Managing downside risks in the later stage of the global bull market



Having now endured for well beyond a decade, the equity bull market in developed markets is officially the longest in history. Over this period, the market share of passive global equity market strategies has increased significantly. The market share of active US equity funds, for example, was 51.3% at the end of 2018, versus 48.7% for their passive counterparts. In 2009, the split was 73% (active) versus 27% (passive).

And while investors have enjoyed the tide of rising markets, the importance of managing downside risks received less attention. But with global growth concerns and geopolitical uncertainty on the rise, so too are the downside risks increasing.

These include rising debt burdens across governments, companies and households and central bank policy starting to shift away from the huge quantitative easing experiment that has supported asset prices over the past 10 years. Furthermore, volatility spikes in equities, bonds, currencies and commodities serve as an important reminder of the latent risk in markets at these levels. Technological change is also severely disrupting a variety of companies and industries, causing earnings forecast downgrades in many cases.

When it comes to generating sustainable long-term returns, avoiding capital losses is just as important as achieving capital gains. This is where the value of good active management truly comes to the fore. Index-tracking passive strategies expect investors to put their faith in a basket of equities, regardless of their characteristics and inherent risks.

Investec Asset Management doesn’t believe a quantitative passive approach is able to fully capture mispriced opportunities or able to generate sustainable outperformance over the long term. As active managers, we believe that in-depth, bottom-up qualitative research is essential to fully evaluate the sustainability of a company’s competitive advantage and profitability.

Quantitative metrics may not reveal, for example, the true strength of a company’s competitive positioning and market share or the effect of short-term currency movements. They also would not demonstrate a company’s dependence on the economic cycle or its relationships with key stakeholders, or business tail risks, such as regulatory/political risk or over-reliance on a single product, market or customer.

Furthermore, aggressive accounting and financial engineering can give a false picture of the actual health of a company. This can distort earnings-based metrics on which quantitative passive strategies rely. Even accurately reported figures can be misleading. For example, high margins may reflect under-investment rather than pricing power or cost efficiency. Overall, different levels of disclosure, accounting treatments and calculation methodologies, as well as corporate activity leading to one-off gains or losses, all make cross-company comparisons difficult using a solely quantitative-based approach.

In addition, quantitative strategies struggle to take advantage of forward-looking themes and trends, such as technological disruption, and social, environmental, political and demographic change.

Our quality investment team scours a global universe of more than 20 000 listed equities from which we select only 25 to 40 stocks for the Investec Global Franchise Fund.The fund has a long-term track record of delivering durable, defensive and differentiated returns. Our portfolio companies have proven to be less sensitive to the economic and market cycle and have offered an attractive combination of resilience and long-term structural growth — much-needed attributes in this uncertain environment.

Clyde Rossouw is co-head of quality at Investec Asset Management

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Clyde Rossouw
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