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Are low-equity funds relevant in today’s investment universe?

Low-equity unit trusts provide cautious protection against a falling market. Martine Damonse, investment specialist in the ManCo Distribution team, discusses the benefits of low-equity funds and how investors can balance the risk-return aspect of their portfolios.

Conventional wisdom suggests that to achieve a better return, one should be willing to take on more risk. But looking at returns across asset classes over the five years to end-December 2022, this theory has been tested – a story best told by the FTSE/JSE All Share Index’s lacklustre returns of 8.0% per year compared to the FTSE/JSE All Bond Index’s of 7.8% over the period, but taking investors on a much bumpier ride. Considering the volatility and lack of obvious reward, it is not surprising that some conservative investors have sought perceived safety and steered away from equity markets to assets with smoother return profiles. 

While equity markets are volatile and can underperform cash and bonds over shorter periods, over the long term, investors have been compensated for this volatility with substantially higher returns. Looking at very long-term data reveals that from 1900 to 31 December 2022, South African equities have delivered on average 9.1% above inflation per year, whereas cash has only delivered 1.1% and bonds 2.3%. This suggests that, over the long term, and especially with higher inflation rates, equities play an important role in any multi-asset class portfolio – including those of risk-averse investors who seek long-term real growth, but also need to protect the purchasing power of their investment. 

But how much equity exposure is enough, and how can investors balance the risk-return aspect of their portfolios? This is a difficult question for many investors to grapple with in their attempts to construct a well-balanced portfolio; it may make more sense to outsource these decisions to an experienced investment manager. A low-equity unit trust that aims to provide inflation-beating returns and protect capital over a two-year period can offer a solution. 

Actively managing asset allocation  

Consider the Allan Gray Stable Fund: The Fund’s allocation to equities, offshore and fixed income is managed from the bottom up.

We have the flexibility to have little to no equities in the Fund in times when we believe that equities are expensive or when other asset classes are trading on more attractive valuations, but we also have the flexibility to increase our net equities to the maximum of 40%, should we find equities attractive relative to other asset classes.  

The recent increase in the offshore investment limit allows us to increase offshore exposure up to 45%. While the increased offshore flexibility gives us more levers to pull, we are mindful of the additional volatility offshore exposure brings, including the risk of exchange rate fluctuations. 

Carefully considering equity exposure  

Adding equities to a portfolio can increase the volatility of a fund, however, we don’t view volatility as the only risk to mitigate; for us, the most important risk to avoid is permanent loss of capital incurred by overpaying for an asset.  

Providing conscious protection against a falling market  

The Stable Fund will be the first among our equity-exposed flagship funds to show any sign of caution towards the stock market becoming expensive. We can employ equity market hedging to protect against the risk of markets falling, while maintaining exposure to our selection of shares, which we would expect to outperform the market in such conditions. 

The large weighting towards fixed income (cash and bonds) is a key component of the Stable Fund, as it helps us achieve appropriate diversification and assists in managing volatility. However, it is not without risk; our portfolio managers pay careful attention to the risks attached to the fixed interest instruments, including credit risk, liquidity risk, duration risk and valuation risk.  

The Fund’s fixed income is also conservatively managed to protect the Fund against the negative effect that interest rate shocks can have on bonds. Given the percentage allocation to interest-bearing securities, the Fund also produces a reasonable level of income. 

Is the Fund right for your portfolio? 

The Stable Fund is appropriate for risk-averse long-term investors who aim to, at the very least, keep up with inflation, but also need some degree of capital protection. Likewise, it is suitable for investors with shorter investment time frames (but longer than two years). The Fund is also appropriate as part of a life-staging portfolio, where investors wish to reduce their equity risk in the last few years before retirement, particularly if they are planning to take a cash lump sum at retirement. It is also an option for retirees or any investor who wants to draw a reasonable and sustainable income from their investment. 

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