Fund investors are often guilty of putting too fine a focus on relative returns, without considering the embedded and disparate risks between funds. Investing is a long-term pursuit that requires perspective and a broader grasp of all of the factors that contribute to growth in value over time. Returns are only one part of the equation – risk is an equally important aspect and one that many investors think about less, particularly when markets are rising. But a single big loss from misunderstanding the true risk in an investment can easily wipe out years of steady growth.
Financial planners play an important role in finding the appropriate balance between the client’s required return and their risk appetite over a given time-frame. Discretionary fund managers (DFMs) then face the unenviable task of analysing and understanding the asset managers’ modus operandi and their vast array of funds, to identify which ones are most likely to deliver the best risk-adjusted returns.
A focus on returns tells you very little about the quality of investment performance
Experienced investors understand that absolute performance is just a small piece of the puzzle. Ignoring risk-adjusted returns misses two important points:
1. Top quartile returns are not necessarily the best on a risk-adjusted basis.
2. Performance below the top quartile does not equate to poor risk-adjusted returns.
Analysing the Sharpe ratio1 for the five-year returns of unit trusts across all sectors (excluding sectors with less than ten funds) yields the following results. 108 out of 809 funds (the red dots in Chart 4 that follows) performed in the top quartile in their sector, yet failed to rank in the top quartile in terms of risk-adjusted returns. 105 funds (the dark blue dots) delivered top quartile risk-adjusted returns, but did not make the top quartile on an absolute basis in their sector. Failing to take risk into account can therefore lead to false assumptions on the quality of returns for more than 25% (213 out of 809) of the market. It is pleasing to note that the Northstar SCI* Income Fund delivered top quartile risk-adjusted returns despite reduced exposure to low volatility credit rich floating rate notes.
Chart 4: Unit trust returns vs standard deviation (primary classes)
Source: Morningstar & Northstar AM (5 years to 31 Aug 2021)
It is true that standard deviation is only one measure of risk (i.e. volatility of returns). Ideally this exercise should therefore be carried out for other types of risk affecting funds, such as credit risk, sovereign risk and liquidity risk, as well as for softer issues like investment style, portfolio manager succession planning, incentive structures etc. For example, there is a large concentration of “low risk” income funds that have concentrated positions in low quality credit, which for the most part has delivered very high returns at a very low standard deviation. Since the high level of potential capital losses embedded in these funds is not captured in price volatility, they currently rank extremely well in terms of Sharpe ratio.
A further point is that not all fund sectors allow managers to diversify across asset classes to reduce risk or adjust their holdings when prospects dim. This means that if a financial advisor put their client into, for example, a unit trust in the SA Equity General sector, they would have seen very weak risk-adjusted returns purely on the basis of poor equity market returns over the last five years. Having a strong understanding of the underlying dynamics driving risk-adjusted returns is imperative to making the correct fund choice, as opposed to relying solely on relative ranking tables.
Northstar SCI Income Fund: enhancing returns and reducing risk
In managing the Northstar SCI Income Fund, we constantly strive to optimise portfolio holdings and asset allocations to ensure the best possible risk-adjusted returns over time. The Fund is currently meeting this objective with a three-year Sharpe ratio of 0.95 and a standard deviation of 2.82%, below our target of 3% . In addition the portfolio has a high liquidity profile and low credit risk given the 24% holding in government bonds, 57% senior bank paper, 4% foreign currency and 9% gold holdings, with the balance of 6% in lower liquidity subordinated second tier paper.
Although the price of gold is relatively volatile, its attractive qualities of durability, divisibility and relatively limited supply have made it an excellent store of value over time, specifically in real terms. Chart 5 shows that the rand price of gold appreciated at a real rate of 5.9% a year over the 41 years from 1970 to 2011, in line with the global equity market (MSCI World index), despite gold not paying any dividends or generating earnings.
Chart 5: Real gold price vs MSCI World total return index (real return indexed to 100 in rands)
Source: INet Bridge (as at 31 Jul 2021)
As global money supply has increased, fixed assets such as land and gold have grown in value as more money becomes available to buy a relatively fixed supply of these durable assets.
Chart 6 shows the growth in US M2 money supply and annualised growth over time, which has averaged above 5% a year and recently hit 25% as a result of the additional stimulus since the start of Covid-19.
Chart 6: US M2 money supply and annual growth (%)
Source: Federal reserve & Northstar AM (as at 30 April 2021)
Chart 7 shows the gold price against the theoretical price for gold if US gold reserves were priced to match the amount of US currency in circulation. At present, the US holds 8,133 tons of gold in reserves. With just over $2.1 billion of US currency in circulation, this implies that the 262 million ounces (8,133 tons x 32,151 ounces per ton) of US gold reserves would need to be priced at $8,100/ounce to reach fair value, compared to the current price of $1 729.
Chart 7: US Gold reserves, gold price and fair value gold price
Source: Federal Reserve, INet Bridge & Northstar AM (as at 31 Aug 2021)
Historically, gold has traded below this theoretical fair value and is currently trading at the 10th percentile of its range. In the context of the ongoing expansion in money supply, gold appears to be attractively priced and increasingly undervalued.
Increased diversity in undervalued assets supports continued strong risk-adjust returns
The recent addition of gold to the Fund’s holdings therefore aligns with our focus on risk-adjusted returns by providing further diversification in an asset at a historically attractive valuation. We believe that this positions the Fund well to continue outperforming its benchmark and generating real returns for investors at very low risk.