Merit in Diversity

Equities will be the core but bonds, cash and property all have merit in diversity

Written 400 years ago, Miguel de Cervantes’ book Don Quixote de la Mancha contains advice well heeded by all investors: “Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.” The trick is to choose asset-baskets appropriate to an investor’s objectives and the risk he or she is willing to assume.

For those with a long-term goal of accumulating capital, equity will always have an important role. The choices are: your own portfolio, actively managed unit trusts, index-tracking funds and absolute/targeted return funds.

Building your own portfolio is not as daunting as it may appear. The secret of most successful long-term equity investors is that they think in terms of investing in businesses.

In essence, they build a core portfolio but remain on the lookout for factors that could alter the fundamentals of their holdings and for opportunities to accumulate others offering good value. Here it is useful to keep an eye on what the smart money is doing.

For those not willing to tackle their own equity selection, unit trusts are an option. When selecting a fund, don’t be influenced by short-term returns. A fund manager should be judged on longer-term returns and, especially, performance during difficult periods such as that between 2000 and early 2003.

Funds that track equity indices are a third way in. Their advantage is low costs. They are also a way of countering the risk of a private equity portfolio or a unit trust selection underperforming.

For most investors, unit trusts are also the route offshore. Though the strong rand has pushed foreign equities into the background, don’t ignore them.

How much further the rand can appreciate is a moot point, given its 100% rise against the US dollar, 50% against sterling and 35% against the euro since December 2001. Some smart money is already on increasing offshore assets now.

Timing of an entry into equity can be as important as which shares or funds are selected. To balance the risk, absolute and real return funds can be of use, though many on offer are just variations of flexible funds or income funds. But a good example of a hedged strategy is Old Mutual Dynamic Floor Fund (OMDF), which is managed to prevent the loss of more than 10% of its value over any 12-month period. During the November 2002 to March 2003 market slide that wiped 17% off the average general equity fund’s value, OMDF fell only 7%.

Interest-paying assets also have a role in a balanced portfolio. How much depends on factors such as the income needed and the investor’s aversion to risk. Though equity may provide the best long-term returns, it is not without risk – as seen when after its January 2000 peak the financial & industrial index took almost five years to reach that level again.

Bonds are an alternative but also hold a degree of capital risk. This is more so after a protracted period of falling interest rates. Most fund managers view bonds as offering, at best, marginal value at the moment.

But if bonds are bought for yield only, the direct route is preferable to bond funds at present. Quite simply, bond funds represent a “perpetual bond” with no maturity date. By contrast, individual bonds can be purchased that match maturity goals, making the risk of interim capital fluctuations less important. Bonds can be bought in “odd lots” of as little as R20 000 or so.

One option deserving a place as a core holding is inflation-linked CPI bonds, which offer a real return of 3,5%/year or roughly three-quarters of what history indicates can be expected from equity funds. CPI bonds can be bought in odd lots and are viewed by many traders as better value than conventional bonds.

Property is closely related to bonds and much of the recent strong performance of property funds is attributable to falling interest rates. Similarly, their future performance is linked to that of bond yields. And though there is general optimism, Marriott fund manager Ian Anderson cautions: “All the good news, such as low interest rates, is priced into the market.”

On a positive note, Anderson expects to see income distribution growing at about 6%/year for up to three years. Risk on the downside is a weaker rand that could prompt interest rate hikes and “could result in a sell-off in the property sector”, he says.

The current-account deficit is also a risk for other asset classes.

A cautious portfolio structure appears appropriate at present. This would downplay the importance of domestic equity, have a solid element of hedged products, favour CPI bonds over conventional bonds and property and have a rising offshore exposure. In the offshore realm, funds with a strong value bias and an element of hedging appear the safest bets.

By Stafford Thomas