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Tuesday, May 1, 2007
Three strikes and you are out?

South African investors who have benefited from the glorious bull market since 2003 have had two wake-up calls over the past year. In May last year and then this year February local equity and bond markets fell sharply as investors demanded a greater expected return from riskier assets. Does this renewed focus on risk have any implications for how investors should construct their portfolios, asks David Crosoer of Glacier by Sanlam?

Investors have largely got away with ignoring risk over the past four years. Or – to put it a bit differently – past performance has been a relatively good predicator of future performance as the funds that have taken on greater risk have continued to be rewarded. The danger with constructing portfolios on this basis is that past performance is not always a good predicator of the future, and it is a particularly poor predictor when the market no longer rewards clients for taking on risk.
Investors who ignored risk were hit hard in May last year and February this year. The JPMorgan Emerging Market Bond Spread, for example, illustrates the premium demanded by investors for holding emerging market debt (which is more risky) over US Treasuries. When investors are not concerned about risk this spread tends to be tight. As the charts below illustrate, periods of market volatility are shown by sharp spikes in this spread (thick line).

The charts also show how the South African equity market (in US$) fell in line with other emerging markets when investors became concerned about risk. The thin line (the All Share Index in US$) and the dotted line (emerging markets in general) fell almost exactly the same.
In addition, the local funds that had performed best in the four year bull market tended to be the ones that fell the most in the market corrections. This was because funds that took on the most risk (by holding riskier assets or shares) tended to fall the most.
Risk-adjusted measures focus not on the absolute performance of the fund, but against the amount of risk needed to achieve that return. There are a number of risk-adjusted measures investors can look at. Two of the most popular are the Sharpe ratio and the Sortino ratio. These measures tell us how much risk a manager has taken on to generate his return. Both measures provide a more detailed analysis of the fund’s performance, than simply focusing on the absolute returns.
The implication appears clear. A substantial re-pricing of risk will adversely affect South African equity markets and other emerging markets. And funds that have chased performance (by holding more risky assets or shares) will be most adversely affected by a re-rating of risk. So investors need to ensure their portfolios are diversified across both local and international markets, and that their local selections take risk-adjusted performance rather than past performance into account. The JP Morgan Emerging Market Bond Spread is still at historically low levels, despite the recent market correction. It is not too late for investors to construct their portfolios appropriately.
 

Copyright © Insurance Times and Investments® Vol:20.4 1st May, 2007
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