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The portfolio construction and management process has several layers which we need to consider before settling on the ideal portfolio for a client.
Here we identify which combination of equity, bonds, cash and property are best suited to deliver for the client over a long period of time. Most investment horizons are ten years and longer, and so we need to ensure that the SAA set is appropriate for an equivalent timeline at least. We research the merits of each: growth expectations, concentration of risks, how each asset class is evolving and what it is dependent on. Also, what relationship it has with other asset classes where they have common return drivers. Ultimately, we need to strip down each asset class to its component pieces, stress test the return drivers which underpin it, evaluate the history and test the relevance going forward, and importantly make sure we understand the specific risks.
A reasonable amount of subjectivity needs to be applied as it is likely the future deviates from the past. For example:
- South African equities have been the leading global stock market for over 100 years, driven by the commodities sector. Looking ahead this seems unlikely to reoccur, so we would temper growth expectations.
- If you consider the exceptional thirty-year history of global bond returns, this may seem like a long time and should cause us to favour bonds as a large part of a client portfolio. However, this has been a single cycle of bond yields compressing from a high base, with the result that returns over this period have been much higher than what you would ordinarily expect. Looking ahead, we would temper our expectations.
We need to consider the interrelationships between the asset classes. Quite often there can be links between them (high quality shares are linked to property and bonds for example), and this means that taking account of this ‘link’ is important in understanding the diversity of a portfolio.
We also need to consider external inputs such as whether clients will be regularly drawing down on the portfolio, or what a minimum investment horizon needs to be to avoid overexposing the client to volatile returns.
This results in an optimal asset class level portfolio matched to the investment objectives.
This part of the process gets much of the intention industry-wide yet is also the area where we frequently see material value destruction by fund managers. TAA is the adjustment of asset class exposure for or against a particular asset class. For instance, if the view was that equities were expensive, then one would expect them to underperform in future which would result in a smaller position being taken in the portfolio relative to what the SAA suggests.
The attraction with implementing TAA positions is what you might term the ‘holy grail’ of investing – forecasting when markets fall allows you to avoid equities; or similarly, knowing where the Rand/Dollar rate will move allows you to take a position to your advantage. The trouble with implementing TAA positioning is that the collective number of potential outcomes which may determine the success of this trade is far greater than an individual or team’s ability to aggregate and process that information. While some decisions taken may prove well planned, the odds of repeated success are low (but not impossible!), and this is borne out in the evidence across the industry.
As a result, we take a very conservative and pragmatic approach to TAA, which is guided mostly by a long list of what not to do, and where we see a higher probability of value add we do act:
We rely on objective scorecards per asset class which aggregate the important facts without any human interference (i.e. we get out of our own way). The natural consequence of this approach is that we may have better odds over a successful outcome, but we still have no control over what time horizon this may occur. This approach allows us to get the most out of the asset classes available, and improve the investment journey through sensible risk management.
Investment markets are complex, and for professional money managers what we find in practice is that managers stay within their own circle of competence, often defined by a belief system to which they stitch their decision making. This belief system – be it a value bias or looking for smaller companies or companies which have a high yield or strong balance sheets – is the technique they follow to add value to clients. No single approach has the monopoly on value add, and we have seen a wide multitude of fund managers deliver value in different ways.
What this means is that if we were to select a single fund to implement our portfolio, we would likely forego potential investment opportunities which may have been excluded (intentionally) by the manager. It’s unlikely any value biased manager would have bought Amazon in 1997 with a PE ratio north of 100x earnings, but which subsequently delivered 36% per year returns for the next 22 years. This despite averaging a PE of 142x and never paying a dividend!
To capture the full opportunity set of returns and achieve the best diversity for clients, we identify the successful traits across the industry where investment merit can be evidenced and combine this into an allocation which differs by investment approach, not asset class. This is what defines our FAA process.
We will use specialists to achieve the outcomes we need as they have the highest odds of delivering within their narrow area of focus. This allows our clients to benefit from both the proven sensibility of value investing, but also to access those managers who can take long term views on high growth companies like Amazon, or smaller companies which are disrupting the incumbents.
No individual manager has proven to us that they should be managing 100% of any investor’s capital over the long term. While we have allocated our top rating to around 25% of all funds covered, there are no instances where we have zero concerns around the fund, team or business. Investment managers are highly reliant on human capital, and human capital is very difficult to retain and replicate over time. In addition, business issues are quite often the root cause of an investment managers downfall. Other businesses which follow a specialist approach (a value manager is a good example here) can go through such long periods of poor performance that their ability to survive comes into question, despite the fact they may well earn back the performance lost.
To counter these longevity concerns, we eliminate those funds which are more likely to detract value for clients. Of the few remaining, we need to identify the best funds per investment approach.
Ideally, we want to capture all the good, and diversify away the bad. There are limitations though – good businesses do make mistakes, fund managers immigrate, teams degrade over time without good leadership, amongst a range of instances which we would term a negative surprise.
Piecing together the SAA+TAA+FAA+FS process leads us to evaluate the end result – i.e. the client portfolio. We want to make sure that the direct and indirect investment exposures are in line with our intended outcome. We are also conscious of falling into the typical behavioural trap – risk aversion. The behavioural tendency is to overdiversify, or hedge all bets, and this can lead to average outcomes at high cost. As we do the detailed fund research, we’re equipped to take bigger positions in what may seem riskier funds and hold them for longer periods, so that clients are invested for a sufficiently long period to reap the rewards. We also test for specific exposures to a range of risks such as currency, liquidity and interest rate risk. While we follow a pragmatic risk management process, we don’t allow ourselves to be led by it.
Mostly, a good portfolio needs to be left alone to do its job. However, there are instances where we need to act: where we identify a new ‘best view’ fund which can replace an incumbent; where investment markets move to present more TAA opportunities or where we see potential to reduce costs. This is a permanent quest to maximise the quality and return potential of client portfolios.