325. Why the traditional 60/40 portfolio is the lazy approach

8 August 2024 (pre-recorded 5 August 2024)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. We’re looking at a newly Elite Radar multi-asset fund today with the manager giving an introduction to the funds aims, objectives and process as well as his views on the recent market volatility and the outlook for the final part of 2024.

Chris Salih (CS): I’m Chris Salih and today we’re joined by Philip Chandler, co-manager of the Elite Radar Schroder Global Multi-Asset Cautious Portfolio. Philip, thank you very much for joining us and explaining this recently Elite Radar fund.

Philip Chandler (PC): Thank you for having me.

[INTERVIEW]

CS: Let’s just start with the obvious and that’s with the portfolio itself. You are looking to deliver an actively managed solution with a sort of lower cost of just 22 basis points. That is significantly cheaper than the market and particularly in the multi-asset space. So maybe just explain what you’re trying to do and how you go about achieving that with that cost base.

PC: So we’re in a great position at Schroders in that we’ve got all the required tools in-house. First, we’ve got one of the largest multi-asset teams in the industry. We’ve got our own economics team, our own capital market assumptions, our own proprietary portfolio construction tools. We are well known for our dynamic asset allocation. And secondly, we’ve got fantastic stock and bond pickers. And we’ve got variety as well. So that gives us choice. We’ve got multiple strategies available to us in both UK and global equities for example. So that allows us to construct portfolios that are balanced by style or we can tilt a growth or value style if we want to. So I don’t think there are many firms in the industry who could even produce this solution of both active asset allocation and active stock selection, let alone at this price.

And as to that, we’ve worked hard to keep costs down. We’re a big firm, we manage over £750 billion worth of client assets including a lot of institutional money. So that gives us economies of scale and a real focus on efficiency to the benefit of our clients. And that enables us to produce this solution of active management, both in terms of asset allocation and stock selection, but an OCF that’s capped at 22 basis points.

CS: Okay. You’ve said before that sort of geopolitical turmoil and inflation and the cost of living has sort of impacted conventional portfolio construction. We’ve talked about the 60/40 (60 equities, 40 bonds) before, could you maybe explain how and why this might continue?

PC: We went through a period when economic growth was really the only real risk for markets and every time growth slowed the Fed and other central banks would ride to the rescue and cut interest rates to boost the economy. Bond investors knew this and so every time growth slowed and equity invested worried about the hit to earnings. So bond investors would get excited, bond yields would fall and thus bond prices would rise. And suddenly anyone invested in a mixed portfolio that mythical 60/40 portfolio for example of equities and bonds would see their equity losses cushioned by bond profits.

And the last couple of years have shown us what happens when inflation is a threat. Both equities and bonds can fall together and that positive correlation means that multi-asset investors that passively hold a fixed ratio of equities and bonds have been burned.

And it’s not just about inflation. You’ve got a big fiscal deficit in the US and there are questions for some other countries to answer as well. Do you think that the equity bond correlation is going to happily revert back to negative levels? Then you can continue with lazy portfolio construction simply combining equities and bonds and enjoying that wonderful diversification benefit. But I think that’s a huge assumption.

Remember that for around three quarters of the last 125 years, the equity bond correlation has been positive. So maybe the first 20 years of this century with the aberration not the norm, we’ve done a lot of work on what we call the 3D reset, looking at how demographics, deglobalisation and digitalisation, the three big structural themes that are all likely to cause a deterioration in the trade off between growth and inflation. So in short, for any given level of growth, inflation is likely to be higher.

So I don’t think you can lazily rely on a negative equity bond correlation to always bail you out in the future. I’m not saying it won’t work at all. If growth and inflation fall together, then bonds will fare well as we’re seeing today. But you can’t control whether inflation will be an issue whenever you need bonds the most and just look at the last couple of years for that.

So if you care about portfolio volatility, if you care about trying to smooth the path of returns, then I think you need to give a bigger role to dynamic asset allocation as opposed to simply sitting with the same passive allocation hoping for the best.

The final thing to say though is, it is not just about switching from equities to bonds or vice versa. It means casting our net more widely to find hedges or opportunities for returns. And in recent years we’ve bought commodities, industrial metals and gold to hedge inflation risk. We’ve got inflation linked bonds. We’ve gone overweight the dollar as a hedge against global liquidity tightening. We’ve bought high yield EMD [emerging market debt] and REITs to add returns. So I think there’s real opportunities for dynamic asset allocation and there’s a real need for it if we can’t lazily rely on that negative correlation between equities and bonds.

CS: You mentioned the dynamic asset allocation there. Maybe just talk us through the three stages of the process for building the portfolio to the listeners and maybe just explain how those sort of assets fit in there in terms of helping with that diversification of the portfolio.

PC: The overall aim is to construct a range of well diversified portfolios, balanced across styles. We’re aiming to generate a smooth path of returns, navigating change as the world evolves around us and aiming to avoid pitfalls. So as you say that there’s sort of three parts to how we construct the portfolios.

The first is constructing a diversified strategic asset allocation for each of the five portfolios. We do this at least annually and we do it ourselves as we want full control over the process. And that’s something I think is particularly important at the moment given the uncertainties about the correlation between equity and bonds, we’re using our own capital market assumptions, our own proprietary optimisation tools and a big healthy dose of judgment. We’re pragmatic with portfolio managers. We are not gonna slavishly follow a black box.

However, just because we’ve done all this clever work doesn’t mean for a second that each portfolio should sit passively at its long-term weight. I think that’s wholly suboptimal and you can really see that over the last couple of years, you know, the first half of 2022 for example, we were underweight equities and bonds at different times and that protected clients from the worst of the inflation driven selloff.

Conversely, in the first half of this year, we’ve been overweight equities to capture higher returns. Portfolio construct is really important to us thinking about the risks out there and how we can hedge clients against the risks that worry us. So whilst we were overweight equities earlier this year, we were underweight bonds, overweight commodities, overweight the dollar at the same time all as a hedge against higher inflation, which we saw rock markets in March and April of this year.

And finally we want to implement our ideas efficiently and we want to take advantage of all the great stock and bond pickers that we have within Schroders. So we choose the Schroders managers that we rate and crucially that choose the ones that we think complement each other because the overall portfolio performance that matters, not how any individual specific part does. So we might combine one manager who’s biased towards value stocks, the stocks that screen cheap and combine him or her with a growth manager looking for companies that are growing quickly. Either they might have to pay high prices for it. By combining different management styles we can have a better balanced portfolio and hopefully generate a smoother path of returns.

CS: Okay. You mentioned that sort of wide breadth of opportunities in terms of the managers you have at Schroders that you can use and have access to across a number of areas, equities, bonds, et cetera. But you do make use of futures and ETFs in the portfolio. Can you explain how, and also just are there specific areas where you target the use of those, particularly on the ETF side?

PC: Yeah, so we want to be efficient in expressing our views. So if we like US equities, then by far and away the simplest, fastest cheapest way to implement that view in the portfolios is to buy S&P 500 futures. I don’t want to buy physical stocks because it takes longer, it costs more and it disrupts the underlying stock pickers. Also using futures opens the door to easy cross market trades.

Let’s say we think that UK government bonds will outperform US government bonds, then quite simply we buy some gilt futures and sell some treasury futures. This is the way that asset allocation works for all our big multi-billion pound institutional clients and I don’t see why UK retail investors should be stuck with a second rate solution.

To be clear, we are not a hedge fund. The portfolio isn’t littered with derivatives now these are just simple trades just conducted faster and cheaper. And then as you say, we make use of some ETFs. So for example, in recent years we’ve used ETFs to buy commodities, both broad commodities and industrial metals. We’ve bought gold, we’ve bought high yield, we’ve bought EMD [emerging market debt], both local and dollar denominated EMD [emerging market debt]. We’ve sort of used it as a way of expressing specific views buying for example European investment grade credit. The critical thing to remember though is that the OCF, which we charge clients, is capped at 22 basis points. So if we buy third party ETFs, then we bear the cost ourselves.

CS: Okay. Let’s just take a sort of step back onto the wider portfolios again. So these are risk map portfolios. So could you maybe just explain how that impacts any of your investment decisions? And that obviously goes back a bit to process and I know when we talked sort of before that you sort of try to be style agnostic if you can. Do you try and remain as sort of diversified across sectors in geographies and on the other side, if you see a really good active position opportunity that perhaps veers off the trail of perhaps where the portfolios are going, are you happy to sort of jump into that if you see that chance?

PC: Yeah, so take those in turns. So our clients like the risk map nature as it means they know what they’re getting. If you’ve got a cautious from adventurous client, then you want to be confident that you are buying a lower or a higher risk fund for them. The last thing you want to do is put a cautious client into a fund and then later discover that it’s stock full of equities and it’s suffered a massive drawdown. So our strategic asset allocations coupled with the ranges that we set around them are important for advisors as it means they can see what they’re getting.

But we’re active investors. We don’t believe in passively following a benchmark with an uncertain actually bond correlation. I think it’s really important your dynamic and adjusting the asset allocation to smooth the path of returns, trying to avoid risks in markets or taking advantage of opportunities. So as you say, where we see opportunities that we will take advantage of them.

I mentioned earlier how in recent years and we bought commodities, gold, EMD [emerging market debt] high yield, the whole variety of different asset classes that we wouldn’t necessarily naturally own, but we saw the opportunity and we took it or we were worried about something happening in markets and we used it as a hedge. So, you know, we are active in what we’re doing because ultimately we are fund managers. We are looking at markets and the portfolio every single day and we can decide to trade anytime that we want and we can implement very quickly. So we can go from having a discussion to trades in the portfolio within an hour or two.

But once again, I don’t want to think that we’re day traders. We’ve got a strong belief in the importance of valuations and the economic cycle as key drivers for markets. And so that means that we’re trying to take medium term views with a time horizon of 3, 6, 9, 12 months as opposed to sort of chopping and changing on annual basis. We want to capture those big themes. I think that’s what’s so important for smoothing the path of returns for clients.

CS: Okay. Maybe just quickly talk about, because obviously the approach and the use of the internal managers at Schroders, maybe just explain how often, what your turnover’s like and how you’re able to change those underlying managers? Is it more a case of like you just said there where one area is perhaps slightly there needs to be balancing up between growth and value or higher and lower risk. And just give us an idea of what would cause you to change a manager within the portfolio in this case.

PC: Yeah, I mean the first thing to say is the advantages of using internal managers is the access we get. I can see their positions, I can run them through automatically run them through my risk systems every single day and I can make sure that the combination of the managers which we’re choosing works together as a whole. Whereas the risk when used third party managers is that information can be out of date. And the risk therefore is that if people start to change their spots, if you get some style drift, it could be that you’ve intentionally combined up a value manager with a growth manager. So a value manager trying to find cheaper stocks, a growth manager trying to find companies that are growing profitability, but they often cost more.

Let’s say you combine these two people together intentionally and you are balancing them off against each other. The last thing you want is that the value person gets fed up that they keep on underperforming because Nvidia keeps on going up and they decide to just start to add some tech stocks into the portfolio and some semiconductors. And suddenly unbeknownst to you, you don’t have that wonderful balance between the two managers anymore.

By using internal managers, I can see what they’re doing every single day I can go and talk to them, I can go and sit on their desk and ask them why the hell have they done something, the access you don’t get with third party managers.

One important thing though is you have to have the sort of roster of managers available and as I said, we’re one of the largest – we’ve got a big firm in the industry – and so we have access to the such a variety of different managers.

The risk of course when you have internal [managers] is the sort of the accusation that may be you are doing it for the benefit of the firm. I wanna really put that to bed because as I said, we’re one of the largest multi-asset teams in the industry and we didn’t get to where we are by just asset gathering for the rest of the firm.

We are fully independent within Schroders. I’ve got a fiduciary duty to my clients. I’m not paid to buy Schroder product. And if I buy a Schroder fund that underperforms, then you know, I get paid less myself, I get fired, I get questions. The real focus is on the return stream that we generate for our clients. So we’re in this wonderful position of having both a big firm with a broad range of capabilities, but within that a big multi-asset team that’s independent and can stand on its own two feet and say no, do the right thing for clients.

So when do we, you know, your final question, when do we change things? The big part, and obviously if performance is a problem, if a team isn’t working out, if you’ve got changes in managers, if you’ve got change, they’re not sticking to their process. That’s a big thing. But the secondary is around that sort of complementarity between the portfolio. If a strategy isn’t doing what it’s saying it’s supposed to be doing, that’s the time when you move out of them very quickly. Because I’m trying to build a set of portfolios that work as a whole and every single piece has got to be working towards that broader whole.

CS: I I want to finish on an outlook and I’ll sort of put a bit of context on this. So we are recording on the 5th of August on Monday. We’ve just gone through a very busy sell off on the Friday and it’s very busy at the moment today. So I’ll ask this on sort of two sort of levels. We’ll start with sort of what’s your positioning been throughout this year, where have you seen the opportunities thus far? That’ll be the first half and then the second half maybe just touch upon the current uncertainty and any sort of views you have on that as well please.

PC: And when you say it’s been a busy couple of days to give some context to that, between the highs on Thursday and the lows overnight, Japanese equities are down 23%. Been busy in that sense. So in terms of this year most of the first half of this year we were overweight equities because we thought that growth was reasonably okay, inflation was moderating. So we want to be overweight equities because earnings have been okay, but as I said earlier, we care about the overall return stream of the portfolio and smoothing that path of returns and therefore to counter out that equity overweight, we had hedges earlier this year by being overweight commodities, underweight government bonds or corporate bonds, overweight the dollar to try and protect the portfolio against the risks of inflation, which we saw in March and April.

More recently, we’ve taken a lot of those hedges off. We took them off a couple of months ago because we didn’t see that inflation threat anymore. Partly because it had been priced in the market and therefore it was already discounted. But also clearly growth is slowing. Inflation has been moderating from the pickup, which we saw in the first half.

Recently we’ve taken risk off further. So a couple of weeks ago we took some risk off the table, which obviously is fortuitous given the moves we’ve seen recently. And the real question we’re grappling with now is these big moves we’ve seen in markets in the last 48 hours. We obviously had a weaker payrolls reports and nonfarm payrolls. Employment data in the US on Friday was a bit weaker, but are we looking here at a soft landing or something worse?

Now this morning the market’s pricing that the Fed will cut 50 basis points to the next meeting, 50 basis points to the meeting. After the meeting after that. Again, the market’s really going for this idea of significant Fed rate cuts. Is the economy really that weak? Are we gonna go from a slowdown here to something far worse? And I think it’s not clear at the moment.

Now if you look at things like the number of people who are being fired in Europe, you’re not seeing a significant pickup. The pickup you’ve seen in things like initial jobless claims, they’re really sort of seasonal at the moment. So clearly they just slowing in the economy and firms are hiring fewer people, but they’re not at the point yet where they’re firing them. And that’s an important difference. And that’s the difference between a soft landing and a hard landing. You’re not seeing significant stress yet in markets. You are seeing a widening of corporate bond spread.

So corporate bond yields are rising relative to government bond yields and that’s showing a bit of stress, but nothing huge yet. So nothing to think that we’re having a banking crisis like we saw back in March of last year or the various sort financial events that we’ve seen. And I think that’s the big sort of difference between a soft landing and a hard landing. So we’re grappling at the moment, as I say, we’ve taken some active risk off the table, do we take some more off? Do we use this opportunity to actually add some more? Those are the questions we’re going through at the moment and that really I think shows the dynamism in the portfolio and the fact that we are fund managers, we are looking at the portfolio every single minute, every single day trying to work out what to do next.

CS: Okay. Phillip, on that note, thank you very much. Given how stressful it is today, I’ll let you get back to a very hectic Monday looking at screens and trying to figure out what’s going to happen next. Thank you.

PC: Well, as I said, the big thing as well is that with the focus on valuations in the cycle, we’re trying to look through as to what the next sort of medium term move is. I think that’s what’s so important for smoothing the path of returns to clients. Not getting lost in the – you know the phrase, lose sight of the woods in the trees.

CS: Thank you very much for joining us today.

PC: Thanks very much.

SW: As discussed throughout this interview, this fund taps into the huge resources within both the multi-asset division at Schroders and their wider range of funds to build a diversified portfolio across both regions and asset classes. To learn more about the Schroder Global Multi-Asset Cautious Portfolio please visit fundcalibre.com