Skilfully managed balanced funds set to come into their own
• Prolonged equity bull market flatters rewards, but investors should prepare for higher risk
After a rocky time in the bear markets of 2000-02 and 2008, global balanced or 60:40 funds have tended to produce good returns for investors at reasonable volatility, particularly when converted into a weaker rand. Both the asset classes that comprise the benchmark have delivered positive returns with low moderate volatility, and the equities bull market has proved to be a lot longer and more resilient than many expected given its traumatic birth in the depths of a credit crisis.
Unlike many of their international peers, South African investors have largely stuck with benchmark-oriented funds, as opposed to the outcome-oriented funds that have grown in popularity internationally. The additional risk that they have accepted — in volatility terms most of the exposure of a 60:40 fund is equity related — has paid off with higher returns. So the key question is whether investors should expect more of the same or is the period ahead going to prove more challenging?
Before we deal with that question it makes sense to take a look at the return characteristics of the peer group over this cycle. If we decompose the returns of the global balanced funds registered for sale in SA, they largely reflect the available asset class returns in global equities and bonds over that period. In fact alpha (outperformance over the benchmark), particularly net of fees, has generally been hard to come by.
Asset allocation hasn’t been particularly well rewarded because we have been in a sustained bull-market environment in the primary-asset classes. Despite persistently higher valuations, US equities have substantially outperformed other regional markets and, due to their greater efficiency, tend to be much harder to generate alpha in. The dollar has been in a sustained bull market, which has tended to depress returns measured in that currency.
Funds that have been fully hedged into dollars or that have had inherent dollar biases have fared relatively well, but only due to structural factors and not manager skill, and it is important not to confuse the two.
This relative performance advantage indeed ebbed in 2017 as the dollar declined from its 2016 highs and other regional equity markets have started to retrace some of their relative declines. Equity-style biases have also been a factor, with quality-oriented equity approaches benefiting from the defensive leadership of most of the equity bull market.
Most global balanced funds available to investors in SA tend to be equity programmes with some additional exposure to other “growth” or equity-correlated assets such as real estate investment trusts or high-yield bonds. Despite excellent and much lower risk returns, developed market bond exposure on average has been quite modest. Defensive exposure often consists simply of high cash levels. Cash provides optionality, or the ability to reallocate to cheaper growth assets after periods of market weakness, but doesn’t provide negatively correlated returns that true diversifying assets confer.
This hasn’t mattered much in the second-longest equity bull market since the 1920s, but if things start to prove more difficult for growth assets, the true risk levels being run will become apparent and returns could turn negative. Certainly the current momentum phase of a mature equity market bull cycle could persist. Valuations could become even more stretched by historical comparison, but a more genuinely “balanced” approach might be considered to be more prudent at this point in the cycle to protect gains and provide optionality to reallocate to growth assets when the risk-reward relationship is skewed to the upside and not the downside.
Hence we believe funds that are run by investment teams prepared to be proactively flexible in terms of asset allocation decisions instead of “hugging the benchmark” are likely to come into their own.
Certain categories of illiquid assets, such as smaller firms and private equity, have delivered excellent returns as investors have enjoyed an additional illiquidity premium. In tougher environments, illiquidity can be highly disadvantageous. Those able to exploit a broad opportunity set — well beyond vanilla equity management — and who make best practice use of derivatives to manage risk will also be well placed.
So, to paraphrase Warren Buffett, don’t wait until “the tide goes out to discover who has been swimming naked”.