I had some difficulty deciding whether to write about Flexible Funds (FF) in English for a broader audience, or to suggest an Italian-only guest post with FinanzaCafona. FF are definitely popular in Italy among retail investors but I have never come across them outside of my home country. However, this may be due to my lack of research on the topic.
Although I will primarily refer to Italian products, I believe that there are enough universal lessons to be learned that would be beneficial to a wider audience.
Sometimes the best way to expose a charlatan is to ask their opinion to a different one. Here is how Moneyfarm, an Italian RoboAdvisor, defines FF:
“Flexible funds are a particular type of mutual fund that is very popular among Italian savers. Just think that in 2021, the investment portfolios of Italian investors included an average share of 33% in flexible funds. Among mutual funds, flexible funds stand out for the high discretion given to the fund manager in the asset allocation activity. In the case of flexible funds, it is the management company that establishes and discretely modifies the composition of the fund based on market analysis. Mutual funds are divided into equity, bond, balanced, liquidity, and flexible funds. While for other funds the composition of the fund is defined in advance, with the percentage indication of the assets used, for flexible funds, the management company does not have such constraints. The only constraint that the management company must adhere to is represented by the risk profile chosen by the investors. Investors who choose a flexible fund leave the management company free to decide on which financial instruments to invest the assets. This means that the management company can freely modify not only the composition of the fund but also the geographical, currency, and sectoral exposure.“
Not a long time ago I wrote about the pains of diversification. Holding an investment that is not working, even if it is just for a limited period of time, hurts. What if I tell you that there is an “expert” that can jump between stocks, bonds and cash allocations to avoid losses? If you look at the past, turning points in the stock and bond markets were quite obvious, didn’t they? Ok, maybe not obvious to everyone but for sure to this money manager who has a great 3-year track-record. And, so conveniently, you can invest with him too! How lucky special you are!
In a nutshell, this is the sale pitch any shady financial advisor would hang in front of you. It is a dream that is easy to sell; so easy that it is proposed to institutional investors too. I wasted my fair share of hours listening to advisors suggesting to ditch static allocations to Corporate, High Yield and EM bonds for a single manager that has the flexibility to invest in all of those categories according to market conditions. These managers are part of big institutions with access to economists, strategists and investment committees: they can leverage this knowledge to take optimal decisions (just forget for a second the fact that those are the same institutions that every year publish the target for the S&P500, to say one, and never nail it).
It is the same logic as internet scams: if you stumble on one, it means someone else fell for it. These funds have clients.
“The experience and market knowledge of the fund managers can therefore become a strength, useful for minimizing risks and maximizing returns.” as expected, from MoneyFarm. “In the case of prudent flexible funds, the discretion of the asset management companies is reduced because there are maximum limits on the equity composition of the fund that cannot be exceeded.” Some FFs have limits on how much the money manager can deviate from a certain, target asset allocation: the fund cannot go 100% stocks one month and 100% bonds the other. This is the implicit recognition by the fund manager (or their boss) that their “market knowledge” is better to be constrained, it is the manager’s risk management at work.
I am your worst nightmare
Said the benchmark to the fund manager. So the clever but not so clever fund manager solved this issue by claiming that their tactical fund should not be compared to any benchmark. Considering that stocks tend to go up, the clever but not so clever financial advisor can generally show a client a positive performance…without the need to contextualise it. What would have happened if I invested in a plain vanilla 60/40…asked no one during those meetings.
The absence of a benchmark comes with the additional bonus of hiding the impact that fees have on performances, especially on long horizons. We are not good at understanding the effect of compounding without a visual aid: now that we can invest in passive AND LOW-COST products, a benchmark can also be a good proxy for the performance drag of costs. If I show you the equity line of a fund that did +20% in 5 years (equivalent to a CAGR of c4%), you might think you have a reasonable investment at hand. It is not immediate to move from that picture to one where you see the difference between a CAGR of 4% and one of 5% (the difference representing the cost of the active mutual fund compared to a passive alternative) over 20 years.
The conceptual goal of a flexible fund is to offer comparable returns to a balanced fund (say 60/40) with less risk: the fund manager shifts allocation out of stocks to while (ideally before) they go down and gets back in while (before) they go up. Not only the fund should exhibit a higher Sharpe ratio, it should do so while cutting only downside volatility.
What gets measured get managed
While a retail investor has many free tools to compare and analyse ETFs, there are just a few that offer the same for mutual funds and even fewer that allow to compare ETFs with mutual funds. Good luck finding that Sharpe ratio for your mutual fund, fam.
And now let’s add 3 additional nice features:
- if I want to invest in a 60% S&P500 / 40% 10-year Treasuries ETF, I do not care if the fund started trading yesterday. I can always backtest that fund using its components back to 60 years ago. If I want to test a mutual fund, the only data that I have are related to the history of that fund. Even putting survivorship bias on the side, the issue with a limited backtest period is that stocks experience severe drawdowns, which I think investors care about, only every decade or so.
- the more a fund is “flexible”, the more its performance is driven by the person(s) in the driving seat. Are you sure the backtest you are looking at was generated by the same manager who’s in charge now? Which part of that performance is quantitative vs qualitative? If the fund employs a quantitative model, who is responsible for its updates?
- many mutual funds have variable costs: entry fees, exit fees, share class fees. Is the backtest you are looking at considering the fees YOU are going to pay (hint: no)?
The Funds
I found this ranking (mutual funds available for an Italian investor) with a simple Google search. I do not invest in these products so there might be something better out there but, by doing so I can effectively replicate the experience of your average retail investor.
This is the BEST fund, not the average, the best possible choice an Italian investor could have made 5 years ago:
The flexible fund lagged pretty badly the all-stock index.
“yes but the last 5 years were a pretty positive period for stocks, the comp is not fair”
I mean, we are covering the COVID crash and 2022 but fine, let’s consider a longer horizon:
Same story, innit? What is more relevant, is that the flexible fund does not seem to cut the drawdowns! Came for the sub-par performance, stayed for the high volatility.
Italian stocks are pretty lame anyway. Let’s have a look at the fund “global” cousin:
I do not want to compare an Italy-focused fund with a global benchmark but we have to look at the global benchmark because that’s what I consider the “standard alternative”, VWCE and chill baby.
The fund manager can go up to 100% stocks, so the comparison is not that unfair. Here is the fund against the Morningstar 80/20 (Agg) and 50/50 (Mod) comps:
Same results as an 80/20 allocation with more volatility?!?
What if we take the global fund from the second house in the ranking (Mediolanum)? Again, we like global investments here but to be fair the fund manager is the same as the Italian one (Mediolanum Flessibile Futuro Italia), so his market timing skills should translate just fine:
Maybe we will have better luck looking at Morningstar rankings:
The top-ranked fund has performed worse than a 80/20 but better than a 50/50; crucially, it has delivered on its mandate to lower volatility (at least in 2022):
But…there is a “trick” here, meaning this is the fund share class that has a normal fee level (73bps). This share class was introduced in 2017; the OG share class, started in the 90s with a 2.23% fee and STILL OUTSTANDING, meaning your financial advisor might advise you to invest in that one, did this:
This is a brief overview of the BEST the market has to offer and would be a useful proxy for investors’ expectations provided they can select the BEST-performing funds going forward, not looking backwards.
I am not excluding the possibility that there are flexible funds that are delivering (or will deliver) on their targets and, more crucially, provide a better risk-adjusted return than static allocations. I wanted to show, at least, how hard it is to find them.
Survival of the Fittest
ETFs have been attracting the majority of saving flows for decades now, it should not be a surprise that also flexible funds would join the party in this wrapper. If you can’t beat them, join them.
Some of the mutual fund tricks cannot be played here, fees have to be transparent and the comparison with other solutions is easier, but I understand it is worth a try.
Or maybe this is just a silly excuse to talk about an ETF that I know exists only because (a long but not so long time ago) I did some “cultural trips” to Amsterdam with the guy who launched it. Another lesson about the impact of luck in anyone’s life…I guess? Anyway, the fund is pretty young so there is not much to say:
It has been indeed less volatile than the Vanguard 60/40 with equal returns. Is the “unknown ingredient” worth the switch? At which level of past overperformance I would be comfortable in declaring “yes, that’s alpha”? Or is this an almost-at-the-money covered call on the fund manager skills, meaning if they have the skill they will jump to greener (better paid) pasture as soon as they can and investors are just enabling their dream without much of the upside?
What I am reading now:
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