Investing in a diversified fund-of-funds portfolio amid volatility

IN our Market Outlook in January, we had projected that 2016 would be a volatile year for markets, and we have already witnessed a dramatic start to the year so far.

Due to Chinese policy uncertainty, the collapse of oil prices and weakening economic activity, we continue to believe that markets will continue to remain volatile going forward.

Against this backdrop, diversification across regions and sectors is key to managing volatility and it is imperative that investors have this mindset when establishing their core portfolios. Investors typically have a momentum-based trading approach where they tend to buy near market peaks and sell near troughs. The challenge for advisers is to convince investors to outsource part of their core holdings to a professional team who will provide a more-disciplined, structured and less-emotional approach to building their portfolios.

Having a core-satellite approach to portfolio construction guides investors to remain focused on long-term goals while allowing flexibility for short-term opportunities. One solution for investors in current volatile markets is to invest in a broadly diversified fund-of-funds portfolio, which include carefully selected institutional share classes of actively-managed funds, liquid alternatives and exchange-traded funds (ETFs). Asset allocation decisions are generated from a structured top-down investment process by the bank's investment committee and are monitored actively against changing market conditions. Managed professionally, the portfolio managers will adopt a disciplined approach when navigating changing conditions.

Access to institutional share classes of actively-managed funds, otherwise only available to institutional investors at higher minimum amounts, will allow investors to access the lowest fee share class, which translates to higher returns. Since the portfolio managers invest across all their clients' accounts, they are able to qualify for institutional share classes.

Allocating to hedge funds within the diversified fund-of-funds portfolio can enhance a portfolio's risk-return profile and should be included as part of strategic asset allocation. Accessing hedge fund strategies via liquid alternatives have the benefits of superior liquidity, diversification and transparency compared to traditional hedge funds. Larger clients with a longer-term horizon, on the other hand, may prefer to access traditional hedge funds as they tend to deliver more attractive absolute and risk-adjusted returns compared to their liquid alternative counterparts, albeit with higher minimum amounts and lower liquidity.

The exposure to ETFs will provide access to targeted investment opportunities in sectors, styles and themes which complement actively managed mutual funds with potential to outperform markets. For instance, it may be more cost-efficient to gain exposure to highly-liquid developed markets like US equities through ETFs, where it is empirically difficult for actively-managed funds to outperform passive strategies.

Smart beta ETFs, in particular, seek to improve risk-adjusted returns through exposure to systematic investment factors, including value, quality, momentum and size.

In sum, the key advantages of investing in a diversified portfolio of fund-of-funds include:

Current market corrections present attractive opportunities for investors to enter and generate above-average returns when the market rebounds. We recommend that investors look through the current volatility in the markets and regularly invest in their core holdings using the cost-averaging approach. Investors who remain invested tend to benefit from a long-term upward market trend. Having a long-term, unemotional approach to investment has proven to be a successful strategy compared to market timing, particularly over periods of increased market volatility.