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    Seed Weekly - Low Risk Investment Strategies

    In my last article, I discussed investors investing into negative interest rate investments and looked at a number of reasons why investors, in this case mostly institutional, would consider such an investment.

    All investing involves a degree of risk. The question that investors need to ask themselves is firstly how can I define risk, and secondly what level of risk am I satisfied to take on. From this starting point, once the various investment options have been identified, a portfolio can be constructed.

    The stylised chart below reflects a range of investment assets (not exhaustive), plotted on the risk and potential return scale.

    While the potential for a higher return can come from a riskier investment, most investors understand by now that there are no guarantees to that return. In fact, often the reverse is true in that less risky investments can and have outperformed more risky investments over long periods of time.

    Warren Buffett’s famous axiom on investing is “Rule number 1, never lose money and rule number 2, never forget rule number 1.” At its core, this rule of investing emphasises the return of capital, ahead of the return on capital. Another way of looking at it in the light of a definition of risk, is “avoiding the permanent loss of capital.”

    In a high growth rate, inflationary environment, where asset prices are generally moving up and liquidity is in abundance, investors will tend to forget about the return of capital and focus more closely on the return on capital, but when risk escalates sharply, capital preservation suddenly becomes paramount.

    Because we live in a world with both known and unknown risks, the question is not so much one of whether lower risk investments be included into a portfolio, but to what varying degree they should be included. When constructing a diversified portfolio of investments, a portfolio manager should look at including a range of lower risk investments in order to reduce the variability of the portfolio’s return, reduce downside risk, and importantly be in a position to take advantage of price volatility in growth investments when they are sold down, becoming more attractive and therefore by definition “lower risk.”

    Considering the range of lower risk investments, these are some of the options:

    • US Treasuries or the US Dollar
    • Developed market government bonds – e.g. US, Switzerland, Germany
    • Gold bullion
    • Other precious metals such as silver and platinum
    • Quality, low volatility shares

    The challenge for investors is that like riskier investments, low risk investments also go through sometimes long periods when they do not necessarily act as a safe haven. For example, BCA Research analysis has found that US Treasuries have been a good safe haven from 2000 until now, while gold from that time became too correlated with the market returns. More recently, however, it has been acting more like a lower risk hedge with low to zero correlation to the market.

    This is, therefore, one reason why portfolio construction is not necessarily a static process.

    Kind regards,

    Ian de Lange

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    Permalink2016-08-31, 10:14:14, by Mike Email , Leave a comment

    Seed Weekly - Qui legit, adtendite: Let the reader beware

    This article is rather paradoxical in that I am writing of the need to be circumspect about accepting everything that you read as fact.

    The following email that I received highlights the issue of perspective:

    A biker is riding by the zoo in Washington, DC when he sees a little girl leaning into the lion's cage. Suddenly, the lion grabs her by the collar of her jacket and tries to pull her inside to slaughter her, under the eyes of her screaming parents.

    He jumps off his bike, runs to the cage and hits the lion square on the nose with a powerful punch.

    Whimpering from the pain the lion jumps back, letting go of the girl, and the biker brings the girl to her terrified parents, who thank him endlessly. A reporter has watched the whole event.

    The reporter, addressing the biker says, 'Sir, this was the most gallant and bravest thing I've seen a man do in my whole life.'

    The biker replies, 'Why, it was nothing, really. The lion was behind bars. I just saw this little kid in danger, and acted as I felt right.'

    The reporter says, 'Well, I'll make sure this won't go unnoticed. I'm a journalist, you know, and tomorrow's paper will have this story on the front page. So, what do you do for a living?'

    The biker replies "I'm a U.S. Marine, and a volunteer for the Republican party.”

    The following morning the biker buys the paper and reads, on the front page:

    “U.S. MARINE ASSAULTS AFRICAN IMMIGRANT AND STEALS HIS LUNCH”

    We can see that the perspective, pet hates and prejudices of a writer are very important, these determine which facts are left in the story, which facts are left out and which facts are emphasised.

    Hindsight bias” is another problem a reader often faces. When writing an article, a writer has all the facts about what happened and why it happened in front of him. In his book “Fooled by Randomness”, Nassim Taleb says that “A more vicious effect of hindsight bias is that those who are very good at predicting the past will think of themselves as very good at predicting the future…”. Whilst looking at the past can help us understand why things happened, the future remains unpredictable so take all predictions with a pinch of salt.

    The last problem that I often have with financial articles as a financial advisor, is that the writer is often expressing an opinion on a very limited set of facts and he does not have to sit with the consequences of “unbundling” a long term plan when he changes his mind a year or two down the line.

    I am the first person to emphasise the importance of reading to broaden your horizons and acquire new knowledge, I do however think that it is important to add a proviso “Qui legit, adtendite: Let the reader beware”.

    Think carefully about what you are reading, think about the writers perspective and why he is writing what he is, and lastly a good rule of thumb is if the writer is making predictions / forecasts about what is going to happen in future, you can probably ignore what he has to say.

    Kind regards,

    Barry Hugo

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    Permalink2016-08-24, 09:26:24, by Mike Email , Leave a comment

    Seed Weekly - Low Volatility Factor Investing

    Equity markets have been characterised by increased volatility in the recent past. Associated with this is the short-term underperformance in the markets, which investors are nervous about especially with more uncertainty going forward.

    Figure 1 below illustrates how market underperformance and increased volatility have historically been associated using the FTSE/JSE All Share Index returns data.

    Figure 1: Rolling 1 Year Return & Rolling 1 Year Standard Deviation of the FTSE/JSE All Share Index in Rand

    Source: Morningstar Direct

    This relationship is in line with the conventional risk-return trade-off principle which basically links, ‘high risk’ to ‘high rewards’. Volatility is a commonly used measure of risk – the more volatile an investment is, the more unpredictable future returns are, and the more likely they will deviate from expected returns.

    My previous article on factor investing (smart beta), highlights certain factors which historically have been deemed to earn a long term equity risk premium. The target of factor investing is to harvest the risk premia through exposure to these factors. One such factor is the Low Volatility factor which by definition captures excess returns from stocks with lower than average volatility, beta, and/or idiosyncratic risk. Excess returns/outperformance from low volatility stocks is quite interesting as it contradicts the conventional risk-return trade-off principle stated above.

    I make use of data from the MSCI All Country World Index as there is limited low volatility data on the local market. The chart below summarises why low volatility outperforms over the long term – simply it is a result of lower drawdowns / limited losses in times of market stress.

    Figure 2: Investment Growth since June 1993 and drawdowns over the same period in USD

    Source: Morningstar Direct

    The long-term outperformance is quite remarkable as it points to the persistence of the low volatility factor, even though the main driver is limited downside. Such a strategy is likely to underperform when the markets are strong, but its strength lies in the period of negative market returns. The market tends to underestimate the frequency, magnitude, duration and impact of market downturns.

    The MSCI low volatility uses two construction methodologies to capture the low volatility premium, minimum-volatility-indices and risk-weighted-indices. Minimum Volatility Indices reflect an empirical portfolio with the lowest forecast volatility using minimum variance optimization. Risk Weighted Indices capture low volatility stocks by weighting based on the inverse of historical variance. The result of this construction is a portfolio of stocks that tends to have more or less similar long-term returns.

    A few behavioural explanations have been suggested to explain the low volatility anomaly. The “lottery effect” is the most common and suggests that people tend to take bets with a small expected loss but a larger expected win, even though the probability of a loss is much higher than the win, and the weighted average of the outcome may be negative – similar to paying a small sum for a potentially large lottery win even though the probability of winning is very small. Investors therefore often overpay for high volatility stocks and underpay for low volatility stocks due to the “irrational” preference for volatile stocks.

    Critics of the volatility factor argue that buying a basket of low volatility stocks may lead to unintended bets on valuation and sectors, because such stocks can be expensive and concentrated in just a few sectors (such as financials). Continued analysis and testing is therefore necessary to optimise the potential benefits of investing in this factor.

    The Seed Balanced Fund currently makes use of the Low Volatility factor as an equity strategy within the fund. Blending this strategy with other uncorrelated strategies forms part of our risk management framework. As a result, the fund has enjoyed diversification benefits, helping to reduce volatility in tough markets.

    Kind regards,

    Tawanda Mushore

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    Permalink2016-08-19, 09:31:51, by Mike Email , Leave a comment

    Seed Weekly - Black Swans & Ugly Ducklings

    The past 12 months have been eventful. Some big events were positive while many others where less so, to say the least. We sometimes refer to these big once-off, unpredicted events as black swan events.

    The most recent black swan was Brexit. Although the topic no longer dominates dinner party conversations, it remains highly relevant as negotiations are ongoing and the outcome still uncertain. What we do know is that following the landmark referendum the value of listed UK properties fell, the Pound depreciated and UK interest rates were dropped to their lowest level in history on the back of renewed growth uncertainty. There were also a few days of panic in which most equity markets across the world were sold down, however most have since recovered.

    On the day the results were announced you either owned assets, such as London property or the Pound, or you didn't. If you held these on the day you would have suffered a loss which has not recovered much of its value since. Nothing you did after the fact could change this. Panicked selling or emotional reactions following Brexit would most likely have exacerbated your headache.

    South Africa experienced its own black swan event in December last year when our finance minister was replaced without reason or forewarning, twice. It caused the value of the Rand to plummet and government bond yields to spike. Some panicked and decided to sell their Rands after the sudden drop when the value was at a historic weak point. Since then, the Rand actually strengthened against most developed market currencies, and many who made the decision to sell the Rand immediately after the tumultuous 3 days in December can chalk up the loss to a sub-optimal, panicked decision.

    Of course we aren't, for the purposes of this article, considering the merits of investing in hard currency or even touching on the topic of how much hard currency one should hold. We are just looking purely at the decision to sell an asset following a black swan event and the loss suffered because of this.
    Not all black swan events are negative. Every SAB shareholder will forever remember the day the merger with ABInbev was announced and the share price shot up by +- 27% in one day. The story is similar to the above negative black swan events, either you owned the asset on the day and made a huge profit or you didn't. What made the SAB black swan event different, was the fact that since the announcement of the merger the Rand share price has in fact increased, although it came with significant downside risk if the deal didn't go through.

    Before the announcement of the merger there wasn't much excitement about SAB. The share was expensive and trading within a band. It was by no means a bad company to invest into as it was profitable and generating cash, but nothing really ground-breaking was going on to get investors excited. The proverbial ugly duckling matured into a graceful white swan.

    Events such as these, whether positive or negative, will always be a part of investing. It undoubtedly changes the fundamentals and outlook, and you should always look to re-evaluate your positions based on the revised outlook. Take a deep breath, and make the calculation whether holding onto the asset is worthwhile despite the recent shock, and if the asset is trading at fair value. When making decisions in a fit of panic, you will almost always find yourself looking back to discover an even bigger negative effect. It is as hard as it is simple - accept what happened as a sunk cost and move on.

    Kind regards,

    Stefan Keeve

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    Permalink2016-08-10, 09:58:54, by Mike Email , Leave a comment

    Seed Weekly - Targeting Returns

    In this third article on targeting returns I am going to focus on a very topical subject, not only now but one that has been on the agenda for the entire 25 years I have been in the investment industry.

    There are many views, themes, strategies and methodologies for evaluating the topic and I am not going to try and pitch one over the other but rather focus on a few big picture ideas.

    The question has been and is, should a South African (asset resident) long term investor invest internationally to get better returns from their portfolio? If the answer is yes the second question is if you were unrestricted what percentage of your investable assets should or would you invest outside of South Africa?

    For most South African citizens their biggest assets are all in South Africa namely, their businesses, pension funds and homes. Apart from pension funds that can have up 25% offshore pretty much everything is in South Africa.

    Below is a chart that illustrates the various sizes of the listed equity markets. You will note that Africa makes up about 1.5% and of this South Africa less than 1%.

    Source: The Money Project 2 August 2016

    It does seem quite obvious that South African investment managers would ideally like the opportunity to invest in the other 99% of the global listed equity economy.

    I have read for many years that it is much better to have a decent portion of your investment offshore and remember the early days of exchange control when R250k once off was officially allowed offshore, this slowly crept up and up until recently when it was announced that an individual can take up to R10/11m p.a. offshore. This effectively now removes all exchange control for 99% of the population.

    Without making the ever present political call, let’s investigate the historical facts based on an investment made in Rands. I have chosen several well-known indexes to represent various equity investment options to illustrate the point. The ALSI for the SA market, the S&P 500 for the broader US market, the FTSE 100 for the UK, the MSCI All World for the broad global market and MSCI Emerging Markets Index. I have also used rolling five year returns to reduce the volatility and to illustrate a more strategic allocation by an investor. Just a reminder the returns p.a. are in Rands.

    Source: ZephyrStyleAdvisor 3 August 2016

    So with perfect hindsight history shows us that choosing to go offshore was not straightforward and in fact you would have been a net loser until about seven to five years ago. Also the out performance of the local market was extreme for the better part of this reporting period.
    If you got your timing right to switch offshore immediately after great financial recession of 2008/9 then you have done very well over rolling 5 year periods since by overweighting to the S&P 500, MSCI AW and the FTSE 100 vs. the ALSI.
    Granted I have only used one asset class to explore the question but the same is largely true of most other asset classes. What is very apparent to me is that you need to tactically time your diversification to benefit fully from diversification.
    What is encouraging is that at Seed we have analysed our past performances and have consistently added value through our tactical asset allocation decisions.

    Kind regards,

    Robert Foster

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    Permalink2016-08-04, 16:17:26, by Mike Email , Leave a comment