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    Seed Weekly - Currency Valuation

    An important part of Seed’s multi management process is performing monthly asset class valuations using our in-house quantitative models. This process covers all of the local and global asset classes that are suitable for inclusion in our multi asset class funds and model portfolios. The output of these models guide our tactical asset allocation decisions, where we under- or overweight certain asset classes in the short term, compared to our longer term target weights.

    When evaluating global asset classes for our funds, we try to separate the currency decision from the underlying asset class valuation. Practically, this means that if global equities show a lot of value, we might allocate even when the rand is weak. Although currency volatility might overshadow our asset class decisions in the short term, investing at attractive valuations pays off over the long term.

    We look at both the trend exchange rate of the Trade Weighted Basket of currencies and the well-known Purchasing Power Parity (PPP) relationship against each of the majors on a monthly basis.

    The Trade Weighted exchange rate of the rand is based on trade in and consumption of manufactured goods between South Africa and its most important trading partners, incorporating twenty different currencies. Presently, the five major currencies in the basket are the Euro (29%), Chinese yuan (20%), US dollar (14%), Japanese yen (6%) and British pound (6%).

    The graph below illustrates that the rand is around 20% undervalued given the long term trend in the Trade Weighted basket of currencies:

    Source: Seed Investments 26 July 2016

    The PPP relationship is based on the law of one price, meaning a consumer should be able to pay the same price for a diversified basket of goods, no matter in which economy the purchase is made. In SA, with local annual inflation running at 6.1%, a consumer will see his purchasing power eroded a lot quicker than in the US, where inflation is 1.0%. Therefore, a SA consumer needs to be “rewarded” with more rand per US dollar each year - resulting in rand depreciation - if this relationship holds.

    Theoretically, PPP implies that SA’s 5% higher inflation should result in around 5% depreciation per annum against the dollar. In practice, actual exchange rates can deviate from the calculated PPP estimate for extended periods. Over the last 10 years, SA inflation has been running at 6.3%, with US inflation at 1.8%, while the rand has weakened by 7.5%, quite a bit more than the expected 4.5%.

    The graph below illustrates that, at a market rate of R 14.70 as at end June, the rand is around 37% undervalued vs. the calculated PPP rate of R 10.69.

    Source: Seed Investments 26 June 2016

    In the wake of the Nenegate sage in December last year, the rand has been exceptionally volatile, prompting many investors to re-evaluate their global exposure. At Seed, we have not traded on the short term volatility, but have maintained our global allocations at close to 25% for our multi asset class funds and model portfolios.

    Kind regards,

    Cor van Deventer

    ***SEED IS HIRING: Click here to view vacancy

    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.

    Permalink2016-07-27, 09:15:01, by Mike Email , Leave a comment

    Seed Weekly - Investment Strategy in a Negative Interest Rate Environment

    My last article discussed various investment manager styles. Included here were styles such as top down, value, contrarian, growth, quality, momentum etc.

    In this article, we explore possible investment strategies and some specific reasons why investors would be explicitly “investing” cash at a negative nominal interest rate, i.e. investing with the guarantee of receiving back less in nominal terms after a defined period of time. Because such an investment approach goes against our normal understanding of investments, it is difficult to believe that an estimated amount of over $10 trillion is already invested into negative yielding assets in the form of mostly government but also corporate bonds.

    As an example, last week it was reported that the German Bundesbank issued €4 billion, 10 year bonds at a yield of negative 0.05% p.a. yield. In this instance investors were prepared to part with a substantial sum of money, with the explicit promise that they would receive a haircut of 0.05% each year off their initial capital invested.

    This is a classic case of investors being so risk averse that they are more concerned with the return of their capital than their return on capital.

    So let’s look at some reasons why investors would adopt this as part of their overall investment strategy.

    One investment approach adopted by many pension funds is the matching of their liabilities with assets. This is known as LDI or liability driven investment. This is an investment style that is focused on the liability side of pension funds. It is mostly defined pension funds that will look to adopt this strategy because they have a defined liability in the form of a promise to their retired employees, which can be actuarially calculated on a year by year basis.

    In order to immunize this liability, pension funds will set aside a portion of the portfolio investments, investing into lower risk bonds. This worked well when bonds yielded higher rates, but many pension funds continue to invest even as yields drift lower into negative territory. It can be justified if, due to deflation, the pension funds liability is decreasing.

    Another buyer of “lower risk” government bonds are insurance companies. Due to increased capital structure regulation, insurance companies own increasingly greater amounts of “less risky” assets. In the past and in order to match their long term liabilities they are “forced” buyers of government bonds.

    Therefore, yields are low and governments are able to issue bonds at these low yields and even negative yields, because there is huge demand.

    • There is demand from risk averse pension funds.

    • There is demand from central banks that are buying bonds issued by government treasuries as a form of quantitative easing.

    • There is demand from the risk averse global savings market, which is generally running higher than new issuance. Because of high demand, governments issuing are able to price yields at lower and lower levels.

    • Another reason is that global investment managers manage according to benchmarks. Where global bonds make up a portion of the benchmark, the decision to not allocate to bonds, becomes a “risky” investment decision, relative to the benchmark and peers. This becomes especially pronounced where the return on bonds has done well. Therefore despite the low and negative yields, investment funds are “forced” to buy bonds.

    According to global bond manager, Pimco, low and negative yields can be pointing to a sharp economic downturn, i.e. a deflationary environment. In this instance investors buying negative yields bonds may still receive a positive real yield, where inflation turns to deflation. For example the real return on a negative 0.05% coupon can translate into a positive 1%, where there is deflation of 1.05%.

    The Economist has called this “slow suffocation” because given the preponderance of negative interest rates, banks and other financial services firms’ profitability will ultimately be hit hard. Not only that but virtually all other investment assets are priced off global bond yields, by adding a relevant risk premium. It therefore makes a difference to all global investment assets, when the starting position is a negative.

    The chart below reflects the steady increase of global funds now invested into negative interest yielding bonds.

    Chart 1: The pool of global negative yielding debt is climbing

    Source: The Wall Street Journal 18 June 2016

    So while there may be lots of reasons why investors, mostly institutional type investors have lots of reasons to “invest” into negative yielding bonds, they are not necessarily making rational investment decisions.

    Regards,

    Ian de Lange

    Seed is Hiring: We are looking for an Investment Business Analyst/Developer to join our Investment Team, click here to view vacancy

    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.

    Permalink2016-07-20, 09:45:28, by Mike Email , Leave a comment

    Seed Weekly - Reviewing our TAA Decisions

    My previous articles focused on how Seed constructs our Funds around predetermined Strategic Asset Allocations (SAA) (click here) and then how we seek to add value through our Tactical Asset Allocation (TAA) process (click here). This week I take this line of discussion to its logical conclusion. Has our decision making added to, or detracted from, performance? Essentially how has our TAA process contributed to returns?

    At the risk of repeating myself, our investment process seeks to incrementally add value to our Funds, rather than risking the fortunes of the entire Fund on one or two outsized allocations. We believe that we have a process that, over time, will produce more good decisions than bad, and we therefore seek to make as many independent decisions as possible so that the law of averages works in our favour and we generate consistent outperformance. Unfortunately in the real world we aren’t always going to get it right, but it doesn’t stop us from constantly striving for this goal.

    Importantly, we have set up systems to analyse the decisions that we have made that allows us to focus our attention where required. The chart below is one of the outputs that we review on a monthly basis. It looks quite busy, but essentially tracks whether the allocation to each asset class has added to (above the 0% line – overweight an outperforming asset class or underweight an underperforming asset class), or detracted from (below the 0% line – overweight an underperforming asset class or underweight an outperforming asset class), the Seed Balanced Fund’s returns on a monthly basis. The total contribution from our TAA is represented by the black dot. This is the granular level at which we make (and then analyse) our asset allocation decisions. The chart tracks the monthly contributions over the past 4 years.

    It is evident that on a monthly basis the return drivers are quite random, with big contributors in one month often being large detractors in the following month. On a monthly basis our TAA process has added value just less than 70% of the time. When extending this analysis to a rolling 12 month view we get a better idea of how our TAA adds to the investment performance. The chart below breaks down our TAA decisions over rolling 12 month periods. Essentially our TAA decisions have added between 1% and 4.4% over any rolling 12 month period over the past 4 years.

    An obvious detractor over the last couple years has been from our underweight Global Bond allocation. Since the inception of the Seed Balanced Fund we have maintained an underweight allocation to this asset class as our research indicates that investors should expect poor returns over the long term. In order to mitigate this position to a certain extent we have overweight allocations to Global Property and Global Alternative. When viewing the underweight Global Bond in conjunction with the overweight Global Property and Global Alternative allocation, it is evident that, in general, this has been a good decision over time (only mildly detracting from returns over the past 4 rolling 12 month periods). The chart below isolates this TAA decision.

    Without going further into the detail I’ll stop this analysis here. Suffice to say that an important part of our investment process is a thorough regular review of the decisions we make. Where they have added to performance we ask whether we should be taking profit or retaining the position. Conversely, where returns have been negatively impacted, we critically assess the investment case again. If the investment case has changed we will not hesitate to cut our losses, but where we are convinced that the investment case has strengthened we are happy to make a higher conviction allocation.

    Take care,

    Mike Browne

    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.

    Permalink2016-07-13, 09:19:46, by Mike Email , Leave a comment

    Seed Weekly - Peer Groups acting as Benchmarks

    The age old discussion surrounding benchmarks will carry on for as long as humans occupy this planet and have money available to invest. Are benchmarks set too low, making them very easy to beat? Are they set too high, making them hard to beat unless fund managers take on excessive risks? Is the frequency of assessment against the benchmark appropriate? In this weekly article we will be focusing on using peer groups as benchmarks and how they can add value to our investors.

    The importance of peer groups can be argued endlessly. There will always be investors and investment managers who will argue that peer groups do not meet the complete investable benchmark criteria. Others will argue that we really do not know who has succeeded or failed because success against one peer group can easily be failure against another comparable peer group, so a manager can be both a success and a failure. Another possible disadvantage of peer groups is that they can mislead investors rather than inform them. The sell side knows how to deal with these problems: use the peer group that makes them look best and it’s the buy side (the investor) that suffers most from the problems with peer groups. Furthermore, the compensation of the fund manager typically depends solely on the value of assets under management, as more managers are moving away from a performance fee structure. Therefore, a fund manager’s bread and butter is not dependent on the value added by the fund manager, as there is typically no reward for outperforming the peer group benchmark and no penalty for underperforming these benchmarks.

    Our view at Seed Investments is that although peer groups are not the perfect benchmark (if there is even such a thing as a perfect benchmark), peer groups have their place under the “benchmark sun”. Some asset managers take the position that they are going to disregard what other institutions are doing, and simply follow their own vision. This attitude ignores what may well be the best thinking on the topic. Some examples of herd behaviour in investing may exist, but in general, any sound asset manager takes their responsibilities seriously and is highly capable. These professionals have, as their responsibility, the task of thinking about what asset mix is best for their funds and then implementing it.

    We believe in what we do, but every now and then we need to measure our performance against our peers to ensure that we have not wandered off and lost the plot completely. While it is good to follow your own ideas and dreams, it is important to respect the conclusions of generally well-informed and well-meaning peers. This does not mean you should not vary from the allocations of your peer group if your mandate or risk tolerance is different from theirs, but you will get in real trouble by thinking you don’t have peers when you most definitely do. Consequently, the long-term success of any fund management house in some way depends on its relative performance against its peer group.

    At Seed Investments, we make use of peer groups as benchmarks across the range of our products. Below is a risk adjusted return graph of the Seed Balanced fund compared to the ASISA South African Multi Asset High Equity peer group. The graph illustrates that the Seed Balanced fund has achieved a higher return than the peer group average albeit at taking on a little more risk (standard deviation).

    Figure 1: Risk Reward (Time period 01/07/2010 – 31/05/2016)

    Source: Morningstar 29 June 2016

    This is one of the graphs we use to compare our performance to the peer group. Seed will always, to the best of our ability and knowledge, use the most relevant peer group to compare our funds against. This will ensure that we keep track of our own progress without losing touch with our peer group and will give our clients peace of mind that they can compare our funds with the appropriate funds in the industry.

    Kind regards,

    Stephan van der Merwe

    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.

    Permalink2016-07-06, 08:56:27, by Mike Email , Leave a comment