I say under the mattress quite literally as in most cases putting it in the bank in the US earns you less than zero percent in real money (interest rates less inflation) and even less after bank fees. Even in South Africa at the moment, with inflation expectations at the high end of the SA Reserve Bank’s (SARB’s) 3% to 6% band and bank yields at around 4%, there’s a very high likelihood that it’s a losing game, with your money not keeping up with inflation.
As a result, the two broader offerings in investment management – equities and fixed income – have merged in some respects and have become a little crowded. Fixed income managers often search for yield in the equity dividend space rather than traditionally less risky fixed interest markets.
In the world of investments, it’s often said that there is no such thing as a free lunch, and aiming for higher levels of returns within any type of portfolio comes with the unfortunate side-effect of taking on more risk.
For equity markets, in particular, the more buying pressure there is in the market, the higher prices go, and, without underlying growth, the earnings remain flat, inflating the P/E ratio. That brings us into the environment we now find ourselves in at the start of 2021, with the P/E ratio of the S&P 500 sitting at its highest levels in more than 60 years.
The phrase that comes to mind is caveat emptor – let the buyer beware. That’s not to say equities are a definite sell. Given the lack of alternatives and the resultant buying pressure, earnings yield compression is an unfortunate side-effect. But the added risk should be at the forefront of investors’ minds.
This highlights the need for balanced fund portfolios to search for yield in places outside the traditional large-cap equity and government bond space – while searching for diversification opportunities to reduce portfolio risk at the same time.
Assets like infrastructure, commodities, credit, small-cap equities and geographies like emerging markets have become the order of the day. It takes an entirely new skill set to identify opportunities in these asset classes. Either you have to have the expertise to select single issuances in these more exotic universes, or the ability to gain passive exposure to a large selection of issuances, which reduces the risk of single issuances going wrong. In the latter case, you would invest in the overall theme via an index (say infrastructure) rather than the individual value case (for example, an infrastructure company that is mispriced).
When it comes to investing in balanced funds in South Africa, there are two broad categories to consider – passive and active. Passive funds generally take exposure to a fixed, weighted portfolio that doesn’t change, say for simplicities sake 60% JSE Top40 and 40% All Bond Index, irrespective of the outlook of those asset classes. The responsibility then falls on the investor’s shoulders to determine whether this static mix suits their risk objective in a given environment. The catch is that the environment could be one where bonds yield less than inflation, and the outlook for equities is negative – and the investor ends up staying the course in a fund with a pretty dismal outlook.
Active funds would generally take a bottom-up active approach. They would most probably remain close to those original asset buckets, perhaps even at the same weights, but select stocks within the buckets representing a good value case even if the asset class has a poor outlook on the whole.
There is another alternative: combine passive and active, and you get a top-down approach where a fund manager actively reweights the portfolios toward more attractive asset classes based on the macro-economic environment while being relatively ambivalent about single companies within them.
At Prescient, we sit right on the fence for the active versus passive approach – we actively allocate towards mostly passive investments. In our view, it is all about a balance, and, in the words of the late Albert Einstein, “Life is like riding a bicycle. To keep your balance, you must keep moving.”
Likewise, investing in a balanced fund with static weights towards asset classes exposes you to the risk of allocating funds, especially in the fixed income markets, to lower fixed yield investments at comparatively high risks than cash – essentially booking in underperformance. In equity markets, allocating weights into markets with weak growth prospects can lead to a capital loss and a bumpier ride.
The key to achieving the balance is finding a stable fund that doesn’t take investors by surprise with wild swings of the bat, and at the same time is dynamic and capable of making both structural (long-term) and tactical (shorter-term) changes. This combination of approaches is much more likely to keep the bicycle on course even if the road ahead is uphill and bumpy. DM/BM
This article was written by Rupert Hare, Co-Head of Multi-Asset at Prescient Investment Management
A candle's flame in zero gravity is round and blue.