When the facts change, change your mindset
The world we live in today is changing at a sometimes dizzying pace and often forces us in completely unexpected directions. In the last year alone, we have witnessed the UK vote in support of Brexit, Donald Trump tweeting himself into the US presidential seat, and Marine Le Pen gaining largely unanticipated support in the French election polls. Locally, we have seen the continued domino effects of President Zuma’s cabinet reshuffle in March.
However, we also know that in the face of such uncertainty lies opportunity. Although we are still facing more uncertainties, such as the various upcoming European elections, we are also starting to see some economic green shoots. This is especially true in the US, with growth and inflation picking up.
This contest between elevated risk levels and a better return environment certainly makes achieving our goal of providing clients with great long-term performance more challenging. However, we believe that it is through times like these that our partnerships with outstanding fund managers can deliver real long-term value for our investors.
We asked Portfolio Managers Omri Thomas from Abax Investments and Iain Power from Truffle Asset Management to explain how they manage the risks of today’s evolving world to protect and grow investors’ money.
Nedgroup Investments Opportunity Fund – Omri Thomas, Abax Investments
Prepare for all outcomes
We are constructing an all-weather portfolio and specifically look for assets with asymmetric return profiles, i.e. assets with a payoff profile skewed to the upside. How do we do this?
- We make full use of our extensive toolkit
We have the ability to look beyond the traditional asset classes (equity, bonds, cash), and value a much broader range of assets and strategies to generate growth for our clients. Our equity allocation currently includes both domestic and global exposure, commodities, and structured notes. Our fixed income allocation includes floating and fixed rate bonds, domestic and global exposure, as well as convertible bonds and preference shares.
- We are active asset allocators
The Fund’s asset allocation has varied widely over time, depending on where we find opportunities. Since the inception of the Fund more than five years ago, our net effective equity allocation, for example, has ranged between 28% and 60%.
- We are skilled stock selectors
The Fund’s equity allocation is currently 55%, which is close to the maximum allowable exposure of 60%, despite equity markets in general being fully valued. This (some might say unexpectedly) high equity weight is explained by the current rolling 12-month cross-sectional volatility (CSV) of the FTSE/JSE All Share Index.
CSV measures the extent to which the performance of the underlying stocks of the index varies. A low CSV indicates that most companies are heading in the same direction and a high CSV means that most stock prices are heading in different directions at various speeds. In this environment, there are a lot of opportunities for active managers to add alpha through their skill of selecting stocks that are expected to outperform the market.
- Diversification is key
In our portfolio construction process, we look for stocks with return profiles that are not dependent on or exposed to the same factors. We do this to reduce concentrated exposure to any single risk event. Currently, our six largest holdings (almost 20% of the Fund) have a low to negative correlation to each other, indicating that there is not a strong relationship between the share price movements of these companies. If anything, they tend to move in opposite directions.
- We take out insurance policies
If a stock offers significant upside, but we aren’t comfortable with the level of downside, we use derivatives to put protection in place. Currently just over 20% of the domestic equity exposure of the Fund is protected against some downside. An example is Naspers. At the beginning of this year when the stock was trading at R2 150, we put a 3-month structure in place to protect us against the share price falling to R1 995 over this time period, at the cost of limiting our upside to R2 500. In other words, we do not share in the first 7% of downside should the share price fall, but will still partake in 16% share price growth over the 3-month period, as shown in the graph below.
- We manage currency exposure carefully
We use currency futures in a similar fashion, by hedging some of our offshore currency exposure back to local currency after a period of rand weakness. This allows us to retain the attractive international asset without exposing ourselves to a potential currency reversal.
After ‘Nenegate’ in December 2015, when the rand traded at R16.50 against the US dollar, we put structures in place to hedge 10% of the Fund held in US dollars at the time. These structures protected us against rand strength beyond the R15.80 level, while we maintained the upside of further rand weakness all the way to R20.50. Put differently, our downside was limited to less than 5% while we kept our upside potential at 25%. As the rand strengthened towards the R12.50 levels earlier this year, we unwound these positions and currently do not have any of our offshore currency exposure hedged. Given the fundamentals of South Africa and its political instability, we feel the risk of currency weakness exceeds that of further strength.
- We invest in structured notes
We are very excited about the opportunity offered by the current levels of the EURO STOXX 50 Index. The Index has underperformed the S&P 500 by approximately 40% over the last five years and is trading at a discount of approximately 30% to its own all-time high. Many EURO STOXX companies earn their revenue in US dollars, but pay costs in euros, which is very beneficial to European margins at the current weak exchange rate. As a result, we believe the EURO STOXX Index offers great upside, although we are concerned about equity market levels. By investing in EURO STOXX notes we get some capital protection, while participating in geared upside exposure. We currently hold six different EURO STOXX structures constructed with four different banks, with a total weight of 9% of the Fund.
- We invest in hybrid securities
The Royal Bafokeng Platinum convertible bond (3% position) is another recent addition to the Fund. It is a 5-year instrument with an asymmetric return profile and an annual coupon rate of 7%. However, should the share price increase by more than 30%, we will effectively swap our 7% annual coupon for the capital growth from a rising share price beyond this point. If the share price does not rise, or if it falls, we will continue to receive our 7% annual coupon. The biggest risk to this instrument is complete failure of Royal Bafokeng Platinum – in which case we won’t get our coupon, return of capital or share price growth. To avoid this scenario, we have conducted extensive research and have determined that the odds of complete failure are very low. We are therefore comfortable with accepting this credit risk within the Fund.
- We manage the Fund’s duration and yield
The current overall gross fund yield is almost 5%, which means we only need to achieve capital growth in line with inflation to maintain our rolling 3-year performance target of CPI + 5%. We have achieved the 5% running yield through opportunistic duration management and investing in high-yield assets, such as Delta property at 12%.
Nedgroup Investments Balanced Fund − Iain Power, Truffle Asset Management
Focus on protecting against capital loss
We define risk as the potential for losing clients’ money. As a result, limiting downside is a crucial part of our portfolio construction process. We do not want to lose capital over a 3-year rolling period. The result of our approach is a diversified portfolio of assets with low correlation to each other. How do we do this?
- We build portfolios from the bottom up
We do not have a specific asset allocation target. Instead, we look at where we can find value in the market.
For a stock to be included in the portfolio, the expected rate of return must be higher than our CPI target. This ‘barrier to entry’ enables us, from the bottom up, to build a portfolio that is expected to beat its CPI target over the longer term. In addition, we focus on stocks with prospective return distributions that are skewed to the upside. We determine this by ranking the expected return as well as considering it in the context of the worst-case scenario for the company. We will invest significantly in the shares at the top of our ranking table, but not without giving due consideration to the non-quantifiable risk factors. It is therefore possible that we will completely avoid or limit our investment in a share that is high on the ranking table.
- We manage risk by diversifying
We believe that superior performance should be achieved by the cumulative impact of many small gains rather than from a few big bets. We therefore hold many independent positions to protect the portfolio from overexposure to a single idiosyncratic risk factor.
- We build in insurance through derivatives
We employ derivatives as hedging instruments at both a single-stock and asset-class level. FirstRand is an example of a single-stock protection structure we have in place. It protects us against the share price falling below R46.08 and also allows us to partake in any upside, up to R53.36. This hedge is proving to be quite valuable in the current environment. In a similar way, we have also hedged some of our equity exposure due to the current valuation levels, which are near or at all-time highs.
Overall, global and domestic risks have increased significantly relative to history, and from our experience we know that the market is not good at pricing political risks. We therefore believe an active risk management strategy is critical.
- We were prepared for the cabinet reshuffle in South Africa
Before the recent cabinet reshuffle, we were already positioned to mitigate the severe impact that an event like this would have on South Africa and especially our currency. We followed a barbell approach with our domestic equity exposure. This entailed holding domestic banks and insurance companies, as well as rand-hedged industrial stocks such as Naspers and Sappi. Going forward, we expect domestic financials to perform well in a stable economic environment, while industrials with overseas earnings exposure will benefit from a weakening rand. In addition, we hold the maximum offshore exposure.
- We have built in a hedge against a French election surprise
We have learnt from Brexit! PIMCO (Pacific Investment Management Company, LLC) recently shared the results of their use of artificial intelligence on social media to try and get a clearer view on what the general public is really saying about Marine Le Pen. In their view, the chance of Le Pen being victorious is much greater than the 15% the polls are suggesting. Because we know the outcome could surprise everyone, we have reduced our European exposures and hedged our euro exposure into US dollars.
- We are wary of a Chinese deleveraging
Due to the risk of a financial crisis in China and the impact this will have on commodity producers, we currently have low weightings in diversified miners.
- We have hedged our US exposure on over-optimism about Trump
The S&P 500 was already at an all-time high before the US election and has shot up even further since Trump was elected. We are not yet convinced that he will be successful in his infrastructure investment or tax cut plans and many of his policies will be difficult to implement. As a result, we believe there is currently too much good news priced in. With volatility levels as low as they are (as shown in the graph below), derivative structures are cheap. We have used this opportunity to hedge some of our US exposure. This was achieved by purchasing a ‘put option’ − the right to sell at a predetermined price − on the S&P 500. This will help to protect the portfolio against adverse movements in the US market.
The common theme is that opportunities exist, but not without risk. A cautious approach to capital market investment therefore appears to be the most prudent course of action at this time. A closer examination of the positioning of our other Best of Breed™ funds will show that this stance has been broadly adopted. But it is certainly not over yet. Hold on to your seats, as it could be a wild ride for all asset classes in 2017, including the traditional safe haven of nominal government bonds.