK, as discussed below. Although target-allocation portfolios use bonds as the primary diversifier, the sectors comprising the bond allocation can contribute to the portfolio s overall level of risk and to its return variability, particularly over shorter time periods. Historically, the correlation between stock and bond returns has been low, providing the expected diversification benefit. However, in extreme market conditions, the correlation between equities and corporate bonds tends to move much higher, which then diminishes the diversification benefit of holding bonds. Alternatively, in extreme market conditions, an allocation to government bonds (both gilts and inflation-linked gilts) can provide meaningful downside protection at a time when investors most need their bond allocation to react differently from their portfolio s equity allocation. For example, during 2008, the FTSE All Share Index returned -29.93%, but the Barclays Sterling Gilts Index returned 13.02% (See Figure 4). The Vanguard LifeStrategy Funds include UK inflation-linked gilts for two primary reasons. First, since 1999, inflation-linked gilts have, on average, represented approximately 21% and 30% of the UK bond market and UK gilt market respectively. Therefore, excluding inflation-linked gilts would represent a significant bet against a large sector of the UK bond market. Second, investors cannot 11
manage inflation risk with any certainty in a portfolio of nominal bond investments. That is because a bond portfolio s real, or inflationadjusted, value falls when actual inflation exceeds the expected rate of inflation built into market interest rates at the time the investor purchased the bond. Since inflation-linked gilts provide inflation-adjusted increases to both principal value and interest payments, an investor can manage the extent to which their fixed income portfolio is subject to inflation risk. On the other hand, by hedging currency risk, the diversification properties of global bonds are preserved, but the reduction in the global bond portfolios total volatility is marginal. In addition, the costs and operational hurdles inherent to currency hedging can overwhelm the marginal diversification benefits. For these reasons, Vanguard decided to allocate the fixed income portion of the target-allocation funds to the UK bond market only. Next, the funds exclude high-yield, or junk bonds. UK high-yield bonds represent a marginal portion of the total UK bond market ( 29 billion of the 1.655 trillion UK bond market or 1.7% according to Barclays Capital, as at 31/12/2012. As a result, while high-yield bonds have the potential to diversify a portfolio of investment grade bonds any meaningful allocation would represent a significant overweight to a very small asset class. So while the intent of a fixed income allocation is often to diversify equity market risk, the higher volatility of high yield bonds (12.0%) versus investment grade bonds (4.8%) has negated much of the potential diversification benefit. 14 Lastly, Vanguard s target-allocation funds do not invest in global bond markets outside the UK. Fixed income securities issued by governments and corporations domiciled outside the UK can offer diversification to those risk factors specific to the UK bond market because they expose investors to interest rates, inflation, economic cycles and political risks across a number of different markets. However, a primary concern for UK, bond investors is that global currency movements can have a significant impact on the theoretical benefits of a globally diversified bond portfolio. Indeed, global currency movements can create return volatility well above that of the underlying bonds. With currency left un-hedged, a portfolio of international bonds tends to engender greater volatility than UK bonds, reversing the diversification effects of a global bond portfolio. Role of inflation-linked gilts for investors at, or near, retirement Inflation-linked gilts can be particularly relevant for investors at, or near, retirement, who hold more conservatively allocated portfolios. In the accumulation stage, salaries and higher realreturning assets, such as equities, can provide effective inflation protection for investor portfolios. But, once in retirement, it becomes more difficult for investors to add to their portfolio using additional earnings. As a result, investors must balance their need to preserve capital, often through bond and cash-like investments, with their need to preserve their portfolio s purchasing power, or real value. Since inflation-linked gilts adjust to changes in inflation quickly, they may serve as an effective substitute for a portion of the portfolio s equity allocation during retirement 14 Volatility is defined as the standard deviation of returns for the Barclays Pan-European High-Yield Sterling Index and the Barclays Sterling Aggregate Index from 31/12/1999 through 31/12/2012. 12
Property To the extent that property-based securities are part of the global equity portfolio, the Vanguard LifeStrategy Funds include exposure to UK and non-uk property at their market weights as part of the respective equity allocations. However, the funds do not maintain a separate allocation to Real Estate Investment Trusts (REITs) or Real Estate Operating Companies (REOCs). Because propertybased securities currently account for approximately 1.8% of the UK equity market capitalisation (according to FTSE EPRA/NAREIT as at 31 December 2012) and 1.7% of global equity market capitalisation (according to FTSE), any additional allocation would represent a significant sector overweight. In order to justify a strategic weighting to property-based securities, investors must be comfortable with the fact that property-based equities tend to perform more like equities than property. Property investors must also be comfortable with the possibility that the property portion of their investment portfolio may correlate with the value of other property holdings in their total portfolio, such as their primary residence. 15 Non-traditional asset classes and investment strategies Vanguard s target-allocation funds do not include non-traditional asset classes or investment strategies. Non-traditional asset classes include commodities, private equity, emerging market bonds and currency. 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. However, it is difficult to assess the degree to which investors can consistently rely upon these asset classes and investment strategies to deliver their potential benefits, especially for those strategies where investable beta is not available for comparison. Strategies such as long/short, market-neutral and private equity depend exclusively on manager skill. This subjects investors to significant manager risk, as the distribution of manager skill is such that investor success depends on consistently accessing and selecting top managers. 16 Vanguard does not include commodities, and specifically commodities futures, in targetallocation funds based on our assessment of the risks, costs and complexities. While recognising the historical diversifying benefit of commodities futures, Vanguard cautions against making such an allocation solely based on historical commodity returns. The long-term economic justification for expecting significant, positive returns from a static, long-only commodities futures exposure is subject to ongoing debate. 15 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. 16 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 Commodities: Myths and Reality. 13
The role of passive fund management When constructing the target-allocation funds, Vanguard strongly believes that any risks investors bear should be expected to produce a compensating return over time. Modern financial theory and years of investment practice lead us to conclude that diversified, broad-based index exposures represent precisely this kind of compensated risk. While some active managers can add value at least some of the time, outperformance cannot be guaranteed. Vanguard investigated the construction of portfolios using actively managed funds. We compared the average returns and volatility of a portfolio constructed with actively managed funds to market benchmarks in both UK equity and UK bond fund categories. Figure 7 shows that, on average, the actively managed portfolios had lower returns and a higher level of volatility the exact opposite of the desired result of an efficient portfolio. Figure 7. Portfolios of actively managed funds can mean lower returns and higher volatility 10 9 8 UK stock market Average active equity portfolio 7 Annual Return (%) 6 5 4 3 UK bond market Average active bond portfolio 2 1 0 0 2 4 6 8 10 12 14 16 Annual Volatility (%) Source: The Vanguard Group, Inc., based on data from Morningstar, FTSE and Barclays. 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: Europe OE UK Flex-Cap Equity, Europe OE UK Large-Cap Blend Equity, Europe OE UK Large-Cap Growth Equity, Europe OE UK Large-Cap Value Equity, Europe OE UK Mid-Cap Equity, or Europe OE 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 Europe OE 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 2012. Active fund returns are net of fees and include surviving funds only. 14
While active management offers the potential to outperform, the evidence suggests that investors do not consistently see this benefit. According to data from Morningstar, over the 5, 10, and 15 years ended 2012, 72%, 74% and 67% of actively managed UK equity funds underperformed their respective benchmarks, or merged/liquidated within the period. Investors did not fare better in bond funds, where 91% and 100% of actively managed UK bond funds underperformed their respective benchmarks or merged/liquidated over the 5 and 10 year periods ending in 2012. As shown in Figure 8, success also tends to be fleeting, as even the best funds in one time period can rapidly fall out of favour. Vanguard found that, of the top 20% of funds in 5-year performance ending in December 2007, nearly 40% of those previously top-performing funds had fallen to the bottom 40% in fund performance or were merged or closed over the following 5 years ending in 2012. Of course, if fund managers displayed persistence in achieving top performance over time, nearly 100% of the top performing funds would remain at or near the top. Instead, the data reflects a significant randomness in fund performance. Figure 8. Among those that do add value, leadership is quick to change Subsequent ranking of former top 20% funds 30 25 20 15 10 5 0 19.5% Remain in top quintile 29.7% Nearly 40% of the funds ranked in the top 20% through 2007, fell to the bottom of the rankings over the 5-years ended 2012 Fall to 2nd quintile 10.9% Fall to 3rd quintile 9.4% Fall to 4th quintile 10.2% Fall to 5th quintile 20.3% Fund closed or merged Source: Vanguard and Morningstar. Notes: We ranked all active UK equity funds based on their risk-adjusted returns (total return divided by volatility) during the five-year period through December 2007. We then re-ranked the fund universe as at December 2012, and identified where each fund ended up. The columns show the percentage of top-performing funds (top 20%) as at December 2007, and the subsequent performance ranking those funds achieved over the five years through December 2012. 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: Europe OE UK Large-Cap Blend Equity, Europe OE UK Large-Cap Growth Equity, Europe OE UK Large-Cap Value Equity, Europe OE UK Mid-Cap Equity, Europe OE UK Flex-Cap Equity and Europe OE UK Small-Cap Equity. 15
Why index investing works In any market, the pounds invested are bound by the zero-sum game: For every pound buying a security, there must be a pound sold. That is, for every belief that a security will outperform, there is a counter view that it will underperform. At every moment, an index, or a fund that tightly tracks that index, reflects all of these beliefs, trades and positions. But, after accounting for the constant drag of higher transaction, management and other costs, a majority of actively managed portfolios fall to the losing side of the index s performance. The funds that do successfully outperform a benchmark over a given period often find it extremely difficult to maintain that outperformance in subsequent periods. 17 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. Efficient: Portfolio turnover is limited to additions and deletions from an index, M&A and other corporate actions. Rebalancing is continuous and costless since security weights reflect the market weight. Transparent: Because an index fund holds all or most of the securities in a given index benchmark at the same weights as that of the index benchmark, investors can always determine which securities constitute their portfolio and how they performed. Financial advisers and target-allocation funds Vanguard believes target-allocation funds provide financial advisers with a number of ways to add value to their clients. Target-allocation funds as a core investment For many clients, broadly diversified, low-cost portfolios may serve as the core component of a broader investment strategy. By using a targetallocation fund as the core portfolio, a financial adviser achieves a significant degree of low costs and risk control in the investment portfolio, while also having the flexibility to invest in more specialist indices or actively managed funds. In addition to low costs and risk control, a core investment in a Vanguard LifeStrategy Fund can potentially mitigate the downside risk of an adviser s total portfolio when compared with the broader capital markets and the adviser s peers. 18 But the adviser may still seek to outperform the market average or index, or achieve a specific investment objective, using the satellite component of their investment programme. Using target-allocation funds within a core-satellite investment approach gives advisers the chance to add value for their clients in a risk-controlled way. Bespoke strategies Vanguard LifeStrategy Fund Diversified: Index funds tracking broad benchmarks hold all or most of the securities that comprise that benchmark. Investors benefit from the mitigation of security and sector concentration risk. Lower cost: Index funds typically have low management fees and low operating costs. 17 Philips, 2010. See Figure 8. 18 For more on the benefits of using index funds as a core portfolio, see Philips and Kinniry, Enhanced practice management: The case for combining active and passive strategies. 16
Figure 9. 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 Significant life events Review progress Statement of Investment Principles Categorise and evaluate Determine risk/return requirements Develop a written plan 4 Implement plan 3 Construct portfolio Best execution Tax efficient trading Automate rebalancing Strategic asset allocation Sub-asset allocation Passive/active mix Asset location Manager selection Target-allocation funds as a source, not a use, of focus and time Investing in the Vanguard LifeStrategy Funds can allow advisers to focus their time and resources on others aspects of their client value proposition. Here s how. Let s take the example of an adviser who serves as a financial planner to an individual client. Figure 9 shows a representative multi-step investment advice process. The financial planner may work very closely with an investor on steps 1 and 2, which offer the opportunity to build credibility and exercise some level of control over client outcomes, such as developing trust or documenting a well thought out investment plan. The adviser may then decide that a risk-graded, professionally-constructed target-allocation fund ensures both prudent and suitable portfolio construction and implementation, thereby fulfilling steps 3 and 4 with a straightforward, yet sophisticated, investment selection. This investment selection may free up the time and resources traditionally spent on activities such as manager selection and oversight, while helping to mitigate the risk that performance-based promises hurt the adviser s credibility. Once an adviser makes an appropriate investment selection for the client, the periodic adviser-client review, as represented by step 5 in the figure, offers opportunities for the adviser to enhance a long-term client value proposition. During this step, financial advisers can play a central role in periodically 19 reassessing a client s investment objectives, risk tolerance, changes in personal circumstances and progress toward reaching chosen financial goals to ensure the targetallocation 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. 19 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 it should reflect significant changes in investor circumstances, such as retirement, having children or a large unanticipated health expense. 17