Concepts that drive investor outcomes over the long term - November 2017
The power of compounding is critical to long-term wealth creation. To highlight the effect that compounding has over long periods of time, consider the following scenario: Investors A and B started their careers on 1 October 1973 when both were 21. Investor A decided to invest R100 per month in the domestic equity market (FTSE/JSE All Share Index) from age 21 to 31. At 31 she elected to stop her monthly contribution, but left her accumulated capital in the equity market until retiring on 30 September 2017 at the age of 65. Investor B also invested R100 per month in the same equity market, but only started on 1 October 1983 at age 31. He then continued to diligently contribute that same amount per month until he also retired on his 65th birthday on 30 September 2017 (i.e. contributing for a period of 34 years).
FIGURE: 1 THE POWER OF COMPOUNDING
The important point to note, as illustrated in Figure 1, is the significant difference between the end values for each investor. At 65, Investor A, who only contributed for a period of 10 years and then left the investment to compound over a period of 34 years, had accumulated an amount of more than R10 million, which is 8 times more than that of Investor B who contributed for 34 years, but started 10 years later (and had just more than R1.2 million).
TIME DIVERSIFICATION AND THE COST OF MARKET TIMING
A long time horizon allows investors to have a larger risk budget - making it possible to have more exposure to growth assets with higher expected returns and the attendant variability from year to year.
In The Effective Investor (Pan Macmillan, 2009), Franco Busetti writes that ‘after compounding, time diversification of risk is your second-best friend in the market’. The concept of time diversification refers to the decrease in risk of holding growth assets as an investor’s investment time horizon increases.
Take for example an investment in equities. Given the volatility inherent in this asset class, the possibility of suffering a capital loss in any one year is far greater than if you were invested in cash or bonds. However, the longer the investment period, the lower this variability becomes.
The figure below shows the range of returns achieved by the FTSE/JSE All Share Index over different investment time horizons (rolling 5 years, 10 years, 15 years, etc.). While the average returns achieved are similar, the range of returns (low versus high) progressively narrows as the investment time horizon increases.
FIGURE 2 RANGE OF RETURNS OVER ROLLING PERIODS
Allowing the benefit of time diversification to work in your favour, requires patience over a long period. Investors are often tempted to time markets in the pursuit of even better outcomes by switching funds. This inevitably leads to wealth destruction. For example, an investor who missed out on only the 25 best days for the local equity market over the past 15 years, would have earned an annualised return of 8.2% compared to the 14.8% annualised return that could have been earned had he/she remain invested for all 5 468 trading days (as illustrated in Figure 3).
FIGURE 3 THE COST OF MARKET TIMING
THE IMPORTANCE OF AVOIDING NEGATIVE RETURNS AND FOCUSING ON LONG-TERM CUMULATIVE PERFORMANCE
In the performance assessment process, our evolutionary biases make us prone to place too much emphasis on recent performance and the consistency of outperforming market indices, but don’t give enough credit to managers who can preserve value in down markets.
The following case study talks to some of the pitfalls in assessing investment performance. Figure 4 shows three hypothetical scenarios in which the market delivers a cumulative return of only 6% over five years. In the first scenario, the ‘steady fund manager’ delivers the perceived holy grail: consistent outperformance of 4% every single year. In the second scenario the ‘lumpy fund manager’ delivers the same aggregate alpha* over the five years of 20%, but its performance is lumpier. In scenario 3 the ‘bear market manager’ also delivers the same aggregate active return, but does it all in the first year (which happens to be the only down year in the period).
Over the full period, the final outcomes for the three managers’ clients are materially different and completely at odds with what we intuitively would have expected! The ‘steady manager’ delivered a compelling cumulative return of 31%, the ‘lumpy manager’ did even better with 39%, but the ‘bear market manager’ did best with 49%.
FIGURE 4 HYPOTHETICAL COMPARISON OF FUND MANAGERS
What this case study demonstrates is that as much as we desire consistent outperformance year in and year out, the ‘steady manager’ ultimately delivered the lowest value-add, beaten by the ‘lumpy manager’ whose alpha* was more inconsistent. But ultimately, the manager who did best was the one that delivered in a down year and then delivered only the market return for the next four years.
As observers, our expectations of cumulative performance are often very different from reality. This is why Coronation so consistently argues that it is the cumulative, long-term performance of an investment house that matters. Assessment periods of less than five years have little value. They usually reflect only one part of a market cycle and don’t capture what really matters: the actual capital accumulated by clients over the full period of their investment with that fund manager.
The industry term used to describe the difference between the return of an actively managed fund and that of the market index. In the case of Coronation’s unit trust funds, we always show alpha after all management fees and fund costs have been taken into account. If the investor receives zero alpha, it means the earned return is equal to that of the market.
ASSET ALLOCATION AND DIVERSIFICATION
Investment markets are not static. New opportunities arise as companies, industries, countries and asset classes develop and contract. Relative valuation levels between local, developed market and other emerging market assets, as well as between equities, bonds and cash, change over time. The emergence of new asset classes such as inflation-linked bonds, or a deepening of an existing asset class through new listings and more activity (as was the case in the domestic listed property market) add to the investable universe. Regulations that restrict or enhance the freedom to invest in foreign markets change. Investors can therefore enhance their eventual outcomes by making good strategic and tactical asset allocation decisions in response to this dynamic environment.
While equities typically have the highest expected return over time (as we will illustrate in Figure 9 on page 14), this is not always the case. Market price levels can change both for fundamental (i.e. sustainable earnings and dividend growth) and sentimental reasons (i.e. investors in aggregate are more/less optimistic and hence prepared to apply higher/lower ratings to companies). This insight supports the use of a strict valuation discipline when deciding what the optimal portfolio structure should be, informed by the difference between current price levels and well-considered long-term fair values in different markets.
Figure 5 illustrates how the asset allocation of our flagship balanced fund, Coronation Balanced Plus, has changed over the past 10 years. The stand-out features are:
- Our comfort with temporarily holding relatively high levels of cash at times when we believe valuations to be stretched in higher return/higher risk alternatives such as bonds, property and equity; and
- The increase in offshore equity exposure over time, primarily at the expense of local equities. This trend was partly due to regulatory action, as exchange control limits were gradually relaxed to the current 25% foreign asset limit, but more importantly, driven by the more attractive relative valuation of global compared to local shares.
The return expectations underpinning the fund’s current asset allocation are explained in more detail in the following section.
FIGURE 5 ASSET ALLOCATION FOR CORONATION BALANCED PLUS