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Value – time to shine?

We have entered the point in the investment cycle where active value managers will be rewarded for consistency in their investment approach.

By: Paul Jennings – NFB Financial Services Group

It is in these times of uncertainty that we need to return to our financial plan to remind ourselves of the basics of investing. Its’ time to revisit our investment goals and timeframes.

The starting point is the knowledge that over 90% of investment returns come from the asset allocation decisions. Asset allocation is the investment decision of how much to allocate to each asset class be it equities, property, bonds, cash and alternative investments – linked to this is the allocation in each of these sectors to onshore and offshore investments.

The balance of the investment return equation is the selection of underlying securities in each of these assets classes for example choosing one bank over another.

With such a huge weighting of performance attribution being driven by asset allocation it is little wonder that in the recent past most retail investors, both locally and internationally, have favored balance funds over sector specific offerings. Through a balanced fund the investor potentially enjoys the investment manager’s skills as they relate to both asset allocation and stock selection. With the importance of asset allocation it is somewhat surprising that investment managers don’t report more specifically on their asset allocation and stock selection skills.

Generally, there are two approaches when considering asset allocation which can be described as either strategic or tactical. The strategic approach sets ridged benchmarks such as 60% to equities, 10% to property and 30% to income investments – then on a regular basis, say annually, portfolios are rebalanced in line with these benchmarks – the argument is that asset allocation is more determined by risk and therefore one needs to rebalance from out-performing sectors into those which have under-performed. For example assume one’s allocation to South African equities is 50% and at the review period South African equities represent 60% of one’s portfolio then 10% is sold and reallocated to an underperforming sector. This follows the principle of sell high and buy low.

A tactical approach maintains that value can be added through active asset allocation and therefore the investment manager operates through sector bands. For example, with equities, instead of a rigid 60% allocation, the investment manager operates through a band of say 40% to 75%. Meaning that when they consider equity markets to be overvalued then all other things being equal they revert to the lower band of the range.

Over these last few years there have been two trends emerging and in some respects competing, first of which has been a massive shift to balanced funds as discussed above.

The second trend which has been identified is a shift to passive or index type funds – which has been particularly true in developed economies such as the US where passive fund investment fees are extremely low and where most active investments managers have failed to produce superior active return that can at least cover their investment management fees. Essentially the advocate of a passive strategy believes that markets are perfectly priced or efficient and little value can be added by investment professionals in either asset allocation or stock picking and therefore why pay active management fees when passive management can be obtained with much lower investment management fees.

 

Is there a there a preferable approach, active or passive?

It must be said that globally this argument, if judged in terms of money flows, is towards the passive approach. This is a reflection of the fees charged by international active managers and more particularly that few international active managers have consistently outperformed their benchmarks. Part of the reason for this is that in bull markets, markets are primarily driven by momentum as opposed to value, which is where a passive approach tends to come into its own. One of the signs of a momentum bubble is that when a small number of shares dominate index performance.

As markets become more fully priced there is often a drift back to an active value investment approach. To demonstrate the worth of this approach one needs to look at the composition of the performance statistics. These figures should clearly demonstrate that for value managers in up or bull markets they tend to underperform but in down markets because they are more adept at understanding value are able to protect the permanent loss of capital. These statistics are freely available on minimum disclosure documents (MDDs) which show maximum percentage declines over any period. It is this capital protection that, over the cycle, ensures superior long term performance. Another way of expressing this view is the selling of over-priced shares and buying those that show greater value. The difficulty with this approach is when share prices are running or momentum is strong then over-priced shares tend to become more over-priced and the opposite occurs with underpriced shares – so that over a shorter term value managers can be made to look very silly.

We could advocate that we have now reached a period in the investment cycle where value managers are starting to come into their own. We have witnessed a period where equity markets both locally and globally have become highly concentrated, meaning that a few shares have performed extremely strongly and these have tended to carry the various indices be they the ALSI or the S&P500 and have left pockets of undervalued shares.

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