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Why adding hedge funds to your portfolio makes sense

Eben Louw: Naviga Solutions, Portfolio Manager.

Over the last 15 years amidst market volatility, the average local balanced fund has achieved the commonly used CPI+5% benchmark only 42% of the time over a three-year investment horizon. Consequently, investors have increasingly turned their attention to alternative investments and return sources, especially in the wake of recent bond market volatility and the uncertain outlook for equities. Hedge funds are an attractive entry point to alternative assets given their increased regulation, liquidity, and transparency. Other alternatives, however, often have little information on underlying instruments, lock-up periods, and high minimum investments. Adding hedge fund exposure to portfolios offers investors a lower correlation with traditional portfolios, diversification benefits, and a means of minimising volatility.

While the average drawdown (peak to trough move) of the FTSE/JSE All Share Index was more than -11% during the past five years, the typical local long-short equity hedge fund limited this drawdown to -4.8%. Fixed-income and market-neutral strategies limited this drawdown even further (to approximately -0.9% and -0.6% respectively). While limiting the downside, these strategies can still participate significantly in market rallies. Over the past 10 years, the typical local long-short equity hedge fund has outperformed traditional local equity funds 71% of the time over a three-year investment horizon.

Hedge funds, like traditional unit trusts, can invest in a wide variety of assets but also make use of additional tools such as leverage, derivatives, and short positions, which gives them the potential to profit from market downturns. Hedge funds can follow different strategies and risk levels that deliver significantly varying performances. Among the most common long-short equity funds available locally, the one-year difference between the best and worst performer can average up to 30%. Therefore, as with any investment, thorough research and due diligence remain crucial.

What to do when things get a lot worse in South Africa

How short-sightedness hurts your investments in the long term

Dr. Francois Stofberg: Senior Economist at Efficient Wealth and the Managing Director of Efficient Private Clients, with specialist input from Renier van Zyl.

Taking a hiatus from checking your investment portfolio for a month can be akin to stepping back from the canvas of daily market fluctuations. It is a deliberate act of patience, allowing the market’s ebb and flow to paint its own picture before returning to assess the masterpiece.

In the intricate tapestry of financial markets, September often paints a canvas of uncertainty and volatility. Historically, September has proven to be the worst month for equity market returns. In fact, it has been the worst-performing month, on average, going back nearly a century. It is a period when investors are reminded of the unpredictable nature of the financial landscape. Market participants refer to this phenomenon as the “September Effect”. It is a calendar-based market anomaly in the sense that it occurs without any real causal link or event, challenging the efficient markets hypothesis.

Challenging the established order is crucial, especially when the downturn is more pronounced than usual, as is the case this year. There are several reasons for this: The looming threat of a United States (US) government shutdown is causing market uncertainty. This potential shutdown is owing to a sharp ideological division between House Republicans that could lead to a halt in federal agency funding by 30 September. The shutdown will continue to loom unless Congress agrees on all 12 appropriation bills in time for the new fiscal year beginning on 01 October.

In August, Fitch Ratings downgraded the US owing to precarious debt ceiling disputes between the Democrats and the Republicans. This downgrade highlights the fragility of US fiscal policymaking compared with its AAA-rated counterparts. Another government shutdown would only exacerbate this vulnerability.

Additionally, the US is already walking a financial tightrope with the nation’s debt now exceeding $31.1 trillion. It is a complex interplay of economic necessity, political debates, and global repercussions, all influencing the US’ fiscal future. In the last week alone, the US managed to add a staggering $100 billion of additional debt (this is more than a quarter of South Africa’s annual gross domestic product (GDP)). Persistently high interest rates will lead to the US refinancing its debt at increasingly costly levels, potentially surpassing $1 trillion in annual borrowing costs before the end of 2023. Without a debt limit, there is little incentive for fiscal restraint. If the situation continues to deteriorate, it could result in another downgrade of the country’s debt rating.

Then there is the consumer: The US economy will stay utterly dependent on the consumer to steer it to a place of relative safety; investors are, therefore, constantly monitoring the health of the US consumer. Intriguingly, the latest downward revision of second-quarter GDP consumption figures paints a challenging picture. As a result of the revision, quarter-on-quarter GDP growth plummeted from an annualised rate of 1.7% to 0.8%, the lowest rate since the onset of the COVID-19 pandemic. Personal consumption, constituting more than 68% of nominal US GDP, faces mounting pressures owing to tightened lending conditions, student loan repayments, and dwindling savings. Even Bloomberg reports that most Americans, excluding the wealthiest 20%, now have less cash on hand than when the pandemic began. Expiring support programmes are also adding to the strain.

In this environment, patient, methodical financial planning becomes evermore important. Planning of this kind helps investors steer away from being short-sighted and running after deceptive returns. Usually, these short-sighted investment decisions are fuelled by emotions rather than by logic, and this does not play out well in the long term. Independent, holistic financial advice allows investors to step back from the canvas of short-term market fluctuations (read emotions) and make the most of long-term opportunities by buying the right companies at the right prices. In the current environment, the right company is resilient, with a strong balance sheet and products that are in high demand. With patient, methodical financial planning, uncertainty and volatility eventually fade away, and all that remains is peace of mind.

The answer to South Africa’s predicament is complete state reform

Bottom-up and top-down investment strategies

Dr. Francois Stofberg: Senior Economist at Efficient Wealth and the Managing Director of Efficient Private Clients, with specialist input from Christiaan van Wyk.

The investment industry, like most other professions, has evolved over time with various approaches and strategies coming to the fore, each with its own inherent characteristics. When investing in listed shares, two dominant approaches stand out: Fundamental bottom-up and top-down investment strategies. These approaches represent distinct methodologies for selecting and managing investment portfolios, each rooted in a unique perspective and analysis framework. Fundamental bottom-up investing is based on the scrutinisation of individual assets or securities, assessing their intrinsic value, and making investment decisions based on the merits of each specific opportunity. Conversely, top-down investment strategies take a broader macro-economic viewpoint, where investors first evaluate global or sectoral economic trends and then identify industries likely to benefit from those trends before honing in on specific investments. Understanding these two contrasting approaches is crucial for investors seeking to tailor their strategies to their investment goals and risk tolerances.

Fundamental bottom-up investing offers several benefits. One of the primary advantages is its ability to provide a deep understanding of individual securities. By focussing on the intrinsic value of each investment, investors can potentially identify undervalued opportunities and make well-informed decisions based on the specific strengths and weaknesses of each company. However, fundamental bottom-up investing also has its drawbacks: It can be time-consuming and resource-intensive, requiring extensive research and analysis for each individual investment. This approach may not suit investors who prefer a more hands-off or passive approach to managing their portfolios. Moreover, it can be challenging to anticipate macro-economic trends or market shifts that could impact the performance of individual assets, as the focus is primarily on micro-level analysis.

The top-down approach, in turn, is primarily centred around its macro-economic perspective, allowing investors to assess global economic trends, sectoral developments, and broader market conditions. This strategic outlook enables investors to allocate their capital effectively and to capitalise on emerging opportunities, potentially yielding higher returns. Furthermore, top-down investors can adapt their portfolios to changing economic climates, making it a flexible approach when navigating market volatility. However, top-down investing is not without drawbacks. One significant challenge is that it may lead to overgeneralisation and missed nuances, as it emphasises broader trends over individual asset analysis. Investors relying solely on top-down strategies might overlook potentially lucrative opportunities within specific sectors or companies. Additionally, accurately predicting macro-economic trends can be exceptionally challenging and even small miscalculations can have adverse effects on portfolio performance. This approach can also lead to a lack of diversification if investors become too concentrated in a particular sector, increasing portfolio risk in the event of unexpected market shifts.

We, at Efficient, believe that the best approach to managing equity portfolios is to balance the macro-economic perspective with careful stock selection, which increases the investor’s potential to achieve favourable long-term returns. An investor must understand the underlying drivers of profitability for each company that they invest in, as well as the price that they pay for their share in those profits, while also managing the overall portfolio risk by comparing the portfolio exposure with the expected economic climate and secular themes at play. As with most things in life, finding an appropriate balance often leads to optimal outcomes.

Tough times never last

Dr. Francois Stofberg: Senior Economist at Efficient Wealth and the Managing Director of Efficient Private Clients.

Last week, prices of both grades of petrol went up by R1.71 per litre while diesel increased by close to R3 per litre. The recent jump in fuel prices is driven by a twofold weakening of the exchange rate and a substantially higher oil price. Having started at around R17 to the United States (US) dollar at the start of the year, the rand has now depreciated by more than 11% year-to-date. The oil price, in turn, has increased by more than 10% already this year, reaching its latest level just above $90 a barrel. A higher oil price will likely add to inflationary pressure, although the impact of higher fuel prices is usually overstated.

In our estimate, we consider the year-to-date deprecation of the rand and the oil price increase. We also factor in the second-round price effect, namely that higher fuel prices make “everything” else more expensive. But, even then, the higher fuel prices we have experienced in 2023 should not add more than 1.08% to consumer inflation on an annual basis. What is more important is to consider the impact of higher fuel prices in the context of the deteriorating macro-economy. For this reason, we still believe that inflation will remain close to 4.5%, the mid-range of the South African Reserve Bank’s (SARB’s) target, in the medium term.
Overall, we do not expect the SARB to increase interest rates again, unless the US Federal Reserve becomes even more hawkish. If that happens, we might see one more increase of 0.25%. We agree with some analysts that we may even see our first interest rate decrease by mid-2024, which will be a welcome relief to most South Africans.

According to the FNB/BER Consumer Confidence Index (CCI), South African consumers have started to claw back some of the lost ground. Unfortunately, the index remains well within negative territory. Confidence among individuals who earn more than R20 000 per month plunged to an all-time low of -40 in the second quarter of 2023 but rebounded to -17 in the third quarter. The confidence levels of households earning between R5 000 and R20 000 per month also improved, from -22 to -15 during the third quarter.

Theoretically, the FNB/BER CCI can vary between -100 and 100 but the overall index has fluctuated between -33 (indicating an extreme lack of confidence) and +23 (indicating extreme confidence) since the BER started measuring consumer confidence comprehensively in 1982. The average of the index is +2 and could, therefore, be regarded as the neutral level. So, even if we have seen an “improvement” among certain household income groups, consumer confidence is still far from neutral levels, and even further away from what can be considered a consumer base that is once again confident about the economy and their future.

It is becoming clearer that 2023 will be a very difficult year for the South African economy. Even though the economy grew slightly better than expected in the second quarter, 0.6% instead of 0.3%, most analysts expect that we will only grow about 0.3% for the entire year. Some argue that we might even see an annual contraction. Add to this, our deteriorating state finances and balance of payments, and you start to understand why our local markets are not attracting even short-term capital. All the while, the chances of a Goldilocks (too good to be true) environment in the US continue to increase.

So, what should investors do in times like these? Do not try and do it on your own. Always seek independent, holistic financial advice so that you can get the best objective advice that considers your unique financial objectives across generations. Also, do not be hasty. Do not fall for scams that promise you the moon and the stars; be extremely cautious about anyone who guarantees you more than 10% returns annually. And always remember, tough times never last, only tough people do!

The superiority of independent, holistic financial advice

Dr. Francois Stofberg: Senior Economist at Efficient Wealth and the Managing Director of Efficient Private Clients.

The term “economics” has its roots in ancient Greece. It is derived from two Greek words, namely “oikos”, which means “house”, and “nomos”, which means “law” or “custom”. When combined, “oikonomia” roughly translates to “household management” and concerns itself with the efficient allocation of resources within a household. The first “economists” one might, therefore, argue were not the clever philosophical mathematicians of the eighteenth and nineteenth centuries but rather the ancient stewards who used their expertise of providence to steward households towards prosperity, wealth, health, and happiness.

Over time, economics evolved to encompass a broader meaning whereby it sought to understand and to analyse how societies manage their resources to achieve their goals and to improve their well-being. Economics also became more of a mathematical science and the stewarding skills which it once embraced were all but forgotten. Today, wealth and investment managers try to replicate what the prodigal stewards once did but most fall short because they neglect the independent and holistic approach followed by the experts of old.

Our approach is, however, different: We not only combine wealth and investment management expertise but we do so independently and holistically. In this way, we can truly guide families with providence towards prosperity, which is an all-encompassing term that refers to the wealth, health, and happiness of individuals and their families across generations.

Independent financial advice offers clients unbiased, personalised guidance that considers their unique financial circumstances and goals. This can lead to more informed financial decisions and a more appropriate product and service mix, which, ultimately, leads to more efficient returns in the long term. But independence also leads to increased financial security and greater confidence in one’s financial future, that is, greater peace of mind. Unfortunately, too many clients receive less efficient guidance from advisors who do not offer independent advice but only those products and services of the company that they represent.

Holistic financial advice considers the individual, their family, and even the generations to come. It also considers each one of these from the much broader perspective of wealth, health, and happiness. By addressing these three dimensions together, holistic financial advice aims to improve a person’s overall well-being. This approach acknowledges that financial success alone does not guarantee health or happiness. The key is to find the right balance between accumulating wealth, maintaining physical and mental health, and pursuing a fulfilling and purpose-driven life. In essence, holistic financial advice recognises that wealth is a means to an end, and that end is often health and happiness. It provides a roadmap for individuals to use their financial resources to create a life that aligns with their values, promotes well-being, and, ultimately, leads to greater contentment.

Like the ancient stewards, we aim to provide independent, holistic financial advice to our clients in a way that can improve their wealth, health, and happiness for generations to come. To do this, we partner with the best product and service providers, and offer our clients unbiased, personalised advice in the context of their overall well-being.

Stick to the principles

Behavioural finance and why it matters

Dr. Francois Stofberg: Senior Economist at Efficient Wealth and the Managing Director of Efficient Private Clients, with specialist input from Christiaan van Wyk  

The world of finance and investments is often associated with numbers and statistics but the real-world experience looks a bit different with behavioural patterns often playing a significant role in financial markets. Behavioural finance is the study of the psychological influences and biases that both investors and financial practitioners experience when making financial decisions. These influences and biases can explain some of the market anomalies that we observe, such as dramatic moves in stock prices that are unexplained by the numbers and available information alone. Behavioural finance, therefore, attempts to explain why investors make different decisions than would be expected from a perfectly-rational individual that only makes decisions based on facts and sound reasoning. When working with real-world investors, one quickly realises that constructing financial plans based on the ‘optimal solution’ that a perfectly-rational investor would prefer, often leads to suboptimal outcomes as investors struggle to stick to these plans because of their inherent biases. We, as financial practitioners, therefore, have an obligation to educate investors on the various pitfalls that behavioural biases create and, where necessary, adjust our recommendations to accommodate these biases.

One example where a middle ground may be found is when an investor exhibits a bias known as ‘mental accounting’. This bias refers to the tendency of individuals to treat money, which should be seen as perfectly fungible, differently, based on the source or specific purpose assigned thereto. For example, individuals expecting to draw an income from their investment would often take on too little risk in their total portfolio because they tend to choose a ‘safer’ investment to the detriment of long-term performance. To accommodate investors, we often employ the bucket or layered approach to portfolio management, where each financial goal, whether it be income or growth, has its own sub-portfolio. The total portfolio is often less optimal than the perfectly-rational portfolio but the client is more likely to remain invested, leading to a better overall outcome.

Another common behavioural trait exhibited by both investors and financial practitioners is ‘herding’. It is very common for individuals to ‘follow the herd’ when making decisions, which often leads to irrational behaviour and asset bubbles. History is full of examples of this phenomenon and, admittingly, it is very difficult to swim against the current, especially if you must do so over an extended period. We, as financial practitioners, must build controls into our processes to avoid making the costly mistake of comfortably following the herd to avoid being different. Advertisers have gained enormous reach through online marketing in recent years, which increases the risk of investors succumbing to this bias because they have the perception that ‘everyone’ is investing in this new product, increasing the feeling of FOMO (fear of missing out).

The list of behavioural biases that impact investors is extensive. We believe that the perfectly-rational solution, although theoretically optimal, might not be the correct recommendation for all clients in reality. It is, therefore, important to properly understand and identify biases that investors exhibit, educate clients and, if necessary, manage behavioural biases for the ultimate benefit of investors.

Steps towards a more equal South Africa

Dr Francois Stofberg
Managing Director: Efficient Private Clients.

For almost three decades, the ruling party in South Africa (SA) has been relying on redistributive policies to build a more economically-just society. In doing so, SA’s inequality, as measured by the Gini coefficient, improved but only marginally. Unfortunately, SA is still the most unequal country in the world. But by using the incorrect policies, we now also have the highest unemployment rate, especially if we consider youth unemployment and that almost half of our population still lives in poverty. Life expectancy, an aggregate measure of success in advancing human life in a country, has remained unchanged. On this front, the ruling party has failed SA fundamentally. On the other end of the spectrum, after about four decades, the Chinese government used wealth-creative policies to significantly improve access to healthcare, education, and other services, while lifting more than 800 million people out of poverty. Life expectancy in China increased from 70 to 78 since 1995. From this perspective, we believe that it is easy to conclude that what the Chinese government achieved is much more “just” or, put differently, equitable.

Social-upliftment policies in SA focus mainly on redistribution, with black economic empowerment (BEE) at its core. Economic-upliftment policies in China, but also those which saw South Korea rise to prominence, focus on wealth creation. Even those social-upliftment policies that China had, for example, the redistribution of land, were tied to economic principles of productivity and surplus. Charity of this kind was to allow for subsistence farming, that is, to redistribute from one class (or race) to another. Even the core of China’s Communist Party policies is linked to market efficiencies. Civil servants and grant recipients are held accountable for their development, that is, they are individually responsible to contribute to society in a meaningful manner. Similarly, companies who receive subsidies are held accountable through export discipline: Lucrative tenders are not awarded to enrich themselves or those closest to them. If any business, or individual, does not produce competitively, first in the local market and then internationally, they are cut off from state support.

South Korea used a similar strategy and three decades later had Kia and Samsung, both industry leaders in their respective fields. By linking redistributive policies to the ruthlessness of market efficiency and export discipline, individuals, companies, and even the government are forced to invest in labour, capital, and technology to remain internationally competitive. The result has been extreme surpluses and extreme amounts of wealth in China and South Korea. It is important to note that, although the Chinese authoritative model will not work in SA, South Korea, among others, was able to achieve similar results with a system that allows for freedom and individual expression.

Wealth-creative policies are, therefore, able to create an environment of participative justice, equal access to private property, and opportunities to engage in productive work. It is important to note equal access, not equal result. Equal result speaks of charity, which is a result of redistributive policies that are unable to create opportunities like wealth-creative policies can. The next stage of our development in SA must, therefore, be wealth creative. All forms of government assistance (grants, subsidies, and even social-upliftment policies like BEE) must be tied to productivity and to producing internationally-competitive employees, products, and services. In this way, recipients and civil servants are forced into accountability, into taking responsibility for their decisions, actions, and, most importantly, their results. Finally, we must invest more in wealth-creative policies like education, healthcare, and infrastructure. But crucially, when we do, these too must be linked to export discipline through accountability