This article was first published in the 4th-quarter 2015 edition of Personal Finance magazine.
With inflation matching the average returns from money market funds, investors in these funds – the traditional “safe house” or “parking place” for cash awaiting deployment – have enjoyed no protection from inflation and have been losing buying power. Inflation over the past 36 months, as measured by the Consumer Price Index (CPI), has averaged 5.5 percent, while the average return of money market funds has been 5.54 percent over the same period.
Three years ago, 23 percent of investments in local unit trusts were in money market funds; today, it is 16 percent. It is difficult to track exactly where the missing seven percent has gone, because the definitions of the unit trust categories have changed over the past three years, but there is no doubt that much of it found its way into higher-risk, interest-bearing funds and multi-asset funds.
What options do out-of-pocket money market investors have? Funds in the South African interest-bearing variable-term and the South African multi-asset income sub-categories are two.
Funds in the interest-bearing variable-term sub-category can invest only in interest-generating assets, such as cash and bonds, whereas funds in the multi-asset income sub-category can, in addition to cash and bonds, invest in equities and listed property. The managers of funds in both these sub-categories switch between asset types when they believe one offers better value than another.
Have these sub-categories produced inflation-beating returns? According to ProfileData, the average return of the South African interest-bearing variable-term sub-category over the three years to September 17, 2015 was 5.14 percent a year, while the South African multi-asset income sub-category has turned in 6.07 percent a year over the same period. Given that investors are searching for a substitute for the ultra-cautious money market fund, it is worth noting that, in addition to superior performance statistics, the multi-asset income sub-category emerges with better risk statistics than the interest-bearing variable-term sub-category.
Having identified a sub-category, how do you identify a suitable fund? There are 54 funds with a three-year track record in the multi-asset income sub-category. All the big asset management companies are represented, as well as a range of boutique investment companies and white-label funds (funds that are housed under the umbrella of an asset management licence-holder).
Figures from ProfileData show that, over the 36 months to the end of August 2015, the Prescient Income Provider Fund returned 9.86 percent a year, with superior risk statistics as measured by maximum drawdown and volatility scores.
The objective of the Prescient Income Provider Fund is to out-perform inflation by three percentage points without losing money over any three-month period. It is suitable for investors who want stable, above-inflation returns.
The fund is managed by a team of four investment professionals led by Guy Toms, an industry veteran and a co-founder of Prescient. He is assisted by Farzana Bayat and Jean-Pierre du Plessis. Meyer Coetzee, the head of retail at Prescient, is in charge of marketing the fund.
Some of the funds in the multi-asset income sub-category have CPI-related benchmarks, which are easier for investors to understand. Why didn’t you choose an inflation-related benchmark?
Meyer Coetzee: Although the official benchmark for the Prescient Income Provider Fund is the Short-term Fixed Interest Index times 110 percent, the return target is CPI plus three percentage points a year. Both appear on the fund’s fact sheet.
Funds in the multi-asset income sub-category have on average returned 6.07 percent a year over the 36 months to September 17, 2015. Inflation is five percent. Some of your competitors have produced below-inflation returns. How did you avoid this?
Risk management is crucial for a fund that aims to out-perform inflation consistently over any 12-month period. We invest only in assets that we believe will out-perform inflation, but, before we buy any asset, we ensure we understand the risk that that particular asset will bring to the portfolio. If there are scenarios where the asset might endanger the stability of returns (or result in the fund failing to beat inflation over 12 months), we would adjust the exposure to protect the targeted return.
Take us through the fund’s philosophy and attitude to losing money.
The philosophy is simple: buy a diversified pool of quality assets that can be expected to provide investors with stable, inflation-beating returns throughout the market cycle. This fund has no room for cowboy-style investing, because capital losses cannot be tolerated, but it also needs to avoid being too conservative, because inflation is enemy number one.
What is the fund’s mandated allocation to the various asset classes, and why and how does it differ from the sub-category limits?
The fund is classified in the multi-asset income sub-category, which means it invests predominantly in income-generating assets. It can hold up to 10 percent in equities and up to 25 percent in listed property. At least 70 percent of the assets must be invested in South Africa.
Beyond the sub-category requirements, the fund does not have strict internal limits. However, assets with more volatility, such as property, are kept at a lower level to ensure that capital stability is maintained. The fund currently holds no equities and about five percent in property, because these two asset classes can introduce unnecessary capital risk. Although the fund holds about 20 percent offshore, we hedge the currency risk to minimise the risk of capital loss if the rand strengthens, as it did from the end of 2001 and early 2009.
How do you take enough risk to produce inflation-beating returns, but avoid the capital losses associated with “bad” risk?
We do not want capital losses over any rolling three-month period; that’s the “risk benchmark”.
There are a number of areas where one can enhance returns, but one always needs to be careful to manage the risk of capital losses. The major areas in which we can enhance returns are:
* Duration, which is the sensitivity of the price of a bond to interest rate movements. Broadly speaking, the longer the outstanding term of a bond, the riskier it is, but also the better the prospect of higher returns. Cash has zero duration.
* Credit, which is where the portfolio invests in bonds not guaranteed by the government, such as those offered by banks and listed companies. These bonds offer higher returns, but, again, it is crucial that defaults are avoided, such as the one suffered by African Bank. The processes to check credit risk must be comprehensive and robust to ensure that the potential rewards for taking on credit risk are adequate and to minimise the risk of defaults.
* Offshore assets. Although the rand has been a one-way bet since 2011 – depreciating in excess of 15 percent a year – we often forget that there have been periods when the rand strengthened significantly over the shorter term, resulting in currency losses on offshore assets. When the rand weakens, the United States dollar value of the fund increases, which results in higher returns. More assets held offshore mean higher returns under this scenario. However, the opposite is also true, hence holding offshore assets can result in significant risk for the fund. For example, between the end of 2001 and 2004, when the rand strengthened by more than 20 percent a year against the dollar, and between early 2009 and mid-2010, when it strengthened by more than 15 percent against the dollar, investors holding dollars lost 20 percent a year and 15 percent a year respectively.
Although rand strength looks highly unlikely at the moment, it does not mean that the risk doesn’t exist; therefore, we have locked in the great returns the fund has enjoyed over the past number of years by hedging the currency risk.
Ultimately, one must never lose sight of the objectives of the portfolio and the risk profile of the typical investor, and then manage the assets so that you never disappoint them.
Market volatility has resulted in an increasing number of fund managers wanting to invest in multi-asset funds. What effect does this have on the availability of suitable underlying holdings?
The availability of assets in multi-asset funds has never been an issue for us. Most asset classes, such as bonds, money market and property, are generally fairly easy to buy and sell and are readily available for investment. Credit bonds are less liquid, but the credit market has grown substantially over the past decade, so there is no shortage of credit bonds in the market. Also, since the Basel III regulatory framework introduced new capital requirements for banks, it has become expensive for companies to borrow from banks, which has resulted in more companies borrowing directly from asset managers, and we expect that trend to continue. Preference shares are the least liquid asset class in this sector, and getting in and out of a position can take a few months.
What are some of the buy-and-sell decisions that have worked particularly well over the past few years?
Over the past three years, stable yields generated by local cash and short-duration bonds accounted for about six percent of the fund’s total return every year. The remaining three to four percent a year came from holding a combination of offshore assets, local property shares, inflation-linked bonds and some preference shares.
Within the offshore component, property shares such as Rockcastle and Growthpoint Australia performed very well, particularly with the rand weakening by about 15 percent.
Offshore interest rates and bond yields are at historical lows, but nearly 20 percent of your portfolio is invested offshore. Why is this?
Offshore investments offer a number of potential benefits for investors, including some attractively priced opportunities not available in South Africa. The fund can benefit from this diversification, either from the return of the underlying asset or via exposure to offshore currencies.
Broadly speaking, interest rates and bond yields globally are at, or very close to, all-time lows. However, the wider offshore universe provides us with more opportunities; one example we like is listed property.
We believe that local listed property values are high and might introduce unnecessary risk to our fund. However, the yields on offshore property offer good value, particularly if converted back into rands and after taking a possible increase in interest rates into account. This opportunity would not have been possible in a local-only mandate.
How do you identify listed-property opportunities?
We invest in property shares when the historical and future income distribution offers value relative to both the company’s history and alternative property investments. The added risk of including property investments in an interest-bearing portfolio is weighed up and discussed at length before the allocation is made.
At the end of August 2015, the fund had assets of just over R6.6 billion and was the fourth-biggest fund in its sub-category. The two largest funds in the sub-category have assets of R25 billion and R13 billion. What role does fund size play in this sub-category? Do you think that bigger funds can negotiate better deals, with bonds, for example?
Fund size is a double-edged sword. If you’re too small, you don’t have the bulk to negotiate attractive deals with issuers – for example, banks. When you’re too big, you might negotiate better terms, but typically you can’t find enough assets to buy to capitalise on those terms and therefore to have a meaningful impact on the fund’s returns. We find ourselves in the best of both worlds and do not foresee being hampered by size in the near future.
One of the aims of the Prescient Income Provider Fund is to generate income, but, according to ProfileData, the fund produced a yield of 5.01 percent over the three years to the end of August 2015, which is one of the lowest in the sector. Why is this?
Prescient manages the fund with a total-return focus rather than just maximising yield. At the end of the day, the combined interest and capital growth is to the benefit of the investor. The fund therefore offers a balance of income and capital growth, with the benefit that capital growth is taxed at a lower rate through capital gains tax than interest.
To elaborate, our fund has been designed to generate quarterly income, as well as long-term real (after-inflation) returns. To meet this dual objective, the fund must offer stable returns and beat inflation. The fund has met both of its objectives since it was launched in December 2005: it has not lost capital over any three-month period and has delivered CPI plus 4.3 percentage points a year before fees, on average, since inception.
Part of the strategy is to optimise the distribution yield, but not at any cost, which means that higher-yielding assets must meet other requirements before they can be included in the fund. We are acutely aware of the fact that chasing yield and potentially sacrificing quality is a very dangerous strategy for an income fund, and, for that reason, the fund might not offer the highest yield in the market.
There are 10 classes of the Prescient Income Provider Fund, with total expense ratios (TERs) of between zero and 2.25 percent. The TER of the retail-class fund is 0.83 percent. Why is there such a wide range of fees?
The fund in the class that charges the lowest fees does not charge any fees at all and is used where the fund is held as a building block for a larger portfolio, to avoid layers of fees. Fees are charged at the level of the portfolio or are invoiced separately. The highest fee class is a legacy of what was referred to as “all-in fund pricing”, in which, as the market demanded, advice and platform fees were included in the price of the unit trust.
All classes in between are used for bespoke fee arrangements, mainly with institutional investors, such as pension funds and multi-managers. They exist purely to simplify administration and are not advertised in the public domain.
Retail investors who invest through a linked-investment services provider (lisp) platform can access the fund at the standard A2-class, “clean fee” (which excludes platform and adviser fees) of 0.5 percent plus VAT, or 0.57 percent a year.
Is it cheaper to buy the fund from a lisp than directly from Prescient?
Lisps charge administration fees and financial advisers charge fees for ongoing advice. These fees must be added to the investment fee of 0.57 percent a year to arrive at the total fee you will pay.
If the fund is bought directly from Prescient, the fee is 0.75 percent plus VAT, of which 0.25 percent plus VAT is payable to your adviser, which you can then effectively offset against your advice fees. If you do not have an adviser, the 0.25 percent is retained by Prescient. The net investment fee, therefore, is the same whether you invest through a lisp or directly, at 0.5 percent plus VAT a year. However, there is no administration fee if you invest directly in the retail (A1) fund.