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Adjusting client portfolios for the “new normal”

23 October 2009 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

Forget all the talk about past market collapses and future recoveries. These ebbs and flows are extraordinary events in the long-term market trend and best exploited by market speculators. That’s why economists refer to the dismal 2008 US-equity market pe

You need a much longer time horizon to determine ‘normal’ market conditions. To find out more about Investing in the “new normal” we attended the October 2009 Association of Savings and Investments SA (ASISA) Financial Planner Forum. John Kinsley of Prudential Portfolio Managers, painted a superb picture of the global and domestic economy as we enter the final quarter of 2009! He also shared Prudential Portfolio Managers’ view on likely returns from various local and offshore asset classes through 2010 and beyond.

Time to re-think offshore diversification

South Africa is an emerging market. This means the majority of local investors’ assets are, by default, invested in emerging market assets. In the past, financial advisers recommended diversifying these portfolios by moving some (up to 20%) of total assets offshore. To maximise the diversifying effect they insisted on going into developed offshore economies. Why developed economies? The theory is that investors should spread their assets across geographic regions, market types and currencies to mitigate risk. It might just be time to question the conventional approach.

According to Kinsley “global capital goes where growth is.” As the world emerges from recession growth will be concentrated in emerging markets rather than the developed world. Investors are going to want to channel their offshore investments to the ‘hot’ emerging market economies like China, India and Brazil rather than the struggling US or Europe. Does this mean you should diversify offshore to emerging markets as a whole? We don’t believe all the economies in the MSCI Bara index – a list of 22 emerging markets – will shoot the lights out next year. Instead investors are going to favour one or other of the emerging market tiers defined by the FTSE Group. They distinguish between advanced emerging markets: Brazil Hungary, Mexico South Africa and Taiwan; and secondary emerging markets: Argentina, Chile, China, Colombia, Czech Republic, Egypt, India, Indonesia, Malaysia, Morocco, Pakistan, Peru, Philippines, Russia, Thailand and Turkey! It looks like the second tier economies will provide the best returns over the next couple of years!

Dealing with sticky inflation

You will have to structure your local asset allocation to reflect South Africa’s ‘sticky’ inflation.

Administered prices (most notably electricity) and excessive wage settlements mean the core inflation rate is ‘stuck’ approximately 150 basis points above where it should be. Kinglsey says this alters the real return equilibrium. Real returns from cash, index-linked bonds and government bonds will decline slightly while those on A-rated corporate bonds, property and equities should improve. “Investors must move their money up the ‘risk’ curve,” said Kinsley.

Conservative investors will have to take steps to enhance yield. One technique that should produce satisfactory results is to create baskets of local and offshore cash, properties and government and corporate bonds. Kinsley believes this strategy will return as much as 75 basis points more than cash with less risk than the ALBI 1-3yr bond. This basket would include a mix of SA Cash (50%), SA ILBs (10%), SA Government Bonds (10%), SA Corporate Bonds (15%), SA Property (5%), US Corporate Bonds (5%) and US Government Bonds (5%). The ‘kicker’ in this portfolio will be provided by SA Corporate Bonds. Kinsley noted that certain A-rated corporate bonds pay 250 basis points above the government bond benchmark!

The challenge for financial advisers will be to balance their client’s primary and secondary objectives. A ‘safe’ strategy might identify a primary objective of 5% real return on a rolling three year period. A secondary objective is to ensure ‘zero’ capital loss on a rolling 12-month period! Assuming an 80:20 split to local and offshore assets most investors will face a “mismatch of expectation and reality” in the “new normal” identified by Kinsley. He suggests the 5% real return expectation will have to decline to 4.5% if investors choose to maintain the secondary objective. And most retail investors will do just that! The most important message you can take to your clients is this. If you structure your portfolio more conservatively you must accept a reduction in yield!

Prudential has a preferred ranking for asset classes at the end of Q3 2009. Locally they rank property and corporate bonds, equity, bonds and index linked bonds and cash (in order from most preferred to least). Offshore they rate equity, corporate bonds and property similarly. Bonds come second and cash doesn’t even get a mention.

Editor’s thoughts: Private investors want the best of both worlds. They want fantastic returns with 100% capital guarantees. In the real world the greater risk you accept in your investment portfolio the higher the chance of an annual negative return. A single ‘outlier’ year (like 2008) can do untold damage to an inappropriately structured portfolio. How do you explain the link between risk and return to your client? Add your comments below, or send them to gareth@fanews.co.za

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