Managed Share Portfolios
Portfolio construction: the art and the science of balancing risk and reward
Investment management involves balancing risk and reward, but importantly, risk means different things to different investors. For example, it can be the potential for month-on-month volatility, permanent loss of capital, underperformance compared to another investment, or the loss of purchasing power over time. At FNB Wealth & Investments, we view risk as the potential for our clients to not meet their goals, which can vary depending on each investor's financial circumstances, existing investments, plans for the future - like a milestone purchase such as a home - and the time horizon they'd like to achieve these goals in.
Time in the market
Decades of market data have shown that identifying an investor's intended investment horizon is a valuable tool in aligning investment strategies with investor needs. For instance, higher-risk asset classes like equities can provide exceptional short-term returns but also carry the risk of significant short-term drawdowns. On the other hand, less risky assets like cash may not have the risk of drawdowns in the short term, but they can underperform and lead to a loss of purchasing power over longer periods.
Historically, as investment horizons have increased, risky assets like equities have had a much higher chance of beating a real benchmark like inflation plus 5%. Over some short horizons, less risky assets have a reasonable chance of beating this benchmark - but as the investment horizon increases, the likelihood of this happening decreases, as shown left in Figure 1.
A practical illustration of this is seen looking at our FNB Multi Manager Balanced Fund, which has a benchmark of CPI + 5% over 7-year horizons, and 1st quartile performance over 15 years. While the fund has given some very strong 1-year returns, and some drawdowns over 1-year horizons, the range of outcomes narrows significantly as the investment horizon increases. The 'cone of uncertainty' is a term used in software development which describes the amount of uncertainty during a project's lifetime. The same concepts hold for managed investments - uncertainty is at its highest in the short-term, but this narrows over time. Time in the market is a valuable strategy!
Balancing risk and reward
While 'risk' can be an uncomfortable topic to think about, we all take risks every day. Driving to work comes with the risk that we get into an accident, and buying a house comes with the risk that properties in that area depreciate in value. Accepting that risk is a feature of moving forward is necessary to achieve your long-term goals - as Figure 1 above shows, depicting the historical probability of outperforming CPI + 5% per annum by asset class as your investment horizon increases. But just as you take steps to manage your risks - like buying a vehicle with good safety features, wearing your seatbelt, and practicing defensive driving - we place careful consideration on the risks inherent in our portfolios, and manage those according to the defined risk profiles of our solutions.
Diversification is one crucial key to balancing risk and reward. The father of modern portfolio theory, Harry Markowitz, called diversification the only free lunch in finance. By holding a mix of uncorrelated assets, volatility and drawdowns can be reduced, thereby reducing the intrinsic risk in a portfolio and supporting long-term capital protection and return generation. At FNB Wealth & Investments, we place great importance on diversification when constructing portfolios - considering the relationships between asset classes both historically and going forward. We use the resources across FirstRand to diversify portfolios across different asset classes, within asset classes, between active and passive strategies, and even between investment managers and strategies.
At the core of many of our portfolios, especially our lower risk solutions, are fixed income assets, which add great value not only in terms of their risk-adjusted returns, but also in terms of bringing low and negative correlations to other asset classes - especially to offshore assets. According to Albert Botha, Head of Fixed Income at Ashburton Investments, "fixed income assets are included in portfolios to increase stability and predictability over time, while also enhancing liquidity. Even the most volatile fixed income asset classes are significantly less risky than equities with significantly more return certainty - and when allocations to funds like Ashburton Stable Income increase it further reduces risk and allows for enhanced liquidity in the portfolio without being forced to sell undervalued assets in times of crises." Ashburton's Fixed Income solutions have seen strong flows from corporate and institutional investors over the last two years as investors have seen the value of increased certainty in an uncertain world. "Fixed income is often seen as boring, but sometimes slow and steady wins the race", he adds.
Just as diversifying between asset classes is valuable in reducing risk, diversifying between investment managers can provide clients with a "blended, balanced exposure to different sources of return". Carla de Waal, Head of Multi Management and Manager Selection, says she likes to think of the multi-manager approach as "a philharmonic orchestra playing a symphony - each individual player is a specialist or expert in his instrument/field, but the full potential of the orchestra only comes to life when these different instruments are combined in the appropriate manner to create balance and harmony". The specialist approach we take in the portfolio construction of our solutions, combined with the expertise of our Multi Management franchise, means that we can select the most appropriate building blocks and package them in a solution designed to be appropriate for our clients' risk and return preferences.
Efficiently harvesting returns
Shan Soobyah, Head of Local Equities at FNB Wealth & Investments, speaks to the quality active investment style followed for private clients investing in segregated portfolios with FNB Wealth & Investments. "We like to hold quality companies that can compound earnings over time and generate a return on capital in excess of their cost of capital through the cycle. Holding these companies for the medium to long term should generate consistent returns for our clients through capital growth and dividends." For segregated mandates, efficiency is important, so "we generally tend to have a low turnover in our portfolios to minimize tax and transactions costs."However, when investing in equities, the 'active vs passive' debate is one that has gone on for years - while the rapid growth in ETF offerings in recent years has shown that there's a huge global interest in gaining broad, low-cost market access. According to Vicki Tagg, Head of Indexation at Ashburton Investments, "ETFs have developed to offer exposure to a huge range of asset classes, sectors, geographic regions, single jurisdictions, and factors, offering significant size and liquidity. The new generation of ETFs also now include thematics and active investment strategies, so the opportunities are really endless." And, especially over the long-term, fees matter! "Multi-asset class solutions using ETFs or indexation strategies are becoming increasingly more popular with asset managers. By using an active asset allocation process with index building blocks, one gets the benchmark returns within the asset classes at low cost in an efficient manner", she adds.
In our multi-asset solutions, we see value in blending active strategies with passive strategies to obtain the most efficient solutions for our clients. FNB's ETF products are used across all of our investment solution ranges and have a strong track record going back to 2008 - and that track record isn't unrecognized. Vicki comments that, "in 2022 our flagship FNB Top 40 ETF was recognized as South Africa's best tracked local equity fund over three years, in the annual South African Listed Tracker Award (SALTA)".
Conclusion
When constructing portfolios, we seek to ensure a carefully balanced exposure to different asset classes, regions, strategies, and individual counterparties, according to where we see value over the long-term. While managing market risk, credit risk, key-man risk, and more, are all necessary responsibilities of an investment manager, ultimately the risk that we most want to manage is that of our clients not reaching their investment goals. Holistic financial advice and solutions designed with outcomes-based targets aligned to investment horizons are the recipe we see fit to manage both our clients' journeys and getting them to their target destinations.
