As we wrote in our most recent article, a look at recent returns of pension portfolios (Regulation 28 compliant) over periods of three, five and 10 years doesn’t make for cheerful reading. So when is it appropriate to panic?
We don’t think panicking is ever in order
The core proviso to this assumes that when you first start investing for retirement, you invest at the appropriate level of risk (equity exposure) for your age and objectives, that your portfolio is adequately diversified, and that the asset managers you initially selected are all still at their desks and making investment decisions in the same way they were when you first chose them.
We believe in designing a strategic portfolio based on long term objectives and staying invested in this portfolio, regardless of your emotions, a philosophy echoed by Warren Buffet in the following quote:
‘To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.’
Retirement portfolios should be carefully structured to take advantage of long term risk premia yet have the flexibility to capitalise on new investment opportunities as they arise. We favour a ‘core satellite’ approach for an investment portfolio, which sets out guidelines for allocation to different asset classes and specialist mandates, yet is structured in a way that makes it easy to up-weight or down-weight more opportunistic satellite portfolios.
There are many rules that determine whether or not a retirement portfolio is compliant with the Pension Fund Act, but for the purposes of this article the most important ones are that:
- The portfolio can have a maximum of a 75% exposure to equities (offshore and local)
- The portfolio can have a maximum offshore exposure of 40% (10% of which is earmarked for investment in Africa), and
- The portfolio can have a maximum investment of 25% in property.
There is no obligation to use these full allowances; fund managers can vary their offshore exposure depending on the perception of value offered by other equity markets. We would recommend that irrespective of value, a retirement portfolio becomes more ‘shock proof’ by using greater offshore diversification and taking advantage of equity opportunities in offshore markets.
An ideal retirement portfolio might look as follows:
- A central core component allocated to passively managed equities or low cost actively managed equity mandates, both local and offshore. This will ensure the long term cost efficiency of the portfolio.
- A local and offshore satellite managed by a fund manager mandated to look for value, index agnostic opportunities that have performances that are not correlated with major equity indices. For example, fund managers focusing on the US healthcare and pharmaceutical sector (to take advantage of aging boomers), or the Indian tech/e-commerce sector (to take advantage of the increasing middle class) or emerging markets (to avoid over exposure to SOEs, heavy industry and resource counters that dominate most emerging market indices).
- A few specialist ‘fixed interest credit’ managers who are able to select bonds and other interest-bearing instruments (as they offer value), and who are able to appropriately manage the duration of the portfolio.
- A specialist property fund manager mandated to select properties for maximum capital growth or to maximise yield.
- An allocation to either a hedge fund manager or private equity fund manager, as rules permit.
Don’t panic, tweak
The only guide we have to the future of investment performance is the history of investment performance. History tells us that over the last 117 years equities have outperformed bonds and money markets. Research published in the ‘Triumph of the Optimists’ and subsequently updated by Credit Suisse shows that between 1900 and 2017, the world’s top 22 countries produced a real equity return of 5.2%. Excluding the USA, this return was 4.5%.
The outperformance of equities over this period was, however, not in a straight line. There have been times when equities or specific sectors (especially cyclical shares) within the stock market have been out of favour, and therefore available at historically cheap prices. At such times, a good financial planner or portfolio manager should tweak your portfolio, taking advantage of good value assets.
Tweaks should be made after the outperformance of a sector, country or asset class, not because of any under-performance of any of these categories. One of the surest ways to lose money is to sell currently undervalued investments, unless the fundamental reasons for owning the investments in question no longer apply. The second leg of this decision-making process is: What should be sold? In theory, this is easy – the most recent outperformer. But this is always emotionally difficult for obvious reasons.
One of the more recent examples of such an opportunity was in South Africa during the 1998/1999 period, when ‘dot com’ shares were over-valued and mining shares were under-valued. Any investor who took advantage of this mismatch and adjusted their portfolio to take advantage of the deviation from long term returns was handsomely rewarded … until 2008, when the commodity ‘super cycle’ ended. Resources subsequently bottomed in December 2015 and have seen a small recovery off these historical lows
It takes skill to identify fresh opportunities, and investment courage to act. Currently in South Africa many investment managers argue that the 30 year-bond bull-run is coming to an end, and with it, the favourable equity environment. So there is a general expectation that equity performance will become more muted in the years to come.
One of the more striking recent investment trends both globally and in South Africa has been the popularity of index funds. Morningstar has estimated that in 2017, of the $131 million new inflows in European markets, $83 million (63%) was invested into either index funds or ETFs.
The increasing popularity of index funds and the consequent appreciation of shares in the indices concerned has had a negative effect on those shares that are not included in popular indices. As the neglect of these mid- and small-cap shares becomes more apparent, active fund managers should be able to load up with good value businesses at below-average prices. There is, of course, no guarantee that this theory will turn out to be correct.
We know how difficult it is to watch similar funds with similar mandates outperform yours. But the only reason to change your manager is if the reason you chose the fund manager in the first place no longer holds. Have they left the company? Has their investment strategy changed? Has their investment style changed? If the answer to all these questions is no, there should be no reason to trade in your manager.
 Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, and subsequent research by Credit Suisse.