The City of Cape Town’s efforts to keep the taps running through severe drought conditions have some peculiar similarities with the asset management industry’s efforts to deliver consistent market returns during a multi-year economic downturn.
Structuring successful investment portfolios could be likened to choosing the right systems to harvest and store water. “We build portfolios to meet specific requirements and achieve specific objectives; if we equate water with market returns then we can see how the analogy plays out," Kingsley Williams, Satrix chief investment officer.
The trick is to have enough different sources of water to survive extended periods of drought, or a sufficiently diverse portfolio to generate excess return through both good times and bad.
Portfolio managers typically structure their portfolios to exploit a particular source of returns. “It is only when you face a lengthy period of poor returns that you discover how resilient and robust your portfolio is,” says Williams, who argued the case for factor investing. Factor investing is characterised by “systematically selecting securities based on attributes that are associated with higher returns”.
“The beauty of factor investing is that different factors pay off through different prevailing economic and market conditions, so they can be combined to construct more resilient portfolios,” he says. You can keep the return tap running regardless of the extent or duration of the drought.
First identify the return characteristics you wish to include; then combine these characteristics into an index or portfolio that provides consistent exposure to these factors which are rewarded over long periods. Williams says that factor investing eliminates the risks associated with “style drift” – when a portfolio does not reflect its underlying philosophy – and exposure to unrewarded factors. You may, for example, believe that you have sufficiently diversified your water storage infrastructure by building enough dams, without considering that they rely on the same factor (rainwater) to maintain supply.
Value, quality and momentum factors are used to create factor index funds, which can then be blended alongside other funds to deliver excess returns. Value investing involves choosing companies that tend to underperform through unfavourable economic conditions like recession or poor commodity prices, but shoot the lights out for investors that are able to wait for economic conditions to improve. Shares such as Imperial Holdings and Super Group sit in the value space because they are “tied to our domestic economy – and are presently trading at discounts relative to their potential”. Quality companies typically trade at a premium to their value peers because they are better able to withstand economic downturns. “They deliver more reliable profits consistently through time. During tough economic conditions we see the value in quality companies being unlocked,” says Williams. Most of South Africa’s major retailers, including Pick n Pay, Clicks, Truworths and Spar, satisfy the quality label. Momentum is a factor that overlaps the dominant trend playing out in the market at a given time.
How do we go about combining different factors in a portfolio? “Blending single factors together is a bit like going to every single tap and choosing how much of the water it produces to include in your portfolio. You have control over how much and when each factor is added to your fund,” says Kingsley.
The next step in the factor investing evolution is to build a portfolio from the ground up containing the desired exposure to each of the factors, something that is done at stock level. A multi-factor approach at stock level ensures that your portfolio has enhanced exposure to the factors you are targeting, while more explicitly managing the levels of risk. “Regardless of the prevailing economic climate, factor investing has the benefit of consistent exposure to the desired characteristics within your portfolio. It addresses the problem of ‘style drift’ and makes it easier to build diversified portfolios for your clients. It is a highly cost-effective way to deliver excess returns relative to the market.”
