HSBC Global Strategy Dynamic vs L&G MI 6/7

bowlhead99

Jon_W wrote: »

Can I just clear-up some basic terminology, folks?

So the static mix a la Vanguard LS = mix determined and the outset and left to grow/shrink accordingly as % of total fund.

Basically Vanguard have promised that the fund will be X% equity and the equities will be approx 25% UK equity and 75% not-UK equity. It is, as you say, determined at the outset.

However, the markets will grow or shrink each day, causing the X% to vary and the UK/not-UK splits to vary. They don't want to just leave it alone for those relative proportions to grow/shrink, so they will sell some of holding A and buy some more of holding B to return the mix to where they started from, in terms of keeping their promise that your exposure is going to be X% equity and 25% equities in UK, so that people subscribing to the fund are generally getting what it says on the tin.

However, the bits where they have *not* made explicit promises in their prospectus (e.g. how much of the equities are US vs Japanese listed, or how much of the bonds will be index linked UK gilts vs French investment-grade company bonds) may ebb and flow with the markets because they are driven by indexes, unless someone makes an active choice to do something about it and perhaps juggle the ratios which might be a long time coming.

Some of their high-equity funds (e.g. VLS 80 and 100) will have lots of different regional equity index funds and very few bond indexes so there is not much scope for manual intervention to change the internal mix of the bonds. Whereas some of their low equity funds (e.g. VLS 20) will have many more bond indexes and just use one or two equity index funds so there is not much scope to change the ratio of e.g. Japan to USA equity because they don't even have a separate Japan fund and USA fund within their holdings, they are at the mercy of the world indexes.

So, you would say VLS range is a static allocation because there is always someone re-balancing the fund back to (e.g.) 60% equities or 80% equities, and rebalancing the equities to 25% UK and 75% not-UK, and the other stuff that is held is pretty uncontrolled and just gets dragged around by the market. There isn't a fund manager watching it to make active decisions on how to evolve the portfolio to give a particular level of risk or volatility exposure over the economic cycle. It will just do what it does, subject to the controlled and published equity ratio and agreed 'home bias' (the latter has actually changed since they first launched but they did tell everyone about it when they did it).

Meanwhile:

Does active mix allocation mean:

i) returning the fund to its initial bonds/equities and/or equities sector/country mix;
ii) tweaking the mix in according to performance expectations or;
iii) both of the aforementioned?

i) is not really what people think of as active management, if you are just getting a computer or a robot to automatically drag something back to where it started.

In a sense though, if you are truly trying to be black-and-white about it, you would have to acknowledge it is some sort of active management because if you were truly 'passive' you would let everything go wherever it wants, like holding a single world-trackers and just leaving it. But returning to a standardised unchanging mix is not really what people think of as being an active fund. Really that description is what people would call 'static allocations' (like what Vanguard does with its defined "x% equity" lifestrategy funds).

Really there are a few potential 'levels' of active management, which I'd describe as follows:

passive - a fund that just follows an index up and down, whether it's a specialised index or a broad one.

active level one - Everything is not allowed to just 'roam free' as in the passive fund ; someone keeps the asset allocations in check with intentional reallocations driven by keeping their mind on a target

active level two - assuming someone is keeping allocations in check to a target, is that target that they are aiming for something that the fund manager will change based on new information (e.g. actuarial calculation of volatility says more short-dated bonds should be held and fewer north american equities if we want to stay within risk level six out of eight)? Changing the target is another level of active decision making.

active level three - having decided in level two how we want the assets to be allocated between different asset classes or regions or industries, how do we decide which company's shares or bonds to buy or what types of government securities to hold? Do we just say we will have an index for our UK equities and an index for our US equities and an index for our emerging markets equities and an index for our UK gilts and an index for our various bond markets? Or do we go to this extra level three and employ stock-picking people (or, e.g., invest in other actively managed funds) to try to get exposure to certain selected stocks which they think will meet our objectives of (e.g.) higher levels of natural income or higher total return or lower total volatility etc.

If there is active stockpicking somewhere in the fund structure, that's more 'active' than just actively selecting and monitoring the high level asset mix and letting all the indivdual underlying holdings run off indexes. Those three levels of active-ness are not industry standard terms, just what I've made up off the top of my head. Other people would find even more nuances between funds and management methods to talk about, but the above seems to cover it.

So in my made-up set of definitions:

- a FTSE All-World tracker or a Russell 2000 tracker is pure passive, just buying what the index tells it.

- Vanguard Lifestrategy is level 1 active - there is a target being worked towards and if equities became 85% of the fund they would drag it back to 80% or if UK became only a tenth of the total equities they would sell some overseas stuff to top up the UK. But the building blocks are all pure passive funds.

- L&G Multi-index series is level 2 active because they buy-in their allocation targets from someone who performs risk and volatility ratings of asset classes which they maintain over time, and which may shift over time. If the fund labeled as risk level 5 out of 8 were to have its US equities and long-dated UK gilts grow as proportion of the fund such that it shifted towards a 6 out of 8 allocation they would reallocate the asset mix to drag it back to the middle of the 5 band ; but they have choices over how they could accomplish that by changing lots of different types of holdings as long as what they end up with is something that is considered to keep them at risk 5 out of 8. The mix will not necessarily look the same in March 2017 as it did in summer 2016 or autumn 2015 or the middle of 2010. But they don't pick individual stocks, or invest in other funds that pick individual stocks. They use indexes as the building blocks other than a small direct commercial property component which by its nature can't be an index.

- A level 3 active investment vehicle - a 'fully actively managed fund' might be something like a couple of investment trusts I have, RIT Capital Partners and Personal Assets Trust. They decide from time to time how much they want exposed to individual sectors and how they will accomplish it. They purchase direct holdings of individual companies, bonds and other assets together with stakes in other actively-managed investment funds from time to time to achieve the exposure that they want. You could probably call some investment trusts 'level 3-plus' active, because on top of deploying their investors' funds they can also borrow money from banks to 'gear up' and put more money than they actually even have into the markets, taking an active decision on financial gearing, and may do things like buy back their own issued shares to reduce the size of the fund if it's financially efficient to do so.

There are of course other 'funds' which are multi-asset and have 'level 3' active management - you don't need to look into the world of investment trusts at all, they were just a couple of examples as I was looking at my holdings this morning.

Jon_W

As ever, I am indebted, thanks. That reply was so comprehensive I have taken notes! Seriously!!

Implied by your discussion of L & G, more actively-managed funds may have to keep to their prospectus-quoted risk level - something which I hadn't considered.

I would imagine your 'Level 1' funds like Vanguard LS don't do this as the risk level doesn't vary THAT much as the % equities and % bonds are fixed, as is the 25% UK and 75% rest of World equities within the defined equity %.

Would I be right in thinking (if we are being dogmatic) that even the 100% passive funds have some active management, as they will rebalance according to each country's (and sectors companies within those countries) market cap? Or are they literally "You are buying world indices in these proportions, however they pan out, they pan out: we leave them be"?

I wish I could buy you some pints for all his help, you know.

coyrls

Jon_W wrote: »

As ever, I am indebted, thanks. That reply was so comprehensive I have taken notes! Seriously!!

Implied by your discussion of L & G, more actively-managed funds may have to keep to their prospectus-quoted risk level - something which I hadn't considered.

I would imagine your 'Level 1' funds like Vanguard LS don't do this as the risk level doesn't vary THAT much as the % equities and % bonds are fixed, as is the 25% UK and 75% rest of World equities within the defined equity %.

Would I be right in thinking (if we are being dogmatic) that even the 100% passive funds have some active management, as they will rebalance according to each country's (and sectors companies within those countries) market cap? Or are they literally "You are buying world indices in these proportions, however they pan out, they pan out: we leave them be"?

I wish I could buy you some pints for all his help, you know.

Level 1 would follow a single index, so there is no rebalancing. That single index could be a world index, in which case the allocations to sectors, countries etc. will be determined by the index, there will be no active management.

bowlhead99

coyrls wrote: »

Level 1 would follow a single index, so there is no rebalancing. That single index could be a world index, in which case the allocations to sectors, countries etc. will be determined by the index, there will be no active management.

In my terminology, a single index fund was 'passive' or perhaps 'active level 0'. My 'Level 1' is the first level at which there is active management by defining some elements of an asset allocation and rebalancing towards that allocation, like Vanguard Lifestrategy does.

Whatever we call it though, you are right that a specialist fund based off a single index e.g. FTSE UK All-Share Index or the US S&P Total Market Index or the MSCI All Companies World Index does not try to 'balance' to individual companies and sectors market cap. For example if it is trying to follow the US index it just buys all those companies in the proportion that they make up in the index, and holds them.

Imagine Jon_W, that you put £100 into the US index. Apple represents about 3% of that index (£3) and Technology is about 20%(£20). If tomorrow Apple doubles in size from being worth $750bn to $1.5 trillion, and everything else stands still, Apple's value increase from £3 to £6 will increase your overall fund to £103 of total value.

Within that, Apple will be almost 6% of the £103 of value and Technology will be about £23 (about 23%). So, Apple is a bigger proportion of the index and Technology is a bigger proportion of the index and Computer Hardware is a bigger proportion of Technology. But your index-tracking fund does not need to go and buy more Apple and more Technology and Computer Hardware. It already held the Apple shares and the shares are now more valuable relative to everything else so the work has already been done for it.

Similarly if you held the All Companies World Index and again everything stood still while Apple doubled in value from being 1.5% of everything to 3% of everything: Apple goes up, technology goes up relative to oil and gas and banks etc, and Apple's relative size compared to Samsung increases so clearly the US exposure goes up relative to South Korea.

So in the 'pure passive' fund that follows a single index, everything is all done for it. If you decided to subscribe £1000 to the fund last week they would take your money and spend 3% on Apple. If you decided to subscribe £1000 to the fund next week instead, maybe they would need to spend 6% on Apple because Apple is at a new larger ratio at that point when they look up the index on their screen. But at no point in between do they need to 'rebalance' to sell anything and buy more Apple, because 'getting more Apple' is just something that automatically happens by virtue of their Apple shares getting more valuable.

Having said 'everything is done for it'- it's only 'nearly' everything because from time to time a company will exit the index because it is taken private or merges or gets too small and a new one is promoted into the index at the start of the next quarter. But that is a relatively small amount of adjustment required once a quarter.

So, a pure single-index fund things are simple and there is literally no active management other than a manager thinking, hmm there are 5000 companies in the index I can probably just hold 4800 representative ones and not bother with these tiny ones, it might change the result very slightly but save us some admin costs.

- -
However, if it is a multi asset class fund and the fund manager has set some ground rules like, for example, I am maintaining separate investment holdings for US and Asia and Europe and UK, and I want US and Asia and Europe between them to always be 75% and the UK at 25%; then when Apple doubles in size from £1.50 per £100 to £3 per £101.50, he needs to do some work.

The UK would only now be £25 per £101.50 with rest of world at £76.50. So we need to buy more UK shares, in all their UK proportions, to get to £25.38 for the UK as a whole which is the full 25% of the total fund value of £101.50 that we have. In order to do that we will have to sell some other global allocations to get our hands on the 38p of cash to buy more UK stocks.

In trying to raise this 38p of cash, if the fund manager has committed to always having a fixed ratio between Europe and Asia and US, then he may need to sell relatively more of US than he does of Asia to fix the problem of Apple going up more than Samsung and the US vs Asia being a bit out of proportion too.

However if he has not said that he will maintain a fixed US to Asia to Europe ratio then the ratios of those regions can probably freely float, within reason, just like they would in an all-world index. So if that's the case, he can get his hands on 38p by selling £0.38/£76.50 ths of each one of his Asia and US and Europe holdings. In that way he will never address his 'Apple growth vs Samsung growth has made US bigger than Asia' problem, because he doesn't consider it a problem. Although after a period of years if US became a massive dominant part of the portfolio he may consider paring it back if he thought the investors were not so keen on literally following the 'free float' method.

coyrls

bowlhead99 wrote: »

In my terminology, a single index fund was 'passive' or perhaps 'active level 0'. My 'Level 1' is the first level at which there is active management by defining some elements of an asset allocation and rebalancing towards that allocation, like Vanguard Lifestrategy does.

Sorry, yes my answer refers to a Level 0 below Level 1. I was thrown by the reference to 100% passive funds but as you say that wouldn't sit at your Level 1.

Jon_W

Bowlhead, you explain things clearly. I wish you'd write a book! :-D