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Low equity funds are in back the sweet spot

09 November 2016 Ian Scott, PSG Asset Management
Ian Scott, head of fixed income at PSG Asset Management.

Ian Scott, head of fixed income at PSG Asset Management.

For the first time in some years, the low-equity unit trust funds – once the darlings of conservative and retired investors - have moved back into a sweet spot.

These funds have traditionally been used by investors to deliver small above-inflation returns at relatively low levels of risk. They have done this by largely investing mainly in fixed interest assets like cash and bonds, with a small exposure to equities. For a long time however, large portions of the fixed interest market have offered investors negative real returns, making these funds dependent on the more volatile equity markets to achieve their real return targets of 3-4%.

“Lately however, low equity funds have been spoilt for choice. This has enabled managers to lock in real yields at relatively low levels of risk,” says Ian Scott, Head of Fixed Income at PSG Asset Management

When managing clients’ money, every individual investment opportunity must be thoroughly analysed, Scott says. For each opportunity, it’s important to calculate what return you need it to generate, given its fundamentals. Starting with inflation, you can add a premium based on the riskiness of the investment. Then, invest only when the expected return from the investment exceeds the required return.”

PSG applies this approach to equity investments as well as bonds and cash instruments as the same metrics are relevant across asset classes.

As opportunities arise, managers can allocate from their cash resources. The more opportunities that arise across the asset class curve, the better for any multi asset fund.

Inflation - the foundation of decision-making

Investors should focus on achieving real returns, that is their actual return minus inflation. A long-term inflation assumption is thus a key input to investment decision-making. The South African Reserve Bank (SARB) has earned credibility through many economic cycles by ensuring an average inflation rate of close to 6%. Even over the past two-and-a-half years the SARB has increased rates by 2% despite the low-growth backdrop, indicating that they are committed to their mandate of price stability. “All things considered, we believe that going forward inflation will average around 6%,”says Scott

Optimise returns while maintaining liquidity

Some fund managers tend to hold large amounts of cash when awaiting attractive real yields. If so, they usually follow a highly detailed cash process to ensure that they can optimise returns while maintaining liquidity, and avoiding any significant credit risks. “In this process we largely use bank NCDs of various durations. In the past our NCDs have resulted in real returns and we believe that the current yields on offer in the market will continue to do so,” Scott says.

The NCD market is anchored by the repo rate and therefore priced for an expectation of local inflation. The market has been concerned about the local inflation outlook which caused a clear mispricing in the NCD market.

“We shopped aggressively across the curve, meaning we backed the SARB rather than the market hype. Given the good liquidity of this asset class, the PSG Stable Fund has been able to lock in significant real yields of up to inflation plus 4% for five years.” The fund has consequently increased its fixed rate NCD exposure during 2016 from around 9% to around 35%.

Buying bonds below fair value

Corporate spreads of typically cyclical companies and bank senior unsecured paper have risen over the past two years. Again, it is important to perform detailed bottom-up research on the bond issuers to find opportunities to buy the bonds of quality companies for less than they are worth.

Bank bonds have however been the standout opportunity. Bank senior unsecured bond spreads over the three-month Johannesburg Interbank Agreed Rate (Jibar) indicates how the market has priced the risks of new bond issuances by the major South African banks. These spreads have risen over the past three years, which should indicate rising risk in this sector. A deeper look into the fundamentals of the South African banks however indicate quite the opposite – risk has reduced. “We therefore increased our exposure to the major South African banks,” Scott concludes.

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