CAPE TOWN – Anybody wanting to make a unit trust investment in South Africa is faced with a daunting choice. Investors have to sort through more than 1 300 unit trusts to identify which ones will be right for them.
Even if you specifically want to invest in equities, there are 153 South African general equity funds, seven small cap funds and a further 69 flexible funds to choose from. That is without considering worldwide or global funds that will provide exposure to offshore equities.
It is therefore vital that an investor knows what they are looking for. Equity fund managers approach their task in different ways, and to make informed choices, investors need to understand what makes them different.
The way in which a manager evaluates and selects stocks is known as their ‘investment style’. Different styles will lead to different kinds of portfolios, which will perform in different ways.
“It’s important for investors to be aware of these different styles because they lead to portfolios that have different risk and return characteristics,” says Rian Brand, portfolio manager at Sygnia. “At different points in the cycle, styles can differ dramatically in terms of how they perform.”
At the highest level, the first style distinction is between active and passive. This is the difference between a fund manager who makes the decisions about which stocks to invest in, and an index tracker that aims to replicate the performance of the market.
The next level of styles refers to specific stock selection approaches such as growth, value, quality and small cap. Managers who adopt these styles look at the market in different ways to identify what they believe are the best investment opportunities.
Broadly speaking, value managers try to find stocks that are trading at prices that are cheap on metrics such as price-to-book, price-to-earnings, or dividend yield. Growth managers, on the other hand, look for companies that are showing above-average growth, even if their share prices look expensive.
Quality investors try to identify companies that offer reliable earnings, enjoy strong balance sheets and display high profitability. Small cap managers focus on the smaller companies in the market that are likely to show higher growth over time.
Each of these styles is likely to perform differently at different times.
“For instance, 2008, 2009 and 2010 were periods of out-performance by value, and particularly strategies that focused on dividend yield,” Brand says. “The dividend index dramatically out-performed the SWIX over that time. Over the last three years, however, value has dramatically under-performed and the dividend index has given up all of those gains.”
This is a fairly extreme example, but it clearly illustrates how styles can go through periods of both strength and weakness. In the short term, no one style is going to always deliver the best performance.
“That is how the cycle changes,” Brand says. “And if you find yourself on the wrong side of the cycle, you can see your investment under-perform dramatically.”
When choosing which style to invest in, it is therefore important to know your own risk tolerance and risk appetite. Certain styles will offer less short-term volatility, while others may tend towards the extremes.
“If you have a higher risk appetite and risk tolerance then it is tempting to choose styles with a higher risk-return profile, such as deep value,” Brand says. “But then you must know that there will be times when your investment will be volatile and may incur losses.”
He suggests that the most prudent approach for most investors may be to blend different styles together to create an optimal portfolio. This smooths out returns and captures performance through the cycle.
“In our minds the default is to always start off with tracking a well-diversified benchmark, and from there you can blend and mix styles,” Brand argues. “Having this passive core means that you bring down the total cost of your investment, and then invest portions of your money with managers who use a certain style to capture performance at different periods.”
- This content was sponsored by Sygnia.