IS THE IMA BARKING UP THE WRONG TREE?

Cautious Managed - the sector's new classification may fail to ensure funds are cautious and may exclude the ones that are ...

Main Points:
1. The IMA has made changes to the sector classifications for the Cautious Managed sector;
2. The changes were made due to the increasing correlation between property and equities;
3. It can be argued that taking a multi-asset approach does not mitigate risk; and
4. It is difficult to draw comparisons between funds within the sector because of the inherent differences between them.

"The IMA has recently 'tightened' the specification for funds within the IMA Cautious Managed sector. Bearing in mind the increasing confusion over funds within this sector, this most recent change beggars belief. The rules used to specify simply that there was an upper limit of equities of 60%. Because this was not considered cautious enough this rule has been supplemented by an additional requirement that at least 30% must be held in a combination of cash and fixed interest - to remove the risk effects of any increasing correlation between property and equities.

"Cash may be low risk but it can hardly be considered an investment. And is fixed interest low risk? It may not be correlated to equities and may, over the longer term, involve lower volatility but can it really be considered cautious? Again, this raises the question about the nature of risk as well as drawing to mind the various risk assessment/asset allocation tools that seem to be breeding like rabbits and which often guide investors to fixed interest. Over the last few years fixed interest has certainly not, in my view, been low risk.

"If the IMA was going to tinker with this sector why didn't it simply divide it into two or three new sectors with much more specific indicators of stated risk objectives? It’s very hard to see how one can justify putting funds with an emphasis on investment in emerging markets into a 'cautious' sector with funds such as WAY Global Cautious, which includes guaranteed funds, zeros and property and has a target equity weighting of 30%.

Industry Innovation
"The contemporary investment market has changed almost beyond recognition in recent years with the emergence of new asset classes and an increasing array of sophisticated vehicles using all manner of derivatives and specialist investment areas. These changes have been recognised within the fund management industry and by the UK and European authorities with the introduction of UCITS 3 and, in the context of asset allocation, the introduction of NURS (non-UCITS retail schemes).

"Many funds launched in the last couple of years have been launched as NURS schemes and several other pre-existing funds have been converted into NURS. The benefits of NURS within multi-management are fairly well-known, especially as fund management has evolved and new and slightly esoteric investment opportunities unfold.

"Managers may mix all sorts of asset classes and types within the same fund so that both risk and reward can be enhanced by blending the most contemporary of investment vehicles. A NURS fund can invest up to 20% in a mix of unapproved securities and unregulated collective investment schemes (including hedge funds). It can have permanent borrowings of up to 10% permitting a minor level of gearing. It can comprise larger holdings both of individual securities and of collectives. Importantly, it can invest in property and gold.

"This freedom opens all sorts of doors for the professional manager and consequently many fund of fund managers are choosing to switch their portfolios to NURS rules. This allows them so much more freedom to mix and match investment types and include absolute return funds, structured products, bricks and mortar, funds from strange or specialist jurisdictions as well as commodities.

"NURS rules permit managers to select funds which are managed very precisely by objective or within very esoteric areas, such as oil exploration or particular commodities. Funds such as these are frequently closed-ended funds (often investment trusts) which allow their own managers to drive longer term strategies without having to worry about their capital base shrinking or expanding through outflows or inflows of shareholder money.

Too Cautious
"There has always been a strong case for multi-management in achieving economies of scale, tax-efficiency, wider diversification, lower risk and higher returns, compared with running individual portfolios of shares or collectives. This case is strengthened even more by the emergence of highly sophisticated asset blending with judicious use of derivatives and other contemporary vehicles (following the introduction of NURS rules) to fine tune both risk and reward profiles.

"So one has to ask how these developments fit in with the new definition of the Cautious Managed sector as one which includes funds with a minimum of 30% in cash and fixed interest and a maximum of 60% in equities! On the basis of the new rules, WAY Global Cautious will probably have to leave the sector because a minimum of 30% in cash and fixed interest cannot be guaranteed at all times. But this is not because, as the IMA might imply, we are not cautious enough, it is because we are too cautious.

"In the interests of our investors we can now incorporate absolute return funds, guaranteed funds and property funds into the mix to reduce both volatility and the degree of correlation between our cautious fund and the equity markets. It is time for the IMA and for advisers and their investors to re-evaluate the quality of NURS funds operating within the Cautious Managed sector.

"One of the dilemmas faced in the marketplace is the focus on performance tables. Many truly cautious funds, such as WAY's own, have a benchmark equity weighting of some 30% against an IMA benchmark for the Cautious Managed sector of "up to 60%". This means that these more cautious funds will always under-perform the sector during bull market conditions because they have far less of an allocation to the one class which is driving markets forward.

"However, one has to ask whether a portfolio which contains 60% equities can reasonably be described as being cautious. Surely we are now operating with sector definitions based on investment considerations from the dark ages. Discussions amongst today's managers surrounding cautious returns are not focused on high income equities or simply reducing the equity allocation by a few per cent, they centre on well-diversified portfolios containing a range of asset classes including property, absolute and guaranteed funds. It is this kind of mix which will deliver lower volatility and robust cautious performance but which nevertheless will not deliver 60% of equity performance. Whilst the IMA Cautious Managed sector is full of star-rated equity income funds, the 'genuinely' cautious funds get little credit for the conscientious job they do for their conservative investors."

Paul Wilcox,
Chairman & Technical Director, WAY Group.
7th January 2008.

Press Release Date: 7th January 2008.

Please Note: The above article first appeared in the Investment Adviser on 7th January 2008. Reproduced with kind permission.

Note: This commentary has been prepared for Financial Intermediary Clients and Professional Associates of WAY Investment Services Ltd and is not intended for and must not be distributed to Private Investors. This information is supplied to you in confidence and you may not pass it on to any other party without prior written consent. Past performance is not necessarily a guide to future returns and changes in rates of exchange between currencies may cause the value of investments to rise or fall. No representation or warranty is given (express or implied) as to the accuracy, completeness or correctness of the information nor the opinions, interpretations and conclusions contained in this commentary. The commentary does not constitute investment advice or a recommendation to purchase or sell any security. Neither the author nor WAY Investment Services Ltd accept any liability whatsoever for any loss or damage arising in any way from any use of or reliance placed on the commentary. WAY Investment Services Ltd is an Appointed Representative of WAY Fund Managers Ltd which is authorised and regulated by the Financial Services Authority.

Press Release Date: 7th January 2008.