As an investor, what should you prioritise: a multi-asset solution focused on alpha generation or one that aims to limit downside risk?
After contemplating this for some time, I believe boxing serves as a great analogy for these two approaches. It might sound like a stretch, but bear with me. Consider this: at the extreme end of the spectrum, a fund manager prioritising only alpha generation with little or no regard for downside protection is like an overly eager boxer.
They flail their arms, desperately trying to land a knockout punch, with little concern for getting hit themselves. On the other end, a fund manager solely focused on downside protection is like a boxer who never throws a punch, just keeps their guard up and bobs around the ring each round.
Clearly, a strategy that blends the best aspects of both is ideal. But what if you could only ask your fund manager to focus on one or the other: alpha or protection? What should you ask them to prioritise?
To answer this question, I will focus on the most extreme cases of multi-asset funds prioritising alpha generation versus those aiming to limit downside protection. By examining these extremes, we can determine what will best help you and your clients achieve optimal investment outcomes.
The big-hitting alpha generators
How will the fund managers fare in the alpha corner?
To identify fund managers prioritising alpha over downside protection, our investment team examined five funds in the IA Mixed 40-85% sector that exhibited the highest levels of tracking error over the past five years.
Why tracking error? It measures how closely a fund manager follows the performance of a benchmark index. In simple terms, a high tracking error indicates that the fund manager is taking more risks and making unique investment decisions.
If these decisions pay off, the fund can achieve higher returns than the benchmark, leading to higher alpha. Conversely, it can also lead to significant underperformance. In other words, the greater the tracking error, the more the fund manager is swinging for knockout returns, but they’re also exposing themselves to taking a few hits in the process.
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The data showed that high tracking error can lead to very good performance, but it’s also highly variable. In some years there was outperformance of the benchmark by nearly 27%, and then in other years underperformance of 15%. While this approach might be interesting in a boxing match, it doesn’t translate well for client interactions.
For example, having such variable returns from one year to the next is not particularly helpful in managing the emotional needs of your clients. A strong year of performance might set return expectations too high, causing disappointment in subsequent years. Conversely, a big loss could lead to clients wanting to sell their investments in a panic, which is rarely the best course of action.
Moreover, large amounts of tracking error and risk-taking can wreak havoc with your risk profiling process, which typically requires funds to stay within a controlled range of risk. Not to mention consumer duty, where avoiding ‘foreseeable harm’ seems to be at the heart of the regulation.
There’s an expression I’ve heard that sums up my view nicely: ‘The best return a client can get is the one they most expect.’ In essence, a blind focus on alpha generation can lead to exceptional performance, but it also typically creates a lot of performance variability and risk, which may ultimately be difficult to manage with most clients.
Guard up! Downside protection
And in the other corner, we have the downside protection fund managers.
To identify these fund managers, the investment team considered volatility instead of tracking error. Clearly, a fund manager prioritising downside protection should have lower volatility, as they have their guard up to prevent hits to performance.
To illustrate this, they pulled out the five fund managers with the lowest annualised volatility over the previous five years in the IA Mixed 40-85% sector to review their performance.
It may not be surprising to see that fund managers with very low volatility, indicating strong downside protection, underperformed. In fact, on average, the funds underperformed in four out of the five years observed. I’ve not met a single client yet who would be happy with that outcome.
Crucially, to deliver decent investment returns, you need to take risks. Just like in boxing, you need to throw a few punches if you want to win.
What does it take to be a multi-asset GOAT?
Rather than looking at extreme examples, a balanced approach of alpha generation and downside protection makes the most sense. Take a risk-first approach, complemented by calculated risk-taking – this is surely the best way to box clever?
Consider Floyd ‘Money’ Mayweather – a true boxing GOAT – with 50 wins and 0 losses. He is regarded as one of the best defensive boxers in history and one of the most accurate punchers. In investment terms, this means managing downside risks while tactically adding value when possible. Recognising that alpha generation should not be about swinging for returns; in fact, good alpha generation can sometimes improve diversification.
To build on this, here’s a simple example. Think about a fund manager who has ten investment ideas, nine of which add value, but one detracts. That’s great, it’s a 90% hit ratio!
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But what if that one bad trade knocks you out and wipes out the gains from all the other nine trades that worked? A risk-first approach is about preventing that from happening; it’s as simple as that. As such, a key element of a truly great multi-asset solution must ensure that active decisions are sized and managed appropriately – to prevent this problem.
In the UK, demand continues to grow for multi-asset products, and so for investors looking to avoid a knockout, finding a solution that balances alpha generation and downside protection effectively will be absolutely crucial.
Smera Ashraf is head of global wealth – UK at Aviva Investors
