We are currently facing a very challenging time as investors, where we are experiencing low returns and an adverse set of circumstances. We have referred to this kind of environment as “Slow Poison”, while a fund manager of ours recently related to it as being, “sand-papered to death”.
When the risk that investors take for allocating their funds to growth assets is not paying off, the most common thought is, “But wouldn’t I be better off with my money in the bank?” Obviously, portfolios like the Dynasty Wealth Preserver Fund of Funds only contain a portion of equity exposure (maximum 40%), but equities remain the driver of returns in the long-term. What this means is that, when the markets are not performing, all portfolios struggle to provide compelling performances.
It then becomes necessary to reflect on the past instances where a lack of returns has led to similar despondency.
Two points are worth noting from the graphs below:
- The stock markets don’t go up in a straight line, and
- They don’t provide signals as to when the returns’ “tap” is going to be turned back on.
The first chart is a 27-year chart of the S&P500 – the US’s most representative benchmark equity index – on a log scale.
Source: Inet BFA
What we’re depicting here is how the performance of one of the world’s key equity benchmarks can be split into three distinct phases. The first phase is a ten-year period from the beginning of 1990 to late in the first quarter of 2000 where the S&P500, excluding dividends, returned 15% per annum in USD and increased in value by over 300% over the period – the good years.
The US bell-weather then entered a period of consolidation where it lost approximately half of its value, recovered and proceeded to repeat the cycle. The net result was that the index, which is a representation of the entire US stock market, spent almost all of the next thirteen years below the level it had first achieved at the end of the previous millennium. Put differently, an investor who, around the turn of the century, had placed their faith in the US stock market to deliver performance, would have spent thirteen years waiting to see a positive result, excluding dividends.
The market then entered the third phase, where it continued the recovery rally which started in early 2009 and saw it regain the 1500 level, to return 10% per annum (excluding dividends) for the nearly four-year period from 2013 to date.
The return experience for a buy-and-hold investor for the entire period spanning nearly 27 years would be 7% per annum, plus dividends. In an environment where inflation has been low and is currently elusive, a 7% (closer to 10% including dividends) return is substantial and leads to real growth in wealth.
The takeaway, however, is that patience, discipline, and time are required to adhere to the investment plan while facing the lean years. It is also the reason that an asset allocation strategy away from portfolios consisting of pure equities is advised for investors who do not have the financial ability or appetite for risk to survive the time taken to reap the rewards. This is the very reason that property, bonds and cash are added to our more conservative portfolios.
The Current South African Situation
In SA we’re currently experiencing a period that is testing investors’ patience and resolve, as can be seen in the following chart, which depicts the FTSE/JSE All Share Index (ALSI) since June 2014.
Source: Inet BFA
The local benchmark index (also excluding dividends) first broke through the 51 000 level in June 2014. As at the end of October 2016, it is below that level, which means that the SA equity market has delivered no performance in rand, over more than two years. What is worse is that the period from when the market peaked in April 2015 to 21 January 2016 saw a drawdown of 16.4%. In addition, with local inflation of approximately 6% per annum, there has been a real decline in value over the period.
What we know is that we have been through similar periods, even as recently as the early 2000’s. The following chart shows how no compelling growth had materialised in the ALSI in the period from January 2000 to November 2003.
Source: Inet BFA
Investors were disillusioned at this time and, having experienced disappointment over the prior four years, could quite easily have viewed the slight rally into January 2004 (the orange portion above the line) as an opportunity to exit the market. Believing that the market was range-bound and had formed a short-term high would have been quite reasonable after four years of disappointments.
The chart below shows that such an investor would have felt justified as the market did indeed sell off over the next four months.
Source: Inet BFA
Then, without providing any signals, the market entered the period depicted in the graph below where it gained over 34% per annum (excluding dividends) for five years to increase in value by more than 4.5 times, without offering any substantial correction for investors to re-enter.
Source: Inet BFA
Effectively, what we’re trying to show is how periods of consolidation can be followed by periods of growth and these periods can appear without warning. It is therefore not feasible to expect to be able to switch into cash while the equity market is not performing and then switch back again when the market starts running. Apart from cash being extremely tax inefficient, it is also not a hedge against inflation and currency depreciation. Cash can, therefore, be the worst performing asset class in treacherous times of currency weakness and heightened inflation.
While our market is currently in a phase of consolidation, we don’t believe that we will be required to endure a 13-year period before we once again achieve inflation-beating returns. Internationally 2016 has been a strong year for many equity markets, and the returns of the funds that we utilise have shown strong growth to the end of September. Emerging Markets (EM) have also recovered well and so, where the EM returns are viewed in dollars, the returns are high. In the same manner, SA returns are being hampered by the recovery of the rand in 2016, and so once this rand improvement abates, we should see a pick-up in rand-based returns.
To illustrate how the large capitalisation shares are dominated by rand-hedge companies, the Top 40 Index is up 1.44% for the year-to-date ending 30 September 2016. In comparison, the locally dominated Mid Cap and Small Cap Indices are up 25.6% and 20.2%, respectively, over the same period.
We also believe that 2016 will be the year in which SA’s GDP growth bottoms out and, while we should still expect subdued growth for the next couple years, the forecast is for improving local conditions.
The Emotional Rollercoaster of Investment Performance
Each investment cycle can be characterised into phases. The following chart shows how investors will typically experience the cycles.
Source: Philo Capital
It is uncanny to see how the emotions experienced and the behavioural biases that they lead to, resonate so clearly with the interactions that we have with clients, fund managers and other investment professionals. It’s illuminating to note how the period marked “Most people BUY here” is above the level marked “Most people SELL here”. Effectively the reactions lead people to buy high and sell low – the exact opposite of their intentions. It would seem that we are hard-wired as human beings to react in this manner, and it is our role at Dynasty, as the investment advisor and asset manager, to assist clients in avoiding these emotional reactions.
Our portfolios reflect our “house views”, which have been well researched and have proven that they achieve the desired outcomes over time. For example, the Dynasty Wealth Preserver Fund has a rolling 3-year investment return target of SA inflation plus 3% (annualised). The chart below shows that the cumulative return of an initial investment in 2004 of R1.0 million in the investment target would now be worth R2.81 million whereas a similar investment in the Dynasty Wealth Preserver Fund would now be worth R4.27 million.
Source: Dynasty Investment Committee
We gain comfort from the fact that clients that have followed our advice in the tough times of the past have benefitted and are pleased with their results. Our five and ten-year returns remain competitive and have often been achieved at much lower risk than the benchmarks that we set.
The Cost of being Out of the Market
The above chart hopes to illustrate how being out of the market can cost investors. The chart shows the ALSI performance over the period of 17 years, from the October 1999. There are 4245 trading days in this period, averaging a return (excluding dividends) of 0.018% each day. The red dots indicate the best 33 daily returns over the period, so approximately two days per year, or less than 0.8% of all the days. The yellow line shows how different an investor’s return would have been had they missed just those 33 days’ performance over the last 17 years. The ALSI return over the period is 12.5% per annum, which equates to 638%, excluding dividends. The yellow line compounds at 2.8% per annum or 61% in total over the period.
Therefore, the unfortunate investor who missed only the best two days per year would have less than 22% of the value of the buy-and-hold investor after 17 years.
What is also interesting to note is that very few of these trading days occurred during the steady bull markets where things were looking rosy, and it was easy to remain invested. No, the vast majority of the best trading days, the ones that we can ill-afford to miss, actually occurred during periods of heightened volatility and during the Global Financial Crisis of 2008/2009, in particular. It shows that the point of desperation in the previous chart, where most investors are likely to sell, is where investors can face the biggest opportunity cost of being out the market.
We were facing a similar situation of client concerns in 2015 on our offshore portfolios – as the returns were weak and some of the managers we invest with had taken positions of conviction, in Emerging Markets for example. The situation has since reversed and, as in SA this year, the underperforming funds of 2015 are the outperforming funds of 2016.
As South Africans, we’re currently facing a period of structurally low growth, which is exacerbated by the fact that political uncertainty is leading to local businesses sitting on higher cash reserves than they normally would. It is possible that we may avoid a foreign sovereign credit rating downgrade in a month’s time, but part of the fiscal shortfall that has to be closed to prevent a downgrade will need to be funded by increased taxes – a phenomenon that is likely to further subdue growth.
Offshore exposure has hurt our rand based portfolios, but the investment case remains.
Therefore, it remains prudent for us to maintain the offshore exposures that we currently have, despite the fact that, with the rand recovering substantially this year, the offshore allocation has weighed on rand-based performance.
The further benefit of investing offshore includes the fact that there is a much broader universe of companies which operate in a wider range of sectors, thus providing true diversification away from SA. Many of these multi-national companies produce consumer staples that are sold around the world and are therefore not cyclical regarding their profitability. These companies’ global exposure also dilutes the country-specific risks they face to their bottom line.
History is thus on our side whilst employing the balanced approach that we take to investing. The non-equity asset classes provide a cushion when markets panic and provide a yield when markets tread water. This is a much more sustainable approach than trying to time the markets between risky and less risky asset classes, as demonstrated above. It also, as outlined above, leads to returns from our portfolios for our clients both locally and globally that significantly exceed those of cash over the medium to long-term.