By Francis Marais, 11 March 2016
This has led to a proliferation in the amount of data available, leading to new professions such as data science in order to interpret this massive amount of data. The speed with which new data gets disseminated or acted upon has also increased dramatically. Add to this, trading bots or “high frequency trading” and the financial markets are increasingly becoming a very dangerous playing field for those without a set plan, those that are not adequately diversified or those behind the information curve and not able to interpret massive amounts of data diligently enough.
Professionals should rather be doing this, and the less constrained they are the better. Portfolio managers with a well-proven track record, a strong investment philosophy and a robust investment process are indeed more capable of dealing with the modern challenges of portfolio management than the average man on the street and flexible funds provide an additional edge.
Why do we say this? Let’s compare some of the best performing equity funds with their peers in the SA Multi-Asset Flexible Category. The figures below are rolling five-year performance figures with monthly shifts over a 10-year period.
The dashed lines represent the flexible funds. It is clear to see they are consistently concentrated at the top, and therefore outperformed their general equity peers. Flexible funds will on average be less exposed to risky assets over time than equity funds and more exposed to less riskier assets such as cash and bonds. So where does the outperformance come from? It all has to do with the fact that flexible funds are less constrained than equity funds, as equity funds have to have a minimum investment of 80% in equities. Flexible funds, however, can revert to cash or any other asset class if the managers feel that equities provide little value or if the risk of investing in equities is too high. Secondly because flexible funds can add more cash or bonds to their portfolio and reduce the overall risk, they are able to take higher conviction positions in those equities they do feel offer value. Flexible funds can better manage risk and its opportunities, which leads to better asymmetrical return profiles.
This asymmetrical return profile is clear (particularly with regards to PSG, Truffle and Bateleur) from the chart above, which plots the funds’ up capture ratios and down capture ratios against each other. Once again we have used five-year rolling returns, with monthly shifts which represent how much of the JSE/Alsi (J203) up and down movements are captured by these funds.
One might be tempted to dismiss this and advance the argument that equity funds should not concern themselves with trying to avoid the down-movements of the market and rather go all out and try and outperform the JSE during bull-markets, but closer inspection of equity fund’s returns reveals that their performances are in fact also due to sharing less in losses (when markets go down). They tend to underperform the JSE when it is advancing, but outperform when it is falling.
In the graph above, the grey bars represent the funds’ outperformances of the J203, with the coloured bars breaking the outperformance down. Here it is once again clear that when the JSE was up, these funds underperformed, so all their outperformances come from the fact that when the JSE was down they started to outperform. They are in fact very good risk managers. Cash and reverting to less risky assets at the right time could amplify this effect.
It is never a good idea to look at returns in isolation and therefore we should be cognisant of the risk. We have already established that in most instances the funds protect capital well in terms of market drawdowns, especially so with flexible funds, but what does the volatility profile look like?
Once again it is clear to see that the flexible funds have delivered superior returns at lower levels of risk. Consequently they have superior risk adjusted returns, when measured by such measures as Sharpe ratios, Sortino ratios and also Calmar ratios.
Deep-value managers should also consider using flexible fund strategies more. It is a high conviction strategy and would go a long way in helping deep-value managers avoid those “value traps”. They could revert to cash should the quality of a value opportunity be doubtful.
A key differentiator of flexible fund managers is their asset allocation capabilities. When evaluating these managers it is critical to understand their asset allocation process. Asset allocation is either a function of their bottom-up valuation process, i.e. not finding enough opportunities with an expected return of CPI + 4%-6% and then reverting to cash, or it is a function of their top-down macro process. Either way, it is key to understand how they interpret information, or the valuation assumptions they make when conducting fundamental analysis, but also how they make sense of an increasingly complex world with different themes playing out.
In summary, in a highly complex world, where volatility is bound to make certain investors anxious, it is best to leave investment decisions to those who are the most capable of acting on information and interpreting this information. Additionally, the more choice these managers have at their disposal and the less constrained they are, the better their chances of generating superior investment returns.
As always, before choosing a fund to invest in, it is key to work with your financial adviser to develop an investment plan, where your risk profile will be determined and to ensure that the fund forms part of a well-diversified investment portfolio.