South African multi-asset funds have rewarded investors handsomely over the past three years, helped by a rare period in which almost every major asset class produced strong gains, writes Laura Du Preez.
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South African multi-asset funds have rewarded investors handsomely over the past three years, helped by a rare period in which almost every major asset class produced strong gains.
But the returns may have left many multi-asset or balanced fund investors exposed to two dominant drivers: the gold price in local assets and technology, particularly artificial intelligence (AI), in global markets, says Chris Eddy, head of investments at 10X Investments.
Eddy told the recent Meet the Managers conferences in Cape Town and Johannesburg that South African equities returned 70% in total over the past three years to the end of May, global equities as measured by the MSCI World Index returned 49%, local bonds returned 69%, gold rose 90%, and cash delivered 26%.
This delivered great returns for investors in multi-asset funds, but now investors should look beyond past performance and ask what really drove it.
Exposure to the gold price
The average South African multi-asset fund suitable for retirement fund investors has about 45% in local equities and property, and about 15% in bonds, according to the Alexforbes Large Manager Watch. That means a large part of many portfolios is exposed to South African risk assets.
At the start of the three-year period, the rally in South African assets was driven by falling bond yields, a stronger rand and a rerating of local equities as political risks eased after the general election and the formation of the government of national unity (GNU). More recently, however, the driver shifted to gold and precious metals.
Eddy said South African gold and platinum group metal miners now make up a significant portion of the JSE, and the correlation between equity returns and precious metals has increased steadily since the metals rally in 2021 and 2022. As a result, movements in the gold price can have an outsized effect on an index tracking South African equities.
Metals impact on bonds
Gold is also influencing bonds. Higher metal prices support hard-currency exports, which can strengthen the rand and reduce inflation pressure. That, in turn, supports lower interest rates and bond yields.
Eddy said local investors saw both equities and bonds sell off when the gold price fell in March, illustrating how the two asset classes can move together instead of providing diversification.
“You may not be as diversified as you think,” was his key warning. He said he could not predict whether gold would rise to $6 000 an ounce or fall to $2 000, but investors should recognise how much of their local portfolio return is now linked to one commodity trend.
Offshore tech concentration risk
The same concentration risk exists offshore, Eddy said. Global equity markets have been driven to a large extent by technology and AI since Covid and the launch of ChatGPT. Technology shares dominate the indices for developed markets, while emerging market indices have also become increasingly exposed to beneficiaries of the AI trend – companies such as Taiwan Semiconductor Manufacturing Company, Samsung Electronics and SK Hynix.
These three, the largest shares in the MSCI Emerging Markets Index, now make up just under 30% of that index, Eddy said. For South African balanced fund investors, this means the offshore portion of a portfolio is heavily geared to the continuation of the technology and AI theme.
Correlated risks
Historically, gold and global technology might have diversified each other. Over the past three years, however, both rallied strongly at the same time. Eddy said this convergence helped produce returns of inflation plus 10 percentage points for many balanced funds.
But if global equity risk increases, technology valuations fall and gold also retreats, investors could find that both the local and offshore parts of their portfolios come under pressure together.
Eddy said he was not arguing that market sectors driven by AI trade were about to collapse. He said the market could continue to rise for another year. His concern is the high valuations and the concentration risk.
Global shares are expensive, and he warned that the next five to 10 years could resemble the “lost decade” for global equities in the 2000s, if starting valuations prove too high.
Bonds offer diversification
Eddy said 10X Investments’ response was to allocate to asset classes that offer attractive prospective real returns over a longer five-year period – and this includes bonds.
South African real bond yields remain high, and inflation-linked bonds can lock in about 4% above inflation. Global bonds, while deeply unpopular after the bond market sell-off in recent years, also now offer real yields of roughly 2.5% to 3.5%, which Eddy described as reasonable for a defensive global asset class.
Lourens Coetzee, an investment professional at Marriott Investment Managers, also argued that bonds should be judged in the context of South Africa’s lower inflation target. Bond yields have fallen sharply over the past three years, with the 10-year government bond yield declining from about 12% to 8.6%. Investors may question whether 8.6% is still attractive, but Coetzee said it depends on where inflation settles.
If the South African Reserve Bank succeeds in anchoring inflation at 3%, an 8.6% bond yield translates into a 5.6% real return. Even if inflation remains at 4%, the real yield would still be 4.6%, which Coetzee described as very attractive.
Adjust your return expectations
Coetzee said investors should also adjust their expectations: if inflation is lower, future nominal returns should also be lower. A balanced fund aiming for inflation plus 5% would deliver about 3% if inflation is 3%, while equities might be expected to deliver about 10%, or inflation plus seven.
Coetzee said South Africa looks better as an investment destination than it has for some time. The GNU appears relatively stable, the country has exited the Financial Action Task Force grey list that affected it as an investment destination, and its credit outlook has improved.
History suggests that buying bonds at above-average yields can translate into good returns when yields later decline. Lower interest rates would also increase the value of bonds bought at today’s yields.
Consider SA Inc
Simon Sylvester, chief investment officer of Rezco Asset Management, suggested another diversification opportunity in South African companies that earn their money from the domestic economy – known as SA Inc shares.
He said investing through an index at a reasonable valuation is often sensible, but investors can become a crowd that herds into expensive pockets of the market. Active managers, therefore, need to assess the valuation and downside risk of the assets they choose and not just rely on momentum investing.
Sylvester said there is no euphoria in South Africa, but the economic backdrop is the best it has been in 15 years. Economic growth of about 2% is still weak, but it is an improvement. More importantly for investors, there is change. South Africa’s risk is decreasing, more money is coming in than going out, companies have cash on their balance sheets, and investors are again willing to fund projects.
Low valuations
He argued that good South African companies that survived a very difficult decade are now stronger but still neglected. Their valuations are low, which improves the potential for future growth and reduces risk.
Rezco was cautious about local and global indices due to inflation risks and geopolitical uncertainty, but Sylvester was more optimistic about selected domestic shares.
Takeaway
While your balanced fund may have delivered well these past three years, it is time for your managers to consider diversifying into other areas of the market.
You should expect your manager to make changes now that may reduce your returns in the short term, and you should expect lower returns from local asset classes if inflation eases.
Keep your eyes instead on your average returns over longer periods and ensure they beat inflation in line with your exposure to riskier asset classes and your investment goals.
This article was first published on SmartAboutMoney.co.za, an initiative by the Association for Savings and Investment South Africa (Asisa).
For detailed fund information – including unit trust comparison tools, investment calculators and investment industry research – go to FundHub.co.za.
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