Investing is a skill that requires patience, knowledge of the industry and markets, and is different for each individual. Blending of the various asset classes (equities, bonds, cash, hedge funds) when formulating an investment strategy should not be overlooked as economic cycles tend to favour one asset class over the other and an optimal blend of asset classes should provide protection against short-term volatility whilst delivering long-term growth.
For example, any person who has invested in the South African equity markets of late would know that if they were on the wrong side of the resources ride they would have lost a lot of money. Some of the key factors that should be taken into consideration when constructing an equity blend of funds include:
1. Sector Exposure
Getting the right mix between the three key sectors (Resources, Financials, Industrials) is fundamental. The key is to manage a neutral exposure between these sectors. By being underweight or overweight in a sector, one is taking an active bet on the future performance of that sector. Let’s face it – if we could get that right the best financial minds in the world wouldn’t be facing the current turmoil that is being experienced in global financial markets. When considering which equity managers to invest with, one must scrutinise the sector bias of the underlying managers and look to create a blend of managers without being too over- or under-exposed to a particular sector.
2. Style Mix
When considering style mix, one needs to decide if one is looking for value or growth? Value managers focus on determining the true economic value of companies based on fundamental balance sheet analyses to determine whether a share currently trading in the market is cheap or expensive. These shares generally have low price earning (PE) ratios. Growth investors on the other hand expect to beat the market by focusing on companies with above average earnings growth and the stocks of these companies generally have high PEs. One needs to understand the underlying style employed by the fund manager and ensure that the overall blend of managers employed does not have a bias to any specific style. The best is to maintain style neutrality.
3. Size Bias
This refers to the size of companies in relation to their market capitalisation. To put this in perspective (large cap = Anglo American, medium = Imperial and small = Bell Equipment). The reason why this is so important in the formulation of an investment strategy is because different size companies trade differently. Large and medium cap companies trade frequently with tight bid offer spreads and experience large volumes of trade and are hence considered liquid; whereas small cap shares trade less frequently and generally the bid offer spreads are much wider and the volume of shares that trade is much smaller and therefore these shares are considered illiquid. Once again different market cycles favour different stock sizes.
4. Passive or active
Passive funds are perceived to be much cheaper than active funds because less effort is required to manage them. Active funds are based on the premise that managers do have skill and can add value by identifying opportunities where shares may outperform or underperform the index. One disadvantage of a passive fund is that it could be heavily weighted towards resources as is the current ALSI index and will do well or poorly depending on commodity prices. Active managers on the other hand have the ability to adjust their portfolios to prevailing market conditions. In conclusion, the process of constructing good investment strategies is not easy and requires skill and expertise.
