Creating Multi-Asset Exposure

Patrick Armstrong is CIO of Armstrong Investment Managers, a boutique fund management firm focused on multi-asset investing. Paul Amery, editor of, asked him about his firm’s use of index-based investment strategies and his current market views. Patrick, your firm offers clients a choice of two portfolios, both with benchmarks based on inflation indices (UK retail price index plus 4% per annum over a market cycle, and UK RPI plus 7%). Why have you chosen these benchmarks rather than aiming simply to produce positive absolute returns?

Armstrong: We chose these targets after feedback from clients, both institutional and retail, who said they have two main objectives: first, to protect capital and, second, to achieve returns above inflation, which should result in long-term portfolio growth at a rate above the growth of liabilities. On your firm’s website you distinguish between efficient markets, where you say it makes sense to use passive, indexed investments, and inefficient ones, where it doesn’t. Where’s the dividing line?

Armstrong: As an example of an inefficient area of the market I’d take commodities. There, most indices are based on commodity futures and, specifically, on front-month contracts. This implies large transaction costs and, worse, the whole world knows how and where US$150 billion of assets are going to be rolled each month. In fact, we’ve taken the opposite position to a lot of these trackers, regardless of our view on commodity prices, by going short the GSCI index and going long the underlying 24 commodities by means of a more efficient roll schedule, typically the second month of every contract. So, in your view, investors should not be buying commodity trackers based on front-month contracts?

Armstrong: No, definitely not. Although you’re starting to see the launch of commodity ETFs with more efficient roll schedules – db x-trackers has had one such fund for a while, UBS has recently launched constant maturity ETCs (as reported on here), for example – most commodity indexed investing is still based on the traditional roll method, which we think doesn’t make sense. And which markets are efficient enough to be used for passive products?

Armstrong: Government bonds, for example, where there’s really no way you can beat the market, and where you can buy the markets and choose the duration exposure you want very easily. Large-cap equities are another efficient area of the market, if not completely so. Most of the time when we want exposure to a developed equity market it will be through a passive vehicle, quite often via an ETF. And if you’ve decided to invest via a tracker of some type, when is it via an ETF and when not?

Armstrong: Currencies are an example of an area of the market where we wouldn’t use an ETF. Trading costs in currencies are minimal so it’s better to invest directly.

However, ETFs are an efficient way to gain exposure to some thematic areas of the equity market where swaps are not widely quoted. For example, we use an ETF to track stocks involved in the water industry.

For broader indices, such as the S&P 500, it may make more sense to use futures or swaps than an ETF to gain index exposure. How do you execute ETF trades – at the market price, using NAV trades, closing auctions?

Armstrong: Generally at the market (risk) price. Once we get larger as a firm we expect to do more NAV trades. For short/inverse market exposure do you use inverse ETFs?

Armstrong: Yes, though typically only for short periods (say a few days or a week), since after that performance can start to diverge from a true short position. We held an inverse ETF on European industrial stocks in January, for example. If we want to be short for a longer period we’d rarely use an ETF. You’ve been active in the dividend swap market – can you elaborate?

Armstrong: Yes, last year we noticed that it was possible to sell the 2010 swap on the DJ Euro Stoxx 50 dividends and buy the 2015 swap for the same price – the market was pricing in no expectations of dividend increases from European large cap stocks. Now things have shifted a bit and dividend swaps or futures are discounting around a 1-1.5% per annum growth rate over the next 10 years, but we still think it’s a good trade to buy the longer-dated contracts as we think dividends could grow by 6% or so per annum over that period.

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