For example, if you were to take a sample of multi-asset funds, the chances are good that both the best-performing funds and the worst-performing funds would each have a high equity allocation. This would suggest that the difference between these funds’ performances is attributable to the choice of specific stocks rather than the differences between the asset managers’ allocations to cash, bonds and equities.
Next, consider the differences in portfolio performance between two of the main Asisa fund categories: the South African equity general and the South African multi-asset high-equity sub-categories.
South African equity general portfolios must hold at least 80percent of their investments in JSE stocks, implying that performance should mainly be driven by stock selection. South African multi-asset high-equity funds are constrained by the regulation 28 limits on equity and offshore exposure, but managers can greatly vary their asset allocation within the limits, as well as make active stock picks.
Examining Morningstar fund data from the five years to the end of March, the best-performing equity fund delivered average annual returns of 11.2percent and the worst-performing -2.2percent, compared with the best-performing multi-asset fund at 10.5percent and the worst-performing at -1.1percent.
This suggests that the cross-sectional distribution or variation in fund performance in equity funds is greater than that in multi-asset funds, further supported by the table.
This simple analysis points to the fact that stock selection can indeed be the main driver of performance, or at least return variability.
However, the table also clearly highlights the fact that over the past five years the average South African multi-asset high-equity fund outperformed the average South African equity general fund, mostly because of multi-asset managers’ ability to allocate to global equities.
Consider, for example, that over the past five years the FTSE/JSE All Share Index delivered average returns of 6.5percent a year, while the BEASSA All Bond Index achieved returns of 8.3percent and the MSCI AC World NR Index achieved 13.4percent in rand terms. Given the broader context of a South African economy that has continued to struggle while the rest of the world has experienced above-trend growth, investors’ need for offshore exposure has been undeniable.
Furthermore, by making stock selection the key driver of performance, investors are likely to increase the risk and return variability of their portfolios, making their final investment outcomes far more uncertain.
Main driver of performance
Strategic asset allocation is, in our view, by far the most important decision an investor can make, and is one of the four pillars of our investment philosophy.
Following this, the crucial next step in the investment process should be tactical asset allocations, or judging where to deviate from the strategic asset allocation and increase the weighting of asset classes with superior expected returns. Further, as we approach the end of a decade-long global bull market, our asset valuation models indicate that equities may potentially deliver less attractive returns. The final decision in the investment process should be selecting specific stocks or funds.
As already demonstrated, stock selection can impact performance, and equity portfolio managers could possibly construct a portfolio with the ability to substantially outperform the benchmark by concentrating the portfolio in certain shares or sectors, or by taking liquidity or specific-factor risk.
However, we believe that taking on these risks is not in a client’s best interests in the long term. Active positioning relative to the index should only be taken to the degree that value can be added on a risk-adjusted basis.
Ultimately, both asset allocation and stock selection play an important role in long-term performance, and the real question is rather which one investors should choose to determine your portfolio’s performance.
And, to our mind, correct asset allocation, particularly for South African investors, can produce a diversified portfolio with lower risk, better potential returns and greater certainty in terms of outcomes, increasing the likelihood of meeting your investment objectives.
Andrew Möller is a director and chief executive of Citadel.