The past three years have seen a powerful combination of positive factors contributing to a buoyant local economy — structural reform, high and rising commodity prices, low inflation and historically low interest rates — putting South Africa on a growth trajectory not seen since the 1960s.
One thing is clear in financial markets, though: things seldom stand still, and the next three years are unlikely to look exactly like the previous three, says Glenn Silverman, global chief investment officer at Investment Solutions.
Fund managers and investors will need to position themselves according to their view as to whether they see a bull market or a bear market, or a sideways market — with volatility.
Silverman says that, notwithstanding Investment Solutions’ positive bias, a number of risks, both global and international, could cause the current happy circumstance to flip around. These include a sharp fall in world growth, with a concurrent fall in commodity prices and a potential error in reading the cycle by central bankers, both locally and internationally.
“These events could very quickly change risk perceptions, and turn the very positive net inflows — about R157-billion into equities alone over the past three years — into net outflows. This would mean that financing the current-account deficit approaching 6% of GDP, would become problematic, and [affect] the rand.”
But making a call on these risks is not easy, says Silverman, with as many negative views as there are positive. Worries about the mortgage-backed securities market and the sustainability of stock market gains in the United States are countered by the Investment Solutions view that equity assets are relatively cheaply priced to take into account these risks.
Further divergence in outlook is found among South African managers, says Silverman. One pattern emerging is that local managers are no longer finding South African equity markets cheap when compared with global markets.
Silverman says managers would likely look to increase their global exposures, but current legislation restricts the extent to which they can do this.
Furthermore, managers will increasingly look to return enhancing approaches, such as tactical asset allocation (TAA), to add value, especially if they perceive downside risks.
“We do not see TAA as the same as the much ‘demonised’ market timing,” explains Silverman, “but it rather seeks to exploit short-term and, in particular, extreme anomalies in valuations across asset classes.”
Through tools such as derivatives, TAA allows a manager to take profits on asset classes that have run too hard, or to buy into asset classes that have fallen too sharply, where the fundamentals may in fact not have changed much, though perceptions of risk may have. This ‘risk event’ provides the rational investor with opportunities.
TAA works best in volatile times, and thus may well come into its own now, given recent volatility in equity markets. With the “easy money” in South African equities now behind us, investors will need to work harder for returns.
“In local and global equities we have taken some profits on recent gains, but our long-term view is that equities remain inexpensive, especially relative to bonds, so we are maintaining our overweight equity positioning,” he says.
Silverman says TAA has had a significant effect on returns over the past three years for Investment Solutions, realising well more than R100-million a year on approximately R23-billion-worth of portfolios, where TAA is applied.
Other alternative strategies to be considered include the use of hedge funds, absolute return funds and private equity.
“International hedge funds have delivered in terms of beating bonds and cash and in limiting downside risk versus equities, but have, at least more recently, not necessarily delivered returns in line with expectations,” says Silverman.
A huge amount of money has flowed into this asset class — now more than $1,3-trillion — but not always wisely.
Says Silverman: “We have made considerable progress with respect to launching some other international options, in addition to the more ‘traditional’ hedge fund of funds approach. These would be more along the lines of ‘long only, absolute return’ funds with flexibility; that is, allowing for TAA within the manager’s mandate.”
Private equity is also very topical at present, but more suited to those with a high risk appetite and who are prepared to pay high fees for long lock-in periods (typically seven to 10 years). This “asset class” also typically requires an investment of large sums of money (R50-million-plus), often putting it out of reach of the individual investor.
The current buoyant South African market and economy has created an environment where 19 start-up managers have come into existence in the past three years alone, according to Investment Solutions research. “We have seen these cycles before” and for some, it may end badly.
“With the proliferation in new managers, investors are likely to see more, rather than fewer offerings and choices in the next few years,” says Silverman. “Clearly, not all of the new managers or investment offerings will necessarily prosper, survive or meet the high return expectations of some investors.
“Investors should thus be careful and read the ‘packaging’, related to the new offerings, carefully. Whilst we remain bulls on South Africa and equities — though now more cautious ones — the ride is likely to become a bumpier one, and the road signs may well mislead. Caveat emptor — the buyer beware!”