Boutique insights: is picking stocks worth the effort?

Five years ago, the Nedgroup Investments Core Diversified fund was named as the best aggressive allocation fund at the Morningstar Awards. This was a remarkable achievement for a passive balanced fund with a static asset allocation.

The market environment in the years leading up to that point had, however, been extremely different to what we have seen since. Over the past five years, the Nedgroup Investments Core Diversified fund falls just outside the top quartile in its ASISA category.

This is not a reflection on the value of this particular solution. It is instead an illustration of how things have shifted, and how active asset allocation has become a more important determinant of returns.

Looking at the top-performing multi-asset funds over the past five years, there is a bias towards managers who have been willing to make significant tactical shifts in their portfolios. This is most obvious in the success of the top-performing high equity fund over this period – the Gryphon Prudential fund. It also relies entirely on index-tracking for its underlying exposures, but with a highly active asset allocation approach.

The success of both the Nedgroup and Gryphon funds also highlights a second consideration for multi-asset managers: if funds that exclusively use index-tracking in their portfolio construction can be this successful, how much is there to be gained from stock-picking in this space? Many managers expend extensive resources on identifying individual stocks, but how much value is that actually adding in a multi-asset fund?

Citywire spoke to five South African boutique asset managers about their multi-asset low equity solutions, how they weigh up the value of stock picking against the importance of asset allocation, and whether the Covid-19 crisis has changed this dynamic. Their insights were fascinating and varied.

Errol Shear – Co-portfolio manager of the Sasfin BCI Stable fund

Over the last few years, has it been more important to get the asset allocation right, or to be in the right stocks?

Research over the years has shown that asset allocation is the most important contributor to long-term returns. There have been isolated cases where individuals have taken punts on single stocks and doubled (or lost) their money in a short space of time, but that is gambling.

On average the variability in returns is dominated by asset allocation. In the last 25 years in South Africa we have seen swings in annual returns for equities from +70% in 1999 to -23% in 2008. Bonds have enjoyed highs of 30% and losses of 4%, and listed property swung from +50% in 2005 to -26% in 2018.

How do you think that will change over the next few years in the wake of the Covid-19 crisis?

In a career of more than 30 years I have never seen such a synchronised collapse in almost all asset classes over such a short space of time as we witnessed in March. Equities, bonds, credit and property values all collapsed simultaneously, driven by extreme fear.

We have subsequently seen a recovery in most asset classes, despite the tepid outlook for economic growth. Yes, the world has changed because of the fear of Covid-19, but there will be other changes in future, and there is no question in my mind that getting asset allocation right is all important.

We should also not just assume simplistically that equities will give the best return over time. Even over a 10-year period, equity markets have previously experienced declines in South Africa, the USA and Japan. We believe that getting asset allocation right over time is what counts for clients to experience solid returns.

Madalet Sessions – Co-portfolio manager of the Denker SCI Stable fund

Over the last few years, has it been more important to get the asset allocation right, or to be in the right stocks?

In the long run, investors’ outcomes are determined by their asset allocation. The multi-asset low equity category restricts the percentage a fund may invest in risky assets, such as equity and property. Therefore, for this category, the most impeccable stock picking will add limited overall value.

In addition to getting asset allocation and stock picking right, we believe there are other factors that impact long-term returns – as reflected in our value proposition. We don’t try to add value by picking stocks. Instead, we focus on achieving equity market returns at the lowest possible cost and in a way that is as tax efficient as possible. We marry this low cost, tax efficient approach with risk mitigation to provide the capital stability required by investors in the multi-asset low equity category.

How do you think that will change over the next few years in the wake of the Covid-19 crisis?

Covid-19 will likely result in increased variance in company outcomes as some business models disappear and new businesses emerge. However, for this category, low equity exposure reduces the value that can be created by getting these highly uncertain stock picking calls correct.

Sam Houlie – Portfolio manager of the Counterpoint SCI Cautious fund

Over the last few years, has it been more important to get the asset allocation right, or to be in the right stocks?

In broad terms, I have observed the following over the past 18 years. Between 2003 and 2005 the virtuous combination of very high embedded real yields in the fixed income space and very depressed equity markets suited a ‘formulaic’ and ‘strategic asset allocation’ approach. The since-inception track records of low equity funds launched before the great financial crisis in 2008, will generally show real returns in excess of 4% and even as high 6%. The initial yields and valuation tailwinds ensured these high real returns.

Asset allocation mattered most (and added the most value) in these early years. Since 2009, however, both asset allocation and security selection have been equally important. Notably, security non-selection (stocks or sectors which you can intentionally avoid) has mattered more in equity markets that have become distorted by central bank intervention.

I have always believed that the low risk-budget (40% maximum equity exposure) allowed in low equity funds offers the greatest opportunity for aggressive and high-conviction positioning. In addition, the range of risk-opportunities has expanded significantly over the last 18 years. The offshore potential has increased from 10% to 30%; direct commodity exposure has expanded in breadth, and trading liquidity has increased; and the use of hedged equity strategies is now more common.

The secular decline in interest rates has also reduced the real-return prospects of the strategy on a formulaic basis. A 1% to 2% real return is now attainable at much higher volatility. That is a far cry from the embedded returns available 18 years ago.

How do you think that will change over the next few years in the wake of the Covid-19 crisis?

The heightened uncertainty from Covid-19, will suit a portfolio management style that is more nimble, with the ability to change your mind as new information becomes available. The speed of the recent decline, response and recovery is an indication of how quickly markets move nowadays.

We believe that asset allocation and stock selection are equally important, in managing a low equity balanced fund. The aftermath of Covid-19 and lower interest rates will increase the importance of using the full equity risk budget in the most optimal way.

The best way to do this is to be nimble and ready to exercise judgement aggressively when the risk-reward profile is favourable. The risks you choose to accept and the ones you choose to avoid, will become more important. For example, if bonds become a lower yielding, higher volatility asset class – why not hold cash and allocate to bonds at extremes (as was the case in February to April of this year)? Prioritising exposures will become even more important.

Francois Roux – Co-portfolio manager of the Autus Prime Stable fund

Over the last few years, has it been more important to get the asset allocation right, or to be in the right stocks?

The debate around the relative importance of asset allocation versus stock selection is controversial. A 2008 article from Citywire UK offers an apt summary on the topic:

‘While few doubt the importance of asset allocation, the exact extent of its effect on returns remains open to interpretation.’

The origins of the debate are rooted in a 1986 paper by Brinson, Hood, and Beebower in which the authors conclude that over 90% of a portfolio’s return variability over time is attributable to asset allocation policy. This claim is often misrepresented to suggest that 90% of a portfolio’s returns are generated by asset allocation, and that stock selection is unimportant. In fact, security selection typically contributes meaningfully to the total performance of a portfolio.

The equity exposure in the Autus Prime Stable Fund is limited to a maximum of 40% according to the fund’s mandate. From this perspective, stock selection has a somewhat smaller impact on total return compared to a pure equity fund.

How do you think that will change over the next few years in the wake of the Covid-19 crisis?

While many aspects of the Covid-19 crisis are without precedent, there are some parallels with previous crises. During a typical crisis, we often observe a strong short-term correlation between individual securities as indiscriminate selling takes place across the board. Stocks also tend to stage synchronised recoveries during the initial phases of emerging from a crisis.

Under these circumstances, exposure to the right asset classes may play a more important role. In the long run, however, we expect correlations to revert to historical norms.

Ruen Naidu – Portfolio manager of the Argon Absolute Return fund

Over the last few years, has it been more important to get the asset allocation right, or to be in the right stocks?

Stock selection has long been the segment of investing that attracts the largest amount of cognitive energy. As Paul A. Samuelson observed, modern markets are micro efficient but macro-inefficient.

Substantial evidence of this observation was shown by Jung and Shiller in “Samuelson’s Dictum and the Stock Market”. Intense focus on security selection does, by definition, lead to the result of said micro-efficiency.

Why then are markets macro-inefficient? This can be explained by structural factors underpinning the established investment infrastructure at both the retail and institutional level. The largest pools of capital typically follow investment policy portfolios with limited deviation from the benchmark allocation. Large deviations from benchmark allocations are difficult to achieve due to sheer size of these funds. The only game left is to outsource security selection to outperform the benchmark, hence the intense focus on this domain.

Furthermore, there is substantial career risk involved in making large deviations from strategic allocations. We ignore career risk and focus on the risk of capital destruction. We were free to take our equity allocation from a starting point of 10% underweight to a level of 30% underweight in March, ahead of the Covid crash. These decisions were, as always, informed by top-down macro factors that influence asset allocation.

How do you think that will change over the next few years in the wake of the Covid-19 crisis?

For most of the last decade, the causal driver of asset returns has been macroeconomic policy, particularly trade, fiscal and monetary policies. Given that the structural inefficiencies at a macro level are likely to persist, the decision about what markets you are in will continue to dominate what securities you select within those markets.

Patrick Cairns is South Africa Editor at Citywire, which provides insight and information for professional investors globally.

This article was first published on Citywire South Africa here, and republished with permission.