June 29, 2023

Do well-diversified portfolios translate to consistent returns?

By Laurette Ndzanga, Research Analyst, PPS Investments

Balanced funds, or so-called multi-asset funds are a combination of bonds, money market instruments, equities, and real estate in a single fund. Equities, considered to be a high-return but high-risk asset class are included in portfolios for their inflation-beating abilities, while bonds and money market instruments are included for risk reduction and income generation. Multi-asset funds are considered to be well diversified across asset classes, offering both income generation and capital appreciation, depending on the balance of income and growth asset classes.

How ASISA classifications serve as a guideline for risk exposure

Typically, the fund manager determines this balance, based on the objective of the fund, however, the Association for Savings and Investment South Africa (ASISA) does offer some guidance in its classification system. Multi-asset funds that aim to provide capital growth over the long term with low short-term risk, are classified as multi-asset low equity funds. They can have a maximum equity exposure of 40%, maximum property exposure of 25%, and a maximum allocation of 45% to offshore assets, which increased to  30% in February 2022.

But does easy access to a well-diversified portfolio through a multi-asset low fund translate to consistent performance?

To answer this question, we looked at the dispersion of net of fee returns for all the funds in the (ASISA) multi-asset low equity category over the last 10 years. The results show that the dispersion of returns was wide for each calendar year and that it ranged between 9.5% in 2017 and 31.1% in 2021. For example, in 2020, the dispersion was 21%, with the best-performing fund returning 11.6% and the worst performing -9.6%.

Source: Morningstar

Focussing on 2021, which had the widest dispersion of returns, risky assets shot the lights out. Equities in general, both local and offshore, and small capitalisation JSE shares significantly outperformed the more defensive asset classes such as bonds and cash, both locally and offshore. Funds that tended to be defensively positioned from an asset allocation perspective lagged their peers.

2015 was the worst year for local bonds which returned – 3.9% when then finance minister, Nhlanhla Nene was dismissed and replaced with a politically motivated individual, a move that sent negative market sentiment.

The Rand weakened by 34% as a result and funds with more offshore relative to local exposure outperformed. Within local equities funds with exposure to the largest shares on the JSE, and those that avoided resource shares, which were down 37%, fared much better.  

2022 was unique in that bonds were as volatile as equities, driven by the fastest interest rate hike cycle in history, and along with global equities, and bonds showing negative returns. This brought their traditional role as an equity diversifier into question. 2022 saw global cash and select local equities; resource shares and small capitalisation JSE shares drive performance.

What is clear from this analysis is that offshore assets have had a material impact on the dispersion of returns, an asset allocation call. Moreover, the increased offshore allowance will result in a wider dispersion of returns going forward. Additionally, for a category with low equity exposure, high conviction equity views, whether it be in resources or small capitalisation shares will tend to have a significant impact on whether a fund leads or lags from a performance perspective. Another factor that could determine a fund’s performance, is the duration or interest rate risk.

In conclusion, simply having access to a well-diversified portfolio is not enough to guarantee consistent performance. A manager’s investment style will influence how they allocate to the different asset classes and the type of equities they invest in, stock selection. A more consistent performance could be achieved by selecting best-in-class fund managers within a particular style and blending fund managers with different styles.

While one cannot predict the markets, an in-depth understanding of a fund manager, and how they are likely to construct their portfolio can provide some predictability into how they are likely to perform through the cycle. Such an understanding can only come from a well-researched, repeatable manager research and selection process that not only considers recent performance but rigorously assesses whether the fund manager’s investment philosophy, approach, and risk management processes are reflected in their portfolios.

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