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    Seed Weekly - Smart Beta – The Art of Factor Investing

    The passive versus active debate has raged on and evolved over the years. More investors are embracing passive investment strategies as they realise the benefits of such strategies over the long-term, both in performance and cost. I highlighted in my previous article that there is a place for both active and passive investments in constructing portfolios.

    As a multi-manager, we look for the best solutions to ensure we meet our clients’ investment objectives and this at times involves blending active and passive management products. In this article, I delve into the intelligently named Smart Beta products (also known as factor investing) which are a form of passive investments.

    The name Smart Beta was coined in the 1990s, although factor investing as a strategy has been in use since the 1970s. Smart Beta is considered an intersection of active and passive management as it combines characteristics of both methods through the focus on specific factors. A factor can be thought of as any characteristic relating a group of securities that is important in explaining their returns and risk. Popular fundamental factors include Value, Momentum, Quality and Low Volatility (shown in Figure 1 below).

    Figure 1: MSCI Factor indices investment growth since January 1997 (in USD)

    Source: Morningstar Direct

    Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market capitalization based indices. In Figure 1 above, the factors have delivered better investment growth relative to the MSCI All Country World Index (MSCI ACWI) since January 1997 to May 2016. Empirical studies show that historically, factors exhibit excess returns above the market. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. Therefore, they diverge from the traditional market indices by focusing on only the area of the market that offers an opportunity for exploitation. In the same way that an active manager filters for Value or Momentum stocks for example, Smart Beta does the same.

    Table 1: Fundamental factors commonly used

    Source: Seed Investments

    The table above lists some commonly used fundamental factors and the areas of the market that they focus on to extract excess returns. This gives an idea to the link between Smart Beta and what active managers are doing. The good active managers however should have the additional stock picking ability and specific fundamental research to generate alpha.

    Figure 2: MSCI Factor indices risk and returns characteristics since January 1997 in USD

    Source: Morningstar Direct

    It is important to note that these factors go in and out of favour at different times, so one cannot expect one factor to outperform all the time. The chart above shows that over the period January 1997 – May 2016, the Momentum factor has been the clear outperformer but also with the highest volatility. All the factors outperformed the MSCI ACWI, both on an absolute and risk-adjusted basis. A blend of the four factors above (equally weighted) results in fairly decent returns and more importantly, reduced volatility. Therefore, since factors move in and out of favour, there is a case for blending factors in managing risk.

    At Seed, we like the idea of Smart Beta and recognise the potential benefits of such a strategy in a portfolio. The Seed Balanced Fund makes use of the Low Volatility factor as a strategy within the fund. This strategy is blended with other uncorrelated strategies to ensure that we get the diversification benefits and risk management from both passive and active investment management.

    Kind regards,

    Tawanda Mushore

    Tel +27 21 914 4966
    Fax +27 21 914 4912
    Email info@seedinvestments.co.za

    Please click here to view our disclaimer. For more information please visit our website.

    Permalink2016-06-29, 09:03:48, by Mike Email , Leave a comment

    Seed Weekly - The Look-Back Folly

    Looking back and reflecting is essential to the human experience. You can learn much from your preparation for and reaction to past events and mistakes in an effort to better yourself. This is crucial to the investment process, but herein lays both opportunity and danger.

    Looking back may lead to naïve extrapolation of past results into future expectations. Although this may sound condescending it is by no means the intent, it happens to the best of us. While price momentum undoubtedly exists and is a valid input in the investment decision making process, it relies on a couple of underlying factors that do not necessarily work in isolation. It is deceptively easy to assume that because a certain company or asset class produced good recent returns it will continue going forward (or vice versa) without due regard for potential pitfalls of this line of thinking.

    Many of the various decisions you need to make really come down to one line: “Are you positioned correctly for the future given that you know today?” Although it sounds very simple it is by no means easy to do. Selling out of a position that performed well recently is hard enough, but buying into one that has done poorly in recent times is sometimes even harder.

    Keep in mind that no-one is going to be right 100% of the time. When you reach the point where you need to cut your loss and move forward it is imperative to make the choice by thinking ahead instead of looking back. Focusing on your discontent with a particular outcome will not add much value.

    When reviewing your portfolio it is important to determine the effectiveness of each strategy in context. A well-constructed portfolio will contain various strategies which will inevitably pay off at different times. Even if a strategy did not perform well compared to the overall portfolio it may have done exceedingly well given the goal (which may include risk reduction), and have good prospects going forward. Looking only at the bottom line of the strategy without context may lead to a sub-optimal overall portfolio and is detrimental to the eventual performance. Reviewing a strategy should have the primary goal of determining if the strategy worked, did what it was supposed to and whether it can be improved, reviewing thus helps to optimise the strategy. Reviewing should not necessarily be the step where the strategy is dropped or included.

    Successful investing is hard when you only follow the trend and invest in good news stories. You normally won’t be the first there and will most likely lag the early adopters. There is merit in strategies such as these but it relies on being quick to enter and exit and having a high tolerance for error. Spending too much time and energy on looking back may lead a person to follow the herd, leave little room for looking ahead and ensuring you are positioned for the future.

    South African investors looking back over the past year will have little to be happy about. Sure the Rand weakness may have pushed up the value of offshore assets in our own currency and there were little pockets of very good performing assets/strategies, but overall the sentiment’s been mostly negative. We are unsure of how long this malaise will last and when the outlook will turn positive. What we do know is that positioning going forward will be of utmost importance when volatility is high and the near-term outlook is not very positive, diversification and proper portfolio construction will get you out alive at the other end.

    Kind regards,

    Stefan Keeve

    Tel +27 21 914 4966
    Fax +27 21 914 4912
    Email info@seedinvestments.co.za

    Seed is hiring: Visit Seed Analytics LinkedIn Profile to view vacancies.

    Please click here to view our disclaimer. For more information please visit our website.

    Permalink2016-06-22, 07:16:17, by Mike Email , Leave a comment

    Seed Weekly - The Look-Back Folly

    Permalink2016-06-22, 07:11:28, by Mike Email , Leave a comment

    Seed Weekly - Different Investment Manager Styles

    Seed Investments constructs and manages investment portfolios as a multi-manager. This means that in building a portfolio, we may look to combine various underlying asset classes and various types of funds into one portfolio. The rationale is simple - there are numerous types of investment styles and strategies that managers employ and the reality is that there is no one single style or strategy that has the corner on the market. Each one has merits and drawbacks.

    Tawanda discussed passive versus active three weeks back (click to view article) and our conclusion is that there is a place for both of these major investment styles into a portfolio. At the same time we recognise the merits of including underlying managers with various investment styles into a portfolio.

    Beside the active versus passive debate, other investment styles that active investment managers employ can be described as:

    • Top down
    • Bottom up
    • Value investing
    • contrarian
    • quality
    • Growth investing
    • Momentum

    A top down investment strategy means that the investment manager places a high emphasis on macro-economic factors and forecasts. The manager may spend up to 50% or sometime even 70% of their time trying to understand aspects such the direction of interest rates, debt levels in an economy, commodity supply and demand, foreign investment flows, investor sentiment etc. and how these impact on the consumer on various types of company earnings.

    A bottom up investment strategy pays more attention to valuations of individual businesses and very little to no emphasis on macro-economic factors. The most famous bottom up investment manager is Warren Buffett, who says “The key attitude of managers that adopt this investment strategy is their view that no one can accurately and consistently predict macro events and so time is best spent analysing companies at a more micro level".

    A value investment management style is one that leans to searching for an investment that on some analysis trade at a price below their assessment of intrinsic value. The key premise is that for a variety of reasons, but typically when there is a preponderance of negative news, the price of an investment trades below what the investment is truly worth. It is these type of opportunities that value investors will seek out, looking to profit as prices revert closer to intrinsic value.

    A contrarian investment style is often a more extreme version of a value style. These managers are attracted to companies that are deeply out of favour with the investment community, or where investment holding companies trade at large discounts.

    Often in contrast to a value investor, a growth biased investment style is one that places a higher emphasis on company earnings and specifically on those companies that are able to grow their earnings at levels at a higher rate than competitors. The key premise with this strategy is that discounted future earnings determine the current value and that those businesses that are able to grow ahead of their competitors or the overall market will reward shareholders with higher company value over time.

    A more extreme version of a growth strategy is a momentum investment strategy. This is a strategy that focuses on recent price movement of shares, investing into shares that have moved up ahead of competitors. History shows that price momentum has a high degree of repeatability.

    Each one of these investment strategies and styles has both merits and drawbacks. Often investment managers blend investment styles, but at the same time there is typically a dominant style that the investment manager fashions their philosophy and process around.

    Investment styles themselves can move in and out of “fashion”. For example over the last few years, momentum and growth strategies have outperformed against value strategies. This can be seen in the chart below, where the momentum style of global markets is reflected against the value style. This has not always been the case and so investment managers with a strong value or contrarian bias have typically struggled versus their peers. Being in a position to blend various styles and strategies is therefore advantageous to investors.

    Chart 1: MSCI Growth versus Value Indices

    Kind regards,

    Ian de Lange

    View Disclaimer

    Tel +27 21 914 4966
    Fax +27 21 914 4912
    Email info@seedinvestments.co.za

    www.seedinvestments.co.za

    Permalink2016-06-08, 10:33:27, by Mike Email , Leave a comment

    Seed Weekly - Different Investment Manager Styles

    Seed Investments constructs and manages investment portfolios as a multi-manager. This means that in building a portfolio, we may look to combine various underlying asset classes and various types of funds into one portfolio. The rationale is simple - there are numerous types of investment styles and strategies that managers employ and the reality is that there is no one single style or strategy that has the corner on the market. Each one has merits and drawbacks.

    Tawanda discussed passive versus active three weeks back (click to view article) and our conclusion is that there is a place for both of these major investment styles into a portfolio. At the same time we recognise the merits of including underlying managers with various investment styles into a portfolio.

    Beside the active versus passive debate, other investment styles that active investment managers employ can be described as:

    • Top down
    • Bottom up
    • Value investing
    • contrarian
    • quality
    • Growth investing
    • Momentum

    A top down investment strategy means that the investment manager places a high emphasis on macro-economic factors and forecasts. The manager may spend up to 50% or sometime even 70% of their time trying to understand aspects such the direction of interest rates, debt levels in an economy, commodity supply and demand, foreign investment flows, investor sentiment etc. and how these impact on the consumer on various types of company earnings.

    A bottom up investment strategy pays more attention to valuations of individual businesses and very little to no emphasis on macro-economic factors. The most famous bottom up investment manager is Warren Buffett, who says “The key attitude of managers that adopt this investment strategy is their view that no one can accurately and consistently predict macro events and so time is best spent analysing companies at a more micro level".

    A value investment management style is one that leans to searching for an investment that on some analysis trade at a price below their assessment of intrinsic value. The key premise is that for a variety of reasons, but typically when there is a preponderance of negative news, the price of an investment trades below what the investment is truly worth. It is these type of opportunities that value investors will seek out, looking to profit as prices revert closer to intrinsic value.

    A contrarian investment style is often a more extreme version of a value style. These managers are attracted to companies that are deeply out of favour with the investment community, or where investment holding companies trade at large discounts.

    Often in contrast to a value investor, a growth biased investment style is one that places a higher emphasis on company earnings and specifically on those companies that are able to grow their earnings at levels at a higher rate than competitors. The key premise with this strategy is that discounted future earnings determine the current value and that those businesses that are able to grow ahead of their competitors or the overall market will reward shareholders with higher company value over time.

    A more extreme version of a growth strategy is a momentum investment strategy. This is a strategy that focuses on recent price movement of shares, investing into shares that have moved up ahead of competitors. History shows that price momentum has a high degree of repeatability.

    Each one of these investment strategies and styles has both merits and drawbacks. Often investment managers blend investment styles, but at the same time there is typically a dominant style that the investment manager fashions their philosophy and process around.

    Investment styles themselves can move in and out of “fashion”. For example over the last few years, momentum and growth strategies have outperformed against value strategies. This can be seen in the chart below, where the momentum style of global markets is reflected against the value style. This has not always been the case and so investment managers with a strong value or contrarian bias have typically struggled versus their peers. Being in a position to blend various styles and strategies is therefore advantageous to investors.

    Chart 1: MSCI Growth versus Value Indices

    Kind regards,

    Ian de Lange

    View Disclaimer

    Tel +27 21 914 4966
    Fax +27 21 914 4912
    Email info@seedinvestments.co.za

    www.seedinvestments.co.za

    Permalink2016-06-08, 10:33:19, by Mike Email , Leave a comment

    Seed Weekly - Tactical Asset Allocation – Enhancing your Experience

    My last article was on how our funds/portfolios are structured with different Strategic Asset Allocations (SAAs) for investors with different investment horizons and risk appetites. This week I’ll take a closer look at Tactical Asset Allocation (TAA), i.e. how we adjust the asset allocation away from the SAA in order to improve the fund’s risk/return profile.

    While we are comfortable that a fund’s SAA should generate sufficient returns over its recommended time horizon, our research indicates that by systematically applying a valuation based tactical overlay the investment experience (either through reduced risk or increased returns – or both) can be enhanced.

    Practically speaking, we believe in mean reversion. This is where cheap and expensive assets will both revert to fair value over time. We therefore look to systematically increase our allocation to cheap assets, while at the same time we reduce our allocation to expensive assets.

    For the purposes of this article I’ll show a couple examples of how our valuation models have filtered into the positioning of the Seed Balanced Fund. Firstly, when looking at the allocation to local equities, as Cor showed in his May article, local markets are currently as expensive as they have been for at least the past thirty years. The chart below shows the local market’s valuation at the end of April 2016 (for a refresher on how to read the chart please click through the link above to Cor’s article). Based on this valuation, the allocation to local equities is hovering near the fund’s all-time lows (35% at the end of April versus SAA of 50%). We expect substandard returns from the local equity market and have therefore reduced our exposure to this asset class.

    Four years ago the picture was different. The chart below shows the local market’s valuation in April 2012. At this juncture, the fund was slightly overweight to local equities (53% vs SAA of 50%) as the market was offering slightly better value than its long term history suggested. Over the intervening four years we have been gradually reducing the fund’s exposure to local equity as the market became ever more expensive.

    The other asset class that is currently at extreme levels when using our valuation techniques is our currency (the Rand). With all the weakness that has been experienced by the Rand in the last few years it is easy to think that it has always been a one way bet, but this is not the case.

    At the end of 2010, the Rand had strengthened by more than 50% over the previous two years. From the end of the Global Financial Crisis (GFC) in 2008 the Rand strengthened from over R10/$ to R6.60/$. Investors (particularly those who had taken their money offshore in the panic of 2001) did not want to hear about investing offshore. Remember, this was just after our successful hosting of the football world cup and emerging markets (especially BRICS) were also the flavour of the month in the investment world. The chart below shows the ZAR vs USD and our best estimate of fair value (PPP) at the end of 2010.

    It was at the end of 2010 that the Seed Balanced Fund’s allocation to global assets was moved to its maximum mandate limit, and this allocation has been broadly maintained (to much success) over the past 5 years. With the currency blow out in December 2015, and subsequent weakness, the Rand is now trading at levels (vs PPP) rarely seen – the chart below shows the extreme weakness witnessed over the past 5 years.

    We continue to favour global assets over local assets, and have therefore retained our global allocation at its mandate limit (25% + 5% Africa) but since the beginning of the year, in a series of transactions, we have implemented zero cost structures that protect half of the global assets from any currency strength, while at the same time allowing the Fund to profit from any weakness up to around R19.50/$.

    While we don’t have a crystal ball that will tell us what the return of the ALSI will be in 2016 or where the Rand will end the year vs the US dollar, our research indicates that there’s a good probability that investors in the local market will be disappointed over the next 5 years, and that we shouldn’t be surprised if the Rand strengthens going forward. We have therefore positioned our portfolios in such a way that they are able to capture these expected moves.

    Since the launch of the Seed Balanced Fund in 2010 our TAA decisions have consistently added value (both by reducing risk and enhancing returns) and as we develop our TAA process further we expect this to continue.

    Kind regards,

    Mike Browne

    Tel +27 21 914 4966
    Fax +27 21 914 4912
    Email info@seedinvestments.co.za

    Seed is hiring: Visit the Seed Investments and Seed Analytics LinkedIn Profiles to view vacancies.

    Please click here to view our disclaimer. For more information please visit our website.

    Permalink2016-06-01, 09:07:16, by Mike Email , Leave a comment