Cautious allocation funds: Mediocre, but hang in there

The Morningstar database contains 220 funds in the cautious allocation category.

This type of fund is designed for investors who want a broad diversity of asset classes in a "one-stop" shop. The funds can invest up to 40% in equities, and all the major ones in the sector have the discretion to take up to 30% offshore.

In the risk spectrum it sits between variable fixed income and balanced funds. It makes up 12% of the unit trust sector. But over the past 12 months it has come under pressure, with net outflows of R6bn.

Investors expect some extra return from investing in a cautious allocation fund, rather than staying in the cash or fixed-income sector. But over the past three years that extra return has not materialised. All the asset classes in which these funds invest have produced mediocre returns.

David Knee, chief investment officer of Prudential, says it would be the wrong reaction to exit these funds impulsively and move into cash.

Knee says nobody can predict when a recovery will take place, but it is likely to be lumpy so there won’t be time to come back in and enjoy the full ride. There’s no better opportunity than now to invest monthly into these funds.

And many more inflation hedges are likely to be available in public markets soon, such as infrastructure funds, as well as a much more sophisticated corporate bond market.

There is a lot more flexibility available to these funds now that up to 30% can be invested internationally, plus a further 10% in the rest of Africa. There isn’t always going to be a good match between liabilities linked to SA inflation and hard currency assets, but Knee says that, in the long run, offshore assets are a useful way to preserve capital, given the long-term trajectory of the rand.

The funds in this sector are all from established houses, but we have left out two of the largest funds, Allan Gray Stable and Coronation Balanced Defensive, which have featured in earlier issues. In any case, these funds have become the default options for the less industrious financial advisers, who need to look more broadly at the market.

The second-largest, Prudential Inflation Plus, has been included as it took a pioneering approach to dynamic asset allocation back in 2001, when the orthodox wisdom favoured a fixed-allocation approach. The only fund that needs attention out of the five is Stanlib Balanced Cautious, which has underperformed in the face of continual restructuring and some poor leadership. But it has strong distribution support through Standard Bank, and some clever minds are doing their best to revive this fund and its manager.

There are some interesting contrasts between the funds in this category. Both PSG Stable and Old Mutual Stable Growth are well managed and deserve a higher share of the financial advisers’ pie; PSG Stable is ahead, but investing in either or choosing their sister balanced funds would be a good decision for the conservative investor for the longer term.

These funds are to some extent run as diluted balanced funds, with extra cash and bonds. SIM Inflation Plus, like its Prudential namesake, has an more academic approach and is less predictable.

Those people who stayed away from SIM Inflation Plus after its former manager, Philip Liebenberg, moved to Abax, can get back into the water. The current manager, Natasha Narsingh, might be a retreaded mining analyst but she’s fiercely clever and fully understands the serious responsibilities of running a low-risk fund.

Prudential Inflation Plus

The fund is one of the largest in the sector, with R36.7bn under management. It is run jointly by chief investment officer David Knee, absolute return manager Michael Moyle and equity specialist Johny Lambridis.

It was launched in 2001, when inflation-linked bonds were in their infancy. Since inception it has returned an annualised 12.5% after fees. For most of its history it has been able to achieve at least inflation plus 5%, though over the past three years, on the back of poor asset class returns, it has barely matched inflation.

It has been perhaps the most consistent owner of inflation-linked bonds, which now make up 22% of the fund. It also has a full allocation to equity (23% local and 17% foreign) and a slug of SA nominal bonds (12%). It differs from its competitors as it has very little cash (1% each between local and foreign) and a hefty allocation to local property of 15%. Growthpoint and Redefine together make up 6% of the fund.

In April an underweight exposure to SA equity and international fixed income helped the fund, but the high international equity and property detracted from it.

The equity portfolio is more diversified, with Naspers, the largest share, making up less than 3% of the fund. Along with British American Tobacco this has not helped it in the short term, but financial shares such as Standard Bank and Old Mutual added value. The fund is geared to an improved global economy through Sappi and Trencor, and to global growth through shares such as Richemont, Anglo American and BHP Billiton. It has a low exposure to the US, preferring Europe, Japan, global financials and selected emerging markets such as Turkey and South Korea.

Prudential implements its international strategy through nine new funds it has created, which are more closely aligned with its needs than the funds it used to use that were designed for its London parent M&G.

Knee says that with US treasury yields reaching 3% many investors started to consider switching to them from equities. But global bonds continue to trade at high valuations, Knee argues, and remain at risk from rising interest rates. The fund is underweight sovereign bonds and keeps duration low. With oil rising prices and renewed rand depreciation further cuts in SA interest rates are unlikely.

The fund’s clients like a steady ride and feel uncomfortable in today’s volatile markets, but they have benefited from the strong performance of nominal bonds, which gained more than 7% in the first four months of the year, and, to a lesser extent, by inflation-linked bonds, which gave up most of their first-quarter gains in April.

Stanlib Balanced Cautious

The fund, with about R8.8bn, has been an underperformer, but partly because its asset allocation has been conservative even by the standards of the low equity sector.

Its 27% allocation to equity may not look conservative right now, but many of its peers have taken profits recently and before that were nudging the 40% limit.

The fund fortunately had negligible exposure to local property, which was by far the worst asset class in the first quarter, losing 20%.

It is hard to see the source of the fund’s disappointing run. Its 43% allocation to cash is very much in line with the peer group. Its top holdings also look similar, with Sasol in resources, Standard Bank, FirstRand, Old Mutual and Sanlam in financials and Vodacom, Mr Price and AVI to supplement benchmark stalwarts Naspers and BAT. One thing that stands out is the preference for low-return foreign bonds and cash (15% in total) over foreign equity (8%).

The fund’s Robin Eagar says concerns about US wage inflation are a backdrop to international markets, and equity volatility needs to be managed. But he says the business cycle remains strong, giving a positive outlook for earnings growth. The franchise will continue to buy selectively after the first-quarter correction — though a recovery in April meant some bargain prices were short-lived.

The fund uses derivatives when it feels they are necessary, but believes the diverse basket of assets will produce inflation-beating returns in the long run.

SIM Inflation Plus

The fund is almost 20 years old and was originally designed as an absolute-return fund rather than simply a low-equity balanced fund.

It has a comparatively ambitious benchmark of inflation plus 4%, and a sizeable R13.7bn under management, with R35bn run by the absolute-return team overall.

Since 2009 the fund has not produced any negative one-year rolling returns and it has clearly beaten its peers when it comes to downside protection measures such as the Sortino ratio.

The fund is now managed by Natasha Narsingh, who took over about a year ago from long-running manager Philip Liebenberg. Narsingh says it takes its dual mandate — to show real returns in the medium term and to protect capital over 12 months — very seriously. There is a specialist absolute return team, but it is not run as a silo and leverages off the skills of the greater Sanlam Investments team.

Narsingh likes nominal bonds, as they offer a tempting 3% real yield — it has barely 1% in inflation-linked bonds and about 9% on nominals. But she does not slavishly replicate the all bond index, and the duration is often about 60% of that index. Cash remains dominant, making up 47% of the fund, but much of this is in credit-enhanced money market assets.

The equity component has been reduced but domestic equity still makes up 18% of the fund and equity and property are the dominant assets in the 22% allocated to international assets, with a focus towards European shares selected by the London-based Sanlam Four team. It makes full use of the in-house Satrix portfolios, which helps the total expense ratio.

Narsingh says the SA equity market is selectively attractive. She says US shares have become riskier, as so many have taken out debt to buy back stock. In common with other absolute return funds, it protects a portion of the local equities through derivative overlays.

Inflation Plus uses the house view equity portfolio built up by Patrice Rassou and his team. It holds Naspers, though partly in the hope that it will unlock value by listing its neglected pay-TV and classified advertising operations. But it has been a detractor for most of the year to date, as has British American Tobacco. The fund has also recently benefited from the strength of Standard Bank, Old Mutual and Absa. Anglo American has been another contributor, Sasol a detractor.

Rather than second-guessing the equity team (though Narsingh was a good equity analyst in her time) Inflation Plus takes the recommended portfolio; the most it will do is put on single stock futures to cut risk.

PSG Stable Fund

The fund was a finalist in the Morningstar Awards in the cautious allocation category.

It has many of the characteristics of PSG Asset Management, including some of the top stock picks. Brookfield Asset Management, an alternative fund manager in North America, is the top pick, followed by Old Mutual, AIA Group, Nedbank and domestic industrial Hudaco. Discovery is in the top 10. All are believed to have a moat to keep out competitors, though with Old Mutual it is more of a pure valuation play.

The fund is 22% invested in domestic equities and 13% in foreign equities.

Exposure to other foreign assets is minimal (1% in foreign cash, 2% in foreign property). The fund looks for inflation plus 3% over a rolling three years. Over the past three years it has not achieved this, being 0.9% behind the target. It aims to find uncrowded investment opportunities and there is an unusually wide difference between the valuation of fashionable tech giants and out-of-favour sectors.

Chief investment officer Greg Hopkins says the house is finding fewer opportunities to buy high-quality businesses at wide margins of safety while the 30-year bull market in global bonds is coming to an end, even if the easy money generated by quantitative easing has had its day.

The largest exposure is to domestic bonds of 36% — but less than a third of this is exposed to government bonds, and almost half is exposed to FirstRand. There is no domestic property exposure, which has helped given the unexpected decline in the sector after bad publicity surrounding the Resilient group.

There is a 26% allocation to cash, but with current yields that makes sense. Hopkins says the inherent value of cash is never evident in times of exuberance. Its true value shows itself when volatility rises, prices fall and liquidity is in short supply.

The fund is run by Paul Bosman and Ian Scott. Scott says the fund is ready to deploy its cash resources when opportunities arise. Since the beginning of the year the managers have reduced its SA bank allocation from 4.8% to 3.3%, mainly by trimming FirstRand. Discovery was also reduced. It has no domestic property as it does not see any individual opportunities in which long-term returns meet its requirements.

Old Mutual Stable Growth

This is the conservative fund offered by Old Mutual’s MacroSolutions team.

It is part of a series of regulation 28 compliant funds designed primarily for pension fund investors, particularly those who do not consider that a balanced fund matches their risk profile.

It failed to beat a target of inflation plus 3% over three years but comfortably managed over one year. Each fund has its own team. John Orford runs asset allocation and Alida Jordaan runs the equities.

Orford says the philosophy combines top-down and bottom-up approaches, looking at two main variables — theme and price. There is an emphasis on the timing of the exit and entry to and from securities. Jordaan works closely with the other equity managers in the team — Warren van der Westhuizen and Arthur Karas.

Orford is in constant contact with the two other top-down managers in the boutique, Peter Brooke and Graham Tucker.

Stable Growth does not call itself an absolute return fund, though it aims not to lose money over 18 months. There are common holdings across the boutique — Naspers is the largest equity. Old Mutual is another high weighting, as is British American Tobacco.

The value unlock from Old Mutual’s managed separation was belatedly acknowledged by the market. But in the short term the fund took a hit from its holdings in domestic shares such as Woolworths, TFG, Rhodes Food Group and Nampak. Yet it has been adding to domestic shares on weakness such as Super Group, KAP and Steinhoff Africa. The fund is quite light on domestic equity at 18%, which is almost equalled by the 16% exposure to international equity

The fund has an 8% allocation to domestic property, to more conservative counters such as Growthpoint. Cash at 32% is preferred over bonds at 22%. Orford says the global economic environment is underpinned by the US Federal Reserve’s plan to gradually raise interest rates as growth improves. But the fund does not own any global bonds which remain unattractive.