No Free Lunches when it comes to Investing

By Bryan Hirsch

 

WHEN markets are going up it’s very easy for investors to follow the herd and to make money. In my 43 years in this business, this happened only three or four times with the ultimate result that most investors ended up in tears! Why do I say this?

 

Markets never go up in a straight line, and usually collapse with catastrophic results for investors. How often have you heard an investor say: “Whenever I make an investment I end up losing”? Investing is a skill that requires patience, knowledge of the industry and markets, and it is different for each individual. Most individuals do not have the skill and for this reason should always use a reputable financial adviser.

 

I am reminded of the saying that “a lawyer who represents himself, has a fool for a client”.

 

Diversification is the only free lunch when it comes to investing. Financial planners often spend most of their time focusing on the diversification benefits achieved through the optimal blending of the various asset classes (equities, bonds, cash, hedge funds) when formulating an investment strategy. This is very important, and should not be overlooked as economic cycles tend to favour one asset class over the other. An optimal blend of asset classes should provide protection against short-term volatility while delivering long-term growth.

 

But how much time do investment advisers spend ensuring good diversification within the respective asset classes? Underlying factors within these asset classes tend to perform differently during different market periods.

 

For example, any person who has invested in SA’s equity markets of late would know that if he or she were on the wrong side of the resources ride they would have lost a lot of money.

 

So in this article I must thank Fatima Vawda, MD of 27Four Investment Managers, in helping me construct an appropriate article to cover this aspect.

 

We explore some of the key factors that should be taken into consideration when constructing an onshore equity blend of funds.

 

  • Sector exposure
  • Style mix
  • Size bias
  • Passive or active

 

We will cover this topic in two articles and this week we will deal with sector exposure.

 

Getting the right mix of exposure between the three key sectors (resources, financials and industrials) is fundamental. The key is to manage a neutral exposure between these sectors.

 

The importance of this is highlighted in the recent performance of the equity markets.

 

Over the past 12 months (to the end of July), the return of resources shares has been 11,80% (to the end of June, this return was 39,91%), as opposed to financial and industrial shares, which have returned -9,73%.

 

July saw a sharp pull back in resources relative to financials and industrials.

 

What this illustrates is that by being underweight or overweight in a sector one is taking an active bet on the future performance of that sector.

 

Let’s face it, if we could get that right the best financial minds in the world wouldn’t be facing the current turmoil that is being experienced in global financial markets. It is just too risky to take this bet.

 

When considering which equity managers to invest with, financial planners and advisers must scrutinise the sector bias of the underlying managers, and look to create a blend of managers without being too over or underexposed to a particular sector.

 

For example, you could have been invested in star funds such as the Allan Gray Equity Fund or the Foord Equity Fund.

 

Both of these funds are underweight in resources, and you would have been burnt (Allan Gray delivered 7,03% and Foord -4,80% for the period January-July this year).

 

But blending one of these funds together with say for example the Investec Commodities Fund (which delivered 9,87% over the same period) would ensure that you pick up the upside from a boom in resources.

 

When the pullback in resources occurs, upside will be picked up from the exposure to financials and industrials within the other fund.

 

As mentioned, sector exposure is only one of the underlying factors that contribute to the performance of South African equity markets.

 

Next week we will deal with the balance of the factors being style mix, size bias and passive versus active investing.