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By Melvyn Lloyd, 15 June 2015
In this article we will look at how this strategy has impacted both multi-asset fund portfolios and building block portfolios over the past decade. We will also compare drawing income and fees from an income fund as opposed to a money market fund – and look at how this will impact the investment portfolio.
But, before we start, the following assumptions were made:
Over the past couple of years, more and more financial intermediaries have moved away from the traditional building block approach and have opted to construct their clients’ portfolios using the multi-asset fund approach. In this approach the financial intermediary is essentially blending a combination of asset allocation funds to ensure that the portfolio matches the risk profile of the client.
But has something from following the building block approach in the past influenced the way financial intermediaries are constructing investment portfolios today?
I believe that the answer to that question is YES. In the past, when financial intermediaries were constructing building block portfolios, there would almost always be a cash/money market component in those portfolios (with the exception of maybe an aggressive portfolio). And withdrawing income and fees from that cash/money market component made sense - as I will illustrate further on in this article - but does this strategy work when using a multi-asset fund approach where almost all of the funds in the portfolio will have underlying exposure to cash/money market instruments? The answer to this question is NO.
In the graph below we compare the investment values (at the end of each month) of three risk-profiled multi-asset portfolios where the only difference is that the client takes income and fees proportionally from all the funds in the portfolio (so, there is no money market fund in the portfolio) and one takes income and fees specifically from a money market fund that was added to the portfolio. Going forward, the former will be referred to as the proportional portfolio while the latter will be referred to as the MM portfolio.
We then subtract the monthly investment values of the proportional portfolio from the MM portfolio.
From looking at the graph it’s clear that the portfolio where income and fees were deducted proportionally, comfortably outperformed the portfolio where a money market fund was included for the deduction of fees and income.
In the cautious, moderate and moderately aggressive portfolios, the decision to take income and fees proportionally from all the funds resulted in the portfolios delivering R111 695, R193 951 and R359 435 more than those portfolios where income and fees are deducted from the money market fund.
This outperformance equates to 2.2%, 3.9% and 7.2% of the initial R5 000 000 investment. You can agree that this is a significant amount considering the 10 year period over which this analysis was conducted. Given a longer period, the effects of compounding are even greater and the outperformance more significant.
So, what if you decided to deduct income and fees from a slightly more aggressive income fund as opposed to a money market fund? From the graph below you can clearly see that by taking income and fees from an income fund reduces the gap and adds to performance, but it’s still lagging the investment value of the portfolio where income and fees are taken proportionally.
The cautious, moderate and moderately aggressive portfolio where income and fees are taken proportionally is now only R85 820, R164 426 and R320 424 more than those portfolios where income and fees are deducted from an income fund.
But, why is this the case? Why does the portfolio where income and fees are taken proportionally outperform the portfolio where income and fees are deducted from either the money market fund or income fund?
Well, the answer to that question is fairly simple. By adding a money market or even an income fund to a portfolio (cautious risk profile and higher) where multi-asset funds are used – you are essentially “de-risking” the portfolio.
It’s important to remember that the majority, if not all of the underlying funds in the portfolio will already have a cash and/or income component. So by increasing this you are reducing the exposure to risky assets at the same time.
So, how do you counter this? Well, the most obvious answer would be to deduct your income and fees proportionally from all the funds. On the other hand, if you are set on having a money market or income fund for this purpose, then it’s important to increase (depending on your allocation to a money market or income fund) the risky asset exposure in the portfolio to make up for the “de-risking” effect of adding such a fund.
Now, when it comes to a building block portfolio, it makes sense to deduct fees and income from the cash component in the portfolio. Why? Because in essence you are increasing the exposure to risky assets by reducing the exposure to the cash component (because fees and income are taken from the cash component).
In the graph above we deduct the monthly investment values of the MM portfolio from the monthly investment values of the proportional portfolio. As you can see, the portfolio where income and fees are deducted from the cash portion comfortably outperforms the alternate portfolio.
In a cautious portfolio the outperformance is equal to R242 212, while in the moderate and moderately aggressive portfolios the outperformance is equal to R353 786 and R511 739 respectively.
It’s again important to remember that this analysis was done over the past 10 years. Given more time and with the help of compounding, these differences as mentioned above could potentially be significantly bigger.
But what if you decide to deduct income and fees from a slightly more aggressive income fund as opposed to a money market fund? From the graph below you can clearly see that by taking income and fees from an income fund you have significantly outperformed the investment value of the portfolio where income and fees are taken proportionally.
The cautious, moderate and moderately aggressive portfolio where income and fees are taken from the income fund is R403 275, R495 850 and R572 153 more than the respective portfolios where income and fees are deducted proportionally.
The reason for this outperformance is that the income fund is a more aggressive option than the money market or pure cash component. And by replacing the portfolio’s cash exposure with an income fund you are increasing the risk in the portfolio – which should add to the overall portfolio’s performance over the long term. Both the outperformance and increase in risk can be seen in the graph below which illustrates the monthly returns of the STANLIB Income fund relative to the STEFI Composite Index - which can be used as a proxy for cash.
By adding a money market fund to a multi-asset fund portfolio, you are essentially “de-risking” the portfolio. If risky assets outperform fixed interest assets over the long term, the returns produced by the money market fund should be lower than the returns produced by the funds with exposure to risky assets. This return differential over time, thanks to compounding, will result in the portfolio with a money market fund (from which income and fees are deducted) underperforming the portfolio where income and fees are deducted proportionally.
Now, the opposite holds true when following a building block approach. If an investor has a building block portfolio and they decide to deduct the fees and income from the portfolio’s cash component – they will in essence be increasing the overall risky asset exposure in the portfolio. And if risky assets outperform fixed interest assets over the long term this strategy would outperform the building block portfolio where fees and income are deducted proportionally from all the funds.
An investor should always be cognisant of the risks associated with increasing a portfolio’s risky asset exposure. These risks were clearly illustrated during the 2008/2009 financial crisis (see graphs above) where the gap in outperformance was reduced due to the underperformance of the “riskier” portfolio relative to the “less risky” portfolio.
In conclusion, if you have a multi-asset fund portfolio – you should consider taking your income and fees proportionally from all the funds. If on the other hand, you decide to follow a building block approach, then you may be better of deducting both the income and fees from the portfolio’s cash portion and not proportionally from all the funds.
* The outcome of this investigation is based on a reasonable level of income per respective risk profile.
** This analysis was based on monthly returns (provided by Morningstar) over the past 10 years.