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The advent of high inflation and 12 interest rate hikes has hit multi-sector funds hard, particularly for conservative and moderate options, which tend to have high weights to fixed income.
If we look at funds with a CPI +5% target now, the tide has turned. The table below uses data to April 2023
CPI + anything is now a big challenge. The table below shows this relative to traditional market returns.
These returns are the highest 26 from a list of 60 markets, sorted from highest to lowest on the 5-year return column. In this list, CPI + 5% and CPI + 4% are No.4 and No.9. All the ‘CPIs’ are in the top 26.
To beat a CPI objective of any sort, a manager has got to have techniques and processes that add considerable value to the traditional “beta” building blocks used in investment portfolios. It is not an easy task.
Let’s look at some results in the multi-sector landscape.
Investment Objective
The multi-sector space is completely dominated by two types of benchmarks or return targets:
- A CPI-related investment objective - such as CPI + 3.00% p.a.
- The Morningstar Australia Target Allocation Index Family. It consists of five indexes across the conservative, moderate, balanced, growth and aggressive risk spectrums. The indexes are divided between equity, property, fixed income, and cash, depending on the growth/defensive split.
Here is how the Funds break down by investment objective category:
So just under 40% of these Multi-Asset funds have a CPI-related benchmark. Note that of the CPI-related funds, 312 (70% of them) have a target of CPI + 3.00% or higher. That is a solid hurdle.
The Universe
Here is the breakdown of the Funds being analysed.
Success Count
The next table shows how many funds beat their benchmarks:
Success Rate
To look at the success ‘rate’ (the % of funds outperforming), we will summarise and ignore the cash-targeting funds (which are small in number).
The 3-year period looks relatively strong, particularly against the 5-year numbers (which are a low point for the CPI-related funds).
An interesting observation is that the 3 and 5-year numbers are better for the Morningstar benchmarked funds but drop off significantly at 10 years. And the opposite pattern is seen for the ‘CPI’ funds. This is clear in the table below.
What explains this? One possibility is that, in the long run, risk assets tend to outstrip inflation and tend to assist managers in beating CPI, particularly for the ‘growthier’ risk profiles. On the other hand, the Morningstar benchmarks have a peer group flavour to them, which historically has been a difficult hurdle to beat persistently.
The table below summarises the alpha achieved by these multi-sector funds as measured against their own official benchmark. Results are to Apr-2023.
There is a lot of red ink here. On average, multi-sector funds underperform most benchmarks most of the time.
This table shows an interesting pattern. There is a tendency for average alpha to decline as the targeted CPI margin increases. This is particularly true for the 5 and 10-year columns.
This might make intuitive sense – a higher hurdle is more difficult to achieve, and so a higher failure rate should be expected.
Except that the hurdle rate is set by the managers themselves, not by an external third party. It is rational to expect that managers set themselves a goal they believe they can achieve knowing better than anyone else about their capabilities – staff, investment philosophy and style, risk tolerance and many other ingredients to investment success.
Consequently, the rational average alpha expected by managers in aggregate should at least be a positive number (preferably net of fees). The data presented in this note is not supportive of that theory.
There are many possible explanations for these results. It may well be that managers overestimate the level of their own skill and set their objectives too high as a result. There is behavioural finance research that is consistent with that idea. Another possibility is that marketing considerations are a primary driver of benchmark selection, i.e. choosing an attractive high-return objective that will draw investors even if the chances of performance success is uncertain (or even unlikely?).
Others could simply argue that it shows that active management doesn’t work.
At SQM Research, we believe in the value of active management and feel these results show that active management is difficult, not impossible. Note that half the funds with a target of CPI + 3.00% or higher achieved their target over the last 3 years.
True active alpha exists, but it is a scarce commodity that is difficult to identify and challenging to extract.
The chart below shows how a significant negative relationship exists between higher targeted CPI margins and actual alpha outcomes. The dots are red because they are all negative numbers.
Fees and costs are a very important consideration in this discussion.
The Multi-Asset category has relatively high fees and costs, as represented by average ICRs and MERs (see below).
The chart below shows the distribution of ICRs across multi-asset funds. 50% of the funds have an ICR ranging from 0.98% to 2.30%. These types of charges have a significant impact on the net-of-fee alpha statistics detailed in this note.
Appendix
Morningstar Target Allocation Index Structure
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