Unpacking Equity Funds

As an investor you have an abundance of choice when selecting equity funds in a South African context. This abundance leads to a diverse and at times challenging opportunity set. If we exclude the specialist equity funds (industrial, financial, small/mid-cap and resources) you have the option to choose funds from four equity categories. These include the large cap, growth, general and value equity categories. To put this into context you can select from 118 funds. The current ASISA (Association for Savings & Investment SA) category description is useful because it can point you in a particular direction depending on the investment style you are considering. We have seen over the past few years that you can achieve divergent returns within an equity category due to the variety of investment styles and strategies employed.

In this article I’ll be discussing the forthcoming changes to ASISA’s classification of CIS portfolios, basics of general equity funds and finally the investment style and philosophy that asset managers employ.

ASISA’s reclassification of CIS portfolios

ASISA has recently signed off on the proposed changes to reclassify CIS portfolios. These changes include a broadening of the general equity category. As of 1 January 2013 the value and growth equity categories will be amalgamated with the existing general equity category, thereby increasing the number of funds and strategies. There will be approximately 107 funds in the new look general equity category.

Fundamentals of general equity funds

• Long term investments and the main objective is maximum capital appreciation.

The profile of returns which equity funds achieve can be extremely volatile (especially over the shorter term) when compared to the currently more favoured lower risk asset allocation funds. It is therefore important to understand these risks and your liquidity needs because your capital investment can fluctuate over time.

• Equity exposure must be greater than 80% of the fund’s value at all times.

Many of the funds in this category prefer to be fully or close to fully invested at all times (90-95%). There are, however, a few who may hold a larger than average exposure to cash depending on their objective and strategy or how they view valuations.

• Does your fund invest offshore?

General equity funds are allowed to invest offshore up to a maximum allocation of 25%. You will need to ask the portfolio manager if their mandate allows offshore investments or not and if they intend to use it. This can be an additional factor contributing to the variation of returns in the category between funds that invest offshore compared with funds that do not.

• Fund benchmark

Many of the funds are benchmarked to the FTSE/JSE All Share Index (ALSI) but other appropriate benchmarks include FTSE/JSE Shareholder Weighted Index (SWIX) or the general equity category average.

• Fees

Another consideration is the annual management and performance fees. Funds may charge an additional fee for outperforming their benchmark and this is stipulated on their fund fact sheet. That is why it is important that the benchmark is appropriate for the fund. There are however funds that only charge an annual fee or only a performance fee. It is important to understand if you agree with the concept of active management. If not, then a tracker or index fund could be an option.

Investment style and philosophy

Funds in the general equity category are flexible according to the investment style the portfolio manager employs. Funds may exhibit style biases and the resulting return profile may vary as such. Some of the styles and philosophies portfolio managers employ include, but are not limited to, deep value, value and value-orientated (focusing on not overpaying for investments) and growth. In a period where value investing is out of favour, funds that employ a more eclectic approach may perform better.

Currently, according to publications and talking to portfolio managers, resource companies show the most value. You would therefore expect managers with a value bias to be underperforming compared with managers with an eclectic philosophy because a sizeable exposure has been to the undervalued resource companies. Defensive shares for example are considered overvalued by some portfolio managers, while others believe there is sufficient earnings growth to sustain their high rating (PE ratio). Defensive businesses are categorised by their cash generation ability. They are also not impacted to the same extent as cyclical businesses when there are recessions. Some of these businesses include food and drug retailers as well as healthcare shares. These businesses have had a stellar run and many of these are not held by managers who employ a value philosophy.

But value is in the “eye of the beholder”. A “value” share for one portfolio manager may not be the same for another. Therefore when looking at funds it is important to understand what the portfolio manager means by value. Questions such as “when will he/she purchase a share and when will he/she sell a share” go a long way to explain the portfolio manager’s style. At Glacier Research we spend a great deal of time looking at and attempting to understand this. The portfolio manager might not follow a “black box” approach but the investment style a fund manager employs and the consistency of it is a very important driver of returns.

Let’s consider an example:

For the 1 year period ending September 2012 the difference in returns between the top and bottom performing funds was 31.1%. The number one ranked fund for that period returned 37.4% compared with the lowest ranked fund which returned 6.3%[i]. I do not want to focus on the actual returns but rather to give an indication of what the fund was invested in, as this ultimately drove returns. According to the latest available fund factsheets the number one ranked fund had an exposure to the industrial sector of the market of 2.7 times that of the lowest ranked fund. Over this period industrials returned 36.7%, financials returned 36.5% while resources returned 3.0%. As mentioned before industrial businesses, especially consumer related business, have done exceptionally well. But these businesses are also trading at very high ratings. Therefore a manager who follows a value philosophy may have had very little or no exposure to these companies.

Portfolio managers arrive at this sector allocation by virtue of their investment process. Some portfolio managers construct their funds bottom-up, based on the level of conviction they have for each of their investments. They select a weight that does not take the benchmark weight of the share into account. Others may be benchmark cognisant and may look to manage their fund with a tracking error[ii] limit. Finally, some portfolio managers employ a strategy where they try and marry top down (macro-economic outlook) with a bottom-up valuation approach.

Bringing it all together

At Glacier Research we analyse all of these features. We try to understand how managers will perform and look for consistency in the way they manage their funds. Many of the answers to these questions are not available by simply looking at the fund factsheet and that is why we spend our time analysing the numbers, looking at due-diligence documents and meeting with portfolio managers.

It is always prudent to select funds that are appropriate to your needs. An equity fund may not be the most appropriate investment for you because of the inherent riskiness of the investment due to the asset class. If you are investing in an equity fund, ensure you have a long term investment horizon and are able to tolerate volatility and capital fluctuations. It is imperative to talk to your financial adviser to ensure that your objectives are aligned as closely as possible with the funds you are invested in.