Abri du Plessis
07 May 2019
The South African investment market has matured to the point where it is now generally accepted that, when it comes to stock picking, active asset managers struggle to consistently keep up with the index. As a matter of fact, over any time frame, far less than 50% of the active asset managers manage to outperform the index. This means that the odds are not even for beating the market; it is a loser’s game that even most gamblers would not entertain. Index tracking is the answer; efficient index tracking at a low cost.
In single asset class portfolios, such as equities, value is not only added by selecting the winning stocks, but also by adjusting cash levels, sector selection, factor weighting (“smart betas”), etc. It is debatable whether these tweaks in single class portfolios do not actually add more value than stock selection. In other words, asset allocation also adds value to single asset class portfolios; i.e. by adjusting cash and/or sector allocation and/or factor weightings depending on how the asset manager interprets the market cycle.
Which raises the eternal investment myth, “It is impossible to time the market”…
This misconception is costing investors dearly and has given investment advisers and asset managers a place to hide for not doing part of their job. It is commonly pointed out that investors cannot afford to be out of the equity market at any given time because “we cannot read the market” and the market may run, and investors will then lose out on the market run. And thus, common practice is to sit through market downs, whether it’s only a correction or a more serious market crash, rather than be out of the market and risk missing out on the upturn.
Distinction should be drawn between primary and secondary cycles. Primary cycles are usually on average 5-7 years long; approximately 4-5 years of markets moving up (generally called bull markets), followed by a market crash which usually lasts 1-2 years (generally called bear markets). These bear market cycles or market crashes (commonly defined as >20% market drawdown) usually take about 2 years to return to pre-crash levels. This is as opposed to a market disturbance or secondary cycles which occurs during the bull market phases. The secondary down cycles are generally called corrections, with declines greater than 10% but less than 20%, are short in duration (rarely longer than 3months) and usually sentiment driven. The graph below illustrates the occurrences of bear markets in the SA equity market in the past.
Given the magnitude of bear markets, it is prudent that they are not ignored and endured if it is possible to avoid them. Corrections can be ignored because their effect is quickly erased in a raging bull market.
Yes, equity is the asset class of choice to keep up with inflation over time. And yes, it is the asset class one should be invested in for longer through any market cycle. But it is this relative stellar performance of equities over time that has bailed out those advisors and asset managers not doing their jobs properly. By keeping investors in the equity market at all times because of the adherence to the myth that it is impossible to time the market, is a disservice to investors. If an investor has time, there is less risk in remaining in the equity market throughout bear markets, because after about 2 years or so their equity investment should be back to pre-crash levels. But what if the market crashes at an inopportune time for an investor i.e. just when he needs cash and needs to sell out of the market?
The investment community has come up with an ‘acceptable way’ to address this problem and this is called Risk Management.
What risk management does, is it disperses risk. Don’t put all your eggs in one basket. Multi asset funds are thus a varying combination of different asset classes depending on how the portfolio manager reads the market and balances the risks he associates with each class at that point. The myth that the market cannot be timed has resulted in multi asset funds (or their managers) varying only slightly in the allocation spread regardless of the market cycle.
What this does is make all investors average. It is defensible to be wrong, as long as you are not too far wrong or too different from the average.
But, by the mere fact of adjusting the allocation of assets, asset managers/financial advisers tacitly admit that it is possible to time the market. There is more than enough empirical evidence that proves that more value is added by asset allocation than stock selection. If it is acceptable to adjust asset allocation spreads only slightly, it becomes more of a passive investment style, which should be charged accordingly. Investors should start asking what exactly they are paying for; split the costing of stock selection, asset allocation, how much for advice, etc.? If asset allocation tilts are only slightly different from the average and do not vary aggressively dependent on the market cycle, the fee model applied should be similar to those of passive funds or as charged by fixed allocation balanced funds.
Risk profiling investors is another concept that the investment community came up with in what I believe is an abdication of their job. I believe that to propose that people ‘of an age’ should be more invested in income products to protect them against the risk of the equity market is a fallacy. Those ‘aged’ investors need as much protection against inflation as the young guys. And vice versa; the younger investor should be just as protected against the erosion of bear markets. But this a topic for another article…
The Gryphon investment philosophy supports the opinion that, in an efficient market like ours, as well as in sizable portfolios, it is easier, more reliable and consistent to add value through asset allocation than by stock selection. We believe it is possible to time the market! That is, to time the market from an asset allocation perspective, not timing stock selection. For the investor not wanting to be average in the multi-asset space, the Gryphon Prudential and the Gryphon Flexible funds offer something completely different.
Over time, and many cycles, the factors that most reliably drive markets have been identified, researched, implemented…and experienced in real life. What we’ve learned is that it is possible to reasonably consistently call the primary market cycles. Although it may also be possible to read the secondary market cycles, we have not yet been able to identify reliable factors that consistently predict these cycles accurately. As indicated, normally these secondary cycles are short in nature, around 3 months long and not more than 10% in size. These cycles are usually driven by greed and fear, and create a lot of noise in the market, but little direction. In this regard, we agree with the general thinking that the secondary cycles can be ignored rather than risking timing mistakes. The secret is to stand back and unemotionally invest according to the factors that have proved reliable in the past. By unfailingly sticking to the rules, recognising the factors that identify the primary cycle, this simple yet very effective strategy has delivered top decile performance.
Contrary to common thinking, by aggressively allocating between asset classes dependent on the primary market cycle has in fact proven to be conservative because investors are protected from losing value for extended periods of time. We believe that investors do not benefit from the concept of “risk profiling” but would find this strategy to be suitable for investors of all ages.
And so, to the burning question…where are we now in the cycle?
Late August 2018 local indicators indicated a bear market in equities. Based on this, the Gryphon Prudential Fund (Reg 28 compliant) sold down from 75% in equities to 0% in equities. The Gryphon Flexible Fund moved from a 100% allocation in equities to 0%. Since then the All Share Index was down until December when it picked up again. Although accurate on the big moves, it is not always a precise indicator of the top or bottom of the cycle…but it’s close enough. The graph below illustrates that every time the Gryphon Bear Market indicator (simple historic stock market and economic data) falls below the zero line, the All Share Index tumbles.
Note that triggers 3 and 5 in the graph above are comparable to how the market looks currently. In those instances, the equity market also formed double tops before developing into bear markets.
And so, what are the fundamentals saying?
First of all, as you can see in the graph below, historically the equity market is not cheap.
South Africa is a commodity driven market. Although commodity prices have bounced back since December this has not yet triggered a buy signal, and prices appear to be under pressure again in the last week or so.
The local economy is not in great shape and expectations for local earnings are therefore also not exciting. Nowadays at least 40 % of the All Share Indexes earnings are coming from abroad. What are the global signals saying? The important US market is at all-time highs. The current bull market started in 2009 and is the longest in post war history.
The US market is no longer cheap either, as you can see from this long-term price-earnings graph.
USA employment statistics are bottoming out, which in the past has been a reliable indicator of economic downturns and bear markets in the USA.
The USA yield curve is also nearing a point of inverting. This yield curve inverting has also been a reliable predictor of recessions and bear markets in the past.
The local SA equity market never rallies when global markets are in a bear state. With global markets currently already discounting a “Goldilocks” scenario, and the local economy struggling, we cannot see the local equity market (from current levels) beating the 7.5% plus investors can expect from risk free cash. We are comfortable with the fact that our indicators have not yet directed us back into the equity market.
Then the FOMO…!
The challenge for any investor is to have the courage and patience necessary to sit and quietly allow events to unfold. When invested in a strategy such as the Gryphon’s multi asset strategy, the temptation is to second guess the indicators, to watch wide-eyed while you miss out the opportunities in the market. And that’s all the ‘risk’ is…opportunity cost! Bear in mind that regardless of what the market does in this scenario, there is no risk to an investor’s capital – the returns will be aligned with cash returns. This is the mainstay of the objective of these funds – while they may be aggressive in their asset allocation, they are first and foremost protective of investor’s capital.
In closing, a reality check: on the 31st of March 2014, the value of the JSE Total Return Index was 6090.431. At the end of April 2019, it was 8698.631. Over this 61 month period, the total return to investors was therefore 42.82%.
The return of the Gryphon multi asset funds over this period were 47.1% (Flexible) and 46.9% (Prudential), the excess return is testament to the ability to migrate between asset classes when it’s prudent to do so.