Over the last two decades, the Allan Gray Stable Fund has built a solid track record through dynamic asset allocation, bottom-up stock-picking and mindful risk management. Presenting via Zoom webinar, Duncan Artus and Sean Munsie explain how the Fund is positioned to withstand the current challenges and discuss why they are excited about the return potential from here. Watch the 36-minute recording, and see below for key takeouts from the presentation.
The Allan Gray Stable Fund (the Fund) is 20 years old, having been the pioneer in the low equity space.
The Fund was launched on 1 July 2000, when South African equities had performed dismally in real terms for a long period and experienced two significant market corrections in 1998 and 2002. Investors favoured cash and fixed income investments over equities, which had underperformed over a three-, five- and 10-year period with much higher volatility.
Over the long term, equities have delivered much higher real returns than cash or bonds. To encourage investors to increase their equity exposure, the Fund was designed to produce returns in excess of cash, by allocating a portion of the portfolio to equities, but importantly, still seeking to protect investors from capital loss by holding most of the assets in fixed income.
Adding value through active asset allocation and investment discipline
The exposure to equities was capped at 40%, with the rest of the portfolio invested in fixed income assets. Within these limits, the allocation to equities could vary depending on how many attractively priced shares we could identify at any one point.
When looking at the very long-term returns of a theoretical low equity fund, it appears that a 3% real return can be achieved by holding approximately one-third of the fund in equities, with the remaining exposure in cash and bonds. Of course, this passively constructed strategy will produce periods of higher returns when assets are cheap and rerate to higher levels, which are then typically followed by periods of lower returns. Looking at rolling 10-year real returns from each of the asset classes over long periods of time, it is important to note that fixed income is the asset class that produces the most periods of negative real returns. Key then, is to balance the need for protection with the need to generate real returns, by investing the majority of the assets in fixed income, and a portion in equities.
The above talks to the theoretical returns that can be achieved when constructing the Stable Fund using the available building blocks. Achieving our objective of generating real returns of more than 3%, relies on successful active asset allocation, and generating outperformance on both our equity and fixed income selection.
In hindsight, the launch of the Fund was well timed, as South African equities began a multi-year bull market that produced double-digit real returns. This resulted in much higher returns for the Fund in the years before the global financial crisis (GFC) than we would expect through the cycle.
If we look at the history of the assets making up the portfolio, and which type of market conditions provide tailwinds for the Fund, we find that the ideal scenario would be a combination of high real interest rates and cheap equities. The counter is also true, and there have been periods when investors have had to be patient when faced with low or negative real interest rates and expensive equities. It is in these periods when active asset allocation and investment discipline add value.
Over time we expanded the potential asset classes to include exposure to offshore assets, commodities such as gold, and African assets. These provided more tools to achieve the cash-plus-two return target.
At the end of March 2020, the Fund disappointingly produced its first negative two-year rolling return of -0.2% p.a. Cash was the only asset that did not produce a negative return in rands, as bonds were positively correlated with equities and produced negative returns. The offshore exposure helped cushion some of the downturn as the rand weakened substantially.
In March and April many local assets were trading at very depressed levels and we used the opportunity to purchase both nominal and inflation-linked bonds and selected equities. Assets subsequently rebounded aggressively, and the Fund has returned 10.4% since March versus the benchmark of 1.7%. This has resulted in the two-year return increasing to 2.8% p.a. at the end of July. We believe this provides some supporting evidence to our view that South African equities were not expensive heading into the pandemic.
Today cautious investors are allocating ever-increasing amounts of capital to fixed income, including money market, bond, or income funds. This is an understandable reaction to a five-year period of poor real equity returns and an increasingly uncertain world. This trend is being tested as local real interest rates approach zero and investors must take increasing duration and credit risk to generate the required yield from fixed income assets. We continue to believe that real assets, such as equities, have a place – alongside fixed income – in conservative portfolios as evidenced by history. While the current valuations of local assets are not as low as they were in the early 2000s, we think it is important to consider whether investors find themselves at a similar juncture today.
Why choose the Stable Fund?
So why should risk-averse investors, or those requiring a portfolio from which to draw down income, choose the Stable Fund? We believe it is a combination of factors: Firstly, the ability to invest across asset classes, including equities, within predetermined limits, provides us with the flexibility to both generate real returns and focus on capital preservation. Secondly, the way we manage fixed income in the Fund focuses on both generating income, and capital gains. And finally, our active asset allocation and investment outperformance has added to returns, and reduced volatility over the last 20 years.
As such, we remain excited about the future prospects and believe that the initial premise and the structure of the Fund remain as relevant now as they have been over the last 20 years.