There has always been strong demand for investments that are able to generate reasonably high, sustainable returns and which exhibit low levels of volatility. Investment utopia, right? In today’s low return environment, however, it is necessary for investors’ expectations to be reset. In short, if they expect to enjoy the kind of appealing returns they may have attained in the past, they must be willing and able to withstand higher levels of volatility.

A reluctant realisation that investment utopia is confined to a bygone era has prompted many investors to look at their investments through a different lens. Rather than seeking to maximise returns – and thereby expose themselves to unpalatable levels of volatility – many are considering what they really need their investments to deliver. The proliferation of objective-based investment vehicles we have seen in recent years is a result of this changing mindset.

More than balanced funds in disguise

Unable to effectively time the markets, increasing numbers of investors are turning to professionally-managed multi-asset funds. In differing ways, most of these vehicles seek to allocate between asset classes as valuations fluctuate, at the same time as managing risk. Concurrently, there appears to be an increasing acceptance that relying on traditional asset allocation alone is unlikely to be sufficient to meet investors’ return objectives.

As well as managing asset allocations according to long-term valuation drivers, ideally managers should be able to take advantage of shorter-term alpha opportunities. Only around two thirds of the performance of the First State Diversified Growth Fund, for example, is expected to be derived from traditional asset allocation decisions. The remaining performance is generated from the exploitation of shorter-term market inefficiencies. Unlike the traditional balanced fund model, returns are effectively generated through both alpha and beta.

A dynamic and flexible process

With a focus on preserving capital and growing it over the long term, the First State Diversified Growth Fund seeks to generate real capital growth of 4% (UK Retail Price Index plus 4%) over rolling five year periods. Unlike some peers, it is not a fund of funds and does not rely on underlying managers to generate alpha. Instead, it is an unconstrained vehicle with the flexibility to generate performance from dynamic asset allocation.

As a starting point, asset allocations are always established with the investment objective in mind. From there, the risk allocation to alpha positions can be scaled up if market returns are not providing sufficient risk/return opportunities, or scaled down if risk is deemed excessive. The process is benchmark agnostic and entirely flexible; no target allocations or ranges are in place, meaning there is no requirement to be invested in any asset class if valuation support is not present.

There are two building blocks within the investment process. The first, Neutral Asset Allocation (NAA), sets longer-term asset allocations. The second part, Dynamic Asset Allocation (DAA), allows short-term opportunities in markets to be exploited.

In the NAA, proprietary stochastic simulation models are used to determine economic assumptions for each country, forward looking risk premia and expected returns. These expected returns are used as a basis for portfolio allocations, incorporating return objectives, constraints, and the investment time horizon of the portfolio. The process of determining changes to NAA is based on the economic climate, prevailing market conditions, valuations of financial assets, and political and market risks.

The additional establishment of the DAA is in recognition that asset allocation alone is unlikely to be sufficient to meet return objectives over the long term. Shorter-term market dynamics are taken into account, enabling the portfolio to generate additional performance as well as mitigate risks, such as tail events. Among other things, the DAA looks at prevailing market conditions and fundamental data to identify possible dislocations and opportunities on the short term. The unconstrained nature of the portfolio means that foreign currency and alternative investments can be added to the traditional asset class mix to improve alpha generation, provide greater diversification and further mitigate risk.

As well as being unconstrained, the portfolio is completely flexible. Blending NAA and DAA means the amount of alpha and beta in the portfolio can be dialled up and down, depending on prevailing conditions. There is also complete discretion in implementation; a key point of differentiation from the fund of fund model. ETFs can be used to obtain equity exposure, for example, or indices can be replicated with certain sector exclusions, if desired. At all times, cost-effective instruments that provide the most efficient risk/return trade-off are selected. Additionally, both long and short positions can be held; another important differentiator from traditional, long only balanced vehicles.

Equities and bonds look expensive

Equities continue to be supported by low discount rates, but price/earnings ratios are looking increasingly stretched. Unless we start to see higher corporate earnings, strong equity market performance appears unlikely to be sustained. The First State Diversified Growth Fund currently holds of less than 20% in equities demonstrating the virtues of a fully flexible investment process; which should include a focus on capital preservation in times of high valuations.

Periods of market volatility not only present opportunities to add value through DAA, but also provide an opportunity for funds of this type to demonstrate their ability to preserve investors’ capital.

From a current valuation standpoint, emerging market debt and global high yield credit appear preferable to equities and sovereign debt. Following the recent bout of sterling weakness in 2016, foreign currency holdings have also been reduced, reflecting a more balanced view on risks as the UK proceeds with negotiations to withdraw from the European Union.