Consider this All things considered.
SUMMER Edition 2010
PEACE OF MIND!
How prudent planning will make the most of your money
INCOME ENHANCER
A fund with income AND capital growth
THE ART OF LIvINg
Three hotels with art at their heart
RISKY BUSINESS Is this a good time to hold risk assets?
MY LIFE ON A PLATE Raymond Ackerman shares his favourite food moments
What do tennis and investment have in common? The short answer is nothing! But, in tennis, as with so much in life, to be the best requires unparalleled skill, precision and technique. Attributes we feel mirror the philosophies that Prudential is proud to stand behind. And with a South African tennis viewership that fits our target market, it is only apt that Prudential use this parallel to encourage brand awareness. By promoting the Prudential brand essence through intelligent brand placement and strategic sponsorship of the sport and its broadcasting.
I’ll let the racket do the talking. – John McEnroe
Aim small, miss small
Competent in all areas of the game
By associating ourselves with tennis we feel that we can effectively leverage the intrinsic values associated with the game and draw a parallel in the minds of our customers. Additionally the “gentlemen’s game” mirrors the personality and tone of Prudential. We understand what it takes to be number one, but just like any distinguished champion, prefer plain white to garish colours.
For this reason we are currently running two print adverts in Sports Illustrated – the Nadal issue. In doing so we speak to the broader affluent sporting market whilst remaining current and interesting. A bit like our Prudential Equity Fund – the top performing fund over the last 8 years*
This alliance with the sport also allows the Prudential brand to occupy a media space upon which we have previously been quiet. And with television’s broad viewership it is vital we make the most of it by refining our communications to a specific market – something that interest in the game already does for us.
All things considered. Prudential Portfolio Managers (Pty) Ltd is an authorised financial service provider. For more information visit www.prudential.co.za *Rated the top performing fund by Morningstar under the Domestic General Equity Sector for the period ending 30/09/2010.
directions
Putting matters in Pruspective By Bernard Fick, Chief Executive Officer, Prudential
T
his is the second edition of our new-look Consider This magazine. The response from readers to our launch edition has been overwhelmingly positive. Thank you to everyone who wrote to us with comments – we are taking all suggestions under consideration. One proposal was that we should include a simple “Guide to Investing” that demystifies the different asset classes and helps investors to better understand the benefits and risks of various investment options. We have included this in the form of a handy pull-out that can be filed for future reference. We aim to cover various investment topics in future editions. We are pleased to announce the launch of our new-look website. Please visit www.prudential.co.za for information on Prudential, our investment philosophy and people, and detailed information on our unit trust and institutional products. Investors are able to sign up to Pru-Online through the website, where you can manage your personal investment information via a secure on-line facility. Our Prudential Equity Fund received some very positive press coverage in recent months. It is now the best performing General Equity Unit Trust Fund in South Africa over the eight years ending September 30 2010. An investment of R1 000 in this fund on October 1 2002 would have grown to R4 352 (after all fees), relative to an investment in the All Share Index, which
Prudential Lady Pru – the face of
our investment At Prudential, we base of Prudence. ue virt the on phy philoso rated in the rpo Lady Pru has been inco The image 8. 184 e sinc o Prudential log t represent tha s ent elem e thre es compris ire to: asp we t three core values tha -reflection self g isin bol sym ➔ The mirror ction dire g The arrow ➔ representin dom wis g ntin rese The serpent ➔ rep
would only have grown to R2 925. This is evidence that our long-term prudent value investment strategy has succeeded in adding real value to our clients’ investments. In this quarter’s magazine, readers can enjoy articles by members of our investment team. In particular, look out for Juan Nevado’s article on the valuation of global asset classes, in which Juan argues that this is a good time to buy growth or “risky” assets, many of which are offering attractive valuations. In closing, all of us at Prudential wish our clients a joyous and peaceful holiday season. We hope you will enjoy the company of friends and family and get plenty of rest and relaxation. Please travel safely! As always, we welcome any feedback from readers on the magazine or any of the articles.
The views and opinions expressed by the independent authors and those providing comments are theirs alone, and do not necessarily reflect the views, opinions, or strategies of Prudential Portfolio Managers or any employee thereof. Prudential Portfolio Managers is an authorised Discretionary Financial Services Provider in terms of the FAIS Act, 2002. Collective Investment Schemes in Securities (CIS) are generally medium- to longterm investments. The value of participatory interests may go down as well as up and past performance is not necessarily a guide to the future. CIS are traded at ruling prices and can engage in borrowing and scrip lending. A schedule of fees and charges and maximum commissions is available on request from the company/scheme. Commission and incentives may be paid and, if so, would be included in the overall costs. Forward pricing is used. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. In calculating performance figures, initial charges are not taken into account (ie NAV - NAV). Annual service charges are deducted in all calculations. Dividends are reinvested on the reinvestment date at the reinvestment price. For more information, visit www.prudential.co.za or call 021-670-5100
2 consider this Summer 2010
Is this a good time to hold risk assets? If you are a global investor, the odds are currently significantly in your favour to own a basket of diversified risk assets relative to perceived safe havens like bonds and gold. This is the considered opinion of Juan Nevado, a member of M&G’s macro investment team.
4 consider this Summer 2010
Current asset pricing based on consensus forecasts 12
current Neutrality
8
4
SA eY
BrAZIL eY
INDIA eY
INDONeSIA eY
KOreA eY
THAILAND eY
OZ eY
HK eY
uK eY
eurO eY
uS eY
GermAN eY
SING eY
JAPAN eY
uS BBB
uK BBB
uK rrr
uS 30Y rrr
Japan rrr
German rrr
–4
uS cash
0
eu cash
What is interesting to us is not so much that they have gone down, it’s the speed at which they’ve gone down. For us, there is a psychological, behavioural angle to this. The 10-year US bond has gone from 4.0% to 2.6% since April – 140
a. Asian currencies have been broadly strengthening against the US Dollar. The Yen is an example of this; it is perceived as a safe haven. b. Because the US Dollar is the world’s reserve currency and the US has been easing monetary policy, the US has effectively been exporting easy financial
The credit spreads on Portuguese, Spanish, Greek and Irish bonds have risen sharply. Markets are worried about the risk of default and these governments have introduced severe fiscal packages to try and constrain their deficit.
Jp cash
5 Bond yields have declined dramatically and at great speed.
6 The problems in southern Europe triggered more fiscal reform in six months than the last 30 years.
uK cash
Asia, in particular, has seen some booming markets, like Indonesia and Thailand, India and Malaysia. Asia is far less dependent on the US and we are seeing independence of behaviour between emerging and Western markets.
7 Currencies: the US is exporting easy financial conditions to the rest of the world.
basis points. Has the world really changed so much to justify such a move?
Real yield (%)1
An overview of 2010 so far: 1 There has been modest growth in the West such as the US and parts of Europe. Emerging economies such as China are booming. 2 Inflation has been weak and central banks are providing an insurance policy for global economies. 3 So-called “safe haven” asset classes of bonds and gold have done better than “risk” assets such as equities. 4 Equities have not gone down, but they have significantly underperformed safe havens.
Source: m&G Investment management Limited, as at 27 September 2010 1 For bonds and cash, real yield is defined as the nominal yield minus expected inflation. For equities, real yield is defined as an inverted p/e ratio, using forward consensus data. The above data is a hypothetical representation for illustrative purposes only and is not representative of any m&G product or strategy. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.
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conditions to the rest of the world. c. Asians and Latin Americans are easing monetary policy at a time when their economy is already very strong.
To argue that the most likely scenario from here is a renewed recession is dangerous From the highlights of 2010 to date, it is not at all clear that a renewed global recession is the most likely scenario, and yet many risk assets are being priced as if there is more than a 50% chance that we are heading for a recession. There is evidence that investors are so worried about deflation and recession that they have fallen in love with safe havens.
IMAGe: corbIsIMAGes
How is the market pricing risk assets? In the chart (opposite), the red bars show the current real (after inflation) yield for the global asset classes listed across the horizontal axis. The grey shaded section indicates the neutral or long-term equilibrium yield. In other words, the asset classes whose red bars are above the grey shaded section are currently cheap on a long-term valuation basis and those that are below the grey shaded section are expensive.
Cash is delivering a negative return after inflation, and bonds are almost the same What stands out from this chart is that if you look at cash rates around the world you can see that investors are happily going to the bank knowing they are going to lose money, because cash rates everywhere are below the expected inflation rate. Most bond markets around the world are almost the same. If you ask 100 economists what the mostly likely inflation rate for the next 10 years will be, they will tell you 2.4% (on average). Globally, bonds are giving you almost nothing; corporate bonds are slightly different because what we observe is that corporate spreads are still wider than average, which means that investors are still demanding a high risk premium to own corporate debt.
In terms of equities, in most markets around the world the real yield currently available from owning assets is almost at extremes seen in the last 30 years. For example, in Germany the real yield is 10%, which means that if earnings grow in line with trends from here, you’re buying an asset that is going to give you a 10% real return after inflation indefinitely. However, if you buy a 10-year German bond, it will give you a real return today of close to 0%.
Alternative measures of valuation also show that equities are cheap Apart from price earnings ratios, market price to book around the world is on the low side if you look at the 30-year history. so there’s nothing expensive at all about more conservative measures of equity valuation currently. Turning to
summer 2010 consider this 5
never returned to their lowest because companies were so aggressive in cutting costs. This year, you are finally getting to see sales growth after a lot of cost cutting and a rise in profits; business sales are up 8-9% on the S&P 500.
We are experiencing déja vu of 1993 and 2003: a “joyless, jobless” recovery
Asian emerging markets, they may have done well in the past 12 months but a lot of them are still very cheap because their earnings have gone up so much. Markets we like include Hong Kong, Korea, and Thailand, with real yields of 8-11% at a time when real interest rates are 0.
One of the reasons why markets are so cheap in our eyes is because profits have been so strong Globally there has been a very coordinated sharp rise in profit margins and a very aggressive corporate sector around the world. Strong global profits have been driven by stronger than expected productivity growth. In the US, it is at a 60-year high. Technology has had a crucial role to play in this increased productivity. We may have had a TMT bubble 10 years ago, but technology has been a massive driver of productivity around the world over the past 10 years. You are seeing the benefits of that technology boom now. One of the reasons we like this is that it is a very good lead indicator of economic growth, because profits are wealth creation, it gives companies the
ability to increase investment and it gives companies the ability to increase jobs. Admittedly, if you look around the world, job creation is slow, investment is slow, but it is happening. Business confidence is improving.
The key explanation for asset performance over the last 10 years is the starting point of valuation Ten years ago, equities were massively expensive and bonds were cheap – it made sense that bonds did well and equities did badly. Today, we have the total opposite. So the odds are massively in our favour that, over the next few years, equities are going to provide superior returns relative to so-called safe havens like bonds and probably gold.
The facts are saying there is a recovery, yet the markets are saying the most likely scenario is a renewed recession So why are markets so obsessed with the probability that we are going to have another recession? The same issue goes for profit margins. We had the biggest recession in 50 years, yet margins
There are similarities between today and 2003 and 1993 when the world was also coming out of recession. When you come out of recession people are always sceptical because they have been so mentally scarred by the pain of the recession that they never believe recovery will happen. So you get what have been referred to as “joyless, jobless” recoveries – a recovery that does not feel like a recovery.
Why are investors demanding such high-risk premiums to own risk assets? Text books will tell you that new information changes our beliefs and this drives markets. For example, a bank crisis two years ago changes your beliefs and drives down the price of an asset. What the text books don’t tell you is that when the price of an asset goes down after a shock, the price move itself often changes perceptions of the riskiness of that asset. The experience of owning an asset can actually change your perception of how much risk premium you want to own that asset. This is a very unusual feature of financial markets, which is different from goods markets such as a supermarket. If the price of something in the supermarket goes up, you will buy less of it. However, in financial markets, if the price of an asset goes up, people buy more. Why? Because they like the fact that they own an asset that is going up. Similarly, when an asset goes down in price, they fall out of love with the asset.
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German earnings yield versus real 10 year bond yields 12
Earnings yield Real 10 year bond yield
today central banks are easing monetary policy, even in emerging economies. Our bottom line is that there is limited downside to bond yields because they can’t go below zero, and there’s significant upside if the scenario of stronger growth before inflation emerges.
8
2009
0
1990
4
Source: Thomson Datastream
The market thinks that banks are more risky today than they were five years ago Up until 2007, the cost of insuring bank debt was very low – about 30 basis points for four years. If you put that into a risk model you would say that banks’ credit is very safe because there is no volatility, there is a nice risk premium every year and you can lock it away! Then a shock comes along, called the Lehman’s crisis, and look what happens. Credit spreads go to record levels. Then you get the bailout, banks recover and now you’re seeing where we are today – the spread on US banks is about 120 basis points. Five years ago, it was 30. Today, many banks have recapitalised significantly, reduced their leverage, and have been given cheap funding with which to engage in profit making. In addition, the industry has consolidated and profitability has increased sharply, reducing the risk of default. And yet, the market is pricing banks as if they are more risky than they were in 2007. What this example tells us is that people are so mentally scarred by what has happened to them in the past two years that they are demanding a huge
risk premium to own that asset. This is a good illustration of what’s going on in the world today, why risk assets are on such high-risk premia.
What are the odds on offer if you’re a medium-term investor? The interesting thing about bonds on the other hand is that people view them as low-risk assets. If we look at what has happened to bonds since 1982, two- and five-year bonds were clearly a big bull market. Anybody who bought those bonds 20 or 30 years ago has made a massive amount of money and it is not surprising that investors perceive them as a safe haven. The issue now is that a two-year bond now yields 0.4% and a five-year bond now yields 1.1% – negative returns after inflation. Is this really a safe haven? Is this a low-risk asset? Behaviourally, people have fallen in love with bonds as reflected by the speed by which they have fallen recently. People love the low volatility they have displayed in the past. But we don’t know the future. There are many scenarios that could cause these bonds to sell off sharply in 12 months time, especially when around the world
In conclusion: the odds are significantly in your favour to own a basket of diversified risk assets relative to perceived safe havens like short-dated bonds and gold 1 We have had a profit boom which
is wealth creation – great news for sustaining the recovery. 2 We have seen inflation stability despite all the volatility in the system. The biggest valuation anomaly we see today is negative cash rates around the world, which people seem to be happy to put their money in the bank for. 3 We have a record 30-year high in the risk premium between bonds and equities today, and even credit remains attractive because people are still mentally scarred by what happened to them two years ago. The world’s a very complex system, consistently forecasting the future is impossible. But I am very surprised when I observe market valuations today that are telling me that there is a greater than 50% probability that we head back into recession. My objective interpretation of the facts available today suggests that this is a particularly aggressive prediction. Any other scenario, even those which are negative, but are simply less than suggested by asset prices, are likely to be favourable for risk assets and damaging for what are currently seen as “safe havens”.
Juan Nevado Juan joinedNevado Prudential Portfolio Managers (UK), now M&G, in 1988. HeM&G, has been working thebeen macro investment team since 1999. joined Prudential Portfolio Managers (UK), now in 1988. Heinhas working in the macro Prior to joininginvestment M&G, Juan team worked bond economist at the BankPrior of Montreal, and, before that, as an economist the Commodities ledasbya Dave Fishwick since 1999. to joining M&G, Juan worked as a bond for economist at Research Unit, the a private consultancy specialising in an macro and micro on commodities markets. Bank business of Montreal, and, before that as economist forresearch the Commodities Research Unit, a private business
Which is the ruling asset class: equities or bonds? Cromwell Mashengete, Portfolio Manager and Equity Analyst at Prudential Portfolio Managers, reviews the historical path of equity and bond investing.
O
ver the last 50 years, equities were the premier investment asset class. Global pension funds tilted their portfolios towards equities largely at the expense of bonds. The past 10 years have seen a reversal of roles – bond investing now rules. In Europe and Japan, equities are trading at dividend yields above government bond yields; in other words, bond prices are high. US equity yields are almost at the same level as bond yields. Emerging markets are no exception; bond yields are at record lows.
IMAGE: CORBISIMAGES
The historical path of equity and bond investing To assess the relative merits of equities and bonds, it’s worth reviewing the historical path of equity and bond investing by pension funds. Refer to Figure 1 on page 13. 1 From 1920 to 1959, US equities yielded more than US Treasuries or government bonds. 2 From 1940 to 1958, equity yields even exceeded corporate bond yields. The scramble for equity among US investors pushed dividend yields below those on government bonds and corporate bonds. A similar experience was recorded for the UK, Japan and Germany, where dividend yields fell below government bonds in the 1950s.
12 consider this Summer 2010
Since the 1950s, there has been a shift in US pension fund holdings – from mainly bonds to mainly equities In 1952, the Federal Reserve Bank’s Flow of Funds data estimated that private pension funds in the US held about 17% of their assets in equities compared to 67% in fixed interest or bonds. Over the next 50 years, these weightings reversed. By 2006, the same pension funds held 69% in equities and 18% in fixed-interest or bond investments.
A similar shift took place in the UK – pension funds switched from holding more bonds to more equities Although data from the UK does not go as far back as in the US, the Office for National Statistics suggests that in the early 1960s pension funds held more bonds than equities. By the mid 1990s, UK pension funds held 76% in equities, which was much higher than the US, compared with 12% in bonds.
sources estimate emerging markets equity weights ranging from 3% for Korea to 44% and 49% for South Africa and Chile respectively. South Africa and Chile have well developed financial systems that compare favourably to developed markets like the US and UK with equity weights of around 60%. The equity holdings of the emerging market pension funds remain well below those of the developed countries.
The most compelling reason for equity dominance is its outperformance since the 1950s The most compelling reason for equity dominance during this period is their outstanding performance relative to government bonds, especially in the US. From the stockmarket crash in 1929, US equities only reverted to their pre-crash levels in 1954. Thereafter, equities outperformed bonds. To put this in perspective, $100 invested in US equities in 1950 would have been worth $58 380 at the end of 1999 versus $1 651 in bonds. This is massive outperformance over a 40-year period.
In emerging markets, equity holdings remain well below those of developed countries
Since 2000, bonds have dominated
Data on the asset allocation of pension funds in emerging markets is less comprehensive than for developed markets. Pension fund surveys like Towers Watson supplemented by national
Since 2000, global equities have returned just 4% while global government bonds have returned 103%. As a result, investor appetite for global equities has shifted to bonds.
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Figure 1 – US asset yields (%) 16 moody’s us corp bond yield (AAA) us equity dividend yield us 10Y Treasury yield
14 12 10
cult of the equity begins: equity dividend yield drops below bond yields
8 6 4 2 0 20
25
30
35
40
45
50
55
60
65
70
75
80
85
90
95
00
05
10
source: Global Financial Data, Datastream, citi Investment research
In 2009, US private pension funds held 55% in equities compared with 69% in 2006. UK pension funds held 39% in equities in 2009 from a high level of 76% in 1993. In fact, even money being invested in unit trusts is increasingly tilting towards bonds. The new-found elevated status of bonds as an asset class is further enhanced by the fear of a “double-dip” recession in the US economy and the fear of deflation that could engulf developed economies. As a result, bond yields have fallen to historical lows. In the US and the UK, bond yields have almost fallen below equity dividend yields. In contrast, the average dividend yield on emerging-market stocks remains far below bond yields.
Is it time to buy equities or bonds? At Prudential, we focus on valuations to make this decision At the core of the debate about the cyclical attractiveness of bonds versus equities lies the structural shift in relative valuation of the two asset classes. The reign of the equity asset class faded in 1999. In late 2008 and early 2009 – the peak of the global financial crisis – equity dividend yields rose above government bond yields for the first time in 50 years.
Figure 2 – Yield comparison: Global Emerging Markets (end-month) 18%
earnings yield Dividend yield emBI+ sov bond blended yield
16% 14% 12% 10% 8%
6.80%
6%
5.61%
4% 2.30%
2% 0% 1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
source: JP morgan, mscI, Datastream and citi Investment research and Analysis
In hindsight, this presented a wonderful signal to buy equities.
Valuations show that equities are cheap relative to bonds in the US and UK To date, equity markets in the US and the UK including other developed economies have performed dismally, despite solid earnings growth in recent years. Earnings
yields are currently as high as 8%. This valuation gap is episodic. Equities are very cheap relative to bonds in both the US and the UK. By contrast, emerging markets have been performing well and earnings are growing strongly. The average dividend yield on emerging market shares (2.3%) is well below bond yields (see Figure 2 above). Overall, equities are still our preferred asset class.
Cromwell Mashengete joined Prudential Portfolio Managers in November 2005. Prior to Prudential, he worked for Syfrets Limited, a subsidiary of Nedbank and Old Mutual Asset Managers as a Portfolio Manager for the Community Growth Fund.
summer 2010 consider this 13
Prudent planning will provide peace of mind The great challenge we face, apart from educating our children and looking after family, is to have enough income to meet our needs and maintain our lifestyle in the years to come. It sounds simple but without disciplined and prudent financial planning few of us will achieve this. If you spend a little time and effort planning, you can make the most of your money, says Hamilton van Breda, Head of Retail Sales and Distribution at Prudential.
The fact that you are reading this means that you are interested in money matters If you are an investor, you have already foregone the temptation to spend every cent that you own. That puts you ahead of many South Africans who cannot afford to or choose not to save and invest their money. Furthermore, a healthy interest in financial matters is a good start to making better decisions about your money. No matter how good your financial adviser may be, or how well your investments perform, you still play a crucial role in making choices about when and where to invest. And you and your family live with the results of your financial decisions. We are therefore very pleased that, as a reader of this magazine, you already appreciate the importance of prudent financial decisions in determining your financial wellbeing. If some of your investments are already
18 consider this Summer 2010
with Prudential or if you are considering investing with us in future, we would like to say thank you and congratulate you for taking responsibility for making the most of your money.
How did you come to hear about us, and our funds, and what made you invest with us? Chances are that you heard about us from your financial adviser (or financial planner as they are also known), family or friends. We know this because, relatively speaking, we have been prudent when it comes to advertising our services and yet we have benefitted from increasing numbers of investors that stay the course and clearly understand our long-term investment approach. This bodes well for their investment returns. Much of our business comes to us via financial advisers – so, as an investor with Prudential, there is a high probability that you use a financial adviser.
Feel happier and more in control of your money In a recent survey in Australia that CoreData-brand management conducted on behalf of the Association of Financial Advisers Limited, they posed the question “What do financial advisers do, and how do they add value to their clients?” The survey outcome and central proposition was that “consumers who have an advice relationship are better planned, are happier with their investments, have a financial coach to help with major life decisions, provide peace of mind,
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administer financial affairs and assist in facilitating a path to financial freedom”.
image: corbisimages
One of the “significant insights and key lightbulb moments” recorded in the research was that: “Those people who seek advice are significantly happier with the manageability, diversification and return of their current investments than those who are unadvised.” While this is an extract from an australian survey, this insight has a lesson for us in south africa. if you do have a trusted and reliable professional financial
adviser and have been through a holistic planning process with him or her – you are likely to be happier and feel more in control and at peace about your financial affairs. and, at the very least, you will have a financial plan to help you manage the uncertainties of life.
Professional financial advisers: 1 Help you focus on the future so that you achieve your goals Financial advisers fulfil an invaluable role in helping you consider your money decisions carefully and plan. They help you to think long term.
2 Provide reassurance and guidance Financial advisers are in a unique position of trust to help you avoid the many pitfalls of investing. They help you navigate the complex world of finance and the huge range of options available; providing reassurance and guidance when your emotions threaten to get the better of you. 3 Are objective and impartial • They are able to be objective about aspects of your life that are very personal. although the conversation may start with money, the way we spend or save is simply about our personal choices, goals
summer 2010 consider this 19
and priorities. Financial advisers help you take an objective look at yourself – what motivates you, what your commitments are and how you aim to meet these as your life changes. Being clear about this helps you head in the right direction to optimise your money decisions. • It is also important for an adviser to be impartial about the investment options that he or she presents. By this, we mean that the advice and recommendations should not be skewed by any financial or other incentive in favour of one product over another. 4 Fulfil a multitude of roles Developing and maintaining expertise on the wide range of investment choices, tax, retirement planning and life assurance is no mean feat. And navigating the technical complexity of estate planning is challenging but vital in ensuring that when you are no longer around, others will fulfil your wishes regarding your money. However, financial advisers are not just technical experts or administrators of the paperwork associated with the financial aspects of our lives; they help us make good choices. They play an important role as a counsellor or financial coach.
Our role as an investment manager relative to a financial adviser – where does advice fit in? It is worth recapping what our role at Prudential is as an investment manager, relative to a financial adviser. And what do we mean when we refer to financial advice? As investment managers, we focus on generating a return on your money in line with a specific pre-determined objective over an appropriate period. We do not – and legislation prohibits us from doing it – tell you or advise you which investment option or product is best suited for your needs and goals. This is what we mean when we say that we may not give you “financial advice”. We may only give you objective information, facts and figures about the investments we offer.
It is the role of the financial adviser to help you decide which
investment option may be right for you A financial adviser takes into account a number of factors when they put forward recommendations. And remember that although you may only wish to get advice on a certain investment that you wish to make, for a financial adviser to be able to give you the best advice for your circumstances it is preferable for them to look at your overall financial position, your current lifestyle, and all your goals and plans. When they can see the bigger picture, they are able to help you make the most appropriate investment decision for your stage of life.
What are the regulations and laws that govern financial advisers? Unfortunately, just as you get honest and trustworthy advisers, you get dishonest and unscrupulous advisers. This is true of people in all occupations. If you have had a good experience with your financial planner or adviser, please pass the recommendation on to others. Unfortunately, we only tend to tell others about the negative experiences, as much of the media exposure about financial wrongdoing shows. For your protection, there are many laws, regulations and codes of conduct that govern financial product providers and advisers in terms of: • Who may give financial advice; • What qualifications and experience is recognised and how any accreditation should be maintained; • What advice process a financial adviser should follow; • Managing conflict of interest – to ensure that financial advisers are impartial and that product providers don’t exert any undue influence on their advisery process; and • Ensuring that we as consumers are treated fairly.
What financial planning qualification is recognised in South Africa? The Financial Planning Institute of Southern Africa (FPI) recognises the CERTIFIED FINANCIAL PLANNER®/CFP®
designation as well as the ASSOCIATE FINANCIAL PLANNER™/AFP™ and REGISTERED FINANCIAL PLANNER™/ RFP™ designations. To use these designations, financial advisers are required to fulfil a range of academic and practical requirements. To be accepted as a professional member of the institute, advisers must meet the requirements of the four Es of professional financial planning: 1 Education Candidates must complete an approved education programme in financial planning at the relevant level of membership. 2 Examination Candidates must successfully complete the FPI Board Assessment. 3 Ethics Candidates must agree to abide by the Institute’s Code of Ethics and be declared fit and proper by the FPI. 4 Experience Candidates must have completed an appropriate period of relevant practical experience in financial planning. CFP® and CERTIFIED FINANCIAL PLANNER® are trademarks owned outside the US by Financial Planning Standards Board Ltd. The Financial Planning Institute of Southern Africa is the marks licensing authority for the CFP in South Africa through agreement with FPSB. Please visit the www.fpsb.org to learn more about the FPSB and the affiliate countries. The CFP® certification is also globally recognised. An adviser with a CFP® mark has obtained a post-graduate diploma in Financial Planning and has a minimum of three years industry experience. For further information about these designations, please refer to the Financial Planning Institute, www.fpi.co.za.
What about remuneration models? There are a number of ways to remunerate financial advisers for their services. The most common method is via a fee or commission that is deducted from the investment and paid to the financial adviser. The words “fees” and “commissions” are often confused and used interchangeably. There is also an ongoing
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debate about the difference between the two. The main difference is that if payment for advice is deducted from the investment, it is often referred to as commission. If you must write out a cheque to pay the adviser money distinct from the investment you make, it is often referred to as a fee. There are arguments in favour of fees and in favour of commission, but the most important things to note are: 1 Understand how much you are paying for advice regardless of how this is paid. 2 If it is deducted from the investment you should satisfy yourself that the money the adviser is receiving by placing the investment has not skewed or
influenced his recommendation – and that you do understand the quantum of the money that is being deducted from your investment. 3 All fees (whether they are for advice or for the investment management or product) should be transparent, clearly explained to you and disclosed in the paperwork. Simply put: all fees “reduce” potential returns. But if you have the right financial adviser earning that fee, he or she can ensure that the potential return is translated into an actual return applicable to your circumstances. Don’t be afraid to ask questions about this. And keep asking until you understand. If you understand
your investment and all the associated costs of this, it will make for a better long-term relationship with your financial adviser and, indeed, with us as your investment manager.
In conclusion If you don’t have the time or expertise to plan your finances yourself, do seek the advice of a professional financial adviser. Inadequate financial planning can leave you working for longer than you planned. A reduction of living standards and income is painful; you will feel this much more than the relatively small sacrifice of starting to save and invest in a disciplined manner now.
How to make financial planning work for you You are the focus of the financial planning process. As such, the results you get from working with a financial planner are as much your responsibility as they are those of the planner. To achieve the best results from your financial planning engagement, you will need to consider the following. Set measurable financial goals
Set specific targets of what you want to achieve and when you want to achieve results. For example, instead of saying you want to be “comfortable” when you retire or that you want your children to attend “good” schools, you need to quantify what “comfortable” and “good” mean so that you’ll know when you’ve reached your goals.
Understand the effect of each financial decision
Each financial decision you make can affect several other areas of your life. For example, an investment decision may have tax consequences that are harmful to your estate plans. Or, a decision about your child’s education may affect when and how you meet your retirement goals. Remember that all of your financial decisions are interrelated.
Re-evaluate your financial situation periodically
Financial planning is a dynamic process. Your financial goals may change over the years due to changes in your lifestyle or circumstances, such as an inheritance, marriage, birth, house purchase or change of job status. Revisit and revise your financial plan as time goes by to reflect these changes, so that you stay on track with your financial goals.
Start planning as soon as you can
Don’t delay your financial planning. People who save or invest small amounts of money early – and often – tend to do better than those who wait until later in life. Similarly, by developing good financial planning habits such as saving, budgeting, investing and regularly reviewing your finances early in life, you will be better prepared to meet life changes and handle emergencies.
Be realistic in your expectations
Financial planning is a common-sense approach to managing your finances to reach your life goals. It cannot change your situation overnight; it is a lifelong process. Remember that events beyond your control such as inflation or changes in the stockmarket or interest rates will affect your financial planning results.
Realise that you are in charge
If you’re working with a financial planner, be sure you understand the financial planning process and what the planner should be doing. Provide the planner with all of the relevant information on your financial situation. Ask questions about the recommendations offered to you and play an active role in decision-making.
Source: Financial Planning Institute of Southern Africa, www.fpi.co.za
Hamilton van Breda is responsible for all retail sales and distribution. He joined Prudential in 2001. Hamilton started his career with Old Mutual as a legal advisor. He has over 20 years experience in the financial services industry having worked at Lisps and Asset Managers in a legal advisory and sales position. His qualifications include B.Soc Sc, LLB, Post Grad Dip Tax, CFP. Hamilton is currently reading towards his MBA.
Consider a new online experience “The internet is becoming the new town square for the global village of tomorrow.” – Bill Gates
Easy to use, redesigned interface and in keeping with our new look We are proud to announce the launch of our new website, which we believe will make the online experience simpler, easier and more efficient. Giving you only the information that you need, exactly where you’d expect to find it. The interface has been refined to make the viewing experience that much quicker and you will find all the relevant fund fact sheets and documents that you need.
Observing a digital world Of course to be true ambassadors of change we had to consider every aspect of our new online experience and the aesthetics were equally important to us. The new website features our refined look and feel and incorporates the “Observations from the world of Prudential” as its theme. The new site combines beautiful photography with sleek typography treatment as well as a clean, sophisticated layout. In short, a website born of prudent, considered thinking.
Pay us a visit The best way to really see what we’ve done is to pay us a visit at www.prudential.co.za Remember to register (if you haven’t already) and take a tour of the new site.
Guide to Prudential Online The following is a step-by-step guide on how to use the Prudential Online site. Please follow these steps carefully, so that you can enjoy the benefits of viewing all your statements online.
Step 1 Type the following link into your internet browser: https://www.investoronline.co.za/investoronline/prudential/ or you can access the site by clicking on Prudential Online within our Prudential website – www.prudential.co.za
Step 2 Click on register.
Step 3 Please ensure that we have your up to date email address on our records as a verification email will be sent to you confirming the details you supplied as well as a verification code, which is required the first time you log in. Once these fields are completed click on register at the bottom of the screen. Please note that in the event of a failure to register, one of the following could be the reason: t 6TFSOBNF TVQQMJFE IBT BMSFBEZ CFFO VTFE t ID number does not correspond with our records.
Insert preferred username
t Incorrect Investor or Broker Code.
Insert preferred password
t No email address on our records.
Confirm preferred password
t Registered as corporate instead of individual (please note that for corporates, Prudential needs to register on your behalf).
Insert broker code or client unit holder number as found on statements
For companies and trusts only Insert your ID number
Step 4 If your registration is successful the message on the right will be displayed on the screen and you should shortly receive your verification email.
8VHU UHJLVWUDWLRQ VXFFHVVIXO IRU XVHU ³ ´ YHUL¿ FDWLRQ RI WKLV registration will be sent to you via email. If you do not receive a YHUL¿ FDWLRQ HPDLO SOHDVH FRQWDFW \RXU FOLHQW VHUYLFH FHQWUH &OLFN KHUH WR ORJLQ
Looking to enhance your income? Roshen Harry, Portfolio Manager at Prudential Portfolio Managers, explains how the Prudential Enhanced Income Fund provides a high level of income together with capital growth.
W
hen we launched our Prudential Enhanced Income Fund just over a year ago, we explained that cash returns in South Africa were likely to be very disappointing in the next three to five years. Short-term interest rates had already fallen from 12% to 7.5% and there was little prospect for any near term reversal of this. Since then, the Official Repo rate (the price at which the Reserve Bank lends money to the banking system) has dropped another 1.5% and may indeed fall further. This supports our original proposition that investors needed
26 consider this Summer 2010
a higher yielding product but which at the same time did not bring with it the same risks of capital loss of a bond or property fund. We translated these two goals into a primary objective for the Enhanced Income Fund of providing a high sustainable level of income together with moderate capital growth, while aiming for no capital loss over a rolling 12-month period. Our portfolio manager team of David Knee and myself has delivered on these objectives, with the Fund returning almost 16% since its inception in July 2009 through to end September this year,
against a return from cash of about 9.4% over the same period. The graph (right) highlights these returns and includes the Fund’s performance against its benchmark of the All Bond Index 1 to 3 years, which it beat by 4.7%. The Fund’s returns were a full 10% ahead of inflation.
The Prudential Enhanced Income Fund offers the opportunity to improve your income It is a fixed-interest “solution” for those who don’t wish to worry about how much money to invest in bonds, corporate bonds or money market assets
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120
Prudential enhanced Income Fund ALBI (1 – 3 years)
Price Index
115
115.68 15.68%
steFi Inflation*
110.96 10.96% 109.35 9.35% 105.6 5.65%
110
105
100 sep-10
Aug-10
Jul-10
Jun-10
may-10
Apr-10
mar-10
Feb-10
Jan-10
Dec-09
Nov-09
Oct-09
sep-09
Aug-09
Jul-09
Jun-09
ImAge: corbIsImAges
Since inception Cumulative Performance vs Objective (1 July 2009 - 30 Sept 2010) while remaining at the lower risk end of the spectrum. A significant benefit is that investors can gain exposure to assets they ordinarily would not have access to within a cash-only product, such as inflation-linked bonds, corporate bonds or, on a limited basis, property and overseas bonds. The flexibility of the Fund to allocate across a broad range of assets allows it to take advantage of mispricing between them to increase and decrease exposures over time and thereby add value. It also benefits from the riskdiversifying properties of a multi-asset approach since different types of assets
source: morningstar * Inflation lagged by 3 months
summer 2010 consider this 27
directions
do not all go up and down together. In addition, Prudential has a well-established global team, which analyses the wider universe of higher yielding fixed-income securities, both in South Africa and across the globe, whose skills assist in the selection of the individual securities.
Investment objective The Fund focuses on maximising the total return (capital plus income) over the full interest-rate cycle, while at the same time looking to protect the investor’s capital and reduce volatility over the medium to long term.
How it aims to achieve its objectives 1 It has flexibility to access a wider range of underlying instruments – to generate a higher return than a bank deposit The Fund has access to a broader set of financial securities than those used in a typical money market or income fund. The managers therefore use this flexibility to generate higher total returns than that of a bank or money market fund – even in a falling interest rate environment. These include: • government and corporate bonds • inflation-linked bonds • preference shares • listed property • equity (where there is a robust outlook for the production of income), and • other high-yield income securities to achieve a higher return.
2 Active management that leverages off our international and locally proven fixed-interest process and research
The managers actively manage the allocation between different fixed-interest or income producing assets, diversifying between various high yielding asset classes and securities. One of the key aspects that differentiate us from our
competitors is our long and proven track record in asset allocation. Our valuedriven investment process provides a consistent framework against which we are able to assess the prospects for a wide variety of asset types objectively in order to ensure that we are not pulled back and forth by market hype, which, in the end, we often find, is more noise than substance. Unlike many other South African managers, we are supported by a much larger global parent in the form of the UK Life Insurer, Prudential plc, and we draw extensively on the expertise of Prudential’s investment teams that span the globe. The financial crisis proved beyond any doubt that South Africa is not isolated from events elsewhere and the ability to tap into on-the-ground views from our teams in London to Hong Kong to Chicago can be invaluable.
Benefits for you 1 Potential to maintain a high income Investors seeking income are able to avoid some of the downside of a falling interest-rate environment, which they would otherwise experience in a standard cash offering where lower interest rates ultimately have to mean lower returns.
2 Outsource the fixed-interest “asset allocation” decision to the experts
Many investors appear comfortable making the broad asset allocation calls between equities and fixed income but are less so deciding between fixed income instruments such as cash, corporate bonds, sovereign bonds, preference shares, property, international bonds, etc. The Prudential Enhanced Income Fund allows you to outsource this decision to the fund manager whose expertise lies in identifying income-producing opportunities. Prudential is one of the pre-eminent asset allocation managers in
South Africa and across the world.
3 Maintain a more conservative
portfolio than a typical balanced fund for risk-averse investors
The Fund does carry a medium to low risk profile indicating that it is much less risky than a typical balanced or a bond fund. Both balanced and bond funds have experienced capital losses over a 12-month horizon in the recent past. The Enhanced Income Fund is designed to sit between a standard bond fund and pure cash in terms of risk and, in all our analysis of historic scenarios including the most recent financial crisis, a fund structured in this way would never have suffered a capital draw down.
Outlook With cash rates now at 6% and a prospect of them falling further, the prospective returns from money market funds are likely to remain very subdued. At the same time, bond yields have also fallen sharply in the past year and, in our view, are now in expensive territory. As a result, we have been focusing on adding additional yield from buying non-government bonds but, where these have been longer dated in nature, have sought to remove the risk that bonds move back to a less expensive position. We remain reasonably positive on property, where strong income growth is assisting returns and we are content to maintain a modest exposure to international bonds given the level of the rand. Over the next 12 months, it will be tough to generate the double-digit returns seen in the past year. Returns in most plausible scenarios going forward will be lower, but through asset allocation and the selection of higher yielding securities, a high single-digit return appears currently feasible, which will once again compare well against cash alone.
Roshen Harry joined Prudential Portfolio Managers in 2006 as a credit analyst in the Fixed Income team. He has been managing the Money Market Fund since mid-2007. He has B Comm from Rhodes, a diploma in Accounting CA (SA) and a CFA.
A flash of brilliance… A magical moment… A glimpse of talent… Being world champion is none of these things. History doesn’t remember the once-offs. Instead we recognise those who do it again and again, who consider every angle and calculate every movement. Consistently proving that they are a deserving champion. A bit like our Prudential Equity Fund – the top performing fund over the last 8 years*. Evidence that it too, is also destined for greatness. *Rated the top performing fund by Morningstar under the Domestic General Equity Sector for the period ending 30/09/2010.
All things considered. For more information, please ask your financial adviser, or visit www.prudential.co.za Prudential Portfolio Managers is an authorised Discretionary Financial Services Provider in terms of the FAIS Act, 2002. Collective Investment Schemes in Securities (CIS) are generally medium- to longterm investments. The value of participatory interests may go down as well as up and past performance is not necessarily a guide to the future. CIS are traded at ruling prices and can engage in borrowing and scrip lending. A schedule of fees and charges and maximum commissions is available on request from the company/scheme. Commission and incentives may be paid and if so, would be included in the overall costs. Forward pricing is used. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. In calculating performance figures initial charges are not taken into account (ie. NAV – NAV). Annual service charges are deducted in all calculations. Dividends are reinvested on the reinvestment date at the reinvestment price.
Making sense of governance, responsible investing and socially conscious investing What is the difference between governance, responsible investing and socially responsible or socially conscious investing? Kerry Horsley, Head of Risk and Compliance at Prudential Portfolio Managers, explains.
36 consider this Summer 2010
T
he dialogue about governance matters drifts into areas like fairness, access to information, truthfulness, equivalency, rights, duties and altruism. These sound like the Constitutional values such as openness, transparency and accountability that we expect as citizens of a democratic country. But there are, indeed, parallels and these values apply to the private commercial sector just as they apply to the public sector, no matter how aspirational, unrealistic or impractical they may seem. In the introduction to the King III Code on Governance (“the King III Code”), reference is even made to “The new constitution of commerce”1.
Governance is about transparency, accountability and improved reporting within and by companies The King III Code encourages companies to focus on the following three critical issues on which the sustainability of a company is seen to depend:
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1 corporate governance and therefore their structure and forums. 2 Their contribution to social issues. 3 Their impact on the environment. as investors, we have become familiar with discussions about governance in the companies that we work for, invest in, buy products from and live near. We may even have welcomed the push for increased openness, transparency and accountability from the people entrusted with the management of these companies. We hope that the benefits of improved governance will outweigh the administrative cost and burden of change.
images: corbisimages
Self-certified compliance no longer applies because King III is about principle-based disclosure Previously, a self-certification from companies about their level of compliance with whichever governance code applied at the time may have given individual investors in the financial markets increased confidence about their investment decisions and about the safety
of their investment. investors may also have gained a sense of comfort that they were as much “in the know” as anyone else; and they were making an informed decision to invest in a company based on comparable information. With King iii, compliance with a code of governance is no longer a yes or no question before an investor can get on with the real work of analysing the financial ratios. The King iii code has specifically discouraged companies from providing a simple self-certification in their annual reports. it has, instead, encouraged them to: • provide comprehensive disclosure on internal practices and levels of compliance with the code’s principles; • quantify this information; and • make it specific to the company’s current and expected financial position. The qualitative nature and nonstandardised presentation of quantitative information for each company makes this difficult and time-consuming to compare and analyse.
Responsible investing encourages institutional investors to drive longer term, sustainable economic activity in september 2010, a draft code for responsible investing by institutional investors in south africa (“the responsible investing code”) was published for public comment2. recognising that the King iii code is not enforced or enforceable by anyone other than investors, this responsible investing code is aimed at institutional investors and encourages them to use their position to promote higher standards of governance in companies, including: • corporate governance; and • environmental and social issues. it is easy to confuse the concept of responsible investing with investing according to a set of personal beliefs or convictions that influence how you wish to invest your money. The two issues are distinct and we should be careful to consider them separately. The underlying principle for a code to
summer 2010 consider this 37
encourage responsible investing is that it should drive longer term, sustainable economic activity in South Africa so that all current and future generations of investors, customers and communities will benefit. The theory is that investors will find economic value in sustainable, well-governed, and responsible corporate citizens. The Responsible Investing Code encourages institutional investors to: 1 Incorporate environment, social and corporate governance considerations into their investment processes. 2 Demonstrate their approach to ownership and shareholder activism. 3 Collaborate with other shareholders, where appropriate and lawful, on the principles of the Code. 4 Be transparent about implementing the Code. A common theme in the principles is that institutional investors should document and publish their policies about how they apply the principles. The draft Responsible Investing Code suggests that institutional investors should publish their policies quarterly. As the policies themselves are unlikely to change quarterly, this provision may simply mean that the levels of compliance with the policy should be published quarterly.
The Responsible Investing Code applies to asset owners not asset managers It may be useful to clarify that the Responsible Investing Code, when referring to institutional investors, means the asset owner and not the asset manager. In some instances, the retirement fund, medical scheme, collective investment scheme, or other institutional asset owner will actively manage its own investments and will be able to incorporate these principles
xx consider this Summer 2010
without an intervening asset manager. In most instances though, institutional asset owners do have appointed asset managers to give effect to the principles on behalf of the asset owners and their beneficiaries.
Asset owners should therefore be clear and specific on how they wish asset managers to apply responsible investing How this plays out will vary depending on the asset owner and the asset manager. It should be borne in mind though that a number of asset managers do not run individual investment processes per client. Within the constraints of a specific investment mandate, many asset managers apply a consistent investment philosophy and strategy across clients. What this means practically is that asset owners should consider being very specific about how they would want their asset manager to apply responsible investing obligations or allow their asset manager’s guidelines and policies to apply. If each asset owner were to draft or adopt a broad set of non-specific principles for their asset manager to apply,
they could become areas of contention, disagreement, and additional cost.
Socially conscious investing varies from person to person Our social conscience, by its very nature, differs from person to person. How we factor that conscience into our personal hierarchy of priorities differs from person to person. When we are able to determine our own investment strategy, we can act on our social conscience when we invest. This is feasible in some unitised funds such as unit trusts, as long as there are enough like-minded individuals to make a fund that has a specific mandate and clearly defined restrictions viable and sustainable. Institutional investors, on the other hand, face a more challenging task when the beneficial owners of the assets have a diverse and varied set of convictions with distinct personal priorities. But it is not impossible for beneficial owners to agree on a collective position on which the investment manager can act. It isn’t easy to hold other people accountable for giving effect to our personal convictions and beliefs. It is, therefore, most useful for the beneficiaries
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to respond to the code. This will be influenced by their sector, maturity, specific context and business strategy. A core aspect of the King III Code is that companies cannot and should not approach governance as a finite set of compliance rules. They should rather see this as a way to add value to all internal and external stakeholders. We believe that the skill with which different companies will manage the competing and sometimes conflicting interests of the various internal and external stakeholders will have a positive impact on its sustainability and its attractiveness to investors. of an asset such as a retirement fund to agree on a collective position regarding their socially conscious investment strategy before making any investments. This can be complex because of the diverse and multi-jurisdictional structure of most modern listed companies. However, it is better than trying to challenge an existing shareholding after investing. The Prudential position on governance, responsible and socially conscious investing
Prudential Portfolio Managers welcomes the publication of the King III Code on Governance We support the drive towards greater transparency and improved company reporting. We also strongly support a principle-based approach that allows companies to determine the best way
We have not approached governance in the companies we invest in on a quantitative basis Nor have we attempted to analyse and rate companies based on their levels of compliance against local or domestic governance codes. We continue to analyse companies based on our prudent value investment philosophy. Our investment decision making necessarily takes into account the prospects of the company and the reasons for the company either being under- or overvalued. This requires a substantive view of the sustainability of the company. We expect the respective company management teams to: • understand and manage their risks and, therefore, minimise profit “shocks”; • communicate the true financial position and reasonable future prospects of their company;
• balance the need to attract and retain talent to add value for stakeholders rather than to dilute it; and • manage their product manufacturing and distribution processes in a way that maximises long-term brand, goodwill and reputation; and • minimise negative environmental impact. We have not, however, reduced this to a quantifiable element of our investment decision-making process. It is our current view that these factors are better suited to the subjective element of investment decision making.
We do consider ourselves an active and responsible institutional investor We exercise the voting rights of the shareowners or beneficial shareholders to enhance governance in the company and ensure value in the portfolios under our management. These voting records are available to our clients. Our engagement with companies on issues of corporate governance has unlocked value for shareholders. While we consider the nature of the products produced by companies, their manufacturing processes and commitment to human resources, this consideration is limited to whether the company is properly managing any reputational or financial risks. We do not apply personal judgments when we decide where to invest. sources: 1 King III code of Governance, Introduction, 2009, p8 at www.iodsa.co.za 2 At www.iodsa.co.za
Kerry Horsley was appointed as the Head of Risk and Compliance in February 2010. Kerry joined Prudential from the Old Mutual Investment Group where she was the Head of Compliance. She was responsible for regulatory compliance and reputational risk management for the full suite of investment companies within the cluster. Prior to that, Kerry worked at Old Mutual as a legal advisor to the institutional business and as an account executive where she consulted on benefit structuring and administration to a number of retirement funds.
summer 2010 consider this xx
The human investor: foibles, forecasts and flights of fancy
image: corbisimages
David Knee, Head of Tactical asset allocation at Prudential Portfolio managers, asks where individuals should look for “expertise” when making investment decisions.
it is very easy to be swayed by the market when a share that you own goes down by 20%. it challenges you rationally and emotionally. in this article, we explore how easy it is to misunderstand the odds of events happening and how frequently we make errors of judgement when we make investment decisions. We pose questions about whether it is possible to have more expertise, more intellect and more insight than any number of other professionals. asset managers routinely make such claims and we question the credibility of such an approach. We also propose some ways of guarding against being drawn into emotive decision-making and the endless and ultimately futile search for the rock-star status “expert”, who says that they know what tomorrow will bring in the markets.
40 consider this Summer 2010
How do investment managers claim an edge? as investment managers, we frequently face questions about what markets will be doing in the future. This is rarely the far future, but rather the next three or six months. saying you do not know does not sound very credible. in fact, it sounds rather lame, but the weight of evidence shows that it is probably true. Not simply that we don’t know, but nobody knows because the future is subject to too many knocks and bumps to allow anyone to consistently plot the path from here. in “guessing”, you may be right, but if it was only a guess, we can’t rely on this to claim an investment edge. correctly predicting that a coin will toss 21 heads in a row – a chance of one in two million – can only be luck, not unlike
the fact that someone somewhere will win the lottery even though the odds of winning are millions to one. This isn’t skill, and neither are some results that asset managers seek to claim. so, if we are able to admit that our ability to forecast the future is inherently limited, is it possible to then outperform in a market where there are millions of investors, all of whom bring the weight of their experience, knowledge and human capital to bear on the market? in other words, what edge can investment managers really claim?
Do some managers have more expertise, intellect and insight than others? some common responses to the challenge of defining and developing an
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Domestic General Equity Sector vs Shareholder Weighted Index (TR): 7 years ending October 2010 Domestic general equity sector vs Shareholder weighted index (TR): 7 yrs end 8/10
500.0000
500
449.8163
Prudential Equity A
450 399.6325
400 Cumulative performance
349.4488
350
299.2650
SWIX
300
249.0813
250
198.8975
200
148.7138 150
31 Oct 2003 Aug-03 31 Dec 2003 Nov-03 29 Feb 2004 30 Apr 2004 Feb-04 30 Jun 2004 May-04 31 Aug 2004 Aug-04 31 Oct 2004 31 Dec 2004 Nov-04 28 Feb 2005 Feb-05 30 Apr 2005 30 Jun 2005 May-05 31 Aug 2005 Aug-05 31 Oct 2005 31 Dec 2005 Nov-05 28 Feb 2006 Feb-06 30 Apr 2006 30 Jun 2006 May-06 31 Aug 2006 Aug-06 31 Oct 2006 31 Dec 2006 Nov-06 28 Feb 2007 Feb-07 30 Apr 2007 May-07 30 Jun 2007 31 Aug 2007 Aug-07 31 Oct 2007 Nov-07 31 Dec 2007 29 Feb 2008 Feb-08 30 Apr 2008 May-08 30 Jun 2008 31 Aug 2008 Aug-08 31 Oct 2008 Nov-08 31 Dec 2008 28 Feb 2009 Feb-09 30 Apr 2009 May-09 30 Jun 2009 31 Aug 2009 Aug-09 31 Oct 2009 Nov-09 31 Dec 2009 Feb-10 28 Feb 2010 30 Apr 2010 May-10 30 Jun 2010 Aug-10 31 Aug 2010 31 Oct 2010
100 98.5300
investment edge would be to: 1 forecast economic indicators, asset prices and returns, and therein claim you can do this better than others; 2 use skills, techniques or research that others do not have, a claim, for example, that you have more economists, more analysts, better models, more brain power, all of which boils down to suggesting that you are “smarter” than the market in some way; and 3 get opinions from an expert, perhaps a single “insightful” individual, a think tank, a research house. For example, to have Alan Greenspan, former Chairman of the US Federal Reserve, as a consultant to your asset management firm might imply some special “inside” insight is available to you that is not more broadly available in the market. As with the
second claim, in this case the notion is that you are receiving input from someone who is smarter than the market, even if they don’t actually work for the firm.
The facts show that it is very difficult to demonstrate a consistent investment edge over time For all the claims that asset managers make about their edge, does this stand up to scrutiny when we look back through time? Let us examine the last seven years of returns in the domestic general equity sector in South Africa, representing a longer time period over which investment edge might manifest itself. As we see in the chart above, the grey lines are all the unit trust funds that
have existed in the sector for the last seven years and the black line is the SWIX equity benchmark that we believe is most widely followed in this sector. The red line is our own performance, but the real point of the chart, aside from blowing our own trumpet, is to show that despite the great stories that every manager will tell you about their true differentiator, their edge and their unique process, that unfortunately, en masse, they haven’t actually delivered. This is not unique to South Africa. Studies globally show that active managers as a group find it hard to beat their benchmarks, a fact that has allowed the passive fund management market to expand enormously. Based on this evidence, we know that it is actually very difficult to demonstrate a
summer 2010 consider this 41
consistent investment edge over time. And on a year-to-year basis, in the main, we have a random draw of managers who do well and those who don’t, but few do consistently well. So if, in spite of all the investment experts applying their experience and intellectual capital all day (and, in some cases, all night), they are unable to consistently outperform – what chance do individual investors stand, and what is the problem?
The main problem is what makes us human We believe the main reason that it is so difficult to gain an investment edge is the fact that we are human beings and not machines. Human decisionmaking involves personal judgments and emotions. We just can’t help being drawn in. We hate losing money, we rush into things, we look back at events with the benefit of hindsight, we regret the decisions that lost us money, and we waste endless hours cursing the fish that got away. It is all part of being a human investor. It’s not that a mechanical, “machine”based process is the solution either. Economies and markets are dynamic: structures change and political landscapes evolve. As human beings, we are able to take account of such things in a way that a machine might not. Stories of automated trading models going haywire are common. LTCM, the failed US hedge fund, had some of the most complex quantitative computer models in the market and for three years they delivered stunning investment returns but, in the end, they didn’t prevent it blowing up. That said, we do believe that part of the solution to the judgment errors we make as human beings is to develop a framework for valuing assets, which assists in minimising the mistakes.
When it comes to investor confidence versus accuracy, beware! In an academic study, researchers in the US assembled a group of students and a group of investment professionals,
xx consider this Summer 2010
All jazz players
Accountants who play jazz
Probability of being a jazz player must be greater than probability of being a jazz-playing accountant. More detail can make an event seem more plausible when in fact it makes it less so! SOURCE: TVERSKY AND KAHNEMAN (1982)
gave them each month two blue-chip companies and asked each group to forecast which company would outperform over a specific period, as well as asking how confident they were in their forecast. Results showed that the students got about half their calls right. There was no discernible relationship between the proportion they got right and their confidence in their view. The investment professionals, sadly, did a whole lot worse – not only were they right less than half the time, doing worse than pure luck, but the more confident they were, the worse they did. Overconfidence is a key problem. Perhaps the more confident investment managers are, the more confident you should be of ignoring their views. “I do not know” starts to look like an answer we might like to hear more often.
More detail can make something more credible and plausible Markets present us with a vast quantity of information: second-by-second stock prices, swathes of macroeconomic indicators, not to mention the constant stream of publications and opinions from politicians, civil servants, and independent experts. At first glance, the ability to assimilate all of this information might provide a substantial investment edge. However, there is strong evidence that more detail may actually make decisionmaking less robust (and, although not
dealt with in this piece, allow one to subconsciously choose the data that “confirms” our prior prejudices and views). How might this happen? Consider the following example: please take a moment to rank the following statements in order of probability, based on the information provided about Bill. “Bill is 34 years old. He is intelligent, but unimaginative, compulsive and generally lifeless. In school, he was good at maths but weak in social studies.” A: Bill is an accountant B: Bill plays jazz for a hobby C: Bill is an accountant and plays jazz for a hobby The most popular choice for the most probable statement about Bill is A: he’s an accountant. However, next up, most people choose C, as they have already decided Bill is an accountant and therefore, if he plays jazz, he must be a jazz-playing accountant. They forget that Bill might not be an accountant. Thinking about it for a moment, we know there are many more jazz players than people who are jazz players and who are also accountants. The additional information in C against B actually provoked an error of judgment in terms of the probabilities of these two outcomes.
The probability of being a jazz player must be greater than the probability of being a jazz-playing accountant Similarly, even professional investors misunderstand the odds because they have too much information and more information isn’t necessarily better information. We often make judgments about markets where we are misunderstanding the odds. For example, be very wary of jumping on market trends when you have no rational reason to suspect that the next observation will follow the trend, except that the previous observations have done so.
What about following the experts? As one example, the world’s most respected central banker, Alan Greenspan, shows us that even
wisdom
Average forecast error for US GDP/CPI 1991 – 2000 experts get it wrong. In June 1999, Greenspan was asked if he could detect a stockmarket bubble and he replied, “Bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best.” While we admire Greenspan’s honesty in saying that he couldn’t necessarily call the market, it is odd that the market hung on his every comment. Indeed, six months after Greenspan made his observation, the NASDAQ, the US equity index for technology stocks, which had gone up in the three years prior to June ’99 by 300%, peaked and then promptly dropped by 80%. It is easy for us to attribute soothsayertype abilities to so-called experts when we are looking to hang our investment hat on something. Somehow, we want to believe they have insight that we do not by virtue of their position, connections or resources. In fact, there is no reason to expect so-called experts to have any more insight into the future than you or I. We can see this clearly when we consider the accuracy of economists’ forecasts.
Can economists forecast accurately? In seeking to answer this question, the Central Bank of Sweden took a look at the forecasts for GDP and CPI of 40 US economists over a decade, including the big investment banks, the OECD and others who have substantial resources in this area. How did they do? Generally not well, as the Average Forecast error for US Gross Domestic Product (GDP) and Consumer Price Inflation (CPI) for 1991 to 2000 illustrates. Not only were there substantial forecast errors but, it is also evident that the errors were also consistently in one direction across all forecasters – they forecast inflation to be higher and GDP lower than was the
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Note: This diagram is based on the mPe for forecasts made in January for the current year. For unbiased forecasts, the mPe should be close to zero. source: central Bank of sweden, consensus Forecasts
case. This illustrates our second point – that forecasters are influenced by other forecasts. In the same study, analysis of how forecasters changed their forecast relative to how the average forecast had changed shows persistently high correlations. Therefore, not only are they wrong, but we shouldn’t regard them as independent either.
So what can we do about this? At Prudential Portfolio Managers, the starting point is to step back and think about the medium-term valuation. We believe investment edge has a lot more to do with discipline, patience, consistency and humility rather than forecasts, expert opinion and hubris.
We buy assets when they are priced cheaply and offer a risk premium – and take a medium to long-term view Since we have little knowledge about what will happen to an asset in the next three, six or even 12 months, we try to take a longer term view based on valuations. This is easy to say but hard to do because, like everyone else, we get excited when markets go up or down a
lot over short periods. What is needed are tools to assess longer term value and to use these in a rigorous, consistent and disciplined manner. Alongside this, we recognise that sometimes we have to wait for the gravity that this longer term valuation has on markets to affect current prices. Following the collapse of Lehmans, no-one wanted to buy despite the fact that, unless the end of the world was nigh, the market was cheap. It took six months before the market even started to recover. Our process looks to take advantage of such events. In conclusion, as human beings we face significant psychological hurdles to make good decisions. Any investment process based on views of the future is likely to be flawed. Ignore experts, prophets and, dare we say it, economists. An investment edge is hard to claim, even for the vast majority of professional money managers. Rather, entrust your money to an investment manager who focuses on consistently buying assets where the odds are on your side – where mediumterm valuations are attractive – and be prepared to wait. Remember, hoping that you are right is NOT an investment strategy.
David Knee joined Prudential Portfolio Managers SA as Head of Fixed Income in January 2009 and took on the role of Head of TAA in January 2010. David worked for the previous 12 years in the fixed income team at M&G in London, having spent the prior seven years as portfolio manager at another London asset manager and as a fixed income economist for an investment bank.
summer 2010 consider this xx
8
years of hard work years of amazing potential years of brilliance And it was only the beginning At the age of 8 the current world champion won his very first tournament and the sky became the limit. A bit like our Prudential Equity Fund – the top performing fund over the last 8 years* – and a fund which we feel is also destined for greatness. *Rated the top performing fund by Morningstar under the Domestic General Equity Sector for the period ending 30/09/2010.
All things considered. For more information, please ask your financial adviser, or visit www.prudential.co.za Prudential Portfolio Managers is an authorised Discretionary Financial Services Provider in terms of the FAIS Act, 2002. Collective Investment Schemes in Securities (CIS) are generally medium- to longterm investments. The value of participatory interests may go down as well as up and past performance is not necessarily a guide to the future. CIS are traded at ruling prices and can engage in borrowing and scrip lending. A schedule of fees and charges and maximum commissions is available on request from the company/scheme. Commission and incentives may be paid and if so, would be included in the overall costs. Forward pricing is used. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. In calculating performance figures initial charges are not taken into account (ie. NAV – NAV). Annual service charges are deducted in all calculations. Dividends are reinvested on the reinvestment date at the reinvestment price.