Plumber fixing pipe

Is it the workman or the tools?

11 months ago

When not researching passive strategies and products in the day job, I like to spend some of my spare time attending to the never-ending list of jobs at home that my wife keeps updated at Chez McGivern. Whether it’s garden chores, decorating tasks, or simple picture or mirror hanging, no job is safe from me and my trusty toolbox! And for those amongst us who, like me, have a predilection for DIY, there’s always some tools in our toolbox that are super simple, that we know and understand very well, but that we are probably still using incorrectly a lot of the time too. Exhibit A: the humble screwdriver. Known the world over and designed to do one thing well: drive and remove screws. But who can honestly say they haven’t used it at times as a makeshift chisel, a de facto nail punch or a small pry bar when something is stuck…? And, even those enlightened souls that only use it for screws, I ask how often do you use the incorrect size, or use a Phillips driver when a Pozi is needed, leading to the inevitable stripping of the screw head and causing a two-minute job to be an hour-long frustration? Is that just me? I’m guessing we all do it more often than we should, even though we know better! Well, just like DIY tool misuse, in a lot of cases, the same thing can be said for some misuse amongst investment tools that are regularly employed by investors, advisers and product selectors when they’re assessing investments and monitoring performance. The topic of discussion today is one of the most widely known and, theoretically, well understood peer ranking systems in the UK market: the Investment Association (IA) Sector Classifications.

The IA, as we all know, is a trade body that represents the UK’s fund management industry, with its classification framework offering a tool for investors to navigate and filter the open-ended fund market by dividing funds into broad groups based on factors such as asset class, investment strategy and geographical region. The sectors contain over 4,000 funds (including ETFs since April 2021), across 52 categories. Often, each category’s membership is divided into quartiles on a performance basis, with first and second quartile products being above average performers and third and fourth naturally being below average. And, in terms of how the IA sectors are used in the industry, screening as an initial filter – e.g. selecting from the top two quartile products to narrow a broad universe – is common, as is the use of the sector average performance as something of a ‘benchmark’ when an investor or adviser wants to quickly reference the relative performance of their holding against a broad peer group. So far, all very simple and sensible.

However, what on the surface is simple can quickly become complicated and nuanced (like choosing the correct size screwdriver, dependent upon the screw); in some of the classifications, the dispersion in strategy and application can be very wide, meaning the use of the classification peer groups and averages in investment decision-making can potentially lead investors astray. Whilst this issue may be present in many of the IA sectors, it is a particularly prevalent problem in the sectors that the AJ Bell multi-asset growth fund range sits in – the ‘Mixed Asset’ classification, encompassing four underlying sectors: Mixed Investment 0-35%, Mixed Investment 20-60%, Mixed Investment 40-85% and Flexible Investment. These four sectors cover multi-asset products and use each product’s equity weighting as the filter for inclusion into one of the four groups. An example of the sector’s high-level criteria can be seen below:

Mixed Investment 20-60% Shares

Funds in this sector are required to have a range of different investments. The fund must have between 20% and 60% invested in company shares (equities). At least 30% of the fund must be in fixed income investments (e.g., corporate and government bonds) and/or “cash” investments. “Cash” can include investments such as current account cash, short-term fixed income investments and certificates of deposit.

  • Maximum 60% equity exposure (including convertibles)
  • Minimum 20% equity exposure
  • Minimum 30% fixed income and cash
  • Minimum 60% investment in established market currencies (US Dollar, Sterling and Euro) of which 30% must be Sterling
  • Sterling requirement includes assets hedged back to Sterling

Source: – August 2021

Suffice to say, those criteria can represent an extremely broad collection of funds, with very different strategies and asset allocations being followed, but all still being classed as ‘peers’ of each other due to the simplistic category criteria of their equity weightings being within a broad criteria band. And this leads to a problem when investors use the sectors as a quick screener for new holdings or use the IA sector average as a benchmark for existing holding performance; what leads today quite often lags tomorrow, since the market environment can change much quicker than most of the underlying funds can or would want to change their asset allocations. This is especially the case since most funds aren’t managed to the IA sector peer groups at all, but to in-house or third-party risk profile mandates, which in many cases prescribe strict limits on volatility or asset allocation weightings. This can mean short-term peer rankings are volatile indeed and any decision-making or assessment of a fund making use of the sector rankings/averages should be made in full understanding of the underlying strategy of that fund in question.

To elucidate the point, the below shows the average equity weights, annualised returns and volatility for the IA Mixed Investment 20-60% sector’s best performer and worst performer over the last three years, to end June 2021.

Return (Annualized) Peer group percentile Std Dev (Annualized) Average Equity Weight % (Monthly observations)
10.76 1 9.34 59.00%
-15.59 100 26.29 55.33%

Source: AJ Bell, Morningstar – based on three-year portfolio data to end July 2021

The performance and volatility disparity of the above products is clearly demonstrated, in that the funds are doing very different things and getting very different outcomes, with wide dispersion across the sector despite the equity levels being, on average, very similar across the period in review. So much so, it leaves one to ask, can they be called ‘peers’?

Our fund range is managed in line with the Dynamic Planner Risk Target Managed badging system, which sees us structure the funds to ensure the ex-ante volatility is kept within a prescribed volatility band, according to the risk profile of each product. There are also some additional constraints around asset allocation on minimum number of Dynamic Planner asset classes. In building our funds, we do not consider where the IA average equity allocation is set, nor where peers are positioned, instead relying on our capital market assumptions and asset allocation framework to guide us to the appropriate blend of assets. This can mean that sometimes we’re more cautious than the market and at other times we’re more aggressively positioned. As such, changes in market environments can cause short-term swings in the percentile rankings but, for investors that understand and are comfortable with the investment strategy, this should not be a call to action. If one is going to make use of the IA sectors as an aid for selection and monitoring, given that we suggest a longer investment horizon as appropriate for our investors, we would suggest, at a minimum, that a three-year lookback is utilised and, where data is available, five years ideally, to prevent investors or selectors chasing short-term performance.

On a single quarter or one-year lookback, our products that are included the IA sectors change frequently from above average performers to below average performers. However, on a three-year lookback to end July 2021, all our funds that are in the IA sectors are second quartile performers, and so are above average. Similarly, all our growth model portfolios, both active and passive, that have at least three years of data available would also be second quartile performers if they were measured against the IA sector constituents (model portfolios aren’t officially included). We believe this demonstrates that our process and approach is robust and reliable and, as such, we try not to pay too much attention to changes in our short-term rankings within the IA sectors, focusing instead on the three year data as a better measure of our performance, so as to not cause long- term consequences for the investment outcomes for our investors.

If you would like further information, please get in touch with our Business Development Team.

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Terry McGivern

Terry McGivern

Job Title
Senior Research Analyst

Terry’s career in financial services began in 2005 on the Settlements Team at a major bank. He later moved to an investment management company and then to a leading provider of financial services. In 2010, he took up a proprietary futures trading role at one of the world’s largest independent global commodities brokers. Prior to joining AJ Bell, Terry spent five years on the Investment Management Team at a discretionary investment manager in Liverpool, where he was also a member of the Asset Allocation Committee. Terry holds the CFA-UK Investment Management Certificate (IMC) and is currently studying towards the CFA Level 2 exam.

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