Issue: June/August 2008

Market volatility is always an issue of concern, especially for trustees of defined contribution funds. Guest columnist Scott Harvey, head of STANLIB’s Institutional Service Department*, considers some challenges and quirks in our current situation . . .

Harvey... prudential protection

Pension fund members can be forgiven for some confusion as investment volatility mounts. It suggests that trustees may have to field an increasing number of questions about investment performance from members worried about recent returns.

This is understandable as most members obtain their information from the mass media and stock markets only make the front pages or the seven o’clock news bulletins when records are broken or equities slide dramatically.

Some members may be aware the JSE hit a record 31 728 points in October last year, only to tumble in November and December, compounded by further falls in January to around 25 000 points – a decline of 24%.By mid-April, they would have been reassured by headlines proclaiming a new JSE record above 32 000 points.

They would conclude that equities surged in the third quarter of 2007 and then retreated, but that all the lost ground has been recovered and equity investments are once again doing just fine – which should mean another strong showing by fund investments.

Members might then be perplexed by news that even some top-quartile investment managers were reporting lower returns – often negative for March, for the first quarter of 2008 and for the year to date.

There appears to be a mismatch between some current perceptions and current reality. What’s going on?

At least two issues have to be communicated:

  • The special nature of our equity market;
  • The mix of assets found within the balanced funds into which much of the retirement-industry wealth is channelled.

Boards of trustees that explain these factors as part of their ongoing communication effort have a considerable advantage over boards that only provide an explanation when volatility sets in and questions are raised.

The good news is that technical terminology is unnecessary. It is quite simple to point out that the JSE is unique among stock exchanges in relatively diversified markets for its high concentration of resource counters.

Resource companies account for about half of JSE capitalisation. Yet the retail and service sector accounts for 70% of the South African economy.

Resource stocks have had an extremely good run on the back of continued high demand for commodities. Last year, the sector was up 31.43%. Other sectors did not fare nearly so well. Financials, for one, were down 16.28% for the year.

Resource and mining companies operate in a notoriously volatile environment. When things are going well, gains are impressive. When the sector turns or there are safety and operational issues, significant losses can be made.

When deciding asset allocations, it is highly unlikely that any prudent fund manager would commit half of any portfolio to resources. Volatility is just too great. Yet a 50% weighting would be in line with the JSE All Share Index ‘norm’.

Prudent domestic equity allocations would include a more representative spread across other sectors of the economy.

This brings us to questions of ‘balance’ and ‘prudence’ (specifically, the application of prudential investment guidelines as set out in Regulation 28 of the Pension Funds Act) and the creation of balanced funds.

Regulation 28 guides investment managers who run segregated multi-asset portfolios of pension fund moneys, or who operate unit trust funds that mimic the prudential characteristics of pension fund investments.

The STANLIB Stability Fund is a good example of this type of product. In 2007 it showed a one-year return of 28.21%, placing it first in the Alexander Forbes Global Best Investment View survey.

These asset-allocation funds are designed to achieve a balanced mix of security, regular returns and long-term capital growth.

They diversify their holdings across various asset classes. For example, the STANLIB Stability Fund has exposure to seven different asset classes (domestic equities, bonds, listed property and cash, as well as foreign equities, bonds and cash).

The Fund is characterised as a medium-equity product. Therefore the overall equity commitment will be limited, while within the equity category a judicious spread of counters will be evident rather than one massive ‘bet’ on highly volatile resource counters.

Factors such as these indicate that no prudent pension fund portfolio can possibly secure full exposure to the JSE’s biggest current winner, namely resources.

Investment performance therefore will be at somewhat lower levels.

Does this mean that balanced portfolios are doomed to sub-optimal returns for the sake of security? Not if a long view is taken.

Analysts track the relative performance of global balanced funds representing the best investment view in their category. Their returns are compared with the major indices.

As one would expect of balanced mandates, they are never top, but neither are they at the bottom. On the whole, pension fund members can expect a creditable showing.

In 2003, balanced funds were third from eight indices. In 2004, were up to second. In 2005, 2006 and 2007 they were once again third in the standings.

In summary, prudential multi-asset portfolios admittedly fail to reflect all the stellar gains recently made in the volatile resource category, and some short-term negative results have been witnessed. But prudential funds continue to do well over the longer term while cushioning much of the volatility. On balance, that’s a significant plus.

* Institutional Service is a division of STANLIB, a leading institutional asset manager and domestic unit trust company of the year for 2007.