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    Monetary Policy Impacts on Share Prices

    Central banks all attempt to modify the cost of money or interest rates, the supply of money, and the availability of money. This is known as their monetary policy. All things being equal the lower the cost of money and the greater its supply, the greater the economic activity and vice versa.

    Typically a central bank modifies the interest rate through various conventional means. This includes setting short term interest rates, buying and selling short term government bonds from / to financial institutions in the open market.

    Since the global financial crisis in 2007/2008 – which had a severe impact on the housing, employment, and general economies of developed markets – central banks have been struggling to revive their economies. In the years and even decades up to the crash, lowering the cost of debt provided a quick fix to an economy that loved debt. But post the bubble it’s been a struggle to resuscitate economies even as central banks have brought interest rates down to record low levels of close to 0%.

    Because central banks now don’t have much room to manoeuvre on the interest rate front, they have embarked, over the last 4 years, on various methods of quantitative easing (QE). This is an attempt to stimulate the real economy when the more conventional means are not as effective. In the latest announcement from the US Federal Reserve, it will involve buying up to $40 billion per month of agency mortgage backed securities.

    The Federal Reserve did this after the 2007/2008 financial crisis, trying to provide a backstop to the financial system by printing and buying up $600 billion in mortgage backed securities. Then in November 2010 the US Federal Reserve announced a second round of quantitative easing (QE2) through a process of buying $600 billion of treasury securities.

    The chart below reflects the US Federal Reserve Balance sheet expansion due to printing from around $800 billion to almost $3 trillion.

    US Fed Balance Sheet

    Source: US Federal Reserve website

    Now the QE3 announced last week sees a reversion to the government buying private mortgages held by the government sponsored agencies. Because the US Federal Reserve owns a lot of other debt which matures over time, it will also reinvest all proceeds its receives. The sum of these actions is a monthly purchase of around $85 billion and according to the Fed Reserve, “......should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.”

    The Fed is linking the fresh injection of money into the banking system with the labour market and will only stop once there is a substantial improvement in the labour market, saying “To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthen.”

    So far it’s difficult to see what the very accommodative monetary policy has done for the real economy, but one apparent consequence has been an on-going upward rise in share prices following the 2008 sell off. Given the stated intention of officials to continue for as long as it takes, this should provide an on-going underpin to the price of risk assets.

    Kind regards,

    Ian de Lange

    021 914 4966

    Permalink2012-09-27, 09:14:12, by Mike Email , Leave a comment

    Smart Beta

    After our article on the differences between active and passive investing, this week we will take a closer look at smart beta.

    Most investors will not be familiar with a smart beta fund. A smart beta fund tracks a style/fundamental index (e.g. JSE Dividend + Index) or mechanical investing strategy (e.g. JSE Equally Weighted Top40 Index). By tracking a style index, or using a mechanical investment strategy, the fund aims to outperform the market with lower costs than an active investment. A smart beta fund sits between the traditional passive investment, a plain vanilla tracker fund, and active investment.

    Smart beta aims to provide market outperformance at lower fees relative to active managers. It aims to capture certain portions of the market with the possibility of outperformance by changing how the shares are weighted in the portfolio.

    Vanilla tracker fund use the company’s market capitalisation to determine its weighted allocation in the index. A Top 40 tracker fund is an example of this. These indices are biased toward large cap companies and locally to the resources sector. The graph below shows the cumulative performance of the Satrix 40, All Share Index. and Top 40 Index over the past 10 years.

    An ETF or fund will normally underperform the index that it tracks due to costs and management fees. The Top 40 underperformed the ALSI due to its high exposure to resources that underperformed. Below I will be giving a quick explanation of some smart indices.

    Equally Weighted Index

    The Equally Weighted Index looks at the largest 40 companies on the ALSI and assigns a weight of 2.5% toward each. This tries to remove the large cap and sector bias of the current Top 40 companies.

    Fundamentally Weighted Index

    Fundamentally weighted indices use one or another fundamental number to get a weight allocation. The Rafi40 Index is an example of such an index. The company’s weight in the index is dependent on its Rafi score. The Rafi score takes the following metrics into account: Cash flow, sales, dividends, and book value.

    Style Index

    Style indices make use of a certain strategy. The Dividend + Index is an example of this. The Index only takes into account the 1 year forecasted dividend yield in the universe of the top 100 listed companies. The 30 companies with the highest forward dividend yield are included in the Index.

    Smart beta encompasses a range of different ideas and processes with the aim to outperform the market. This is no longer a passive investment as an investor needs to make an active decision in which he or she wants to be invested.

    Kind regards,

    Gerbrandt Kruger

    Permalink2012-09-25, 13:56:26, by Mike Email , Leave a comment

    Active versus Passive Investing

    I was recently at an investment conference and a topic that was discussed on more than one occasion was the merits of actively managed funds versus passive investments and ETFs. Indeed, there is a lot of debate around the world on this topic.

    When ETFs were first launched in South Africa in 2000 the debate began locally, with advocates of passive investing going to great lengths to show how few global managers beat their passively created benchmarks over time, concluding that investing into low cost passive investments (typically ETFs) beat most managers. The reality is that ETFs in South Africa themselves carried a rather high fee structure and at first only tracked the well known indices. Therefore, on an after fee basis, the early ETFs underperformed their benchmarks and in some cases a large portion of the active managers.

    In this environment we felt that doing thorough research, selecting the best active managers AND negotiating lower fees with these managers would offer our clients the opportunity to beat their passive benchmark AND be competitive when comparing fees with the available ETFs and passive funds. There was no guarantee that active managers would outperform their index, but a limited ETF range wouldn’t be able to outperform the indices they were tracking as the cost factor (albeit typically lower than active managers) would result in the performance to the end client being guaranteed to be lower than the index.

    Over the past few years, however, the passive investment market has rapidly developed and asset managers now offer so called ‘smart’ passive products. These are strategies that are designed to be different from your typical market cap weighted benchmark (e.g. ALSI) and will, over time, produce a different (hopefully better) return to the regular index. The investor, therefore, now makes an active decision when making a passive investment. As the industry has grown there has also been pressure on the costs charged, with the net effect being investors getting more choice, when investing into passive strategies, at a better price. Investors are now able to research (what is typically done on actively managed unit trusts) the various passive strategies, be they in the form of an ETF or a passive unit trust, and give themselves the opportunity to outperform (after costs) the typical benchmarks (e.g. ALSI).

    To illustrate how much the passive environment has changed I have included a chart showing the tracking error of two passive strategies (one ‘Old Generation Passive’ and one ‘Smart Passive’) and one Active Manager (deemed to be quite active in relation to his peers) versus the ALSI. As can be seen, the Smart Passive strategy is actually more active than the Active Manager most of the time!

    The Old Generation Passive strategy has a very low tracking error and as such has a similar risk/return profile as the ALSI. Both the Active Manager and Smart Passive have been able to outperform the ALSI over a 10 year period (all strategies shown after costs – ALSI pre costs) with significantly less downside risk.

    As multi-managers we understand that active and passive strategies can both play a role in an investor’s portfolio. We therefore look to combine low cost ‘smart’ passive strategies with slightly higher cost active managers. In this way we attempt to choose those smart passive strategies that will beat the market (ALSI) on an after cost basis and combine them with those active managers that we believe are best equipped to deliver alpha over the long term.

    There are various ways to access passive strategies, with the most common two being through a unit trust OR a listed ETF. Both access points have their pros and cons, and not all strategies are offered as a unit trust AND a listed ETF. Investors therefore need to do their homework to determine on how they will access the passive portfolio with factors such as availability, cost, and efficiency needing to be considered based on the client’s individual requirements.

    The Seed Flexible Fund currently makes use of 1 passive and 2 active local equity strategies.

    Take care,

    Mike Browne

    021 914 4966

    Permalink2012-09-11, 16:28:07, by Mike Email , Leave a comment

    Does GDP Drive Stock Market Returns

    A very common investor error is a fundamental belief that a strong and growing economy is required to drive a strong performance from that country’s stock market. GDP stands for Gross Domestic Product and is an economic measurement of the market value of all final goods and services produced within a country in a given period, typically a year.

    The premise of a direct link between economic growth and market performance, although proven incorrect as has been widely demonstrated, has a logic, which goes something like this:
    • A growing economy is by definition an aggregate of a population that is seeing an improvement in their real wealth and increased output from that country’s companies.
    • If companies are selling and producing more they should be generating a higher profitability.
    • Higher profitability translates into a good investment.

    The logic however starts to break down with the assumption that a weak overall GDP automatically means all companies are not performing strongly. Over longer and even shorter periods of time, the empirical evidence indicates that there is no relationship between GDP and market returns. The charts below plots various country’s GDP and that market’s real return over a 30 year period with no positive relationship, either for developing or emerging markets.

    Source: GMO, MSCI, S&P, Datastream

    Source: GMO, MSCI, S&P, Datastream

    In many cases investors tend to want to wait for “more positive economic news”, “less uncertainty”, or “the European political risk to settle down”, before investing. However this is rarely, if ever, possible and indeed steady price moves up don’t necessarily require positive news or strong GDP growth as reflected above.

    Current news flow, which by definition tends to be negative, is already reflected in share prices and all things being equal will not push prices further down. But because prices are the discounted value of future returns, they are forward looking. That is why after a particular negative economic event as prices are pushed down sharply, it is generally a good time to invest. I.e. the news may continue to be negative for a while, but prices having fully absorbed the bad news start to anticipate an improvement.

    A cursory look at the year to date will reflect a global economy that is still under plenty pressure. While into 2012 the IMF raised their growth expectations, in July these were slightly lowered to a global growth of 3.5% in 2012 and 3.9% in 2013. At the same time the global equity market as measured by the MSCI All Countries World (USD) is up 7.55% for the year to end of August 2012. This is very reasonable in a world of ultra-low interest rates and against a backdrop of weak GDP.

    Warm regards,

    Ian de Lange

    021 914 4966

    Permalink2012-09-04, 11:12:21, by Mike Email , Leave a comment