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There is no magic here

17 February 2004 Angelo Coppola

There is a huge trend in the local market currently to target inflation plus portfolios, says fund manager at PSG Fund Management, Adrian Clayton.

Various market participants hold managers that are attempting this approach in awe, believing that alchemy is involved. Well, we have looked at the probability of achieving inflation plus targets and believe that the devil is in the detail.

Two obvious issues determine the probability of achieving inflation plus returns, the first is the target aimed at and the second being the time horizon over which you allow the manager to operate.

A common problem in our industry is that advisors perceive that fund managers should achieve their target every year, whilst this is certainly nirvana; the reality of the situation is that providing a longer time period raises the odds dramatically.

We have for example established that the probability of receiving a negative return in equities if they had been held for any three and a half year period since 1970 was zero. However, over shorter term periods this is far from the case.

So, the first rule of thumb is that realistic targeted inflation plus returns are more achievable when good managers are allowed time. The second issue is the target actually aimed at and the importance of setting realistic levels.

We have analysed data since 1970 and going forward assumed that inflation is 6%, fees 2% and then required inflation plus 2% and 5%. We were thus setting goals of 10% and 13%. Looking at historical data, the probability of achieving these stated returns with different asset classes was as follows:

Cash - reaching 10%, a probability of 70% and 13%, the probability declines to 43%.

Bonds - 62% chance of reaching 10% and a 53% chance of achieving 13%.

Equities - a 72% chance of delivering a 10% return annually and a 68% chance of reaching 13%.

MSCI in rands - 68% of getting to 10% and 61% of attaining 13%.

The real art is the ability to combine asset classes to achieve the desired result with lower volatility than that which would occur by being in just one of the above mentioned asset classes.

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