Podcast: Balancing risk and returns in the current environment

The legal registered names of the funds are the Denker Sanlam Collective Investments Balanced Fund and the Denker Sanlam Collective Investments Stable Fund.  In this podcast they are referred to as the Balanced Fund and the Stable Fund.

Nigel Barnes:

Welcome to the latest in the series of Denker Capital podcasts. My name is Nigel Barnes and I’m very pleased to be joined today by Madalet Sessions and Jan Meintjes from the Denker team. Madalet heads up the multi-asset business within Denker. Welcome, Madalet. For the benefit of the listeners, could you give us a quick recap of the multi-asset business – in terms of the funds and strategies?

Madalet Sessions:

Thank you very much. In terms of multi-asset products, we have two funds – the high equity Denker Sanlam Collective Investments (SCI) Balanced Fund and the low equity Denker Sanlam Collective Investments (SCI) Stable Fund. The Balanced Fund really leverages the skillset of the entire business, building on bottom up company fundamentals for a long-term return profile. My job is to make sure that we have a risk management process in place that takes the tails out of the outcomes inherent in equity investments. So, for this fund we have long-term horizon and it’s really a pre-retirement product. It is currently still quite small, but we have a five-year track record in place which has been built on the success of the underlying teams’ processes.

The Stable Fund is a low equity product. It is really a post-retirement product. One of the things that we take very seriously across both products is risk management. For a person who makes regular income withdrawals or has capital stability and low risk requirements, that is something that we take very seriously for the Stable Fund. We try to minimize drawdowns and we try to ensure risk adjusted returns.

If you look at comparisons of our drawdowns and risks, compared to other funds in our categories, I think we have delivered on our mandate of risk adjusted returns.

Nigel Barnes:

So, the Balanced Fund is suitable for pre-retirement investors looking for growth with a risk management overlay, and the Stable Fund is ideal for post-retirement investors looking for capital protection to do regular withdrawals. That is our multi-asset proposition.

Madalet Sessions:

Yes, absolutely. One thing I would add, is that both funds completely avoid macroeconomic forecasting as a source of return. The source of return for the Denker SCI Balanced Fund is our stock picking process. That is what we put on the table for the pre-retirement investor, not macroeconomic forecasting.

Nigel Barnes:

Let’s come back to that because, Jan, that’s why you are here – welcome. Please give our listeners a bit of background as to your role in terms of the Balanced Fund.

Jan Meintjes:

Thanks Nigel. My experience is in equities. For over 20 years I’ve analysed locally listed equities, and that is the link that I bring to the multi-asset team. As Madalet described, for the Balanced Fund we really start off by picking stocks – investing in companies that we believe have got good management teams, good prospects and that show the ability to allocate capital very well. From there Madalet and I sit down and look at the risks that the fund will pick up by investing in those underlying equities, and then basically use the asset allocation as a risk overlay strategy to lay off and manage some of those risks. Another way of putting it is that we make sure that we don’t duplicate risks in the portfolio. An example of duplicating risks would be owning a lot of banks, because you believe that that environment is going to be favorable for economic growth and financial activity, while having a big bond position – as the two would have similar drivers. So, our whole process is built on looking at what we see to be attractive on an equity basis, and then using asset allocation to balance the risks for those investments. This is specific to what happens in the Balanced Fund.

Nigel Barnes:

So, to summarise, the equity team at Denker (where you are a senior member of the team) come up with the ideas on a bottom up basis. Then, in putting your portfolio together, you work alongside Madalet to look at the inherent risks within the portfolio and try to mitigate those risks for different scenarios going forward. Is that right?

Jan Meintjes:

That’s absolutely right.

Nigel Barnes:

Can you give us a couple of examples? You’ve mentioned a couple of factors, in terms of not duplicating coverage. Both funds are now five years old. Could you give us some examples of where you recognised certain risks within the equity portfolio and where you took action to mitigate those over the period?

Madalet Sessions:

I can come up with two simple examples.

As Jan explained, local financials are very sensitive to local economic conditions. So, if South African economic prospects improve unexpectedly, your financials will do very well. If financial conditions deteriorate, your financials will do worse than we expect. We don’t pretend to know the future. We have concerns about policy making in South Africa, but we think banks are attractively priced. So, we want to have that exposure in our equity portfolio. But every now and then South Africa fires a finance minister (or has three finance ministers in four days). These are not the norms, but they are events that can really hurt investors. So, we want to make sure that we have enough exposure to the potential returns that companies offer – which are driven by, as Jan unexplained, capital allocation, moats and returns that these firms can generate. Those are things that we want to buy but we know that these companies don’t operate in isolation, they operate in an environment where there is risk. And so, we ask ourselves which other asset classes we have that would do well in the environment where South Africa does badly. Or if there is another asset class that would have similar risk exposure then we would want to avoid that asset class. We haven’t owned bonds for a couple of years because we’ve owned a lot of SA Inc. In fairness, we could have had a lot better performance had we not mitigated that risk. But over the five years, taking mitigating steps and banking what you can see has worked. So, we are going to keep with it.

Jan Meintjes:

To add to what Madalet has said – there was a recent article on the Balanced Fund in Citywire which mentioned that this fund hasn’t owned local bonds for the last year or so. The picture was painted of almost an aggressive positioning. We don’t see this as aggressive positioning because, in our underlying SA equity portfolio, we had a big exposure to the SA consumer and the drivers for those stocks to do well are very similar to those of bonds. Not having exposure to bonds is a perfect example of not doubling up on our view that we had that the SA consumer is still in a recovery phase after the global pandemic.

Madalet Sessions:

A second example is, in the heart of the Covid-19 pandemic, when South African property had sold off a lot, we didn’t have a big property exposure. We had, I think, 2% or 3% in the Balanced Fund. We switched out of local property and into global financials. It was a call on the attractiveness of the asset classes, but also on the risks to the two asset classes. So, both of those are interest rate sensitive – different interest rates, but South African interest rates don’t move in isolation. And, bang for buck, the opportunity was in global financials and not in local property. Local property has done well, I’m not taking that off the table, but we were very happy to have the global financial position and not double up on interest rate exposure with the local property position. This is another example of deliberately giving up returns for avoiding massive exposure to a single macroeconomic variable or risk.

Nigel Barnes:

So, there’s a lot of thought and scenario planning that goes into the day-to-day construction of the Balanced Fund portfolio. This is quite different to the way a number of other houses would do it – they would focus on a particular macro view and potentially go all-in on that view. As you often say, the future is behind a closed door so it’s very difficult to predict.

Moving on to the Stable Fund where, Jan, I think you almost take a step back here because in the Stable Fund, Madalet, you manage the equity components slightly differently. Just explain that please.

Madalet Sessions:

Let me just say that Jan doesn’t really take a step back. He takes a different step. On both the Balanced and Stable Funds, Jan is a fantastic sound board. One must never underestimate the value of a sound board. But yes, on the Stable Fund we don’t do active equity selection and it is not because we don’t think that we can add value to equity. It is because, for the investor with limited equity exposure, the value of that equity alpha is capped. We think that it is far more valuable to have a low-cost implementation, which is what we do. That low-cost implementation without any risk drops into the bottom line return for the investor. We think that is more valuable than the potential for uncertain alpha. So, what we do in the Stable Fund is we allocate both local and offshore equity passively. But we don’t do so through direct script. So, we don’t own the stocks. We essentially own futures. We are very happy with that approach to constructing the low-risk portfolio.

Jan Meintjes:

I’ll just add to that. For an investor that is post-retirement and investing directly into this fund, this implementation method has got the added benefit that, because the fund doesn’t earn dividend income, there’s no dividend tax applicable. Therefore, if you look at an after-tax return for that type of investor, it’s closer to the reported return than other funds might have that actually invest directly.

Nigel Barnes:

So, you focus on the tax efficiency and the cost effectiveness of the strategy?

Madalet Sessions:

Exactly. On that product, we literally try our hardest to implement in a way that results in the most benefit for the client. And that comes through in how we construct the portfolio, how we implement trading… literally everything in that fund is geared to be maximum benefit for the investor.

Nigel Barnes:

In terms of blending with other asset classes in the Stable Fund, how does that work? You’ve got your core equity component. What do you add to that?

Madalet Sessions:

In a low equity mandate, you’re capped at 40% exposure to equity. We are not currently near 40%. The volatility in equity markets, for the investor with the long run horizon, is not that painful. For the investor who might need capital in the near term, volatility can be very painful. So, we have limited equity exposure. We are at roughly 30% at the moment. And, with that, we own local bonds. Again, compared to our Balanced Fund, it is not a comment on the attractiveness of local bonds. It is a comment on the attractiveness of SA Inc., which is why we don’t own a lot of local bonds in the Balanced Fund, but we can’t make that nuance to play in the Stable Fund. So, we own in the order of 30% of local bonds in the portfolio and roughly half in inflation linkers and half in vanillas. We don’t really want to take a view on inflation in South Africa. We trying to maximize the probability of earning the real return on offer in the bond market in the linkers, and with that we also have a local cash and an offshore cash component.

We often get questions about our offshore cash and, by and large, what is forgotten in the discussion about offshore cash is that offshore cash goes up in value when other asset classes go down in value. It is a phenomenal, negatively correlated asset which provides capital stability for an investor. We put capital stability very much front of mind in how we construct our portfolio. And yes – when inflation offshore is running 9% offshore cash seems very expensive, and it is. And so, we are looking for alternatives for that position. We have not yet come up with something that offers the same risk/return profile as offshore cash. That position has been under review for a while. It’s not obvious with what to replace it, that provides you with the same risk return profile.

Nigel Barnes:

So, the two strategies are very different in their makeup but have one big common focus around risk management – which is great. I’m interested to know how you integrate with the wider Denker team. Some people might think that there are only two of you running multi-asset but it’s a much bigger team input than that.

Madalet Sessions:

I often tell clients, jokingly, that everyone in the business works for me and multi-asset. That’s actually true. The entire local equity team works on the local equity component of the Balanced Fund. The entire global team has exposure in the Balanced Fund. So, all our products are in the Balanced Fund. Which means every single individual in this business is contributing to the Balanced Fund. Our pensions are also in the Balanced Fund and a number of individuals in the business will come and discuss the portfolio with me and probably with Jan as well – looking for ideas and looking for ways to mitigate risks. We have regular and ad hoc meetings where we discuss relevant topics.

We put different scenarios and risks on the table, and this is mostly a portfolio manager discussion (if you have too many heads in a room, not every head is concentrated on the discussion so we try and limit it to PMs only). We put a number of scenarios on the table and say: ‘What happens if …?’; ‘How do we mitigate?’; ‘What does this mean for financials?’; ‘What does this mean for the Balanced Fund?’; ‘What are the opportunities or risks?’; ‘What’s the downside and what’s the upside?’.

So, every PM in the business, at some point in a month, will come and have a conversation with me or with Jan about what they expect and what they worry about. With that, Jan and I will sit down and discuss what do we do in the portfolio to make sure we can capture the returns available in the equity processes but doing so in a way that doesn’t expose the client to excessive downside or specific macro risk.

Jan Meintjes:

It’s also useful to know that Madalet sits in the team meetings of the local equity team on almost a daily basis. She also sits in the global equity team meetings. And then, there are team members in those different teams that also sit in one another’s meetings. We’ve done a lot of work in the last few years to make sure that there’s information flow throughout the teams. There’s a common thread to make sure that all the experience and the benefits of the gray heads that work here actually find their way into each decision that is made at every level in the business.

Nigel Barnes:

Sure. Being just past your five-year anniversary, I’m pleased to say that the performance numbers (and especially the risk adjusted performance numbers) look extremely strong. The Balanced Fund is top decile over all time periods*. The Stable Fund is doing what it says on the tin – in periods of market stress it’s really doing a great job of protecting capital. So, well done to you both on that. Finally, looking back over the five years, is there anything you would’ve done differently?

Madalet Sessions:

Hindsight is 20/20. I think with the benefit of hindsight I would’ve wanted to have had more exposure to South African equities in the Stable Fund. We’ve had limited volatility, which is what we pursue and that’s what we say we want. But perhaps we could have had a little bit more risk in 2021 – that would’ve helped returns. The problem with pursuing risk adjusted returns is that you are always making sacrifices. You end up asking yourself if you’ve sacrificed too much, and if you could have sacrificed differently. No one knows which risks you took which didn’t come to pass. I suppose, in a way, both the Balanced and Stable Funds present regret because if we hadn’t done any risk management those funds would’ve done much better. But in my opinion, it’s not really something that you can do consistently.

Nigel Barnes:

Well, that’s not the strategy.

Madalet Sessions:

Yeah, it’s not the strategy. It’s not what I believe in. I believe that you should minimise regret and not go all out for the best upside. I think that there is a reason we diversify, and owning a lot of stocks with the same macro drivers is not a diversified portfolio. I mean, South Africa has NeneGate – that can really write off 20% of your capital if you’re not diversified. And so, when large risks don’t come to pass, you’re going to have regrets. Then you realise, on the other side of large risks, that actually you don’t have regrets and you’ve done this right. You’ve stayed in the game, and that’s really what we pursue.

Nigel Barnes:

Jan, any thoughts looking back?

Jan Meintjes:

The only thing that I would say is that investments have taught me that regrets are often a short-term phenomenon because when markets move in a certain way, you never have enough or too much of anything. But, as time goes by, as you build a track record you actually see the benefit of not being too hasty in making your decisions. Having a measured approach actually works out over time. So, for me, in the short term yes, I’ll always say that I wish I had more of this or that. But, looking back over the longer term, I don’t have too many regrets – certainly not in the way that we’ve been able to manage clients’ money in these products. I think we’ve done what we set out to do and we should be very happy with that.

Nigel Barnes:

Thanks guys. You know, results speak for themselves. Thank you both for taking some time to be on the pod today. I’ll leave our listeners with one final thought: When you’re looking at performance numbers, do you look at the absolute performance numbers or do you look at the risk rated performance numbers? Thanks for listening. We’ll catch you next time.

*Source: Morningstar, 31 July 2022.  The performance of the A class of the Denker SCI Balanced Fund is ranked in the top decile over 1 year, 2 years, 3 years, 5 years and since its inception on 2 May 2017.

Disclaimer:

The information in this podcast belongs to Denker Capital (Pty) Ltd and Sanlam Collective Investments (RF) (Pty) Ltd. The information should only be evaluated for its intended purpose and may not be reproduced, distributed or published without our written consent. Although all reasonable steps have been taken to ensure the information in this podcast is accurate, Denker Capital and Sanlam Collective Investments do not accept any responsibility for any claim, damages, loss or expense – however it arises, out of or in connection with the information. No member of Sanlam gives any representation, warranty or undertaking, nor accepts any responsibility or liability as to the accuracy of any of this information.  The information does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act, No 37 of 2002 (FAIS). Use or rely on this information at your own risk. Consult your financial advisor before making an investment decision. Sanlam Collective Investments (RF) (Pty) Ltd is a registered and approved Manager in Collective Investment Schemes in Securities.

Collective investment schemes are generally medium- to long-term investments. Past performance is not necessarily a guide to future performance, and that the value of investments/units/unit trusts may go down as well as up. Changes in the exchange rates may have an adverse effect on the value, price or income of a product.  A schedule of fees and charges and maximum commissions is available from the manager on request. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Forward pricing is used. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The manager has the right to close the portfolio to new investors in order to manage it more efficiently in accordance with its mandate.   If the fund holds assets in foreign countries, it could be exposed to the following risks regarding potential constraints on liquidity and the repatriation of funds: macroeconomic, political, foreign exchange, tax, settlement and potential limitations on the availability of market information.  The fund may invest in other unit trust funds which levy their own charges and may result in a higher fee structure for our portfolio. All portfolio options presented are approved collective investment schemes in terms of Collective Investment Schemes Control Act, No 45 of 2002 (CISCA). The forecasts or opinions in this podcast are not guaranteed to occur.

Sanlam Collective Investments retains full legal responsibility for the co-branded portfolios. The portfolio management of the fund is outsourced to Denker Capital (FSP no: 47075), an authorised financial services provider in terms of the FAIS Act. For more information, visit www.sanlaminvestments.com