An investment strategy designed to avoid unforced errors

An investment strategy designed to avoid unforced errors

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Article highlights

  • Not taking enough diversified risk – This leads to having too little growth assets when markets rally
  • Timing markets at an asset allocation or share level
  • Not taking enough diversified risk – This leads to having too little growth assets when markets rally

In the previous Insights article, we discussed the common unforced errors in investing and how investors can avoid them. In this article, to follow on, we will examine how the Nedgroup Investments Core Range of funds has been designed to help investors avoid these errors and at a lower cost.

Firstly, it’s important to remember that avoiding the common unforced errors in investing[1] requires two important components: A clear investment plan and an appropriate investments strategy. The investment plan, preferably written down[2], should include all your different saving goals, how you will achieve these goals and to whom you will give the responsibility for the different roles in this plan (financial advisor or coach, fund manager etc.). Then, the chosen investment strategy should be designed to fit within this investment plan and give you the best chance of achieving your goals.  

Designing low cost solutions which reduce the number of unforced errors

The funds in the Nedgroup Investments Core Range were designed to fit into a holistic financial planning model that focuses on matching clients’ future expected cash flow needs with portfolios that target specific real returns objectives. The financial planners who requested these “solution” funds also sought to avoid the investor behaviour penalty that is often associated with clients moving from underperforming funds into recent top performing funds, just at the wrong time.

Avoiding some of these “unforced errors” in portfolio management is the most effective way to achieve this two-part investment goal of consistently delivering the real return targets over minimum investment horizons while making sure that the investor stays the course.

In designing the Nedgroup Investments Core Range we tried to avoid the following unforced errors in investing:

  • Not taking enough diversified risk – This leads to having too little growth assets when markets rally.
  • Taking too much concentrated risk – This increases the risk of a single event having a big negative impact on a fund, e.g. Steinhoff.
  • Timing markets at an asset allocation or share level - This is notoriously difficult and introduces behavioural biases in the implementation of the fund, e.g. buying too early or selling too late.
  • Buying and selling too frequently and incurring unnecessary costs and taxes, e.g. brokerage and STT.
  • Underestimating the impact of costs and taxes on investment growth.

Let’s take a closer look at some of these unforced errors. How has the Core Range of funds benefited from avoiding them over the past decade?

1. Taking diversified risk while avoiding concentration risks

The long-term growth in a portfolio is determined by its allocation to equities and property and therefore the three risk-profiled Core funds have different strategic allocations to these asset class:

  • Nedgroup Investments Core Accelerated Fund – 90 % (75% Equity and 15% property)
  • Nedgroup Investments Core Diversified Fund – 75 % (67.5% Equity and 7.5% property)
  • Nedgroup Investments Core Guarded Fund – 42 % (35% Equity and 7% property)

These funds all follow long-term strategic asset allocations with around 10% tolerance bands. For example the Nedgroup Investments Core Diversified Fund has a 50% SA equity allocation which is allowed to drift by 5% up or down before being rebalanced. This means that the funds may hold slightly more equities and property over the long term than many of the peers as can be seen in the graph below.

Historical and combined allocation Q2 2019

Instead of relying on market timing to manage risk, the Core funds use diversification across and within asset classes. The funds are highly diversified and provide exposure to five domestic and five offshore asset classes (equity, property, bonds, inflation-linkers and cash). The strategic allocations to these asset classes are constructed to maximise the likelihood of meeting the portfolios’ objectives over their stated investment horizons.

The Core Range is also very well diversified within asset classes as each fund holds over 170 South African and nearly 3 000 international shares (equity and property combined). It also holds over 200 South African and nearly 8 000 international interest earning instruments, meaning that you don’t have all your eggs in one basket. In the event of any one company failing, the risk is mitigated by having only small amounts invested in any one instrument. The largest holding in any equity share is limited to 10% of the total equity allocation - for example, Naspers, which is capped at around 5% in the Nedgroup Investments Core Diversified Fund[3]. Similarly, the holding of property shares is limited to 20% of the total property allocation.

This strategy has worked well in mitigating drawdowns. This is shown in the graph below where we have compared the Nedgroup Investments Core Diversified Fund’s drawdowns against the large balanced funds.

Historical drawdown Q2 2019 Jannie

2. Focused on cost efficiency

The Total Investment Charges (TIC) of the Core Range are over 1% per annum less than the average charges in similar balanced funds. While this cost difference poses a significant performance hurdle to peers, it is not the only advantage of cost efficiency. In a study by Morningstar[4], it was found that costs had a negative impact on both fund and investor performances. In fact, they illustrated that the higher the fees charged by a fund, the greater the gap between the fund returns and the investor returns. The graph below shows the high correlation between costs, fund returns and investor returns.

Average 10 year returns Q2 2019 Jannie

We have performed a similar study on the ASISA SA Multi Asset High Equity category (SA balanced funds) over a nine-calendar-year period - from 2010 to 2018[5].

Q2 2019 Jannie 4

Q2 2019 Jannie 5
The two tables above show similar results for fund returns to the US study, provided fund size is also taken into consideration. It is interesting to note that South African investors have done marginally better on average than the returns their funds delivered. The return gap, however, varies between -1.1% and 1%, so there are funds where investors have done worse. The Nedgroup Investments Core Diversified Fund was the only rules-based balanced fund in this study and delivered higher investor and fund returns than the average of the largest 10 SA balanced funds.

We performed a similar analysis on the SA equity category and found the same trend that a combination of fund size and fees having an impact on fund performance. The return gap for SA equity funds varies between -1.9% and 1.6%, which is greater than the SA balanced category.

The Nedgroup Investments Core Range has delivered “what’s on the tin”

The Nedgroup Investments Core Range was designed to fit into an investment plan and to avoid common unforced errors in investing. Over the past nine years the funds in the Core Range have delivered superior risk adjusted returns at a fund and investor level compared to most peers. During recent market drawdowns the Core Range has also illustrated how broad diversification can assist in reducing drawdowns and volatility.

The relative outperformance can be attributed to the cost savings and the reduction of unforced errors; each contributing around 1% per annum versus the peer median in each funds category! Furthermore, the Core Range can be easily combined with traditionally managed active funds without necessarily sacrificing performance while bring down TICs.

[1] See “How to avoid unforced errors in investing”, Newsletter Q1 2019.  

[2] See “Why a written investment plan is a good idea”,Newsletter Q1 2018. If you have a financial advisor, most of this information should be included in your record of advice.

[3] See “How do you obtain sensible low-cost exposure to South African equities?”, Newsletter Q2 2018

[4] Morningstar, 2016 Global Asset Flows Report

[5] There were only 38 funds with track records and flows data which could be used to perform these calculations. This is a significantly smaller universe than the US study and so we would expect the results to be less smooth and correlated.