We now operate in an environment of low to negative interest rates. What are the challenges for wealth managers? 

The challenge facing wealth managers is simply to meet the expectations of their clients in terms of delivering acceptable returns, but without taking on board unacceptable levels of risk. The danger for all investors lies in pretending that historically available rates of return are available with sufficiently smart investment strategies. That may be true for some investors, but on average, total returns are going to be lower, and clients need to understand they have to accept lower returns for the same risk, or the same returns but for more risk. Or investors may just need to save more in order to meet their objectives.

How should asset managers explain the situation to clients?

I think it is important to explain asset class projections in terms of long-term characteristics and in terms of bands of uncertainty. Anything more exact will impart a misleading degree of precision to an investor's portfolio prospects. To take a simple example, total returns on investment grade fixed income (global hedged) over the next ten years is likely to average between 1 per cent and 2 per cent in nominal terms. That compares with at least 6 per cent returns in the most recent 20 years.

To what extent does the environment affect the blend of active and passive strategies a client should have?

I believe it is a fallacy that active managers tend to do better during particular phases of the market cycle. Instead, I think the investor's own preferences and actions are more important for determining their ideal active-passive blend.

For an investor who knows little about an active manager except the track record of the fund, the best approach will most often be to go completely passive. The evidence shows that, on average, such an approach will deliver higher cost-adjusted returns at lower volatility.

But if an investor or wealth manager has conviction in a particular strategy, either because of a strong understanding of the investment expertise of the managers, or of the investment process and philosophy of the firm, then an active strategy can be profitable relative to a passive benchmark. Importantly, the cost to the investor of that active strategy is probably the most important ex ante indicator of likely excess return.

Finally, even for the fund selector who has always favoured an active approach, it is important to recognise that the incorporation of passive funds into the overall portfolio can help to lessen the volatility of a portfolio and may help to dissuade clients from withdrawing funds when active funds go through periods of underperformance (as even the best funds do).

To what extent can active strategies add meaningfully to portfolios over extended periods of time, once fees are taken out?

On average, the zero sum game tells us that active funds will underperform once costs are taken into account. But this does not mean that it isn't possible to find well-designed investment strategies that can outperform the market for sustained periods (though even then, not for all periods).  But these winning funds are not easy to pick; it certainly isn't just a matter of picking previous winning strategies. Focusing on low-cost investment strategies is a very good place to start. But beyond that, our experience shows that it is critical to invest resources in understanding the investment expertise of the fund managers concerned and the investment philosophy and process of the overall firm. This due diligence is typically beyond the resources of the typical retail investor but it does mean that sophisticated investors, or their clients, can outperform for sustained periods.

Medium-term volatility is low - and so is liquidity. How can investors benefit?

Low volatility can be exploited by investors by using suitably designed derivative-based strategies, effectively taking a bet on whether volatility will continue to stay low, or that it will increase again. This approach to investing is relatively esoteric and subject to higher risk.

Can you explain a bit about how Vanguard calibrates its product offerings to suit the current and medium-term market environment? 

Vanguard calibrates its market offerings for the long-term investor. Passive market beta building block funds (in funds and ETFs) for the investor who wishes to stick to passive funds; and active funds, always low cost active funds, to appeal to those investors who wish to take more risk to achieve higher returns, embracing a range of fundamentals-based and quantitative strategies in fixed income and equities; and single fund solutions (i.e. multi-asset strategies) for the investor who wants a pre-packaged portfolio to meet their investment goals. Our product offerings are never opportunistic in the sense of trying to pick the latest market fad which may appeal to investors for a short period. We design our products with the long-term interests of the end investor in mind.

Can you set out your active investment processes, in terms of how the strategies are chosen, monitored and where necessary, changed?

We have three types of active strategy available at Vanguard globally, though only one currently available in the UK, as indicated below. First, fundamentals-driven equity funds, which are externally managed by a number of investment partners on our behalf. Second, we run a number of active fixed income funds in-house, run by an experienced staff of fixed income investment specialists; and third, we run a number of quantitative equity funds (including our global factor ETFs, recently launched in the UK), which are again run in-house by our quantitative equity group. All these funds are monitored closely by an independent product review group, which meets regularly, involving senior management representation, up to and including the chief executive, to ensure that the funds concerned are meeting their designed investment objectives.

What is Vanguard’s approach to investment risk?

Vanguard’s senior risk managers are responsible for monitoring portfolio management and trading activities, working alongside colleagues in other supporting functions related to processes, technology and data. All of these groups are responsible for identifying, analysing, controlling, and managing the risks and performance for our funds. They maintain clear frameworks for managing portfolios and documented ground rules to ensure that portfolios are managed in accordance with established expectations. Close attention is given to trading on both a pre- and post-trade basis to avoid unnecessary risks and to ensure best execution.

Regular formal meetings are held to review portfolio results and to continuously be in a position to make necessary adjustments to effectively manage risk and performance. On a weekly basis the investment risk team undertakes risk review meetings with the portfolio management and trading teams. These meetings review and analyse investment risk and performance and proactively discuss related topics including upcoming activities, market conditions and investment strategies.

Important notes

This information is directed at professional investors and should not be distributed to, or relied upon by, retail investors. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

This document is designed for use by, and is directed only at, persons resident in the UK.

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

The opinions expressed in this article are those of individual author and may not be representative of Vanguard Asset Management, Limited.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2016 Vanguard Asset Management, Limited. All rights reserved.

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