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How to deliver superior returns in difficult markets

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How to deliver superior returns in difficult markets

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How to deliver superior returns in difficult markets


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“To achieve real, robust returns, it is important to build efficient portfolios that contain a combination of more aggressive stock-selection strategies, balanced with index tracking strategies. It is only the ratios that differ…” says Patrice Rassou, Head of Equities at Sanlam Investment Management

As we pass the halfway mark of yet another turbulent year, we reflect on the generally poor returns across local asset classes and increasingly correlated markets. Currently, markets are delivering below inflation returns and asset owners are not sufficiently rewarded with a premium for taking on additional risk. In light of this, we attempt to address the ongoing challenge carried by trustees and principal officers.

As a fiduciary, how can you build optimised portfolios and generate strong risk-adjusted returns for your retirement funds, in tricky market environments? How do we find returns that are less correlated with more benchmark-cognisant funds, without taking excessive risk?

Says Rassou, we need to look at how we can use smarter portfolio construction techniques to eke out positive (real) returns for clients in tricky markets. The underlying rationale for our solution is premised on cross-sectional volatility (CSV); considered a good indicator of the potential outperformance of markets for active managers to exploit.

What is cross-sectional volatility?

Explains Rassou, unlike a measure such as the VIX (fear) index, which measures the volatility of an entire index (S&P), cross-sectional volatility (CSV) measures the difference in volatility between stocks in an index. This more granular approach allows for a better understanding of the variability of (or dispersion between) individual stock returns and an active manager’s true skill.

The basic argument is that as CSV rises, the likelihood of outperformance of the market and other active managers increases, because the variance between the best and worst-performing shares is great, which should be beneficial to a discerning stock-picker.  However, in an environment of low cross-sectional volatility, the likelihood of outperformance falls, making it much harder to beat other active managers (and the market). In this instance we should have a bias for a simple indexation (market tracking) strategy.

In the chart below, we show a retrospective view of several cycles from 2008 to 2017. It illustrates the relative over and under-performance of a superior stock picker’s strategy (using the Sanlam Investment Management (SIM) Top Choice Equity Fund as an example) over the past ten years during times of high and low dispersion of returns (or high and low CSV).

Figure 1: Correlation between high CSV and outperformance through a stock-pickers strategy


Let’s reflect on the cycles illustrated in the graph above.

Global financial crisis (Cycle 1)

Immediately after the Global Financial Crisis, the market dislocation that followed allowed discerning stock picking managers to pick up quality stocks that were sold off indiscriminately, resulting in massive outperformance in the second half of 2008 (refer Cycle 1: 2008 – 2010 in graph above).

But as central banks around the world started pumping liquidity into financial markets and equities recovered at the start of 2009, dispersion in returns fell – which meant that all stocks started recovering irrespective of the underlying fundamentals of the companies (i.e. correlated markets). This decline in volatility made it more difficult for a stock picking fund to differentiate itself.

Taper tantrum (Cycle 2)

As can be seen over the 2011/2013 cycle, the volatility of stocks started rising again. This was due to the risk of Greece exiting the European Union, which shook financial markets globally, and a series of ‘taper tantrums’ leading to further dislocations in financial markets as investors started to worry about when the aggressive printing of money by central banks would start winding down. In this environment of rising volatility, stock picking funds such as the SIM Top Choice Equity Fund were able to deliver strong alpha.

Lower cross sectional volatility (Cycle 3)

As we entered 2014 and through to 2017, volatility once again flattened out as it became clear that the EU would survive in its present shape and the market was reassured that liquidity would remain plentiful globally.  As the dispersion of stock returns declined, so the opportunities to deliver alpha declined and it became more difficult to beat the market, although some outperformance was evident.

How to build efficient portfolios in the current environment

Now, we could potentially be entering a new cycle of either rising or falling dispersion in stock returns. In the absence of a crystal ball as to what the next cycle will hold, we propose a simulation exercise to capture two potential scenarios.

Says Rassou, we need a balanced approach that will include the optimal combination of (higher risk) stock-picking strategies to deliver outperformance, and (lower risk) index-tracking strategies that will produce market-like returns. The quantum and ratio of each will vary dynamically depending on how conducive markets are.

Simulation exercise to achieve outperformance

Extrapolating the lessons learned above, one would need to switch dynamically between two possible strategies depending on market conditions and dispersion of returns (outlined below).

Scenario One: Rising dispersion of stock returns (high cross-sectional volatility)

Let’s assume a scenario where the rate of dispersion in returns is high or rising.  In this scenario we consider it to be a stock-pickers paradise, and one should therefore show a bias for a more aggressively-concentrated stock-picking strategy, with a lesser allocation to indexation components. This way, investors can extract superior results by exposing themselves to the alpha-generating capability of a stock-concentrated portfolio, while also lowering costs and volatility. For the purposes of this exercise, we use the SIM Top Choice Equity Fund to represent an aggressively-concentrated stock picking fund.

Proposed tactical solution: Blend SIM Top Choice Equity Fund (75%) with an index fund (25%)

Scenario Two: Declining dispersion of stock returns (low cross-sectional volatility)

Assuming an environment of declining stock dispersion, here you would reduce your relative exposure to an aggressively concentrated fund and increase your exposure to a cheaper indexation strategy. A slightly more diluted tactical blend would then apply.

Proposed tactical solution: Blend SIM Top Choice Equity Fund (50%) with an index fund (50%)

As can be seen from the chart below, blending the SIM Top Choice Equity Fund as per the scenarios above reduces the volatility of the blended fund well below that of the market, while still outperforming the market handsomely. In addition, a blend with an index fund would also reduce the cost of the blend, paying a lower cost for beta when dispersion in stock returns is low and only paying for performance when alpha is delivered in high dispersion environments.


Source: Sanlam Investment Management, July 2017


To build optimised portfolios and ensure robust returns, a balanced approach is required. An aggressive stock-picking strategy  can be optimally combined with a simple index fund to extract superior results by exposing an investor to the fund’s superior alpha-generating capability when the market is more conducive (ie when CSV is high and rising). Similarly, when CSV (the rate of change of dispersion) is falling, one would reduce exposure to a stock-picking strategy and increase exposure to a cheaper index fund.

The advantage of including an index fund in the blend is that it reduces both the volatility and cost of the blend, paying a lower cost for beta when dispersion in stock returns is low and only paying for performance when alpha is delivered in high dispersion environments.

An aggressive stock-picking capability such as SIM Top Choice Equity Fund is made up of the best ideas of the equity portfolio managers at SIM. Now, as central banks are poised to raise rates, could dispersion of stocks rise again? If so, this could see the fund well poised to capture more of the alpha opportunities as they arise in future.

Mandatory disclosure

All information and opinions provided are of a general nature and are not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information or opinion without appropriate advice after a thorough examination of a particular situation. We endeavor to provide accurate and timely information but make no representation or warranty, express or implied, with respect to the correctness, accuracy or completeness of the information or opinions. Any representation or opinion is provided for information purposes only. Unit trusts are generally medium to long-term investments. Past performance of the investment in no guarantee of future returns. Unit trusts are traded at a ruling price and can engage in borrowing and scrip lending. Sanlam Investments consists of the following authorised Financial Services Providers: Sanlam Investment Management (Pty) Ltd (“SIM”), Sanlam Multi Manager International (Pty) Ltd (“SMMI”), Satrix Managers (RF) (Pty) Ltd, Graviton Wealth Management (Pty) Ltd (“GWM”), Graviton Financial Partners (Pty) Ltd (“GFP”), Radius Administrative Services (Pty) Ltd (“Radius”), Blue Ink Investments (Pty) Ltd (“Blue Ink”), Sanlam Capital Markets (Pty) Ltd (“SCM”), Sanlam Private Wealth (Pty) Ltd (“SPW”) and Sanlam Employee Benefits (Pty) Ltd (“SEB”), a division of Sanlam Life Insurance Limited; and has the following approved Management Companies under the Collective Investment Schemes Control Act: Sanlam Collective Investments (RF) (Pty) Ltd (“SCI”) and Satrix Managers (RF) (Pty) Ltd (“Satrix”). Although all reasonable steps have been taken to ensure the information in this document is accurate, Sanlam Collective Investments (RF) (Pty) Ltd (“Sanlam Collective Investments”) does 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 to follow does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Use or rely on this information at your own risk. Independent professional financial advice should always be sought before making an investment decision. Sanlam Group is a full member of the Association for Savings and Investment SA (ASISA). Collective investment schemes are generally medium- to long-term investments. Please note that past performances are not necessarily an accurate determination of future performances, and that the value of investments may go down as well as up. A schedule of fees and charges and maximum commissions is available from the Manager, Sanlam Collective Investments, and a registered and approved Manager in Collective Investment Schemes in Securities. The maximum fund charges include (including VAT): An initial advice fee of 1.14%;  annual advice fee of 1.14% and annual manager fee of 0.91%. The most recent total expense ratio (TER) is 1.19%. Additional information of the proposed investment, including brochures, application forms and annual or quarterly reports, can be obtained from the Manager, free of charge. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Collective investments are calculated on a net asset value basis, which is the total market value of all assets in the portfolio including any income accruals and less any deductible expenses such as audit fees, brokerage and service fees. Actual investment performance of the portfolio and the investor will differ depending on the initial fees applicable, the actual investment date, and the date of reinvestment of income as well as dividend withholding tax. Forward pricing is used. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The performance of the portfolio depends on the underlying assets and variable market factors. Performance is based on NAV to NAV calculations with income reinvestments done on the ex-div date. Lump sum investment performances are quoted. The portfolio may invest in other unit trust portfolios which levy their own fees, and may result is a higher fee structure for our portfolio. All the portfolio options presented are approved collective investment schemes in terms of Collective Investment Schemes Control Act, No 45 of 2002. International investments or investments in foreign securities could be accompanied by additional risks such as potential constraints on liquidity and repatriation of funds, macroeconomic risk, political risk, foreign exchange risk, tax risk, settlement risk as well as potential limitations on the availability of market information. The Manager has the right to close any portfolios to new investors to manage them more efficiently in accordance with their mandates. The portfolio management of all the portfolios is outsourced to financial services providers authorized in terms of the Financial Advisory and Intermediary Services Act, 2002. Standard Bank of South Africa Ltd is the appointed trustee of the Sanlam Collective Investments Scheme. Income funds derive their income from interest-bearing instruments as defined. The yield is a current yield and is calculated daily.

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