Edition: April / June 2016
Editorials

INVESTMENT STRATEGY

In times of extreme volatility . . .

Some of the larger asset consultants share their advice to pension funds.
Don’t write off SA!



Lester ... more favourable SA outcomes

Ant Lester of Willis Towers Watson: Investment markets are always challenging because the future is unknown. So it is better for clients to build robust portfolios rather than naively believe that it is possible consistently to forecast the future and accordingly construct a portfolio that will only perform well if the forecast is realised.

A robust portfolio is one that, with the benefit of hindsight, delivers a particularly good outcome because it captures a wide range of market outcomes but it is not the best (or worst) strategy.

To construct a robust portfolio the pension fund’s board (or its investment committee) needs to have well-developed investment beliefs that are framed over the long term. A common belief for many of our clients it that, over the long term, investors are rewarded for allocating significant amounts of capital to the equity asset class.

Indeed, the history of global financial markets suggests that investors are well compensated for investing in the economy via the equity market. But there are three conditions precedent: the capitalist system must remain in place with strong property rights; the country must not lose a major war as it represents a waste of human and capital resources, and the initial price paid for the equites should not be outrageously expensive.

Within this framework, a key challenge now facing boards is to consider – given the significant political risk associated with SA – whether one can be sure that a strong form of the capitalist system with good shareholder rights will remain in place for the long term. Our view is that there is a real danger of investors being too negative on SA.

A useful tool for risk management is scenario analysis. It forces one to think about alternative outcomes and to assign a probability to each outcome. Whilst the highest probability event may be assessed as less secure for shareholder rights going forward, there is in our opinion still a reasonable chance of better outcomes. Robust portfolio construction would lead one to have some exposure to more favourable outcomes in SA.

The second issue for boards to consider is whether the pricing of the main asset classes is fair. Our assessment is that most of the main asset classes are on the expensive side (but not outrageously expensive) with a few asset classes being close to fair value.

Under these circumstances we would advise our clients with a long-term investment horizon to look for opportunities to diversify risk and also to adopt a slightly more conservative approach. The one asset class that we consider to be very cheap is the rand. It may be appropriate for clients to consider what hedges they have in place against the rand appreciating significantly.

Almost all the ideas we generate for our clients have a long-term focus. We believe that markets are far too complex to get short-term decisions right consistently. Within this long-term framework we consider that an opportunity that has presented itself over the last few months is to be more positive on SA.

Some may consider this to be a contrarian view. We would not be advising our clients to move a significant amount of assets to capture this possibility as it remains the less likely outcome. However, consistent with the robust approach to portfolio construction, clients should evaluate whether their portfolios have some exposure to better-than-expected SA outcomes.

Prasheen Singh of Riscura:



Singh ... full offshore exposure

By now SA pension funds’ portfolios really should be at their full offshore exposures as allowed by Reg 28. We believe that most of them already are.

Unfortunately, this is yesterday’s story. At some stage, if the rand weakens too much, trustees will possibly want to go the other way. When the currency is particularly weak, there is a strong possibility that it recovers (for such reasons as being oversold and people becoming more positive on emerging markets). In this case, full utilisation of the offshore allowance could have some negative consequences if the currency bounces back.

That said, we would always argue for the full offshore allocation allowed by Reg 28. Given that 65% of SA equity is foreign-based, and concentrated in a handful of shares, one should rather utilise the full allowance abroad. This is where the same foreign exposure can be gained, but with access to over 20 000 counters.

The question then becomes how to structure the local portfolio. Unlike SA equity (again, which is mostly foreign-priced), the performance of local SA cash and bonds is driven by local conditions. Due to large volatility in the local market, it’s important to respond quickly to changing market conditions by reallocating between locally-available assets when opportunities present themselves.

Retirement funds with assets held in bonds would have been down in December, recovering in January, but probably still net down as a result of interest-rate movements. Inflation-linked bonds (ILBs), however, have more or less recovered. What would be interesting to see is the liabilities of funds which are valued in reference to ILBs. The bottom line, though, is that holding bonds would have cost funds over this short period.

On the flip side, foreign assets did well given the rand weakness in December. This weakness turned to strength in the middle of February and then weakness again. This weakness is positive in general for local equities and foreign portfolios.

However, trustees cannot be complacent. If the rand recovers, offshore assets will show losses. So while members of defined-contribution funds might have banked the currency-related returns in their minds, currency strength at some stage may cause portfolio losses.

Incidentally, JSE-listed property has been the hardest-hit asset class. It has not recovered quite like bonds, although it may have already have been overpriced.

Jonathan Selby of Ginsburg Asset Consultants:

Despite the rand’s sell-off and apparent undervaluation, a suitable exposure to domestic-listed rand-hedge equity instruments should form a core part of the equity portion of the portfolio. Ensuring exposure to companies with an offshore earnings base will enhance the portfolio’s return profile in the event of further rand weakness. The use of a commodities ETF (exchange-traded fund) can also form part of a strategy to provide diversification and rand-hedge exposure.



Selby ... domestic rand hedges

If feasible, utilising the Africa-ex SA 5% allowance (dependant on valuations) should be considered. Rand weakness is generally a primary driver of inflationary pressures. So ensuring the portfolio has some exposure to asset classes or instruments that are negatively correlated with the exchange rate remains an appropriate strategy.

The starting point for prudent portfolio construction is always valuations. At present we see demanding valuations across rand-hedge industrial and consumer shares. The lack of breadth in the rand-hedge industrial and consumer shares is another risk factor that needs to be considered, with Naspers, SABMiller and BAT having dominated index returns.

There is still a high concentration in rand-hedge shares across asset managers as a result of the defensive properties of these businesses, notwithstanding the price premium. We have recently seen managers starting to increase exposure to the resource sector due to the favourable long-term valuations. This has played out positively for those managers who avoided the significant derating in 2014-15 and increased exposure in early 2016.

Looking forward, the construction of local-only portfolios will be challenging given the uncertainty in world markets . It will have inevitable spillover effects for SA, together with increasing domestic economic headwinds.

The main avenues to access rand hedges are through equity and commodity ETF exposure. A client’s risk profile largely determines the portfolio’s overall exposure to these asset classes. Consequently, the quantum of rand-hedge exposure will be determined by the client’s risk profile and valuations prevailing at a given time.

Presently, industrial rand hedge assets are trading on demanding valuations. For this reason, exposure to these instruments would currently be lower than under “normal” circumstances. However, exposure to commodity-based rand hedges is offering a higher level of potential return, albeit with a higher level of risk.

The starting point for prudent portfolio construction is always valuations. Investing in quality companies at reasonable valuations must form the core of any portfolio. The exact percentage exposure would be the end result, not the starting point, of a detailed investment process.

An opaque global economic and financial market environment requires an investment strategy that ensures the investor is not excessively exposed to any one particular outcome. The implications for a prudent and suitable investment strategy mean ensuring an appropriate allocation of the portfolio’s risk budget. This can be achieved through diversification across managers and styles.

Investors do not buy and sell economic growth. Rather, asset-class instruments are traded. It is within this opportunity set that valuations are the most important ingredient for asset managers. Distortions created by central banks’ interest rate and currency policies, amongst other macro factors, should not change tried-and-tested investment strategies.

Buying when investor sentiment is unduly bearish has historically proven to be rewarding. Emerging markets, including SA, experienced a profoundly weak 2015. Measured in US dollars, equity and bond indices have plummeted. Lower asset-class pricing has generally led to improved valuations.

Whilst in some instances higher risk premia are justified, the likelihood is that markets have moved way too far. The compensation for risk in owning emerging-market assets, including SA, has improved.

Andrew Davison of Old Mutual Corporate:

Focus on risks that really matter. The real risk of volatility is in volatile responses.

We are in a period of heightened uncertainty. Many commentators also expect lower returns in the near future (five years or possibly longer), especially in relation to inflation. This is partly because we have enjoyed above-average long-term returns for the past decade or more, despite the global financial crisis, but also because global growth is expected to be lower and SA is facing economic headwinds of its own making.



Davison ... smoothing effects

In such an environment we can either accept lower returns for the same level of risk or take more risk in an attempt to achieve a higher return. The latter is not a guaranteed strategy e.g. if a fund previously had a 50% exposure to equities to target a real return of 4% annually after fees, the fund might now need 60% to target the same return.

Do keep calm. A way to avoid panicking is not to look at your statements or values too frequently. Be mindful of smoothing effects.

Do diversify. There are always asset classes that beat inflation.

Don’t keep quiet and hope it all goes away.

Don’t make changes to your long-term strategy. Beware of market timing in an attempt to avoid volatility.

Because we all save a monthly amount towards retirement, we benefit from rand-cost averaging. The assets we have accumulated at a certain point might be exposed to any market correction but the contributions we are still going to make, both now and in future, will be buying into the market at the lower prices after the correction. Any rebound will be beneficial.

We have always advocated diversification so we have always advised against a purely domestic strategy. Our current advice is to be fully invested offshore to the extent allowed by Reg 28.

Right now we are also advising clients to favour offshore equities relative to offshore bonds and cash, and also to favour offshore equities relative to SA equities.

THANKS, RHONDA

Rhonda Stewart of Stratford Consulting kindly conducted this set of interviews.
It will be followed in our next edition by a look at the asset-consulting industry, to include her views on the 10 characteristics of a good asset consultant.