Blending our best ideas: Lifting the lid on the asset allocation of our multi-asset portfolios

Blending our best ideas: Lifting the lid on the asset allocation of our multi-asset portfolios

Our multi-asset process starts by considering cash
Multi-asset funds can invest across multiple asset classes to meet their portfolio objectives. We aim to allocate capital to our best ideas, balancing risk and potential reward, in line with the client and mandate needs.

Our default position is always cash, and we will only allocate to opportunities that offer sufficient risk-adjusted returns above what can be earned on cash. Every security has a return hurdle based on the risks associated with investing in it. We allocate capital on a bottom-up basis, as the expected returns exceed these required return hurdles. The expected return is a function of the current market price.

Our clients should be aware that our portfolio construction process has the following characteristics. We:

• Deliberately employ a countercyclical approach, as we tend to allocate capital to securities with high expected future returns.
• This often happens when prices are depressed and sentiment is weak.
• Follow a cash-first approach and will run with sizeable cash holdings if the alternatives are unattractive.
• Can be positioned very differently to other market participants and do not use strategic asset allocation.
• Are careful not to overpay, even as we actively seek out securities providing insurance or low correlation to our other ideas (therefore improving diversification).
• Take a patient, long-term approach. Sometimes it takes time for undervaluation to translate into higher prices.

In constructing multi-asset class portfolios, we draw the best ideas from across asset classes
Our portfolio construction seeks to blend our team’s best ideas for all available asset classes. The objective is to reach an optimal balance of risk and return and to ensure a satisfactory outcome in as many scenarios as possible.

While many investors may associate multi-asset funds with the higher-risk balanced funds (which can hold up to 75% in equities, like the PSG Balanced Fund), there are also multi-asset funds with more moderate risk profiles and a lower allocation to equities (like the PSG Stable Fund, with a maximum of 40% in equities, and the PSG Diversified Income Fund, with a maximum of 10% in equities). As the asset allocation changes in line with our process and where we see opportunities emerge, these funds offer a dynamic solution to changing market conditions, while remaining aligned to the stated fund objective.

We believe that, considering the poor expected returns from cash and income assets (as detailed in Our asset class views below), income investors who are able to extend their time frames slightly, should consider how low equity multi-asset funds can be used to address their income needs. These funds offer a compelling alternative to more cautious income-seeking investors who are willing to tolerate some additional volatility.

Our asset class views
Cash and credit
The South African Reserve Bank (SARB) benchmark repo rate has been cut by 300 basis points to a 55-year low of 3.5%, in a decisive response to the Covid-19 pandemic. In turn, yields on cash and money market instruments, which are determined by a combination of market forces and the repo rate, have fallen too.

Our sense is that the current cash market is complacent about inflation and it seems likely that cash and money market instruments will deliver very poor (possibly negative) real returns from current levels. Like much of the global fixed income market, in the SA cash space, risk-free return appears to have turned into return-free risk.

The fortunes of the credit and cash markets are inextricably bound together, as most of the credit market issuance occur on a floating-rate note basis, with an additional credit spread over a base rate, such as JIBAR (which floats in line with the repo rate).

Over the last year, we have observed a substantial decline in both components of the return on credit: base rates (as the repo rate has been cut) as well as credit spreads, which have compressed materially.

The compression in credit spreads (most visible in corporate bonds and money market instruments issued by the domestic banking sector) stands at odds with both the current economic environment and other asset prices. The chart below highlights how credit spreads for 3-year bank paper fell to decade lows (approximately 60 basis points above JIBAR) while bank equity valuations (proxied by the price-to-book ratio) are signalling much more fear. It is clear that investors are currently being paid more to take the equity risk, as opposed to the credit risk of the same issuer.

We think this disconnect can be explained by classic supply and demand: caution and good historical real returns have resulted in a ‘dash to cash’, as seen by substantial net flows into income funds in the ASISA statistics. Meanwhile, this demand has not been matched by supply: the issuers (mainly banks) have slowed lending and retail deposits have surged as bank customers fled to safety. The result is that wholesale credit instrument issuance (supply) has fallen at the same time. Consequently, credit spreads have responded by narrowing (i.e. providing smaller additional returns over the JIBAR rate).

These supportive dynamics have a high likelihood of reversing. It is likely that holding cash, which is the traditionally safe asset class, has become significantly more risky. Poor liquidity and thin trading volumes in the secondary market magnify these risks further.

We are still appreciative of cash as a default position and for the intangible benefits it can provide as dry powder. However, we have low allocations to cash and credit compared to our historical holdings and are instead allocating to alternatives such as short-dated inflation-linked bonds and selected defensive and undervalued equities. In some funds, we have opted to use equity hedging instruments rather than cash holdings for defensive purposes.

Government bonds
We continue to favour SA government bonds.

We are well aware of the precarious fiscal position South Africa finds itself in. However, it is important to put the fears around Government’s fiscal position into perspective. Our research suggests that the fiscal risk premium and bond supply premium (increased government funding requirements) embedded in SA government bonds are excessive. Curves are therefore steep when comparing the mid- to long parts of the curve to the shorter end. This provides an opportunity to enjoy high levels of yield and, given the elevated shape of the curve, investors will enjoy the benefits of a steep ‘rolldown’ as time progresses.

One niche area of the sovereign bond market that stands out as being particularly attractive at present, is inflation-linked bonds.

Inflation-linked bonds (ILBs or inflation linkers) are particularly attractive right now, for a number of reasons:

• Real yields above 4% for longer-dated instruments are high by historical standards (above the 98th percentile) and are among the highest in the world. 
• Total returns look very compelling relative to cash and fixed nominal bond alternatives, especially after adjusting for risk (no inflation or credit risk).
• Foreigners are not large players in this space.
• They provide valuable portfolio insurance in the seemingly unlikely scenario of a spell of elevated inflation or even the expectation thereof (a scenario that would be very challenging for traditional cash and fixed-rate nominal bond instruments).
• ILBs play a valuable role in the portfolio as they bring a significant all-weather dimension to multi-asset and fixed income portfolios by virtue of having an adjustable base rate mechanism. During periods of unexpected, elevated inflation this provides an invaluable counterbalance to many exposures in a portfolio. In times when other floating alternatives are unattractive, short-dated inflation linkers can be an efficient instrument choice.

While short-dated ILBs are a compelling alternative to cash and floating-rate credit today, we also find significant opportunity in long-dated ILBs.

Long-dated ILBs can be volatile given relatively high duration characteristics (price is more sensitive to changes in yield), but at sufficiently high starting real yields, they can begin to compete against equity alternatives, at much lower levels of risk.

In the chart below we consider the expected range of outcomes for the FINI 15 equity index (a good proxy for SA interest rate sensitive equities) and a long-dated ILB maturing in 2050 looking forward over a one-year horizon. We consider four scenarios below. A bear case, in which we assume a return to the (all-time) low levels reached during March/April of 2020, a status quo scenario where there is no normalisation in rating, an upside scenario where the rating reverts to the 10-year average and, finally, a bull scenario where the 10-year 90th percentile rating levels are reached. Currently, the two investments have similar starting dividend/ coupon yields of 5.0% and 4.3% respectively. Assuming no change in rating and that capital grows in line with inflation (assumed at 5%), we arrive at very similar status quo returns. However, considering the range of outcomes on the down- and upside, we see very favourable asymmetry from the long-dated ILB – especially considering the risk-free nature of the investment.

The last year has seen a profound recalibration of the fixed income opportunity set (see the chart that follows). We have responded by reducing our cash and credit exposures and adding to nominal and inflation-linked bonds, where short-dated linkers are playing a valuable cash-type role and longer-dated instruments are providing equity-like expected returns at substantially lower risk.

South African listed property
The South African listed property sector has had a torrid few years. The sector was facing headwinds even before the onset of the Covid-19 pandemic, and once the pandemic hit, many fundamental concerns were amplified. The negative conditions dogging the listed property sector are very real, and a large part of the reason why we had avoided the sector over the past few years.

However, our interest is piqued when extremely negative narratives become conventionally accepted wisdom, and we are carefully sifting through the train wreckage, and incrementally and selectively adding to opportunities in this space. The chart below illustrates that the South African Property Index is currently trading deeply discounted and at a fraction of long-term average net asset values, as an indication of how negative the sentiment has turned.

Equities
As highlighted in Shaun le Roux’s article Why our funds remain offensively positioned when equity markets are high, we are taking advantage of some very compelling investment opportunities in high-quality companies.

We believe the prospects look excellent for long-term returns from a portfolio that also includes carefully selected contrarian equity opportunities. Our equity buy lists are full relative to history – a reflection of the attractiveness of the current opportunity set.

Case study: How our asset allocation decisions are reflected in the PSG Stable Fund
The PSG Stable Fund aims to achieve capital appreciation and generate a performance return of CPI+3% over a rolling three-year period. The investment policy provides for investment in a mix of debt securities, money market instruments, bonds, inflation-linked securities, listed equities and property, preference shares and other high-yielding securities and derivatives. The fund may have up to 40% in equities and operates within the constraints of Regulation 28 of the Pension Funds Act. View the full MDD here.

Currently, we are finding compelling opportunities in local and foreign equity markets, selective opportunities in local and foreign property, and fixed-rate and inflation-linked sovereign bonds. Given our current concerns about the credit and cash sector, we hold a below-average allocation to these instruments when compared to the long-term average.