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The stabilising power of diversification: The only free lunch in town?

The stabilising power of diversification: The only free lunch in town?

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Article highlights

  • Diversification adds stability to portfolios and is about understanding the correlation between all the different asset classes
  • Over 12 months, the Fund returned 6.7%, which is above inflation
  • Performance was driven by domestic equities over the past six months and interest bearing backed by the R186

Nick Balkin is a Portfolio Manager at Foord Asset Managers, the manager of the Nedgroup Investments Stable Fund. Nick discusses how diversification is a key component of the investment philosophy at Foord and provides an overview of the Fund’s Q2 performance.

The magic of diversification

The focus of the Stable Fund is to manage downside risk and beat inflation over time. We do that through stock selection, sector allocation and asset allocation. But the real magic is diversification and understanding the correlation between all the different asset classes. The investment industry has a habit of attracting people to the industry who believe that their view is the only view. This results in people trying to maximise returns while worrying less about the downside. This works in good times, but when markets start going down and your assets are correlated, there's nothing to protect you. Diversification adds stability to portfolios. If you have an uncorrelated asset like gold in a portfolio, it will sometimes be a headwind, but also a good support when you need it and will perform in an uncorrelated way to the rest of your portfolio. Often referred to as the secret killer, inflation doesn’t seem scary when it’s at 2%. But, if you have a currency that has 2% inflation against another currency that has no inflation, you will lose half your purchasing power over 35 years. The way we think about managing money, especially for the Stable Fund, is to increase the certainty of achieving inflation-beating returns in our portfolios.  

Stable Fund performance

Long-term performance over 3 and 10 years remains exceptional. Over 12 months, the Fund returned 6.7%, which is above inflation and a strong number in the context of how we manage money. There were some headwinds that impacted the 1-year number, but whatever they were, they were strong tailwinds that provided the 8.1% compound return over the 3- year period. 

Stable Fund sector contribution 

Our biggest average weights are in interest bearing (49%), foreign assets (31%) and JSE equities (12%). The heavy lifting given the weighting over this period was domestic equities, which generated 1.3% return over the six months and interest bearing backed by the R186. Although foreign assets underperformed domestic equities in Rand, they did well in dollars. The Rand was a big headwind and the gold ETF at 5% remains an important diversifier. 

Financial repression

The US had 10% inflation over 30 years ago when you could quite safely have earned a real yield by just sitting in the money market. The Fed has fought inflation quite hard and have been able to reduce their real yield over time until the cross over point around 2010. This is what we call financial repression, which effectively means that the government is ‘stealing’ money from the savers. They’re trying to incentivise savers to stop saving and to spend their money. This forces people into markets, forces people to buy assets and creates inflation. It also deprives the saver of other opportunities to generate a real yield. It creates an issue for a saver where equities is the only game in town. For a very young person with a very long time horizon, you could justify holding a high weighting in equities. They tend to do very well over the long term, but the volatility will be immense relative to cash. Equities are high in value, but you need to be careful and buy equities that have pricing power as this gives you extra flexibility to deal with inflation should it surprise on the upside. Pricing power allows any company to pass it through creating stability of earnings and price and therefore stability of pass through into the portfolio. This is what we're looking for and we need to prepare for higher inflation. 

The Fed is under increasing pressure to justify inflation

Seldom do we see inflation of 5% in the US these days. The Fed has taken the stance that it is transitory and there won't be a permanent change to inflation expectation of 2%-3.2%. 5% will therefore come down as the base effect normalises. The Fed has changed their mandate to a more rolling thought process of where inflation is and will accept higher inflation for longer. This means that in our planning and tail risk planning, we need to think about higher inflation for longer. Following on from their financial repression, this is one way to inflate their way out of the trouble. 

Financial repression – is SA joining the party at the short end?

South Africa has avoided financial repression for a long time. Until recently, we had an interest rate that was higher than inflation, which meant we were able to get a real deal by sitting in cash. More recently, we've seen our inflation pick up and interest rates come down, which is making it a lot harder to achieve our mandate by sitting purely in cash and enjoying the low volatility that it brings. 

SA yields stand out globally

The 10-year bond in South Africa compared to all other global bonds is appealing in nominal and real terms. We don't have the majority of our bond holding in this high yielding 10-year bond as the certainty of return is more important to us than maximizing returns. We continue to be more cautious and choose certainty by going for a more mid-duration bond that will yield closer to 7.5% that you can get with the R186, which has around a five-year maturity. Importantly, inflation will be under control and can be absorbed by that interest rate over the short term and we get our capital back in year five, which allows us to price the bond a lot better. 

Debt stabilization is critical

The SA government debt is on a potentially unsustainable trajectory. We have been bailed out to a certain extent by the resource royalties that we’re getting on their super prices. This will result in dividends flowing out from the resource companies as they pay out these super profits back to the foreign holders once the commodity prices unwind. The tax base is also being hollowed out right now and we need to be cautious about what happens when things normalise with commodity prices. 

Terms of trade supports the Rand

The current account is a good indication of a fair value of a currency. What we've seen more recently is a super profit that resulted in a positive current account as we continue to sell high priced commodities into the market. We even have some port troubles on the other side to import, so we are having to produce a lot more product at home. We believe this will be transitory. In our planning, we believe that the Rand is being artificially driven by unsustainable forces and need to plan for Rand weakness over time.

Focus on stability – don’t bet on one outcome

Equities that have pricing power are the best way to deal with uncertainty. We need to avoid the low returning domestic bonds. Our SA bonds are far more interesting, but we will not have too much in the portfolio. We will maintain balance and gold, although a headwind now, will be a diversifier when we really need it most. This is how stability is generated. 

Stable Fund asset allocation

With the financial repression, the SA money market has moved down from 12.9% to 8.9%. We've continued to move some money out of the money market into government bonds as well as to some smaller discreet opportunities in the SA. Hospitals in South Africa are a great way to play defensive growth that will continue in good and bad times and are trading very well in the third wave. The highest weighting is the R186 at 25% of the portfolio. The Foord Global Equity Fund is one of our building blocks at 16.1% and the Foord International Fund at 14.8%. It's important to understand that having a bigger weighting in a short duration bond is lower risk than having high weightings in long bonds. It's not a higher risk just because it's a bigger weighting, but because of its duration and its high coupon. We’ve also got some financials and resource exposure in SA.

‘Stable’ wins through time – be prepared for multiple scenarios

We need to plan for both a high and low inflation scenario and make sure the portfolio is resilient to achieve a good outcome with inflation-beating returns in both scenarios. Don't be greedy. Understand that we don't have a clear picture of where the world is. We need to plan and diversify across different scenarios to make sure that we continue to achieve everyone’s financial goals in most scenarios.