How the index has been playing hard to get

Our investment committee is always looking at the drivers of investment returns, trends and risks which present. Most recently we took a deep dive into a characteristic of investment performance over the past 12 months which has been a lack of return enhancement from active management. This has been the case within Australian equity funds but has also been notable within diversified multi-asset portfolio solutions. A peer group of diversified actively managed “balanced” (50% Growth) funds we monitor shows an average return for the 2019 financial year of 6.5%. This is significantly below the return of 9.0% posted by the passively managed Vanguard Balanced Fund.

Whether or not a portfolio manager believes in the merits of active management from a stock selection perspective, when managing a diversified multi-asset portfolio there is strong rationale to invest more widely than standard passive benchmarks in order to achieve greater levels of diversification. More specifically, many actively managed multi asset portfolios will vary from passively managed solutions in the following areas:

  1. Within the Australian equities asset class, portfolio managers may seek to broaden the universe of investments by holding specific allocation to mid-sized and smaller sized companies. Because standard indexes, such as the S&P ASX 200 Index are weighted based on the market capitalisation of companies, the indexes tend to be heavily concentrated in larger companies. In the case of the S&P ASX 200 Index, the top 10 stocks represent 43% of the indexes exposure, with heavy concentrations to banks and resource companies. This concentration can be reduced via the holding of mid-sized and smaller companies in addition to the large company orientated investments.


  1. Within the global equity asset class, portfolio managers will often look to include an explicit allocation to emerging markets (e.g. China, India) at a weight much greater than typically included in standard passive benchmarks. Traditional global indexes tend to have low allocations to emerging economies when compared to the size of these economies and growth prospects. As such, geographical diversification is enhanced through holding an explicit emerging market allocation.


  1. The fixed interest portfolios of traditional passive investments are generally dominated by government bonds that have a fixed interest rate duration. High levels of exposure to these bonds can leave the investor exposed to capital loss should interest rates increase. Active managers will often accompany longer term fixed interest bonds with corporate debt investments that have shorter term or floating interest rates. This will have the effect of increasing diversification and also reduce the level of interest rate related risk in the portfolio.


  1. The asset class exposure within traditional passive investment products is considered to be quite narrow and consists predominantly of bonds and equities. This narrow asset class exposure creates a risk that investment returns will be particularly poor should bonds and equities decline at the same time. Actively managed multi-asset portfolios may seek to provide further diversification by adding investments in the “Alternatives” category that are generally not present in passively managed funds. Alternative funds (e.g. hedge funds) are those that rely on manager skill and positioning to produce returns and don’t tend to have a directional return relationship with bonds or equities.


Hence, it could be argued that the traditional passively managed diversified funds have somewhat concentrated exposures and one of the roles of active managers is to try and diversify away some of this concentration – using the 4 approaches described above. Over the past year, however, implementation of each of the above 4 diversification factors is likely to have detracted value from returns as discussed below.

Australian Equities

The chart shows the return differential each year between the S&P ASX 200 Index and the  S&P/ASX MidCap 50 Index (representing 50 stocks ranked in size between the top 50 and top 100). As indicated, mid-sized companies have materially underperformed the broader market over the past 12 months. Therefore, attempts to diversify away from larger companies is likely to have diminished returns. The particularly strong performance of large Australian mining companies over the past 12 months is likely to have been one factor contributing to this return differential.

chart1 Australian equities

Global Equities

A feature of global equity return patterns over the past year has been the exceptionally strong performance of the U.S. market, which makes up more than 60% of the broader global equity market index. Given the strength of the U.S. market and its dominance of the index, investments in regions outside of the U.S. have tended to under perform the broad global equity market index. This includes emerging markets, which have returned 6.6% in the 2019 financial year; compared with 11.3% for the broader global equity index.

Fixed Interest

With the significant decline in interest rates that has taken place over recent years, investments in bonds that have a long interest rate duration have performed exceptionally well. This is because the price of these bonds rises when interest rates fall. Although it has also been a relatively favourable period for investments held in corporate debt securities as well, returns on these investments are more likely to be of a floating interest rate nature and therefore have declined as interest rates have fallen. Hence, as indicated on the accompanying chart, returns from investments with longer interest rate duration terms have outperformed credit orientated investments over the past year.

chart3 fixed interest


Over the medium to longer term, we would generally expect funds in the Alternative asset class to produce an average return of approximately 4% above the Reserve Bank official cash interest rate. Therefore, Alternatives should have a positive relative impact on a portfolio when bonds and equities average a return level below this level. Over past year, however, both bonds and equities have returned above this cash plus 4% benchmark. As a result, the presence of Alternatives in a portfolio is likely to have detracted from returns when compared to passively managed portfolios that don’t hold Alternatives. The accompany chart shows the extent to which a 50 / 50 allocation to bonds and equities has exceeded the cash plus 4% benchmark each year.

chart4 alternatives


The cyclical nature of performance drivers

The 2019 financial year was unique in that all four factors described above had a negative impact on active management within multi-asset funds. This is the only year since at least 2003 when all 4 factors coincided in the same direction. As indicated on the charts shown above, the factors are cyclical and can be expected to change over time.  Investors should therefore be cautious about reacting to short term under performance from actively managed diversified solutions as the cyclical nature of the relative performance drivers described above will inevitably change over time.

Each individual portfolio is constructed and will behave differently, but it is always fun to peel back the different influences which investment strategies behave across market cycles. If you are unsure about any of the above or wish to discuss your own portfolio then please reach out to me at and I would be happy to have a chat.


Pete Pennicott | Principal Adviser

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