‘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.
The information in this communication or document belongs to Denker Capital (Pty) Ltd (Denker Capital). This information should only be evaluated for its intended purpose and may not be reproduced, distributed or published without our written consent. While we have undertaken to provide information that is true and not misleading in any way, all information provided by Denker Capital is not guaranteed and is for illustrative purposes only. The information does not take the circumstances of a particular person or entity into account and is not advice in relation to an investment or transaction. Because there are risks involved in buying or selling financial products, please do not rely on any information without appropriate advice from an independent financial adviser. We will not be held responsible for any loss or damages suffered by any person or entity as a result of them relying on, or not acting on, any of the information provided.
Sanlam Collective Investments (RF) (Pty) Ltd (SCI) is a registered and approved Manager in terms of the Collective Investment Schemes Control Act.
The information to follow does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Use or rely on this information at your own risk. Independent professional financial advice should always be sought before making an investment decision. The manager retains full legal responsibility for the third party named portfolio. The Sanlam Group is a full member of the Association for Savings and Investment SA. If the fund holds assets in foreign countries and could be exposed to the following risks regarding potential constraints on liquidity and the repatriation of funds, macroeconomic, political, foreign exchange, tax risks, settlement risks and potential limitations on the availability of market information. A schedule of fees and charges and maximum commissions is available from the Manager, Sanlam Collective Investments, a registered and approved Manager in Collective Investment Schemes in Securities. Standard Bank of South Africa Ltd is the appointed trustee of the Sanlam Collective Investments Scheme.
Collective investment schemes are generally medium- to long-term investments. Please note that past performances are not necessarily an accurate determination of future performances, and that the value of investments / units / unit trusts may go down as well as up. Changes in exchange rates may have an adverse effect on the value, price or income of the product. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Collective investments are calculated on a net asset value basis, which is the total market value of all assets in the portfolio including any income accruals and less any deductible expenses such as audit fees, brokerage and service fees. Actual investment performance of the portfolio and the investor will differ depending on the initial fees applicable, the actual investment date, and the date of reinvestment of income as well as dividend withholding tax. Forward pricing is used. Additional information of the proposed investment, including brochures, application forms and annual or quarterly reports, can be obtained from the Manager, free of charge. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The performance of the portfolio depends on the underlying assets and variable market factors. Performance is based on NAV to NAV calculations with income reinvestments done on the ex-div date. The Manager has the right to close any portfolios to new investors to manage them more efficiently in accordance with their mandates. Lump sum investment performances are quoted. The portfolio may invest in other unit trust portfolios which levy their own fees, and may result is a higher fee structure for our portfolio. All the portfolio options presented are approved collective investment schemes in terms of Collective Investment Schemes Control Act, No 45 of 2002 (CISCA). The portfolio management of all the portfolios is outsourced to financial services providers authorized in terms of the Financial Advisory and Intermediary Services Act, 2002.