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Investment Strategy
Friday, August 1, 2008
Tricky timing

Absolute return funds aim to protect investors’ capital and provide inflation beating returns, without losing capital over one-year periods. But returns from these funds have been as varied as their strategies, with most recent figures showing one-year returns ranging from 20.45% to -5.30%.

Comments Tamas Kulcsár of Glacier Research, “One wonders how funds in the same category can deliver vastly different returns, and why fund managers seem to be unable to protect capital effectively.”
A fund’s return is dependent on the assets in which it invests. Absolute return funds can invest in equities, property, bonds, preference shares, and cash and derivative instruments. Over the last five years all these asset classes have generated positive returns. But what happens when more than one of the major asset classes stops performing? If a portfolio has 30% in equity and 70% in cash, a 10% fall in the equity market over a year will mean the fund returns just 4% for the year, assuming cash generates 10%. This simple example illustrates how dependent these fund returns are on the performance of equities - made all the more difficult by rising inflation and a stock market buoyed entirely by one sector - resources.
“Managers try to protect capital in the short term by investing in defensive stocks, using derivatives, or switching into cash,” says Kulcsár, “but investors are sometimes unreasonably hard on fund managers when they maintain exposure to underperforming assets in times of uncertainty. In order to outperform inflation over the longer term (>3 years), exposure to riskier asset classes, like equities, is necessary; and continuously timing the market correctly is near impossible, even for experienced professionals.” Unfortunately, investors tend to act first and think later and effectively lock in losses by switching out of funds immediately after a period of poor performance without identifying the reason for such performance or determining the chance of recovery. This creates the potential for the so-called ‘double whammy’ – selling the dog for a diamond, only to see the diamond become the dog.
“So at what point does one disinvest from a fund, and how does one select a new fund?” he asks. “Scrutinise asset allocation to ascertain whether the equity exposure is consistent with the investor’s needs and risk tolerance of the investor.” And bear in mind that a fund with a CPIX + 4% benchmark needs anywhere between 20% and 50% in equities. This higher limit could pose a problem for cautious investors, especially those who require an income from the investment, as volatility of returns increase and capital losses approach double digits (for some funds). Secondly, the fund’s equity sector allocation (i.e. Financials vs. Resources vs. Industrials) needs to be aligned with the investor’s view. Funds invested in resources are reliant on the continued commodity boom, while funds overweight financials and industrials are hoping for an end to interest rate hikes and a consumer driven recovery. Thirdly, investors should determine the extent of derivative use and understand the limitations (and risks) of these instruments. Lastly, in a low return environment, fees become a potential source of relative value, so note what you are paying for your fund.
Notes Kulcsár, “With any investment, your time frame is of vital importance. Managers go through cycles. Some change their portfolio to account for changing conditions, while others stick doggedly to their position. Only time will tell which strategy is best. For now, investors should evaluate the fund specific risks of their portfolio and make an effort to understand the portfolio’s characteristics better. This will go a long way to giving investors some peace of mind during these uncertain times.”

About Glacier

Glacier by Sanlam services intermediaries and clients in the affluent market. Endorsed by Sanlam, the company offers a wide range of financial solutions, designed to assist affluent clients to create and preserve wealth throughout their lifetime. These solutions include investments, shares and fixed interest instruments, estate planning: wills, estates, trusts and offshore fiduciary services, as well as comprehensive asset protection and a personal cover offering. For more information, please visit www.glacier.co.za.
 

Copyright © Insurance Times and Investments® Vol:21.7 1st August, 2008
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