31 Oct 2018
Guaranteeing consistent inflation beating returns.
By: Philip Bradford, Head of Investments, Sasfin Wealth
The investment advice industry in South Africa, both institutional and retail, typically revolves around targeting some form of inflation + x% return. Unfortunately, over the last five years, very few high equity portfolios have achieved these return targets. This has been caused by risky assets such as equities not providing the same generous returns they have in the past. The question most advisors are asking is: “Will they be able to achieve these CPI+ targets in the future?”
History has shown us that the most important decision for investors to make is to select the correct asset allocation. A number of research studies over time suggest that the asset allocation decision will explain over 90% of the variation in returns. However, that doesn’t help us much, because well implemented asset allocation is a dynamic process that is part art, part science. In other words, you can’t just buy good asset allocation off the shelf.
In a world where the current fashion is to ridicule active equity managers, the same critics are very quiet when it comes to passive asset allocation. This is because no one has come up with a “good” benchmark for passive asset allocation. Most passive asset allocation funds simply track some arbitrary benchmark set by regulators (e.g. Regulation 28), or some equally dubious fund categorisation. Are we really going to rely on our regulators to make the most important investment decision for us?
There are a couple of assumptions made when constructing an asset allocation:
- Risky assets will outperform less risky assets in the long run (i.e. equities will outperform bonds).
- A combination of investing higher and lower risk assets will produce a better risk-adjusted result than only investing in risky assets.
But what if lower risk assets are offering similar returns to high risk assets? How do we decide whether it is worth taking the risk? This is not an easy question. In fact, Sharpe, Miller and Markowitz received Nobel prizes for their efforts to address these questions. To help answer this, we can learn from gambling.
Backing the horse or the jockey
In horse racing, the bookies conveniently give us the odds of a horse winning. The favourite may be given odds like 1:2 while an outsider may be given odds of 10:1. This means that if the favourite wins you would make a 50% return and if the outsider wins you would make a gain of 1,000%. In both cases your downside is 100% i.e. both are very risky bets, one just much more than the other.
In order to “hedge” themselves, the bookies offer a range of bets that diversifies their exposure. Over time they make money, not by betting against their punters, but by skewing the odds marginally in their favour. But what if the bookie gets his calculations wrong and you work out that in fact the outsider is the favourite? Well, then you can make a lower risk bet that gives you the same odds as a high risk bet.
Now the process of asset allocation is quite similar. As a Fund Manager, I am constantly weighing up low risk “bets” (like cash and bonds) against high risk “bets” (like equities, commodities and foreign currencies). My job is to effectively diversify (or “hedge”) across a number of investments, and then try to identify situations where lower risk investments are offering higher returns than normal, and higher risk investments that aren’t offering “good enough odds” for their risk.
“Buy when there is blood on the streets” – Baron Rothchild
Usually when these opportunities present themselves, it is because some investments have gone up a lot and are typically very popular (and usually expensive), and others have fallen or are very unpopular (and cheap). The challenge is that by investing in unpopular investments you may receive an excellent return, but some investors may perceive you to be foolish or taking too much risk.
A good example at the moment are certain long-dated, AAA rated, SA government guaranteed bonds that are offering very attractive returns of around 11%. In this example, this means that if you are prepared to lock your money away for 20 years, you will receive 11%, guaranteed. The problem is that many investors are fearful of government, and fail to realise that one of the lowest risk investments is currently offering, is a higher return above inflation than equities have on average for the last 120 years.
The diversified bond portfolio we hold in our Sasfin BCI Flexible Income Fund is currently yielding around 10.5% (after fees and VAT). In other words, the low risk favourite is offering similar odds to the high-risk outsider.
I know where I’m putting my money.