We discuss how the Northstar SCI Income Fund has managed to deliver three-year real returns well ahead of its benchmark and peers, while keeping risk within our parameters. We also touch on how Northstar’s approach helps the Fund to stand out from its peer group and how it is currently positioned.
The Northstar SCI Income Fund aims to provide investors with regular and stable income that beats inflation over the long term, while managing the risk of capital loss in the short term. This presents a challenge familiar to all investors – that of managing the risk/reward trade-off: how to generate consistent inflation-beating returns while keeping risk low.
As managers, we are occupied with maintaining real purchasing power for our clients and target a 2% return above inflation (real return). Over the past three years, the Fund delivered a 7.2% return, a real return of 2.6%, which is comfortably above its benchmark (the STeFI Call Deposit rate x 110%) and ahead of large, well-supported peer income funds, new competitors and the SA Income Fund benchmark return.
Chart 4: Annualised three-year return vs standard deviation
Source: Morningstar, Bloomberg & Northstar Asset Management | Data as at May 2022
This return was achieved while keeping the Fund’s primary risk parameters – standard deviation and modified duration – below their target threshold of 3%. The Fund’s current standard deviation of 2.9% is around 20% of the risk investors are exposed to in the equity market.
Active management and an emphasis on fundamental research
Northstar’s obsession for research includes ongoing monitoring of developments in relevant metrics such as interest rates, inflation and fiscal risk as well as significant time invested in studying how assets behaved at key periods in the past. This includes the degree of correlation between assets so that risk exposure can be further diversified. The output from the research process is used to model the risk of large drawdowns and position the portfolio accordingly.
The Fund’s holdings are primarily through government paper and senior bank bonds – the highest credit quality instruments available in the South African market. These instruments are also highly liquid, meaning that investors can withdraw funds quickly and easily. While lower-quality credit has higher yields, it carries significantly higher credit risk and is less liquid, and major market-moving events can result in significant drawdowns and a far higher probability of default.
The benefits of holding higher quality paper was demonstrated in the Covid crisis, an extreme event during which credit spreads in lower quality Tier 1 credit widened from around 400 basis points to 550 or even 600 basis points, resulting in a drawdown of almost 6%. While higher quality credit was also affected, it was affected to much lesser degree.
Table 1: Performance during the Covid-19 liquidity-related drawdown (mid-March to 30 April 2020)
Source: Iress and Northstar Asset Management I Data as at 30 April 2020
A different approach that makes us stand out from our peers
Northstar’s active management and flexible mandate allows the Fund to adapt to developments in the market, such as changes in the interest rate cycle. Combined with our deep research process, this helps us to unearth opportunities less obvious to others, which means that our portfolio and returns are differentiated from the pack. While peer funds have correlations of 90% and above to the South African Multi-Asset Income index, the Northstar SCI Income Fund has a correlation of 78%, making it an excellent option for diversified portfolios, while delivering above-average returns.
Chart 5: Correlation to the ASISA South Africa Multi-Asset Income index (3yr)
Source: Morningstar | Data as at May 2022
High inflation and low interest rates create a challenging environment for cash
The current high inflation and low interest rates create a challenging environment for generating real returns and money held in cash is currently earning a negative real return.
The yield curve, which maps out the yield and maturities of credit instruments, is markedly steeper now than in previous rising interest rate cycles, when bonds were significantly more expensive. The 10-year point on the yield curve is currently yielding more than 5% above the repo rate.
Our modelling indicates that this steep pitch is discounting future interest rate hikes and pricing in both a sufficient cushion for expected inflation and elevated levels of fiscal risk. The Fund consequently has the majority of its exposure to bonds in the 7 to 15 year space, with yields of 9% to 10.5%, and is holding very little cash or floating rate bonds.
Chart 6: Northstar SCI Income Fund holdings (31 May 2022)
Source: Maitland Fund Services | Data as at May 2022
In addition the fund also holds nearly 9% in gold ETFs, providing additional diversification in an asset that we believe is at a historically attractive valuation.
With inflation spiking and central banks responding slowly from current low interest rates levels, real returns will be harder to achieve from fixed income, while keeping risk within acceptable levels going forward. We remain confident that our active approach and the opportunities in the middle of the yield curve will continue to deliver sound real returns at very low risk, providing investors with security very close to cash but at a return above inflation.