Are low-equity funds relevant in today’s investment universe?

By Martine Damonse, Investment Specialist, Allan Gray

Conventional wisdom suggests that to achieve a better return, one should be willing to take on more risk. But looking at returns across asset classes over the five years to end-December 2022, investors were on a bumpy ride without an obvious reward. It is not surprising that some conservative investors have sought perceived safety and steered away from equity markets to assets with smoother return profiles. 

While equity markets are volatile and can underperform cash and bonds over shorter periods, over the long term, investors have been compensated for this volatility with substantially higher returns. A look at very long-term data reveals that from 1900 to 31 December 2022, South African equities have delivered on average 9.1% above inflation per year, whereas cash has only delivered 1.1% and bonds 2.3%. This suggests that equities play an important role in any multi-asset class portfolio – including those of risk-averse investors who seek long-term real growth, but also need to protect the purchasing power of their investment. 

But how much equity exposure is enough, and how can investors balance the risk-return aspect of their portfolios? A low-equity unit trust that aims to provide inflation-beating returns and protect capital over a two-year period can offer a solution. Let’s use the Allan Gray Stable Fund (the Fund) as an example.

Actively managing asset allocation

The Fund’s allocation to equities, offshore and fixed income is managed from the bottom up.

We have the flexibility to have little to no equities in the Fund in times when we believe that equities are expensive or when other asset classes are trading on more attractive valuations, but we also have the flexibility to increase our net equity exposure to the maximum of 40%, should we find equities attractive relative to other asset classes.

The recent increase in the offshore investment limit allows us to increase offshore exposure up to 45%. While the increased offshore flexibility gives us more levers to pull, we are mindful of the additional volatility offshore exposure brings, including the risk of exchange rate fluctuations. 

Carefully considering equity exposure

Adding equities to a portfolio can increase the volatility of a fund; however, we don’t view volatility as the only risk to mitigate. For us, the most important risk to avoid is permanent loss of capital incurred by overpaying for an asset.

Providing conscious protection against a falling market

We can employ equity market hedging to protect against the risk of markets falling, while maintaining exposure to our selection of shares, which we would expect to outperform the market in such conditions. 

The large weighting towards fixed income (cash and bonds) is a key component of the Fund, as it helps us achieve appropriate diversification and assists in managing volatility. However, it is not without risk; our portfolio managers pay careful attention to the risks attached to the fixed interest instruments, including credit risk, liquidity risk, duration risk and valuation risk.

The Fund’s fixed income is also conservatively managed to protect the Fund against the negative effect that interest rate shocks can have on bonds. Given the percentage allocation to interest-bearing securities, the Fund also produces a reasonable level of income.