Issue: March/May 09

In this challenging investment climate


How should a retirement fund respond to market weakness, volatility and growing nervousness among members? The question gathers urgency with every passing week as the challenges facing business and the investment industry multiply and the future seems ever more uncertain for the average fund member.

Though some market values may retreat, other values remain firmly in place, including the value added by professional expertise in a specialist area such as the management of market risk and the maximization of investment performance.

Before looking at an appropriate professional response in the current climate, we should acknowledge the extent of the current challenge and highlight the need for close monitoring of macro-factors that may have material effects on fund performance.

Recent global and domestic economic indicators continue to point towards slowing activity, although governments and central banks around the world are making every effort to stem the decline.

In SA, the Finance Minister announced during his Budget speech that government’s gdp growth estimates have been cut to only 1,2% for 2009. He also announced that government’s efforts to limit the slowdown would include a cut in personal taxes and an increase in government expenditure.

Most of the stimulation focuses on economic services and social spending, though infrastructural spending will continue to increase.

The SA Reserve Bank also came to the party with a 1% cut in interest rates at the beginning of February. This extends the current downward cycle to 150 basis points with further cuts expected. When announcing the February cut, the Reserve Bank noted:

  • The outlook for the world economy has deteriorated further as a result of the global financial system’s continued difficulties;
  • Domestic inflation has continued its downward trend;
  • A further decline in inflation is expected when the re-weighting and rebasing of the cpi index implemented by Statistics SA comes into effect;
  • The domestic economy is being adversely affected by continuing turbulence in the global economy. The widening domestic output gap and declining international commodity prices are expected to exert further downward pressure on inflation;
  • Stricter credit criteria applied by banks to both households and corporates have been reflected in a further moderation in the growth of credit extension to the private sector;
  • Cpi inflation is expected to decline further and average 7,5% in the first quarter of 2009, and to decline to below the upper end of the inflation target range during the third quarter of the year when it is expected to average 5,2%;
  • The risks to the inflation outlook posed by oil and food prices appear to have eased; and
  • Exports are expected to remain under pressure, given adverse global conditions.

Clearly, global economic pressures will not leave SA untouched. Fortunately, our Reserve Bank has only recently started cutting interest rates and has significant scope to ease monetary policy further in order to stimulate the economy.

The global situation is more dire. The Bank of England recently cut its rate by 50 basis points to 1%, the lowest since the Bank was founded in 1694. The European Central Bank kept its rate steady at 2% even though the Eurozone is suffering the worst recession since World War Two. It is expected that the ECB will be forced to ease rates further in light of the current environment.

The European Monetary Union posted fourth quarter growth of -1.5% (negative), while US gdp declined by a substantial 3,8% quarter-on-quarter in the same period. It’s the worst US economic performance in 25 years.

The US economy relies on consumer spending (65% of growth) and took another knock when employment fell by a further 598 000 jobs in January. In the five months to January, 2,84m US jobs have been lost. The level of unemployment obviously impacts consumer spending (down 3,5% q/q in Q4) and the housing market. We have seen a huge slowdown in housing starts and a decline in house prices year-on-year for 23 consecutive months.

China, too, has felt the impact of weak US demand. Its exports have fallen dramatically.

Should this economic environment have an impact on the long-term investment strategy of pension funds?

In managing money on behalf of pension funds, it is vital to understand the return requirements and the level of risk that each fund is prepared to accept. This understanding determines an appropriate asset allocation for each fund.

A scientific method of establishing the ideal combination of assets to produce the most efficient risk-return characteristics is defined by Markowitz’s Mean Variance Optimization Model, also commonly known as Modern Portfolio Theory. In the accompanying chart we give an example of how the model works.

By plotting the combination of various asset-class blends in a risk-return framework, the line produced along the upper edge of the plotted results is known as the efficient frontier or ‘the Markowitz frontier’. This frontier indicates the blend of assets that, using historic returns, would have generated the highest portfolio return for a given level of risk.

Using this approach, the portfolio would take on increased risk only if it were compensated by higher expected returns. The model assumes that investors are risk-averse; meaning that given two assets with the same expected return, investors will prefer the less risky one.

The Efficient Frontier model works well in selecting the optimal blend of asset classes in a portfolio if one accepts that historic risk-return relationships are a good indicator of future relationships. However, the past 12 months have shown that these relationships can break down. Therefore any passive asset allocation, based on the historic optimal blend, which makes the portfolio a forced holder of an under-performing asset class, would produce an undesirable result.

Equities remain the best performing asset class over any extended period and therefore normally comprise the bulk of any portfolio that attempts to produce significant real returns. However, 2008 was a year in which to lighten the exposure to this asset class in favour of better-performing fixed-interest markets.

Looking ahead, the combination of further rate cuts and increased fiscal stimulus in South Africa should provide the basis for a solid economic recovery into 2010. Consequently, while STANLIB remains cautious on the outlook for most asset classes in the short-term (six months), there is good reason to look to increase exposure to more risky assets, including the equity market, as the year progresses and as it becomes clearer that a global economy recovery is taking hold.

Article sourced from STANLIB, South Africa’s largest unit trust company and the professional partner of numerous retirement funds.