TAKE RISK SERIOUSLY. RISK TARGET MULTI ASSET FUNdS - Aviva

Take risk seriously.
Risk target Multi
Asset Funds
This is for professional clients and/or
qualified investors only. It is not to be
viewed by or used with retail investors.
Introduction
Brian O’Nuallain and Fergus Ryan
The lessons learned
from 2008
Brian O’Nuallain
Risk is part of the
solution, not just
the problem
Fergus Ryan
Risk targeted or
absolute return funds
Nick Samouilhan and Justin Onuekwusi
What is volatility and
why is it important
Gavin Counsell
Enhanced client
solutions
Nick Samouilhan
Is your portfolio
diversified or just varied
Nick Samouilhan and Justin Onuekwusi
Active or passive
management
NIck Samouilhan
avivainvestors.com

Introduction
Of all the differences between multi-asset funds and other
fund types, there is one in particular that helps to explain
their growing popularity and adoption: most funds aim to
outperform a benchmark, while multi-asset funds aim to
provide a solution. Put differently, instead of starting with
a particular benchmark and asking how we can beat it, we
ask what you would like to achieve, and then ensure that we
aim to do that in a clear, well resourced and robust manner
using various asset classes put together in a structured and
dynamic manner.
In Ireland, “multi-asset funds” have
generally meant either the Balanced
Managed funds or their “less risky”
cousin the Consensus fund. These funds,
by diversifying among equities, bonds,
cash and property, hoped to provide
a stable return stream to investors.
However, the lessons of 2007 showed
that this structure, driven by peer group
positions and with significant home bias,
failed to adequately meet their investors’
expectations. While improvements in this
sector have been made and are to be
welcomed, these modifications tend to
remind us of the great Yogi Berra quote
“we’re lost, but making good time”. Put
frankly, there is only so much tinkering
that can be done to something that is
fundamentally built wrong. There is only
so much that can be fixed, a full solution
requires a full rethink about what investors
need, and which fund design is best
placed to meet this.
With this task of building a next
generation fund, our feedback from
our clients led us to build funds that
in our view were global in nature, well
resourced, understandable, affordable
and appropriate for a wide range of
investors. Most importantly, to dove tail
with client expectations, these funds were
built from a risk perspective upwards,
with their explicit aim being to deliver
long term returns within the specific risk
levels that our clients want to take. The
result was our Aviva Irl Multi-Asset Funds,
a fund family of thee risk targeting funds
that represent a complete step change
in product offering for Irish clients.
These funds, built from the ground up
aim to address the diverse needs of Irish
investors, provide a one stop investment
solution for our clients, bringing the global
capabilities and resources of Aviva to the
Irish market within an affordable, market
leading offering.
These MAF funds are a significant
evolution from the relatively simple
“balanced funds”. Indeed, this is a global
trend, with multi-asset investing outside
of Ireland having already moved a long
way from the traditional, old fashioned
equity bond mix. Portfolios are now
diversified across a much wider range
of global asset classes, allowing greater
return opportunities and diversification.
Perhaps more importantly, asset allocation
is more dynamically managed to position
the portfolio in light of prevailing market
conditions, while investment selection
covers the broader spectrum of investment
choices. We have also seen a trend in
multi-asset investing away from peer
group benchmarking towards funds that
target return and more recently funds
that target risk as part of the evolution of
funds towards client needs.
The objective of this compendium of
articles is to provide some insights into the
day-to-day management of multi-asset
portfolios. We review some topics that we
find interesting, relevant and hopefully
helpful. We hope that you find value in
the articles and enjoy reading them.
3

The lessons learned
from 2008 (or the
problem with Managed
and Consensus funds!)
As the saying goes “a rattlesnake that doesn’t bite
teaches you nothing.”
Brian O’Nuallain
Business Development Manager
Main Responsibilities
Brian is a Business Development Manager with
Aviva Investors and has gained vast experience
from a career built in the financial services
sector, particularly in the areas of investment
and asset management, together with client
portfolio and wealth management.
Experience & Qualifications
He is a graduate of University College Dublin
with a B.A. in Economics and English and
the Higher Diploma in Education. He is also a
Qualified Financial Advisor and a Fellow of the
LIA and a former LIA gold medal winner.
4

“We can’t solve problems by
using the same kind of
thinking we used when we
created them.”
Albert Einstein
For the average Irish balanced managed
and consensus fund investor the year 2008
was a big rattlesnake with a venomous
bite. According to the Mercer Managed
Fund survey, the average Balanced
Managed Fund delivered performance
for that year of -34.6% and the average
Consensus Managed Fund delivered a very
similar and also painful -35%.
Managed funds – an abridged history
Managed funds became popular
investments during the 1980s as they
offered investors diversification over 4
main asset classes, i.e. equities, property,
bonds and cash. Equities were invested
globally but there was a high exposure
to Irish equities as a natural consequence
of currency considerations for the
Punt at the time and the level of local
investment management expertise (or
perhaps the lack of global expertise). The
property element was mainly invested
in Irish commercial property and bonds
initially consisted of investments in Irish
Government bonds but in later years
gained exposure to Euro sovereign bonds
following the introduction of the Euro.
These funds would generally have a
greater proportion of their funds under
management invested in equities as
this asset class is generally the leading
performer at the head of the risk return
spectrum over the long term and offers
high liquidity. Property and bonds provided
alternative asset classes that could be
considered to act somewhat differently
to equities during rises and falls in stock
markets providing a level of protection
to investors.
Reward can’t have a downside… can it
The balanced managed fund sector was
defined as medium risk by consensus of
the industry as a whole. However, what
does “medium risk” really mean to an
investor What level of return can be
considered “medium” – a return of
plus 10% or minus 10% for example
– or plus 15% or minus 5% The mere
mention of “minus” in my experience can
magically transform a happily enthusiastic
and adventurous investor to a “keep my
capital intact” investor in an instant. As
you’d expect the 1980s were a more
innocent time. I’m sure I recall that when
one of the now iconic first customer
warnings was introduced, it began its life
as “Warning: the value of your investment
can rise or fall”, which soon was amended
to a more cautious, “Warning: the value
of your investment can fall or rise” Did
you spot the difference This was on the
basis that the original statement might
mislead investors to expect an increase in
their investment before any subsequent
fall (ouch!).
The average investor in a balanced
managed fund since 1987 (according
to the Mercer surveys of returns) has
experienced a variety returns from +34%
in 1997, to -34% in 2008. “Now Mr. and
Mrs Client, tell me, was that the kind of
investment journey you expected from
your “medium risk” fund” A swing in
returns of some 68%, somehow, I don’t
think so!
So where did it all go wrong
Over time a number of factors
contributed to the dramatic negative fund
performance in 2008 and in our view here
5

are four of the central characters in that
tragedy:
––
Fund managers monitored each other’s
asset allocations and performance very
closely through the available industry
surveys and began taking additional risk
by investing more in equities over time in
a bid to outperform their peers. This led
to “herding” around the benchmark and
to a vicious cycle of ever increasing equity
exposures to aggressive levels (of circa
80% in 2007 (source: Mercer) which
were amongst the very highest, if not the
highest in international pension terms at
the time. Ireland may have been extreme
in this respect but it was not alone as
there were similarly high average equity
allocations in the UK balanced managed
fund sector during 2007.
––
There were very high allocations to Irish
equities and Irish assets in these funds
which while justified by the performance
of the Irish economy pre-crash, reduced
the overall protective benefits that wider
global diversification would have
provided. They were also effectively big
bets on a very small economy and stock
market in global terms.
––
Fund managers were also constrained by
investment mandates set for them by
their life companies which required them
always to have a certain percentage
allocation to equities, say 55%-75%. This
was irrespective of the actual market
conditions. For example, in this instance,
if equity markets were in freefall the fund
managers were still mandated to hold at
least 55% of the fund in equities.
––
Also a “one size fits all” approach to
finding a suitable investment solution for
an “average” investor led to these being
most popular fund recommendations
for clients.
The story for Consensus Funds is
different though, right
Wrong! Consensus funds are designed
to deliver the average balanced managed
fund return from the Irish fund manager
market. They effectively remove the risk
of the fund underperforming the average
fund manager’s performance…by… yes
you’ve guessed it, delivering approximately
the average performance of the balanced
managed fund sector. All of the above
mentioned flaws were immediately also
inherent in Consensus funds as they
evolved, and this led to a very similar
looking performance of -35% for the
investors in these funds for 2008.
Thus performance in 2008 demonstrates
that existing Managed and Consensus
funds have fundamental issues which
directly impact on investors. It is strikingly
apparent that there was a dis-connect
between the level of risk being taken in
these funds and the client’s comfort level /
return expectations.
So, what’s the solution then
As Albert Einstein said, “We can’t
solve problems by using the same
kind of thinking we used when we
created them.”
Managed funds in Ireland have been
around for the best part of two to three
decades. The investment industry has
evolved and developed significantly
during this period with access to an ever
increasing number of asset classes. A
number of developing economies around
the globe are also offering increasing
investment opportunities. Innovations in
modern portfolio modelling and the use of
better, together with more technologically
advanced methods of risk management
are enhancing the risk adjusted outcomes
for investors.
A next generation solution…
We believe there is a fresh solution
available to the problems exhibited by
both managed and consensus funds and
to the performance experienced by their
investors – Multi Asset Funds. These types
of funds are growing in popularity in
both Ireland and the UK and are seeing
increasing investment flows into them
since 2008. They are being welcomed
in both markets as a next generation
or a “state of the art” solution to the
weaknesses of the “old” balanced
managed fund model.
6

“One of the critically important lessons arising from the
last few years is that clients’ perspectives have
changed from a return to a risk focus.”
Aviva Investors
These funds are genuinely different from
the past, or at least they should be if they
truly have access to global capabilities
with experts in the field of asset allocation
together with a very wide and increasing
number of asset classes to invest in. The
best of these Multi Asset Funds will usually
include:
––
Robust portfolios built from a much
wider choice of asset classes from an
increasing number of regions of
the world.
––
The expertise and insight of specialist
asset allocation experts who analyse the
long-term forecasts for the valuations,
correlation and volatility of various assets.
––
A specialist short-term tactical team who
assess the threats and opportunities
offered by the economic environment
over the next 6-12 months and how the
portfolio can be adjusted to take
advantage of these.
––
Utilise different styles of investment e.g.
passive/active, value/growth etc., at times
in the economic cycle that are most
advantageous for the portfolio
––
The ability to include an external
manager’s fund, as rarely does one asset
management house have access to all of
the available solutions
––
Access to a diverse range of the latest
developments in asset classes such as
commodities, absolute returns, emerging
market debt and convertibles.
––
Targeting investment risk. One of the
critically important lessons arising from
the last few years is that clients’
perspectives have changed from a return
to a risk focus.
A lot of investors targeting a return of
say 7%-8%, have discovered that they
certainly don’t like the experience of
a potential fall in their investment by
30%-40% (unsurprisingly) at some stage
during their investment term. To address
this, what if fund managers could use
modern techniques and a greater variety
of investment assets to control and target
risk within certain levels to deliver a more
consistent level of return for investors
– a return that would be consistent with
a client’s risk profile
Too futuristic...too optimistic Certainly
not – a select few Multi Asset funds in
the market have now very successfully
addressed this by designing funds which
manage and control the risk of their
funds over the client’s investment horizon
thus providing more clarity around return
expectations.
It is important to point out that all of
this extra fire power for generating a
better risk reward outcome for your
clients needn’t come at an extra premium
– global asset managers can generate
economies of scale which can nicely
translate into an affordable annual
management charge.
This modern approach is a welcome and
significant development, because now,
probably for the first time, the objectives
of investors, brokers, fund managers and
pension trustees are aligned together in
managing or targeting specific risk levels
to provide a better return outcome for
investors.
Finally, a few words of caution – beware
of poor quality and expensive imitations
which have more of a resemblance to the
old managed funds of yesteryear!
7

isk is part of the solution,
not just the problem
Fergus Ryan
Business Development Manager
Main Responsibilities
Fergus is responsible for supporting all
investment related activity with Aviva Life &
Pensions sales teams and their independent
advisors.
Experience & Qualifications
Fergus joined Aviva Investors in September
1998 having worked for the Aviva Life
& Pensions from 1996. He holds a BA in
Economics and Philosophy from University
College Dublin and is a Qualified Financial
Advisor.
8

The reasons for the collapse
in Managed Fund
performance have been well
documented; namely the
over-exposure to equities.
Jana Novotna entered the 1993
Wimbledon tournament playing some
of the finest tennis of her career. Going
into her quarterfinal match with Gabriella
Sabatini, Novotna had lost her previous 6
matches against the Argentine. Novotna
destroyed Sabatini, winning 6-4, 6-3. Her
semi-final match was against the great
Martina Navartilova, who had won each
of their previous 5 meetings. Novotna
prevailed beating Navartilova 6-4, 6-4,
setting up a final against Steffi Graf. At
one set each and serving to go 5-1 in
the final set, Novotna’s game collapsed
as double faults followed fluffed shots.
The process, the years of training that
had led her to the cusp of victory broke
down spectacularly. She had overcome
adversity before but this was different.
She ‘choked’. Graf broke Novotna’s serve
and went on to win the next 5 games to
clinch the ladies title. During the trophy
presentation a devastated Novotna
broke-down sobbing on Duchess of Kent’s
shoulder.
In ‘What the Dog saw’ Malcolm Gladwell
describes how Novotna ‘choked’ at a
crucial point in her game. She retreated
into her process for making shots instead
of playing naturally on instinct and muscle
memory. The more stressful the situation
became the further she retreated into
her process, becoming deliberate and
laboured. How can something that has
worked for so long and taken qualified
people thousands of hours to perfect just
stop working Managed Funds appeared
to stop working in 2007. Did the
Managed Fund process choke According
to Gladwell “how failure happens is
important to understanding why failure
happens.” When we understand why
failure happened we can work on how to
prevent a reoccurrence.
“All change is not growth, as all
movement is not forward”
Managed Funds were the traditional
default fund for savers. They started life
with the noble intent of trying to create
a balanced, diversified fund for the
average investor. The typical Managed
Fund’s mandate (the rules that set out
how the fund is to be invested) state that
your Managed Fund asset mix must be
within certain parameters of the average
Managed Fund, giving flexibility to
differentiate and add value. For the most
part, this worked. Prior to 2007, 7 of the
previous 10 years had seen Managed
Funds return double digit growth (source:
Mercer Group Pension Managed Fund
Surveys as at 31/12/1997)
Like Novotna, Managed funds had come
up against difficult periods prior to
2007 and survived. In 1990 the average
Managed Fund lost almost -12%. In 1994
they fell another -4%. In 2001 Managed
funds fell almost -6% and followed on
in 2002 with a -19% loss. However,
we knew that despite all these knocks
Managed Funds were for the long term
and had always recovered in the past. In
December 2007 as markets had begun
to slide yet again, we were pointing
to the average Managed Fund 10 year
annualised return of 6% saying ‘we’ve
been here before; it’ll work out fine in
the end’. 2 years later, after a significant
stock market correction, Managed Funds
10 year annualised return had collapsed to
0% at the end of 2009. (Source: Mercer)
The reasons for the collapse in Managed
Fund performance have been well
documented; namely the over-exposure to
equities. But why did Managed funds get
so deep into equities When you have a
peer group benchmark based on relative
9

The advantage of categorising funds on their volatility
is clarity for the advisor and investor as to what they
are investing in; it is low risk because the price is not
prone to sharp rises or falls.
Aviva Investors
performance everyone is going to lean
towards the asset that goes up the most.
Through the 1980’s and 1990’s equities
went up consistently, recovering stronger
after any fall. This brought a circularity
to investment decisions in the Managed
Fund process – as the benchmark is
the average mix, and as everyone is
incentivised to increase equities over time
to try and outperform, this will pull up
the average equity position, which makes
people have to hold more equities to
generate an overweight position relative
to benchmark, which pulls up the average
equity position and on and on. As a result
Managed Funds went from having an
average holding of approximately 45% in
equities in 1988 to having 78% in 2007.
(Source: Mercer)
Relative performance peer-group
benchmarking has been shown to have
little safeguard against drastic moves
in equity markets. For example, at the
peak in markets in Q3 2007 Managed
Funds had on average 78% in equities.
Therefore, if a fund manager woke up the
day before the stock market was to crash
and knew the fall was coming and wanted
to get as far out of equities as he could in
his Managed Fund, the lowest exposure to
equities he could achieve is approximately
70% due to the mandate. Your Managed
Fund would be massively underweight,
your relative performance would look
good against your peers but despite your
drastic action for every 10% equities fall
your fund still falls 7% while your peers
fall 8%. Hardly a victory, moreover a small
consolation. The process of benchmarking
against a peer group is flawed.
“The dangers of life are infinite, and
among them is safety”
The fallout from Managed Funds has
spilled over into the broader Fund
Management arena. Irish clients are now
wholly dissatisfied with the idea of funds
in general and prefer to invest in deposit
based or cash funds. Why This is a
representation of how the Irish investors
mind set has changed. 5 years ago if you
asked a client where their emphasis lay
between risk and reward, they probably
would have said reward. Today, the
emphasis is minimizing risk by not taking
any. Unit-linked funds offer an aspiration
towards reward with no apparent measure
of risk. Cash or deposit funds offer little
reward but this is seen as an acceptable
price for not taking any risk. Both of these
solutions are also flawed.
Enter the risk targeted Multi Asset Funds
(MAF), which aim to provide a genuinely
low, medium and high solution for Irish
investors. This is done by selecting assets
based on a volatility range for each fund.
There are no peer group benchmarks for
asset mix or performance and therefore
there are no constraints on where
each of the MAF are invested. The only
commitment Aviva Investors make in
running their MAF is to monitor risk
exclusively thereby aiming to deliver the
investment experience that clients expect
from a genuinely low, medium or high
risk fund.
Aviva Investors created the MAF series
in response to a piece of proposed
legislation on the risk categorisation
of funds. The European Securities and
Markets Authority published a white
paper that recommended Life Companies
in future should categorise funds
based on the volatility of each funds’
performance. Currently, risk categorisation
is at the discretion of the individual Life
Company and most Life Companies have
different scales of risk. The advantage of
categorising funds on their volatility is
clarity for the advisor and investor as to
what they are investing in; it is low risk
because the price is not prone to sharp
rises or falls. Many funds today classed
as low risk are done so on the basis that
it holds less equities or more cash than
other funds. If a Life Company declares
the fund to be low risk, the only way this
can be monitored is by targeting volatility
that is considered truly low risk. At present
Aviva Life and Pensions Ireland are the
only company in Ireland offering such a
fund solution.
In addition to proposed regulation on
fund categorisation, the Retail Distribution
Review is a piece of regulation that
will commence in the UK from 2013. It
requires brokers to prove that the fund
they invest a client in is appropriate to
their clients risk profile and will remain
appropriate for their client in the future.
Aviva launched a sister range of MAF
funds in the UK in Q4 2010 specifically to
address these impending regulatory issues.
Risk rating is nothing unless you’re risk
targeting
At Aviva Investors we believe in order to
deliver a risk targeted solution you need
1. the proliferation of choice that allows you
invest in a truly unconstrained manner
2. expertise to construct robust portfolios to
deliver on the risk target
3. technology that allows you monitor risk
constantly in real-time
10

The Multi Asset Fund team have
approximately 100 different portfolios to
choose from across the 4 assets – equity,
bond, property and cash. The MAF team
blend 16-18 portfolios together to deliver
the targeted amount of risk. They have
absolute freedom to chop and change
those portfolios as they see fit. At no
stage in the process do they consider what
competitors are doing.
In addition to the fund managers and
analysts involved in running the 100
portfolios, the MAF team also use the
Strategic Asset Allocation Team to build
a robust, long term asset mix and the
Tactical Asset Allocation to tweak the
asset mix for short term market events.
On any given day approximately 50 people
from Aviva Investors are working on the
Multi Asset Funds.
To ensure that everyone is doing their job,
the MAF team use the BarraOne online
system for risk measurement specifically
designed for the MAF teams needs. At
any hour of the day BarraOne can provide
detailed analysis of the volatility and the
contributors to the volatility of each of
the MAF.
We accept that at various points in the
past funds have been launched claiming
to be a panacea for all previous errors
in fund management processes only to
fall foul of the next ‘black swan’ event
markets have to offer. Aviva are making
no such claim with their risk targeted
Multi Asset Funds. However, we believe
that investing in MAF firstly, provides an
appropriate solution for clients who are
either low, medium and high risk investors
with the particular level of risk for each
fund being maintained irrespective of
market conditions. Secondly, MAF was
developed with future regulations in mind
and therefore provides the advisor the
comfort that an appropriate fund is on
offer to their client based on risk profile.
And lastly and most importantly, we
understand why failure occurred in the
Managed Fund arena and we feel focusing
on risk through the Multi Asset Funds
can prevent a reoccurrence for clients.
Jana Novotna also understood why failure
occurred; she won the Wimbledon Ladies
Singles title in 1998.
11

Risk targeted or
absolute return funds
Justin Onuekwusi
CFA
Main Responsibilities
Justin is responsible for managing a range of
multi asset funds
Experience & Qualifications
Prior to joining Aviva Investors, Justin was a
fund research analyst at Merrill Lynch where
he was responsible for the research of funds
that invest in traditional and non-benchmark
assets. “Non-benchmark” encompasses a wide
range of asset classes including real estate,
currency, commodities, sector and ethical/
environmental funds. Justin joined Merrill Lynch
in April 2007. Before joining Merrill Lynch, he
worked as an Investment Consultant for Aon
Consulting, focusing on manager research
and selection, asset allocation, performance
analytics and the transitioning of assets for
Aon’s U.K. corporate pension fund clients.
Justin is a CFA charterholder and a member
of the CFA Institute. He also holds a degree in
Economics from the University of Warwick and
the Investment Management Certificate.
Nick Samouilhan
Multi-asset Fund Manager
Main Responsibilities
Nick is responsible for responsible for managing
a range of multi-asset funds
Experience & Qualifications
Prior to joining Aviva Investors, Nick worked
at Investec Asset Management on their
Multi-Asset desk. His specific focus was on
cross-asset research, quantitative modelling
and strategic asset allocation. Before joining
Investec, Nick worked in academia, where
he lectured economics and finance, and has
published multiple academic papers on volatility
modelling, macro-economic forecasting and
portfolio diversification. Nick holds a PhD
degree in Economics from the University of
Cape Town and the Investment Management
Certificate. Nick is also a FRM charterholder
and a member of the Global Associate of Risk
Professionals.
12

As riskier assets, such as equities, generate higher
returns over time than less risky assets such as cash,
fund mandates run against a peer group will generally
tend to take greater and greater equity risks over time.
Aviva Investors
Introduction
With rare exception, most retail funds
are managed with a degree of separation
between the fund manager and the
ultimate end client. Investors, saving
for retirement or a rainy day, put their
money away to be invested in a fund
under the understanding or hope that the
fund’s risks and returns align with their
requirements or investment objectives.
Fund managers, on the other end,
are mostly rewarded on whether their
particular funds perform well or not versus
the relevant benchmark. It is up to the
broker, acting as the intermediary between
the two, to ensure that the objectives
followed by the particular fund manager
are aligned with the requirements of
the investor. Performance fees, for
example, are often defended from
this perspective, in that the additional
reward for outperformance aligns the
incentives of the fund manager with
that of the end investor’s desire for good
performance. Broadly speaking, client
disappointment is often the result of these
fund management incentives and investor
expectations not being appropriately
aligned. Going back to the performance
fee example, by overly skewing the fee
to outperformance, performance fees
are also criticised for incentivising fund
managers to take greater risks than that
desired by the end investor.
This incentive mismatch is a considerable
problem for traditional Balanced Managed
type funds, a popular investment vehicle
in Ireland. Being diversified across equities,
bonds, property and cash, these funds
were designed to be broadly applicable
investment options, suitable for the
investment objectives of many different
clients. However, the key to understanding
the incentives of the fund managers
behind these funds is to note that these
are so called “peer grouped managed
funds”, meaning that the fund managers
objective is to beat the other Balanced
Managed funds that are on offer to
clients (the “peer group”). In theory, such
comparisons will allow investors to identify
the better funds from the rest, allowing
investors to put their money with the best
managers available.
The problems with peer groups
In practice, however, it is important to
think through what this incentive does
to a fund manager’s objective over time,
and whether this relative objective (return
and risk relative to the benchmark such as
excess return and tracking error) is aligned
to the absolute expectations (return and
risk agnostic to benchmark such as total
return and volatility) of the final investor.
Specifically, by managing a multi-asset
fund against a peer group with an aim
of generating the highest return relative
to the others, fund managers are clearly
incentivised to take a greater level of
risk than the average fund in order to
generate the highest return. As riskier
assets, such as equities, generate higher
returns over time than less risky assets
such as cash, fund mandates run against
a peer group will generally tend to take
greater and greater equity risks over time.
This is, indeed, exactly what happened to
the Balanced Managed sector in Ireland.
Worse, as the average return of the peer
group is the benchmark this is an ongoing,
circular process: fund managers take
greater and greater risks in order to beat a
peer group that itself is made up of other
funds which are themselves taking greater
and greater risks. The result is a vicious
cycle of steady increase in risk over time,
13

which may not necessarily be aligned with
the objectives of the underlying investors,
who would generally take less and less risk
as they approach retirement.
Another aspect of concern with these
peer grouped funds has to do with the
flexibility of the fund managers to invest
in ways that they would like. Many of
these peer grouped funds have mandates
that prevent the fund managers from
deviating too much from the peer group
asset allocations, with these rules mostly
written for risk reasons. These are either
expressed as a percentage difference in
allocation from the average fund (say, +/-
5% in Japanese equities versus the peer
group), or in relative risk terms (e.g., no
more than 4% tracking error). This means
that if a fund manager had a view that,
say, Japanese equities were likely to lose
money in the foreseeable future, he/she
could only underweight it versus the peer
group, not avoid it completely despite
feeling it will lose money. Again,
it is unclear that such mandate restrictions
within peer group funds, designed to
manage risks and returns in a relative
perspective, align the management of
the fund with the objectives of the end
investor, who is ultimately interested in
absolute risks and returns, not relative.
Greater client sensitivity following the
recent difficult investment period in
Ireland (the 2008 global credit crunch
and the 2011 European sovereign debt
crisis), especially the disappointment of
many investors in Balanced Managed
mandates, means that brokers are
focusing more directly on this mismatch
problem, ensuring that the funds in which
their clients invest are appropriate to their
expectations. Unfortunately, peer group
managed funds, such as the Balanced
Managed fund sector, will always raise
considerable problems for brokers in
this regard due to the incentivisation
mismatch between the relative focused
fund managers and the absolute focused
end investor.
Alternatives to peer group managed
funds
As part of a broader process of structural
change, the fund management industry
has proposed two different responses
to this mismatch, both in Ireland and
elsewhere. As the starting point of the
investment process is the end investors’
risk and return expectations, both stated
in absolute terms, these two industry
responses are either (I) funds that aim to
generate a specific absolute return each
year regardless of the peers and broader
market behaviour (called absolute return
funds); or (II) funds that commit to taking
a specified absolute level of risk regardless
of the behaviour of other funds and the
market (called risk controlled funds).
The two solutions follow different
approaches because it is impossible to
target both a specific level of risk and a
specific level of return at the same time.
This is easy to understand, as there will
be times when the committed return
target is easier to achieve, and hence little
risk is required, while at other times the
return target requires the fund manager
to take much larger risks to reach it. For
example, it easier for an absolute return
fund to achieve positive returns when cash
generates 4% per annum, as it provides
a cushion for positive returns, compared
to an environment when cash generates
only 1%, all else being equal. Generating
positive returns when cash is at a 1%
14

The specific solution offered to the client will come
down, as always, to ensuring that the objectives
followed by the fund manager, whether to reach a
return target or to maintain a specific level of risk, best
align with the investor’s objectives.
level and yields on bonds are low, and
hence bonds are expected to generate
low total returns, requires taking more risk
elsewhere and more active management
to generate alpha. Conversely, for risk
controlled funds with a risk commitment
there will be times when that specific
risk level will generate large returns due
to the abundant opportunities available
in the market, while at other times
the opportunities available, and hence
returns for that risk level, will be far less.
The opportunities depend, for example,
on the level of interest rates on cash,
yields on bonds, the expected equity risk
premium (i.e., the expected compensation
for taking equity risk) and the relative
valuations across asset classes and
investments.
In conclusion
Deciding on which of these two
approaches works for a specific client is
the responsibility of the particular broker,
with the two options being quite different
in both approach and appropriateness.
Absolute return funds, for example, will
not always make the return target year
after year, and the need for complex
derivatives and dynamic strategies in order
to deliver the return regardless of the
broader market means that understanding
the risks being taken will be hard to
understand and communicate to the
client. An absolute return fund with a
return objective of cash +4% may need to
take equity-like risk and might experience
large negative returns during some time
periods. For risk controlled funds, the risk
targets are likely to be easier to achieve
than those of absolute return funds,
though it would be difficult to understand
what returns would be generally expected
from them over time. Risk controlled
funds do not aim or promise to generate
positive returns year after year, but rather
the maximum return for a given level of
risk. The risk of disappointment may be
therefore lower for these funds than for
absolute return funds.
The specific solution offered to the client
will come down, as always, to ensuring
that the objectives followed by the fund
manager, whether to reach a return target
or to maintain a specific level of risk, best
align with the investor’s objectives.
15

What is volatility and
why is it important
There are many measures of investment risk; the
most commonly used measure is volatility. Whilst it
is commonly used, it is measure that can be open
to different interpretations. We set out below how
we think of volatility, why it is important and how
it can be used to form investment decisions.
Gavin Counsell
Multi-asset Fund Manager, FIA
Main Responsibilities
Gavin is responsible for managing a range of
multi-asset funds.
Experience & Qualifications
Prior to joining Aviva Investors, Gavin was
a Senior Investment Consultant at Towers
Watson within the Strategy team. Within this
role Gavin provided strategic investment advice
to clients. This included portfolio construction
analysis and asset allocation advice, to achieve
both target return objectives and diverse risk
exposures. Before joining Towers Watson,
he worked as a Pensions and Investment
Consultant for Aon Consulting, between 2000
and 2007, focusing on asset liability modelling
studies, asset allocation, portfolio structuring
and performance analytics. Gavin is a qualified
Fellow of the Institute and Faculty of Actuaries.
He also holds a Master of Mathematics degree
from the University of Warwick.
16

Chart 1: Volatility measurement
% 3.0
2.0
Low volatility
High volatility
1.0
0.0
-1.0
-2.0
Returns over time
What is volatility
Volatility is essentially a measure of the
expected level of dispersion in the range
of investment outcomes. More formally
volatility is the standard deviation, which is
a measure of how far investment returns
may differ from the expected return
(ie arithmetic average or mean return).
Broadly speaking, an asset (or a fund) with
large variations in return would have a
high volatility and therefore said to have a
high degree of investment risk. Conversely,
if the returns of an asset/fund are more
stable and predictable, the volatility would
be lower. A fund with a lower volatility
would be described as having a low level
of investment risk.
Typically, volatility is measured in
percentage terms, and referenced over a
particular time frame, with a higher figure
representing a higher level of volatility. For
example, equities have typically shown a
volatility of around 15-20% per annum,
compared to bonds, which have shown a
volatility of around 5-7% per annum.
One point to note (as shown in the
illustration above) is that volatility captures
both potential variations on the upside (ie
outcomes that are better than expected)
as well as variations on the downside.
Volatility captures both good and bad
investment outcomes. This aspect is an
example of one of the potential flaws
in using volatility as a risk measure, as
more often it is the downside risk that
is of more importance and concern for
investors.
Why is it important
Understanding the volatility of a fund
(or an asset) is crucial as it provides an
indicator to the size of the potential
investment gains or, more importantly,
potential losses. It is therefore important
that an investor is aware of the potential
risk exposure before investing. Different
investors may be more willing and/or able
to accept investment risk than others.
For example, would you be prepared to
tolerate an investment loss of 2% How
would you feel if the potential loss was
bigger, say, 10% or may be even 20%
The expected asset volatility can be used
to give an indication of the potential
deviations in return. For example, if we
had two investments with volatilities
of 5% and 15% then if we make
an assumption about the potential
distribution of returns we can estimate
how widely the two investments
may differ.
17

15% volatility “2-in-3 years” range: -10% to 20%
8
Frequency %
6
4
2
0
-48 -38 -28 -19 -9 0 10 19 29
38
48
57
Using volatility to estimate ranges of
return
These graphs show the spread of monthly
returns for two hypothetical investment
funds with annual volatilities of 5% and
15%. For the purpose of illustration we
assume that on average both investments
are expected to return 5% each year.
The graphs show how often returns were
experienced at different points across the
return spectrum.
Range of returns
5% volatility “2-in-3 years” range: 0% to 10%
8
Frequency %
6
4
2
0
-48 -38 -28 -19 -9 0 10 19 29
Range of returns
38
48
57
Visually the high volatility fund has a
wider spread of potential returns both on
the upside and on the downside.
Based on a ‘normal’* return distribution,
we can estimate the likelihood that the
returns fall within a range. Roughly, in 2
out of 3 years investment return are likely
to be within volatility measure of the
long-term expected return. For the 15%
volatility fund, this means that two thirds
of the time returns are expected to be in
the range, -10% (= 5% – 15%) to 20%
(= 5% +15%). For the 5% volatility fund,
this range is 0% to 10%.
* A Normal distribution is an assumption about the potential shape of the return profile. In reality it is unlikely to be an exact match to actual return distribution (in particular
it is often shown that the Normal distribution underestimates the likelihood of extreme bad and good events). We show in the graphs overleaf how actual US equity and
bond returns compare to Normal distributions.
Why be exposed to volatility at all
Given that no one likes or wants to lose
money, why would anyone want to be
exposed to a high level of investment risk
The answer comes down to expected
investment returns. It is widely accepted
that over the long-term, being exposed to
higher risk investments, such as equities,
should result in higher expected returns.
This is why some people prefer to be
exposed to higher risk, higher expected
return investments. The crucial aspect it to
ensure that the investor can cope with the
potential roller-coaster of a ride along the
way, that is, to be prepared to accept large
falls in performance as well as large gains.
To put this into context, although equities
are accepted as having a higher level of
investment risk than bonds, equities are
also expected to outperform bonds over
the longer term (essentially an investor
may be expected to be rewarded over the
longer term through higher investment
returns for being exposed to the higher
level of risk).
Using volatility to assess funds
It is imperative for investors to choose
funds to suit their own risk and return
objectives. Comparing different funds’
volatilities, and understanding what
this means to the risk exposure, is
an important step in investing in
the appropriate fund. Not only is it
important that the chosen fund suits
the investor’s risk tolerance at the point
of initial investment, it is also important
to ensure it remains appropriate over
time. This can be done by monitoring
the levels of investment risk within the
fund or alternatively choosing a fund
that is expected to maintain a constant
risk objective over time (rather than an
objective based on the fund’s peers, for
example).
How we measure volatility
There is a wide range of accepted
methods of measuring volatility. Typically
most measures are expressed as an annual
rate. Whilst expressed as an annual rate,
volatility may be averaged over different
time horizons. For example, you could
look at the volatility averaged over a one
year period, five year period or a ten
year period (or any period in between, or
longer or shorter). Different time horizons
can be used to suit different purposes.
Using longer time horizons make sense for
longer term investors.
We also recognise that when managing
risk, the “long term” journey is made up a
series of shorter terms. To ensure we reach
the “longer term” as expected, we believe
it is important to be aware of the level
of risk along the journey. We therefore
typically measure volatility over a five year
period. This is in keeping with the time
horizons used by European Securities and
Markets Authority for measuring risk.
However, whilst volatility is a useful
measure it is important to be aware that
it is only one measure. It is therefore
often sensible to combine different risk
measurement techniques when making
an investment decision. For example, we
find using “what if” scenario testing a
powerful tool in understanding how an
investment may be expected to react in
different outcomes.
18

Over the long-term equities are expected to outperform lower risk assets (such as bonds) but there are periods (even
lengthy periods) when equities under perform
Since the early 1970s US equities have outperformed bonds
Cumulative Return
Dec 1969=1, log scale
64
32
16
8
4
2
1
0.5
1969
1974
1979
1984
1989
1994
1999
2004
2009
But over the last ten years, equities have underperformed
Cumulative Return
Dec 2001=1, log scale
2.00
1.25
0.50
2001
2003
2005
2007
2009
2011
US 10Yr Treasury
S&P 500
US 10Yr Treasury
S&P 500
Source: Bloomberg, based on monthly data between January 1970 and December 2011.
However equities are also expected to be more volatile than bonds
Monthly returns for US equities
Frequency %
10
9
8
7
6
5
4
3
2
1
0
-15
-12
S&P 500
-9.0
-6.0 -3.0 0.0 3.0 6.0
Range of monthly returns
Normal Distribution
9.0
12.0
These graphs show the spread of monthly returns for US equities
and bonds. They show how often returns were experienced at
different points across the return spectrum.
For example, 7% of the equity experience produced a monthly
return of around -1.5% (compared to 6% for bonds). At the
more extreme, equities have experienced monthly returns of
less than -5% where as bonds have virtually no experience of
15monthly returns this extreme*.
The wider spread of equity returns compared to bond returns
demonstrates the higher level volatility that equities pose.
Monthly returns for bonds
Frequency %
18
16
14
12
10
8
6
4
2
0
-15
-12
-9.0
-6.0 -3.0 0.0 3.0 6.0
Range of monthly returns
9.0
12.0
15
Based on the data shown, averaged over 40 years, US equities
have shown an annualised volatility of 16%pa compared to US
10 year Treasury bonds of 8%pa.
* This is not to say in the future that returns may not be this extreme or worse.
US 10Yr Treasury
Normal Distribution
Source: Bloomberg, based on monthly data between January 1970 and December 2011.
Conclusion
Volatility measures how varied the actual investment outcomes may
differ to the expected investment return. High levels of investment
volatility are associated with high levels of investment risk, ie the wider
the dispersion of investment outcomes (both on the upside and the
downside). It is crucial that investors choose funds that match a level
of risk that is appropriate for them; understanding a fund’s volatility
provides one important tool to do this.
19

Enhanced Client
solutions
October, as the American author Mark Twain
observed over a hundred years ago in his 1894
novel “Pudd’nhead Wilson”, is one of the
“peculiarly dangerous months to speculate in
stocks in. The others are July, January, September,
April, November, May, March, June, December,
August, and February.”
Nick Samouilhan
Multi-asset Fund Manager, PhD, FRM
20

The first step is by far the
most important: we need to
decide what to invest in over
the long-term.
Aviva Investors
Humour aside, October is also pensions
season in Ireland, a time when many Irish
brokers sit down and begin the daunting
task of constructing portfolios that aim
to meet their client expectations while
investing in an uncertain environment.
This year, perhaps, the uncertainty is even
higher than usual given the economic
and political changes and concerns
going on both globally and locally, while
client expectations and trust are still in
need of careful management given the
violent reversal from good times to hard
times seen in Ireland over the last few
years. How should brokers approach
this important task We provide here an
overview of how we at Aviva Investors
structure the portfolio construction
process in our funds, a process that we
strongly believe in and a process that has
stood us well in good times and bad.
Dealing with information overload
A major difficulty with constructing
portfolios is that, like much else these
days, it suffers from the problem of having
too much information rather than too
little. Indeed, it is often hard to work out
from the constant newspaper headlines,
economic announcements and market
moves what information actually matters,
how one should interpret it and how it
impacts (if at all) on the task at hand.
For example, how important is the latest
Chinese GDP number for equities Or the
disappointing US labour market report
for that matter How do these two affect
the Euro What do the European council
negotiations mean for government
bonds Most importantly, how do these
things affect the market over the next few
months versus the next few years Or my
specific equity manager How is he/she
likely to do in these markets
It’s as easy as 1,2,3
We address this information overload
problem at Aviva Investors by breaking
the problem down into three distinct
steps, allowing us to filter and
contextualise what information matters
to what decisions. We are fortunate to
have large dedicated teams working with
us on each step, though the broader
concept of a step wise decision making
process is still one that we believe all
portfolio constructors should follow. The
specific three steps that we focus on are,
firstly, how should we invest over the long
term, say five to ten years Secondly, are
there any strong reasons not to invest
that way for the next few months Lastly,
how do we best put on this view These
three steps, which require very different
perspectives, make up the backbone of
the successful investment process pursued
by Aviva Investors across all of its multiasset
funds.
1. Take a long –term view
The first step is by far the most important:
we need to decide what to invest in over
the long-term. While a thirty year view
(i.e. until retirement) is far too long a
perspective, a five to ten year horizon
helps to frame the discussions away from
the daily, weekly or even monthly noise,
allowing us to sit back and ask what we
should hold in our clients’ portfolios.
There is also some good news here: this
step is the least dependent on daily,
weekly or even monthly news-flow: what
matters here are a few big picture items.
For example, for long term equity returns
it is the dividend yield, economic growth
and profit cycle that matters most; not the
weekly market movements or quarterly
earnings updates. For commodities, it
is the long term relationship between
21

structural demand and structural supply,
not strikes at specific mines in South
America or bad weather in the Gulf of
Mexico. For Government Bonds it is the
yield and (possibly) the credit risk of not
being paid back, not the morning papers’
rumours about the possible outcome
from latest government summit. Simply
put, if you are investing for someone’s
retirement, ignore the days’ details and
invest for the long-term.
2. But don’t forget the short-term!
In our next step we ask ourselves a very
specific, yet simple, question: are there
any strong investment reasons why these
long-term positions should not be held
for the next few months This allows us
to avoid holding positions where we have
a strong view that the short term picture
is negative, or avoid missing investments
that we have strong positive views on
in the short term but are negative in the
longer term. Note the critical phrasing of
the question here: we don’t ask what our
allocation should be in the short-term;
instead we start by looking at investing
over the long term and then adjust it in
the short term if, and only if, we have
strong reasons not to hold the position
in the short term. This approach has
numerous benefits, not least of which
is the avoidance of excessive trading by
chasing the latest market fad or animal
spirit, as is the want of many individual
investors. Even more importantly, we
employ this approach because we have
far more conviction in our ability to get
the bigger, longer term picture correct
than we do in getting the shorter term
picture right given the inherent volatility
and animal spirits at play in the short
run, a view backed up by considerable
industry and academic research. As a good
example of this approach we could believe
that commodities are a good investment
over five years but have strong concerns
about them being overvalued in the short
term. In this case we would look to hold
less commodity exposure or none at all
until our strong short-term negative view
fades. In making this adjustment we at
Aviva Investors are fortunate to have
access to dedicated teams of strategists,
economists and analysts, who build
detailed short term scenarios for us to use,
though again the broader process
of investing long term but watching short
term should, in our view, be a foundation
of good portfolio construction.
22

Managers often have significant style biases and
performance cycles, and we believe that understanding
this is key to choosing a manager that will add value to
the portfolio in the future.
Aviva Investors
3. Get the right exposure
Lastly, we need to invest the money.
We may think that US equities are a
good long term investment, and find
no strong reason to avoid this position
in the short term. How do we invest the
money In this approach the multi-asset
desk at Aviva Investors is very similar to
many Irish brokers, in that we are not
stock pickers but rather “fund pickers”.
If we want to invest in US equities for
our clients’ portfolios, the choice is
whether to buy an index fund, an ETF
or a mutual fund managed by various
fund managers, including Aviva Investors.
In this regard there are two things to
bear in mind. The first is that this step is
often the least important determinant of
whether a portfolio meets its long term
client expectations, it’s the allocation
steps above that determine that mostly.
Secondly, it is not simply the case of
looking in the rear view mirror and
investing in the manager with the best
record over twelve months, six months
or three years (or whatever horizon).
Managers often have significant style
biases and performance cycles, and
understanding this is key to choosing
a manager that will add value to the
portfolio in the future.
We hope this article helps you to build
better portfolios for your clients during
this “peculiarly dangerous” month for
investing. We want to emphasise the
importance of a disciplined, step-wise
approach in avoiding the latest investment
trend or market spirits, helping to
construct enduring portfolios that will
meet your client expectations over the
long-term. Unfortunately this advice was
not taken by the aforementioned Mr
Twain, who lost all of his wealth (and most
of his wife’s inheritance) through investing
in the development of a particular
typesetting machine, only for this to be
made obsolete by a better model only a
short while later. It is not known what
month he made the fateful investment
decision in.
23

Is your portfolio diversified,
or just varied
Justin Onuekwusi
Multi-asset Fund Manager, CFA
Nick Samouilhan
Multi-asset Fund Manager, PhD, FRM
24

It is the diversification of investment returns, and not
assets, that is of benefit to portfolios. In this sense, a
varied portfolio is very different from one that is truly
diversified.
Aviva Investors
One of the key tenets of sound portfolio
construction is that portfolios should be
diversified. By spreading the risk across
different investments this approach
hopes to provide higher, more stable
and less risky long-term returns. Indeed,
the advantages of this approach were
formalised mathematically in 1952 by
Harry Markowitz, who won a Nobel Prize
for proving that portfolios which hold
assets that are not perfectly correlated
with each other could achieve either
the same return with lower risk, or
alternatively a higher return for the
same risk, than less diversified portfolios.
However, while this tenet is often followed
(at least in theory), many investors ignore
two important points about it. First, that
diversification does not negate valuation
concerns i.e. identifying value remains
important and, secondly, that it is the
diversification of investment returns, and
not assets, that is of benefit to portfolios.
In this sense, a varied portfolio is very
different from one that is truly diversified.
Take a simple portfolio with a single
holding in, say, Irish company CRH
as a starting point. This company, a
manufacturer and supplier of construction
materials, has its returns determined by a
number of factors, especially the outlook
for construction industry, the outlook of
the company and the current price of its
shares (i.e. the value of the company). If
the construction market does well, the
investment will do well, all else being
equal. However, the valuation of the
company matters just as well, as if the
stock is overvalued then it is possible,
for example, for the construction industry
to do well while you lose money in the
investment as it becomes more fairly
priced, i.e. is rerated downwards.
To diversify this portfolio you could hold
another stock, say C&C group, the Irish
manufacturer and distributor of beers and
ciders. Again, the factors that will impact
the return are three-fold: C&C’s valuation,
the outlook of C&C and the outlook for
the drinks industry. Holding this stock in
addition to CRH creates a more diversified
portfolio, as there are now two different
drivers of the portfolio (the construction
industry and the drinks industry), and it
is possible to imagine a situation where
one industry does poorly but the other
one does well. In this case diversification
has helped, as one stock will be up and
offsetting the other one’s negative return.
There are two key things to note about
this simple example.
The first is that the portfolio is more
diversified because the underlying drivers
of the two stocks are not the same, not
because there are more “holdings”. A
portfolio of five drinks related companies,
or five construction related companies,
would probably be less diversified than
this simple example consisting of one from
each industry.
Secondly, diversification without due
regard to the valuation or the outlook of
the individual holdings, i.e. a “ticking the
box” or “optical diversification” approach,
is likely to lead to poorly diversified
portfolios. For example, if both stocks are
overvalued, the likelihood is that they will
both revert to “fair value”, irrespective of
whether they have different drivers. Simply
put, to be truly diversified, more is needed
than simply a large number of holdings,
there has to be an understanding of the
valuation and outlook of the companies in
the portfolio.
25

Moving on to multi-asset portfolios,
where diversification of risk is a key
attraction, these two lessons continue
to be important, if not more so. Indeed,
understanding them correctly is the key
to assessing whether a multi-asset fund
holds diversified asset classes, or just
“various” asset classes.
The first point, on drivers, comes across
starkly in multi-asset funds, and the key
to successfully diversifying in them is to
understand both the unique drivers and
the common drivers of the different asset
classes. Japanese economic growth, for
example, will be a larger driver to the
returns of Japanese equities than it is
to US equities. However, both Japanese
and US equities are likely to be more
impacted by changes in international
growth through their exporting companies
and international trade. The returns to
governments bonds are, predominantly,
driven by inflation concerns, policy rates
and, increasingly, solvency concerns.
Commodities tend to be driven by factors
such as inflation, global supply and
demand conditions, seasonal weather
patterns and government actions.
Corporate credit shares similar drivers
to both equities and government bonds,
while Aviva’s Index Opportunity fund
is driven by a completely idiosyncratic
driver: changes in the composition of
indices around the world (e.g. which
companies are going into, or out of, the
S&P 500 the next time it is rebalanced).
Common drivers are also often quite
subtle; investments in Russian equities
and debt issued by Chilean government,
for example, have the common factor of
commodity returns (oil in Russia’s case,
copper in Chile’s). Both oil and copper can
move broadly together at times given their
economic importance, and Chilean bonds
and Russian stocks, therefore, would be
considered poor diversifiers of each other’s
returns at these times.
The second point, on valuations is that
when investing across different asset
classes, valuation and the outlook of
that asset class matter just as much as it
does with individual stocks, perhaps even
more so. Diversifying amongst different
asset classes with different drivers is not a
replacement for analysing whether those
asset classes are a good investment or not.
A good example (of many), is the Japanese
stock market (Topix) which, in the late
1980s, was trading above 2800. Today
it is trading around 850, a fall of around
70%, despite growth in the Japanese
and international economy over those
20 plus years. Why In 1980 Japanese
equities traded at 60 times earnings,
making them incredibly expensive and
therefore a poor investment; in 2010 they
traded at 16 times earnings, and it was
this revaluation that swamped the positive
26

The returns during that troubled period, when
“diversification” in many portfolios famously failed,
should be viewed not as a breakdown of diversification
but rather as a lesson on why doing it properly matters
so much.
Aviva Investors
drivers and led to the large investment
loss. Holding Japanese equities as a
diversifying exposure does not change the
fact that you would have lost 70% of your
investment. Valuation remains central to
successful long term investing whether
its regional equities, government bonds,
commodities, corporate bonds or any
other asset class, and is not replaced by
diversification justifications.
What does this mean for investors
The first is that, despite the problems of
2007/8, diversification should still be one
of the central tenets of sound portfolio
construction, especially in long-term
Managed or Multi-Asset portfolios.
The returns during that troubled period,
when “diversification” in many portfolios
famously failed, should be viewed
not as a breakdown of diversification
but rather as a lesson on why doing it
properly matters so much. Indeed, the
performance of typical Managed funds
during that period is a perfect example of
this, as the returns of the average fund
during this period was dominated by a
single common factor (the Irish property
market, which impacted Irish commercial
property, Irish financial companies and
Irish government bonds) and by investing
in overvalued asset classes. Secondly,
portfolio construction should not be done
through a predetermined “tick the box”
approach whereby you need to have four,
14 or 44 holdings. Rather, start with the
objective in mind (the return requirement,
this maximum loss, that level of volatility
etc.) and then build your portfolio up,
diversifying only when it makes sense to
do so, with a focus on the drivers (and,
importantly, how these interact with each
other) and valuations. Understanding this
will help investors understand whether
their portfolios are truly diversified, or just
varied.
27

Active or passive
management
Nick Samouilhan
Multi-asset Fund Manager, PhD, FRM
28

Firstly in our view, it is important to constantly reiterate
that manager or investment selection, whether active or
passive, is secondary to asset allocation when it
comes to meeting clients’ investment objectives.
Aviva Investors
The active versus passive debate
A lively discussion currently takes place
amongst the broader investment advisor
community on the use of passive funds
versus active funds in their clients’
portfolios. The background to the debate
is the confluence of ever greater passive
options (both in number of asset classes
offered and the number of providers)
and recent underperformance of many
active managers. This discussion can be
easily summarised, with proponents of
passive management arguing that active
managers are often more expensive,
require onerous due diligence and have
often underperformed their respective
benchmarks. In reply, supporters of
active management argue that passive
management exposes investors to
opaque risks beyond their understanding
(particularly with regards to swap based
ETFs): prevents investors from avoiding
obvious problems with certain securities
in the particular replicated benchmark;
bounds to underperform the benchmark
after fees and costs; and gives up
potential alpha.
This debate, while both important and
timely, has become in our view rather
“boring”, being framed as it has in the
unfortunate way of active or passive,
leading to more confusion than clarity
as active and passive fund providers
publicly trade their views. In practice,
management of a client’s full portfolio to
his/her expectations is a complex task, and
a blended use of both active and passive
exposures is, in our view, often a better
way to approach this overall portfolio
management than simply a “one or the
other” absolutist approach. As a large user
of both active and passive investments
in our clients’ funds, we, the Multi-Asset
Fund team at Aviva Investors, view the
management of this blend as a key
component of our role and client offering,
and provide here the broad thinking on
this topic that we follow in
all our portfolios.
Setting the strategic, long term split
between active and passive
Firstly, it is important to constantly
reiterate that manager or investment
selection, whether active or passive, is
secondary to asset allocation when it
comes to meeting clients’ investment
objectives. Asset allocation aligns the
portfolio with the long-term risk and
performance objectives. As such the
focus should remain on getting this asset
allocation step right first and foremost.
Only once the asset allocation decision
has been made the decision on the
specific used to express the allocation
views should be looked at. The choice
between Japanese equities and US
equities, for example, has in the past easily
led to annual differences of over 10% in
total portfolio performance, putting the
possible 1-2% outperformance of the
active Japanese manager versus passive
Japanese manager into perspective.
Secondly, once asset allocation has
been set there are, in our view, certain
asset classes that lend themselves more
to active management than others do.
Emerging market equities and high
yield bonds, for example, have certain
structural and informational inefficiencies
that make active management potentially
more able to add value, and this would
bias us towards having more of this asset
class actively managed, all else being
equal. Other investments, such as hedge
funds and private equity, are potentially
29

attractive because of manager skill and
active management. In contrast, US
equities and gilts are, in our view, more
efficient markets where active managers
will probably struggle to consistently add
value. Hence we would be more likely to
have more in passive investments here
than in active, generally speaking. Asset
classes with a lower potential for active
management should be tilted to passive
investments to reduce costs and free
manager monitoring resources to other
areas in the portfolio. In a typical core/
satellite approach, the core of a portfolio
is invested in cost efficient passive
investments, aligning the portfolio with
its asset allocation, and the satellite is
invested in active investments, where the
potential for outperformance is more
abundant.
Thirdly, it is important to view the active/
passive decision from a total portfolio and
client perspective as part of the overall
portfolio construction process, and not
as a series of independent decisions. For
example, looking at an active manager in
isolation may mean that advisors miss that
this particular manager’s skill and style
may be already present across other active
managers in the portfolio, inadvertently
doubling up the style or sectors bets.
The portfolio’s credit and equity managers,
for example, may all be underweighting
the financial sector, or the European and
Japanese equity managers both investing
in value stocks, leading to large portfoliowide
style and sector bets. Unless these
compounded biases are desired this
particular portfolio would benefit from
decreases in the use of active managers
towards more passive exposure to dilute
these style and sector bets.
Fourthly, the active/passive split is used
to control the overall risk level of the
portfolio. The Multi-Asset Fund team
at Aviva Investors has developed a
proprietary process whereby the total
risk budget of a portfolio (for example,
tracking error versus the benchmark)
is dynamically allocated to three main
activities: Strategic Asset Allocation,
Tactical Asset Allocation and investment
selection. The active/passive split is used
to dial up or down the risk allocated to
underlying investments. The process is
dynamic as asset class risk premiums and
cross asset class relative opportunities,
which drive the risk allocated to asset
allocation, as well as the degree that the
environment supports active management,
constantly change.
Just as importantly, active management
is focused on outperformance over the
long-term, meaning potential periods of
short-term underperformance. Clients
with short investment horizons are in our
view probably best suited to more passive
exposures to reduce the risk of these
periods of underperformance, while clients
with longer term perspectives should have
portfolios relatively more biased to active
managers, all else being equal.
Tactically adjusting the active/passive
split over time
We believe that addressing these points
above will help you to decide upon the
long-term structural allocations of active
and passive exposures in your clients’
portfolios, creating a blended approach
suitable to each specific client. However,
we also believe that there is some value
to be added by tactically changing these
structural allocations over time, aiming
to increase (or decrease) the allocations
30

to active managers when they are
expected to add more (or less)
outperformance than usual. This is, clearly,
a very difficult task and should only be
done on the margin, as should all shortterm
tactical changes. With that qualifier,
we suggest two ways of undertaking
these marginal changes.
Firstly, annual reviews of your active
managers will give you greater or lesser
confidence in their ability to meet their
performance targets, allowing small
adjustments where this makes sense. In
this regard, the views of the underlying
active managers are often insightful as
they are the ones best placed to say
whether the current environment is more
or less conducive to their particular way
of managing money. This clearly requires
a degree of trust and honesty between
the underlying active managers and the
portfolio constructor; though this trust
should anyway form the basis of the
investment relationship.
Secondly, there is considerable academic
and industry research, conducted by
both others and ourselves, showing that
active managers tend to add greater value
during periods of high intra-stock volatility
and unusual cross correlations, all else
being equal. To use a simple if somewhat
extreme example to explain this, if all
stocks in a particular asset class (European
equities, for example) were moving
perfectly together it would be physically
impossible for an active manager to
beat the respective benchmark index by
underweighting or overweighting different
stocks. In contrast, when there are wide
dispersals of stock movements there is a
greater opportunity for active managers
to add value by selecting among different
stocks. By monitoring this level of crosssectional
market volatility or opportunity
within the specific asset classes investors
can marginally change their allocation to
active managers as the opportunity set
grows and contracts, allocating more to
active managers when it makes sense to,
and more to passive when it does not.
In conclusion
Following the points above and
approaching the active/passive decision
from a total portfolio perspective will help
you to manage what has become another
important aspect to multi-asset portfolio
construction. We believe that a blended
approach, using active and passive
investments where they respectively
make sense, provides a far better offering
for your clients than the absolutist one
or other approaches within which the
decision is often framed.
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Unless stated otherwise, any opinions
expressed are those of Aviva Investors Global
Services Limited (Aviva Investors).
They should not be viewed as indicating any
guarantee of return from an investment
managed by Aviva Investors nor as advice
of any nature.
Past performance is not a guide to the future.
The value of investments and any income
from them can go down as well as up.
You may not get back the original amount
invested. The information contained within
this document should not be viewed as
investment, regulatory, tax or legal advice
nor as a recommendation of any nature.
Aviva Investors Global Services Limited,
registered in England No. 1151805.
Registered Office: No. 1 Poultry, London
EC2R 8EJ. Authorised and regulated in the
UK by the Financial Services Authority and a
member of the Investment
Management Association.
MC2738-V001-259966-12/0813/300613
© 2011 Aviva Investors.