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Local investing

How to construct a portfolio for a range of outcomes

The future is extremely uncertain. This isn’t because of any particular global situation; it is always the case. This is why it is important that we build portfolios for a range of possible outcomes, rather than for a single forecast or expectation. Andrew Lapping explains using the Allan Gray Stable Fund to illustrate his arguments.

Fixed interest has been the best-performing asset class in South Africa over the past three years. The All Bond Index (ALBI) returned an annualised 8.9% and money market assets returned 7.4%, compared to the FTSE/JSE All Share Index (ALSI) return of 5.1% and inflation of 4.7% over the period. Furthermore, money market returns have been very stable, whereas the stock market bounced around in a 20% price range. 

It is clear why the Allan Gray Bond and Money Market funds are experiencing record inflows – investors can get excellent real returns with little volatility. Unfortunately, to have benefited from these returns, investors had to identify fixed interest as the best asset class three years ago, not today. For fixed interest to outperform equity over the next three years, a similar set of circumstances will have to recur, which is very possible, but also just one of many paths the future may follow.

just because a particular asset class or share is not performing well today, doesn’t  mean it should be abandoned or excluded in the future

Using cash as a base

When we construct asset allocation portfolios at Allan Gray, we start with a blank sheet, which is 100% cash. We then add selected investments that we think, based on our normal valuations, will outperform cash with a margin of safety. For example, if we think cash will return 7% for the next four years, we only invest in equities where our expected total return is at least 5% above this rate. 

The same process applies when allocating funds offshore. Our offshore partner, Orbis, invests in a portfolio of shares that their portfolio managers believe will generate real returns. We then allocate to Orbis funds while considering our estimate of the rand’s fair value. Given the vagaries of the rand, the offshore allocation can add price volatility to the Stable and Balanced funds. However, this additional volatility is often less than you might expect as the movements in share prices and the rand often offset one another. 

An offshore allocation can be extremely valuable to cover for uncertain future outcomes. South Africa is a relatively small emerging market with both a current and fiscal account deficit. Historically, foreign investors have been happy to fund these deficits through both equity and bond investments. If foreign investors lose faith in the government’s ability to control the fiscal deficit and decide to withdraw their support, a situation could arise where South African fixed interest investments rapidly lose purchasing power. 

This is just one potential future path, but it is something we must consider when constructing a portfolio and choosing between an international investment and a South African investment, which may otherwise have very similar expected total returns. 

Weighing up the long-term opportunities from different assets

Every asset we pick for our portfolios is carefully weighed up and considered. And just because a particular asset class or share is not performing well today, doesn’t mean it should be abandoned or excluded in the future. The Allan Gray Stable Fund provides a useful example. 

Over the past three years, the portion of the Stable Fund invested offshore with Orbis has returned a disappointing 3.4% per year, a clear detractor when compared to inflation and a 50/50 cash/equity benchmark, which returned 9.6%. So, the root cause of this underperformance was not that offshore assets have done poorly, but rather that Orbis has had a particularly severe period of underperformance. 

Orbis is a contrarian value manager (see ‘Are you comfortable swimming against the tide?’) and, similar to all managers that outperform over the long term, they go through periods of underperformance. Orbis invested in shares that they thought were undervalued; these shares have subsequently fallen further. Importantly, in most cases, the Orbis valuation is unchanged, so the potential gain when prices reach fair value is now greater. This bodes well for future returns. 

Like Orbis, the domestic equities we own in the Stable Fund have underperformed the broader market, returning only 3.4% over the past three years and falling 8.4% over the past year. We selected these investments because we thought the shares in question were trading at a discount to fair value and, as you can imagine, the discount to fair value is greater now than 12 months ago in many, but not all, instances. (For more insight into our stock selection, please see Leonard Krüger’s article.) 

Diversifying through Africa ex-SA assets

The different assets held in our asset allocation funds give the funds the opportunity to earn returns from different sources, in different scenarios. It may seem strange to some investors that 5% of the Stable Fund is invested in bonds in other African countries (Africa ex-SA). People often think of other African countries as inherently more risky than South Africa – and granted, many are. However, there is no reason why a diversified portfolio of African debt, bought at the right price, should have a greater risk of loss than rand-denominated South African debt. This is particularly true when you consider that 37% of the Stable Fund is invested in South African cash and bonds. Can you imagine what a global investor would say if their asset manager told them 37% of their portfolio was invested in rand-denominated fixed interest? Rand assets may not be a bad investment, but this would definitely present a very concentrated risk. In fact, we think rand fixed interest has a good risk reward profile, hence the 37% exposure in the Stable Fund.

Applying our shared investment philosophy and process has led both Allan Gray and Orbis to outperform over long periods of time

Interestingly, the Africa ex-SA bonds have been the Stable Fund’s best-performing asset class over the past three years, returning an annual 18.4%. Given the strong returns, and therefore smaller discount to fair value, we have begun to reduce our exposure to the asset class. To our mind, including assets like Africa ex-SA bonds both diversifies the Fund’s risk profile and augments returns. The same applies to Africa ex-SA equities, a much smaller position at 1.5% of the Fund. 

The Stable Fund’s current mix of assets, as shown in Table 1, is different from 10 years ago, when the Fund was basically 25% SA equity, 55% SA cash, and 20% Orbis Optimal. In hindsight, these asset allocation changes were the right decision as bonds outperformed cash, Global Balanced outperformed Optimal, and the African assets have added value. As discussed above, the main factor detracting from returns over the past three years has been equity selection. We think this is a cyclical factor that should move back in our favour over time.

Allan Gray Stable Fund performance attribution (three years to end September 2019)

Applying our shared investment philosophy and process has led both Allan Gray and Orbis to outperform over long periods of time, and we have no reason to believe this period is any different. One thing that has not changed over the Stable Fund’s history is the goal of generating real returns for our clients, while minimising the risk of loss. We will use all the tools available to us to achieve this goal.

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