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A practical approach to volatility

Clyde Rossouw of Investec Asset Management provides some tips on how to be selective in positioning your portfolio and identifying risks.

RYK VAN NIEKERK: We continue with our podcast series with Investec Asset Management about living annuities. In previous discussions we have already covered the importance of managing your drawdown strategy, the need for exposure to growth assets and understanding how market volatility affects annuities. Over the past few years and specifically this year we have seen significant volatility in local and international markets and today we will focus on how to practically manage this volatility. On the line is Clyde Rossouw, he is the manager of the Investec Opportunity Fund, a high equity, multi-asset fund. Clyde, welcome to the show, let’s start with that question, how do you practically manage volatility?

CLYDE ROSSOUW: Volatility has two sides to it, the positive to volatility is obviously the fact that you own assets that have the ability to grow in real terms, which is incredibly important in terms of managing wealth over an extended period of time. So that’s the positive side. The negative side is that share prices don’t always go up, or financial matters don’t behave in a systematic fashion, and there are periods in which they can behave in an adverse manner. So all we try and do in terms of our fund strategy is to try and utilise all the different opportunities that are available to us through the various asset classes and instruments that are available and try and deliver something which produces the real returns, and then try to avoid the obvious areas of capital loss, which is the downside volatility, which ultimately destroys and undermines your wealth creation. Now that might sound simple or simplistic in terms of its goal, but in reality what that does mean is that you have to be quite selective in terms of how you position the portfolio and you have to make sure that you have a very clear perspective in terms of where the risks lie in markets at all particular points in time.

RYK VAN NIEKERK: But say I am a pensioner, I am 75, I draw down a modest 5% and I am looking at the current market environment, where the JSE is not performing well, I see my capital reduce in value, what should I do?

CLYDE ROSSOUW: So, again, generally if someone is 75 years old they probably wouldn’t have all of their portfolio invested in the All Share Index or a tracker fund of that description. They presumably would have a multi-asset portfolio where the equity weighting is substantially less than 100%. Obviously in terms of the way in which we run the Investec Opportunity Fund is we do have a considerable portion of non-equities and in particular non-South African equities and the reason why we have this portfolio mix is that ultimately our performance outcomes should be very different to any single particular financial asset class that a South African can access. As a result of those exposures – because we have 23% invested in bonds, we have 10% in cash, we have 30% in global equities – our specific exposure to difficult circumstances in local equity markets is vastly controlled and, therefore, should be much less of a concern to an investor who has a portfolio which is structured on that basis.

Asset allocation is critical

RYK VAN NIEKERK: Of course, as you’ve alluded to earlier, asset allocation is critical. Are you adjusting your investment approach within the current environment, where equities are under immense pressure?

CLYDE ROSSOUW: At the beginning of this year when we had a bout of enthusiasm in the markets, post the successful transition of the ANC election in December, it caused a little bit of a rally in local stock markets and obviously in terms of the strength of the currency in January, February, we took that as an opportunity to reduce our exposures to a lot of local equities. Not because we were necessarily disbelieving in terms of transition but because we fundamentally are a little bit concerned about the near-term growth outlook for South Africa. Clearly domestically-focused stocks are going to struggle if there is no earnings growth that can be delivered from them. In simple terms, we felt that many shares were actually too expensive. So we reduced our local equity weighting by about five percentage points earlier this year and as a result of that, plus a strong exposure to offshore assets, the weakening of the currency we have seen and ongoing growth we have been able to access outside of SA, it’s actually meant that our portfolios haven’t done too badly this year and certainly our return trajectory, as I said, is very different to the negative returns that the JSE has offered local investors so far this year.

RYK VAN NIEKERK: Does volatility equal increased risk?

CLYDE ROSSOUW: There are two risks, capital volatility in the short term – if it’s just producing up and down, with movements that over time, the value of that capital is growing – is to be expected. But if you are involved in owning assets where the price is wrong, the growth is not there, volatility is often a euphemism for capital loss.

People don’t say the markets are terrible, they say they are volatile. But we know that if markets go down people lose money. So the best thing we can do when we run multi-asset funds or any funds we run, is to minimise that draw down because we also know that investors tend to panic at the wrong stage of the investment cycle. So when markets are great then everyone wants to invest and when markets are down everyone wants to disinvest and that often amplifies or extends the magnitude of the different cycles that we have. So if we do the right thing in terms of having the correct exposures and minimising the drawdowns in our portfolios, hopefully it will help our investors to make the correct decisions in terms of not having knee-jerk reactions with regard to what they do with their own money that’s invested in our fund and, therefore, we can help along the way of ensuring that we can grow that capital in real terms over time. So that’s really our fiduciary responsibility when we run multi-asset portfolios.

RYK VAN NIEKERK: What is the biggest mistake an investor can make right now?

CLYDE ROSSOUW: The first and obvious question that has to be asked is am I in the right strategy, do I have the right exposure to the right opportunities that match my risk profile.

We spoke earlier about the hypothetical 75-year-old – if they were 100% invested in equities, it’s probably fair to assume that there’s a mismatch between the risk appetite and the actual portfolio. I would always say that the first question you have to ask is, make sure that we are in the right strategies with the correct risk profile that either matches our life stage or our risk appetite. That’s the first important thing. If we get that right, then everything else is less coincidental. In simple terms, if we have a long-term time horizon we can ride through volatility and ultimately we won’t be … at the bottom. If we have a shorter-term time horizon we’ll obviously get more anxious about how much capital we’re going to lose because we might be drawing down on that capital to pay ourselves income in the form of a living annuity of some sort. So risk profile is absolutely important.

Secondly, having a portfolio or investing in something which does not have those single-focused areas of concern or risk where they are fully exposed to one or two trends, such as what we are seeing currently on the JSE, where the trend in terms of SA stocks is not a positive one. You don’t want 100% of your exposure aligned to that because then you ultimately will end up having to make some really tough decisions at potentially the wrong time.

Mitigating the risks of volatility

RYK VAN NIEKERK: But intuitively some investors may think let’s just ride out the volatility, move to a fixed income product – is that a mistake, or how should investors look then at fixed income as an alternative to mitigate the risks of volatility?

CLYDE ROSSOUW: Certainly we would see fixed income as playing an incredibly important role in running a multi-asset portfolio for an investor that ultimately wants to get paid out in rand and is reliant on rands as a source of capital or income for themselves, and what’s particularly interesting about the South African fixed income market at the moment is that cash provides one with a positive return, in other words ahead of inflation and long bonds actually provide one with a real yield.

So in simple terms, a yield which is more than the inflation rate of round about 4%, that’s quite an attractive opportunity if you’re looking to at least preserve your capital. So you could take quite a lot of inflation risk before you use capital on the bond market and for that reason we have a relatively large exposure to both cash and bonds. As I said, that’s more than a third of our portfolio holdings in the Opportunity Fund, where that will provide us both with capital preservation and a pretty reasonable yield and, more importantly, is a massive hurdle rate for other opportunities to jump over in terms of being able to compete.

So when we look at other equities in South Africa, until such time that we are convinced that they will provide us with a better return than a mere 10% on government bonds, it doesn’t make sense for us to risk the capital on those holdings. There are still many examples in the local market where we think that shares could reprice down further before we get to the point at which you can get excited about forward-looking returns that would provide you with 10% plus an additional margin of safety for taking equity risk. So we’ll look for those opportunities but in the meantime we are very happy to have a chunk of money invested in cash and bonds.

RYK VAN NIEKERK: The local market is down at least, say, around 9% to 10% following the current performance, especially over the last few weeks. You earlier said don’t react at the wrong time, is it now the wrong time to start maybe moving money offshore?

CLYDE ROSSOUW: The decision to move money offshore is based on a medium-term timeframe and our view on that front is that for the last two years we’ve had the view that we can find better offshore opportunities than what we can find locally and that was our view a year ago, it was our view six months ago and it still is our view. The only thing that is moderated somewhat around that is the fact that we think the degree to which foreign assets will outperform local assets has diminished but there’s still a high probability that offshore assets will outperform onshore assets, particularly with regard to equities.

The currency is ultimately an important decision in that process but it’s not the only decision that one has to make around offshore. For what it’s worth, we do think that the South African rand is probably marginally on the cheaper side of fair value. We think fair value is somewhere between 14.25 and 14.50/US$, so when we are near R15 it doesn’t obviously suggest to us that you’re going to make a lot of money out of taking money offshore.

But more important than that is the fact that we can construct portfolios where we have a high degree of confidence that the companies we own will be able to grow at high single digits or even low double digits in terms of their earnings going forward, which is not something that’s in abundant supply on the local equity market. For that reason, when we put those two decisions together, we still think with that serious consideration for someone who takes more than a three to six-week view on markets and is prepared to take a three-year view because ultimately we think that will be more constructive to monetising the potential extra return you’ll get from foreign assets.

RYK VAN NIEKERK: Returning to the discussion about living annuities, what would your advice be to pensioners who draw from living annuities that are invested in your fund, what would your general advice be as to how they should behave right now? 

CLYDE ROSSOUW: If we look at the work that we’ve done, clearly any additional outperformance that can come from one fund versus another is very constructive to building up an increased capital fund over long periods of time. But the piece that is probably less understood by most people is the role that volatility plays in terms of improving that ultimate position that an investor is in, in terms of improving their return and their ability to draw down on their capital over time.

We think that those are both considerations, so better returns than peers and obviously low volatility are the two best ways in which to construct your portfolio to assist you around building a bigger capital sum and being able to take more capital in the form of withdrawals over time. So our advice would be to make sure that investors are actually in funds that have reasonably decent real returns, hopefully better than peers and, importantly, also take the consideration around volatility when they construct their portfolios. Obviously all that information and data is available to people out there. I do think that at least in a case [of] opportunity we do have some credentials to support that thesis.

RYK VAN NIEKERK: We’ll have to leave it there. Thank you, Clyde. That was Clyde Rossouw, he’s the manager of the Investec Opportunity Fund. 

Brought to you by Investec Asset Management.

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