‘There are no rules’: Multi-index funds leave room for passive diversification
Despite the rising popularity of passive investment options, many index fund enthusiasts are less familiar with multi-index options and the diversification and personalisation benefits they offer. At a time of economic flux, these funds can help round out resilient portfolios, but it’s important to know what to look for, says AMP.
There is a lot of misunderstanding about how diversified index funds are managed, AMP Investments senior portfolio manager Stephen Flegg said in a recent discussion of fund performance and what to look for in diversified passive investing. A key difference involves the level of personalisation and manager discretion at work in multi-index funds.
“People are used to index funds being highly standardised; when it comes to diversified or multi-asset index funds, there’s no standards at all – around defining risk profile, asset classes and industries, how you should rebalance – no overarching rules,” Flegg said.
“Each manager has to answer those questions for themselves, and they all answer in different ways. The investment objective the manager is working to really influences how they answer all the rest of those questions.”
Flegg said a question that commonly arises around diversified index funds involves the differing performances of funds tracking different indexes, which he says is a function of the level of choice involved in designing these funds. Such divergences arise from three main factors: which asset classes go into a fund, how risk profiles are defined and how the fund manages currency.
“One of our objectives is to be as diversified as possible: managing these funds from the top level down, looking at the balanced fund’s objectives and what building blocks we can put underneath that,” he said.
The risk profile and asset class mix are both key to the ultimate makeup of the fund, but, “again, there are no rules – it’s really making an investment decision around what mix of asset classes delivers the best investment outcomes, and there’s judgment involved in that process,” Flegg said.
Once a fund manager has defined risk profiles, set allocations and chosen a universe of asset classes, the next step is to decide on an appropriate index, an extensive process that takes into account numerous considerations including cost and liquidity, particularly in stressed environments.
There are several questions to consider, Flegg said: “Can you trade in these securities? How concentrated are they – are they dominated by a few securities, or is it broadly spread? Do the rules of the index make good investment sense?”
The question of investment sense was behind AMP’s decision to significantly reduce exposure to Australian listed property, where the top five or six names make up a huge percentage of the total index, he said.
“There’s also the dynamic that all these big stocks are already in the ASX 300, so we already own them in our Australian equity sleeve and are actually doubling up in Australian listed property, which diversification,” he added.
A final consideration, he said, is scale. “Bigger funds have benefits, but at some point, there are issues around being too big,” Flegg said – $50 billion is too big, but $1 billion is too small to get efficiencies.