Diversifying into a passively managed multi-asset investment can reduce your risk of under-performing an index, as well as the costs of investing, Old Mutual Investment Group’s index-tracking division says.

Multi-asset funds invest across the asset classes of equities (both local and global), bonds, listed property and cash.

If you have a retirement annuity fund, you will probably invest in a multi-asset fund, because your investments must comply with regulation 28 of the Pension Funds Act. This regulation restricts the asset classes in which a fund can invest, with the main restriction that it cannot invest more than 75 percent in equities.

Many financial advisers recommend that you invest with more than one manager, because it is likely that the diversity of asset allocation calls and investment styles will result in different returns at different times and ensure that you do not earn particularly bad returns at any one time.

But investing in, for example, three different multi-asset funds, is an expensive way to achieve diversification, Kingsley Williams, the chief investment officer for indexation at Old Mutual Investment Group’s Customised Solutions, says.

He says an analysis of the South African multi-asset high-equity sub-category shows that managers have taken very different decisions about how to allocate assets across different asset classes.

A Morningstar analysis earlier this year showed that, while some funds had as much as 76 percent in equities, others had as little as 46 percent. Multi-asset high-equity funds can invest up to 75 percent in equities.

The highest exposure to cash was almost 38 percent of the fund, while the fund with the lowest allocation in cash had 7.2 percent.

The allocation to bonds ranged from 23.4 to 10.5 percent, while the allocation to listed property was between 13.9 and 0.8 percent.

Williams says that these wide variations explain the diverse returns in the sub-category, but by combining, for example, three funds, you will achieve a more average asset allocation, rather than the extreme of an individual manager.

You could, however, reduce your costs by choosing a multi-asset fund that tracks the indices of the major asset classes with an asset allocation in line with the return you need – for example, inflation, as measured by the Consumer Price Index, plus five percent.

One way to achieve this is to have an asset allocation of 50 percent to local equities, four percent to listed property, eight percent to bonds, 23 percent to global equities and 11 percent to cash, Williams says.

If a multi-asset fund with this static asset allocation is combined with two other large actively managed multi-asset funds, back-tested performance using rolling five-year periods measured over the past decade shows that the returns would be within the top 25 percent of the performance of all multi-asset funds, and would be virtually the same as the performance you would have achieved by investing equally in the top 10 balanced funds, Williams says (see graph).

However, the cost of investing in this way would be reduced by including the multi-asset index-tracking fund, because such a fund is likely to have a fee in the range of 0.4 to 0.6 percent, rather than one percent to 1.5 percent, as would be the case with an actively managed fund.

A fee of 0.6 percent means that you will pay just 12 percent of the five percent you expect to earn above inflation, while a fee of 1.5 percent means you give up 30 percent of that return. This will make a substantial difference to an investment over a longer period, as the graph of the effects of four different levels of costs shows (see graph).

Williams says although it is possible to find an active fund manager who can out-perform an index, it is becoming increasingly difficult for active fund managers to deliver more than the market.

An analysis of the rolling three-year returns of all equity fund managers in the Alexander Forbes Large Manager Watch, a survey of major managers of retirement funds released in May, shows a narrowing of the out-performance from the top-performing manager relative to the FTSE JSE Shareholder Weighted All Share Index (Swix), Williams says (see graph).

However, it is impossible to predict which manager will be the top performer at any point in time. It is therefore more realistic to expect that you may be able to select a manager in the top 25 percent or top quartile of any performance survey.

Managers whose performance was within the top quartile of all the equity fund managers in the Alexander Forbes survey provided an average performance very much in line with the Swix, Williams says.

The analysis of the rolling three-year returns of equity managers since 2007 also shows that most under-perform the Swix more than 50 percent of the time (see graph).

Williams says the analysis of under-performance of equity fund managers shows the risk you run of obtaining performance below the index. Including an index-tracking fund in your portfolio is a very cost-effective way to reduce this risk of under-performance, he says.