Investors continue to entrust most of their savings to domestic asset allocation funds, often without understanding the risks they are taking on. And this is particularly the case when investing in the targeted absolute and real return sub-sector.
Prieur du Plessis, the chairman of financial services company Plexus Asset Management, says targeted absolute and real return funds are probably the most misunderstood by the investing public.
Balanced portfolios and asset allocation funds in general are particularly popular with investors who do not want to make asset class decisions themselves, while others are forced to use the funds because they are investing through retirement savings products which require prudent investment in terms of regulation 28 of the Pension Funds Act.
“The fact is that the investment mandates, performance objectives and investment strategies of funds in this sector differ vastly. If prospective investors do not understand exactly what the fund managers are trying to achieve and how they try to attain their objective, they may well end up being disappointed,” Du Plessis says.
Targeted absolute and real return funds are often used by investors seeking to maximise returns while limiting their losses to less than those of the market.
Research by Plexus into the implied in- and outflows to and from South African rand-denominated unit trust funds (excluding money market funds) shows that the asset allocation sector in the collective investment scheme space (unit trust funds and exchange traded funds) had the largest net inflow over the 2010 calendar year – of about R38.7 billion.
Targeted absolute and real return funds, with just under R49 billion in assets under management, are the third-largest sub-sector of the asset allocation sector. For the 2010 calendar year, the sub-sector had a net inflow of R11 billion – the second-highest inflow behind that into the asset allocation prudential variable equity funds.
Du Plessis says the different investment mandates and performance objectives of targeted absolute and real return funds result in the portfolio composition of funds in this sector “varying considerably”.
“Some funds invest only in fixed-interest securities (enhanced-income funds); some have more balanced portfolios with low equity exposure, while others have relatively high exposure to equities.
"The common denominator categorising targeted return funds is the objective to achieve positive returns over a specified period irrespective of market conditions, while limiting the risk of capital loss as far as possible,” Du Plessis says.
“These funds use different investment strategies to achieve this, such as the use of derivative instruments, highly active asset allocation, stringent risk-control measures and share-selection criteria, and exposure to inflation-linked bonds.”
Targeted return funds have absolute benchmarks – namely, a benchmark linked to cash or the inflation rate – as opposed to relative benchmarks such as an equity or bond market index.
The benchmarks or performance objectives of targeted return funds vary considerably: targets range from a modest inflation plus one percent a year to inflation plus seven percent a year.
Du Plessis says that because of these differences, you should not compare the performances of these funds with each other without taking into account the funds’ risk characteristics.
You need to understand that the higher the benchmark or performance objective, the more risk the manager must accept to achieve the objective.
“A high-performance objective can be achieved only by having relatively high exposure to equities. This ultimately results in higher volatility in returns and a higher probability of capital losses when markets are buffeted by financial instability.”
A study by Plexus of the pure returns achieved by the funds in the sub-sector over the year ended December 31, 2010 reveals a variance in return from 27.7 percent to a paltry 4.4 percent – a difference of just over 23 percentage points between the best and worst performers. Even over a longer period of three years, the returns varied from 17.5 percent to one percent, on average, a year – a difference of 16.5 percentage points.
So although one fund may provide lower returns than another, the important thing to look at is the return against the fund's own selected benchmark as well as the risk it is taking in achieving that return.
If the fund achieves or betters the benchmark, then the fund manager is delivering.
The problem, Du Plessis says, is that over the five-year period ended December 2010, only 30 percent of the 30 targeted absolute and real return funds with a five-year track record actually managed to out-perform their benchmarks. He says this under-performance can be ascribed to the first three years of this period, when we had high inflation, high interest rates (in other words, high benchmarks) and at the same time very poor market conditions.
“The most important consideration for choosing a targeted return fund is its risk-adjusted returns,” Du Plessis says.
“A fund that achieves a real (after-inflation) return of three percent a year with a volatility (or standard deviation) of 10 percent is a better risk-adjusted performer than a fund that achieves a real return of four percent a year but with a volatility of 15 percent.”
A scatter graph (see link at the end of this article) shows the risk/return data of all targeted absolute and real return funds with a five-year track record and a benchmark of the consumer price index plus five percent a year. From the graph it can clearly be seen that while the Prudential Inflation Plus Fund A (10.67 percent a year) and the Kagiso Protector Fund A (10.74 percent a year) both yielded very similar returns, the Prudential fund had a considerably lower standard deviation than the Kagiso fund (seven percent versus 9.8 percent). This makes the Prudential fund far superior on a risk-adjusted basis, Du Plessis says.
He says the fund that stands out on the scatter graph is the Investment Solutions Real Return Focus Fund, as it has not only delivered the best performance (11.55 percent a year), but has managed to do so at the lowest standard deviation (5.75 percent). Du Plessis says investors who intend investing in targeted return funds must:
* Determine their investment objectives and then compare the risk-adjusted performance of funds with corresponding objectives.
* Understand the investment strategies of the various funds being considered and know how strictly the funds comply with their mandates.
* Analyse a fund’s drawdown history, especially during times of financial and economic crisis, particularly if the investor cannot afford or tolerate significant loss of capital.
* Accept the fact there is no guarantee that a targeted return fund will achieve its objective all the time. “This is especially true when we experience rare occurrences such as the 2007 and 2008 credit crisis, which affected virtually all asset classes negatively,” Du Plessis says.
“To make matters worse, South African targeted return funds were at the same time competing against a stubbornly high inflation rate, which made it extremely difficult for managers to achieve their objectives.”
Despite all this, Du Plessis says targeted return funds nevertheless deliver some of the best risk-adjusted returns in the industry and therefore deserve a place in a well-balanced investment portfolio. But you need to “make sure your financial adviser has the necessary expertise and tools at his disposal to make the right choice for you”.
This article was first published in the 2nd quarter 2011 edition of Personal Finance magazine.