Constructing our balanced fund – how we improve the likelihood of success
‘Free solo’ is a form of rock climbing where the climber does not use any support or protective gear. This means there are only two possible outcomes for the climber – succeed or fail. The best climbers expect success. When we invest however, we know things don’t always unfold the way we expect. For example, we cannot begin to know if or when an external macroeconomic event could take place. Therefore, to generate attractive returns for our clients over time, we proactively build the Denker Sanlam Collective Investments (SCI) Balanced Fund to be resilient to several different outcomes.
No matter how skilled the climber, climbing without support or protective gear is risky.
Free solo rock climbers like Alex Honnold only rely on their physical strength, climbing ability, and psychological fortitude.
While dangerous, the most successful climbers claim the secret is not to focus on the risk. In 2017, Alex Honnold free solo climbed El Capitan, a near vertical rock formation in the Yosemite National Park in the US, a popular challenge for skilled rock climbers. At over 900m (from base to summit along its tallest face) the granite monolith is nearly the same height as Cape Town’s famous Table Mountain. With a free solo climb of this magnitude, there is no margin for error because every move must be perfectly executed to avoid a fatal fall. Surprisingly, Honnold does not believe that what he does is dangerous: ‘I talk about risk versus consequence. I don’t think I’m taking a risk because I am not going to fall. But there is an extremely high consequence if I make a mistake.’
We see what Honnold does as being very risky because we see risk as a range of potential outcomes.
Nothing he does in preparation for the climb changes the range of outcomes. By not attaching a rope and harness, the outcome is binary – success or failure (with extremely high consequences for failure, as he points out himself). The way we see it is that, if he did use a rope and harness, the outcome of a fall could simply be taking longer to reach the top or sustaining an injury and having to try again at a later stage. But the worst-case scenario is no longer a potential outcome.
What Honnold does (successfully to date) is to dedicate himself to gaining the skills that improve the likelihood of success to the extent that he views success as a certainty. This is why he draws the distinction – he is so well prepared for the climb, so certain of every move, so practised, that he does not doubt his ability to execute the entire climb without error. The probability of success is as close to certain as he can get it. Yet, despite his skill and preparation, if the slightest thing goes wrong, like a foothold breaking away or a sudden rock fall from above, he will fall.
We invest with a rope and harness for those unexpected events that we cannot predict.
In constructing our balanced fund, we consider a wide range of factors that could affect our clients’ investment outcomes.
In constructing the Denker SCI Balanced Fund, we always start with our best equity ideas, which have a high probability of growing shareholder value over time. We look for companies that have attractive economics (moats), with competent, capable and appropriately incentivised management. We believe that firms with these characteristics are most likely to grow shareholder value. By buying these firms when their share prices do not fully reflect the value of these characteristics, we attempt to increase the likelihood that investors will earn attractive returns.
We balance the fund by ensuring we don’t rely on one specific macro result for success.
In a global economy, there are a wide range of factors at play over which we have no control, which means things don’t always go as expected. When we identify the opportunity for attractive returns, we therefore also ask: are these attractive return outcomes dependent on certain macro outcomes? If the answer is yes, we ask: are there other assets we can own that would benefit from those macro outcomes not being realised? In other words, we look for ways in which we can reduce the portfolio’s reliance for returns on specific macro outcomes.
We therefore focus on what we can control and plan for what we can’t with protective measures.
For our balanced fund to fulfil its mandate, we must take a two-prong approach, which we can relate back to the rock-climbing analogy:
- Focus on what we can control: Identify quality assets that are attractively priced that improve the likelihood of earning attractive returns, i.e. focus on successfully getting to the top of the mountain.
- Put protective measures in place for what we can’t control: Reduce the portfolio’s reliance on specific macro outcomes, i.e. attach a rope and harness for those unexpected events that we cannot predict.
By putting protective measures in place, we aim to reduce drawdown risk for investors.
Figure 1 shows the drawdowns of the fund since inception compared to the average drawdowns of its Morningstar category. A drawdown is a peak-to-trough decline over a specific period. Investing with safety gear means we aim to reduce drawdown risk for investors. To date, we have been successful. Applying this method of risk mitigation continuously should benefit investors over the long term.
Figure 1: The drawdowns of the Denker SCI Balanced Fund versus its peers since inception
Source: Morningstar, as at 30 September 2019.
The inception date of the fund is 2 May 2017. The classes used for comparison are the oldest share classes available. The B2 class has zero fees.
The Morningstar category of the fund is EAA Fund ZAR/NAD Aggressive Allocation.
This means that the fund should deliver decent returns at low levels of volatility.
In Figure 2, risk is presented by standard deviation, a common risk measure that determines how much the price of an asset deviates from the mean, in other words, the level of volatility. The wider the range of price movements, the higher the standard deviation and the higher the risk (since it can mean a bigger capital loss), and the other way around. The figure shows how our two-prong approach, summarised above, delivers attractive returns at an acceptable level of risk when compared to the other funds in its Morningstar category. Over the longer term, due to the power of compounding and our investment approach, we aim to achieve outperformance (or above-average returns) through stock picking and not from taking unnecessary risks or relying on specific macro outcomes.
Figure 2: The risk-reward profiles of the Denker SCI Balanced Fund versus its peers since inception
Source: Morningstar, as at 30 September 2019.
The inception date of the fund is 2 May 2017. Returns are annualised and net of fees for the A1 class of the fund, which has an annual management fee of 0.75% (excl. VAT). The Morningstar category of the fund is EAA Fund ZAR/NAD Aggressive Allocation.
We invest our clients’ money with great care and diligence, so we focus on protective measures as much as we can to balance out the risk and rewards.
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