“How I learned to stop worrying and love the market.” Portfolio Manager Piet Viljoen discusses his current thinking on the RECM Global Flexible Fund.
Dr. Strangelove was a black comedy made in 1964 by Stanley Kubrick. Its subtitle was “how I learned to stop worrying and love the bomb”. This was at the time of the infamous cold war, with pervasive threats of nuclear attacks creating widespread uncertainty. The movie made fun of these fears, mercilessly spoofing the military and political insanity of the age.
Today, we live in a time where many politicians are like caricatures of the insane characters in Kubrick’s movie. As a result, our social fabric seems to be fraying, and uncertainty is par for the course.
Today, I want to tell you about one of our funds that is specifically designed to help you “love the bomb”. But first however, a digression is necessary.
As you might know, RECM and Counterpoint merged their asset management businesses recently, with the aim of creating a stronger business and investment team for our clients. However, almost as soon as we started implementing the merger, the coronavirus hit. We were forced to become more inwardly-focused initially in order to build out our team processes remotely and in virtual space. The good news is that under the leadership of Sam Houlie, our investment team is working well under the “new normal”, and we can now pick up our communication where we left off.
In terms of the merger, we intend to merge funds with similar mandates. However, Counterpoint does not have a worldwide flexible fund such as the RECM Global Flexible Fund, so the name will change to the Counterpoint SCI Worldwide Flexible Fund, but I will continue to manage it in exactly the same way as I have done in the past, with Sam as my co-portfolio manager.
Current circumstances also create an opportunity for us to revisit the Fund. I will do this in two parts. The first part will describe what the Fund does, who its natural client base is, and how it tries to achieve its goals. I will also review its history. In the second part, I will describe how the Fund is currently positioned in order to fulfil its mandate.
PART I: The Fund’s reason for being
The Global Flexible Fund is designed to negotiate troubled times smoothly. It is a Fund that can invest anywhere in the world, in any asset class. It can diversify across asset classes and geographies, invest in safe assets and take advantage of distressed assets. Just like a tardigrade (google it), it is designed to survive just about anything. It is designed to manage risk.
The Fund is domiciled in South Africa. It is aimed at South African investors who want to protect their capital, and grow it in real terms. The Fund’s benchmark is SA inflation plus 6% per annum. Its target market are clients who first and foremost want to make sure they protect what they have. Long-term success in any endeavor requires two tasks: Getting something, and keeping it. This Fund is designed to help you with the second of those tasks: keeping your wealth intact, in real terms.
The Fund was launched in April 2003, so it has quite a long history. It was RECM’s flagship fund when the business was started. At the time, asset allocation funds were out of fashion. Sector funds were quite popular, and investors preferred to build their own portfolios by combining sector funds. This didn’t work out too well though, with the financial crisis of 2008/9 forcing a rethink.
The result was that asset allocation funds, and specifically balanced funds, became popular for a while. But, in financial markets, fashions don’t last very long and today the wheel has turned once more. Now, many intermediaries offer asset allocation as an additional service to their clients by combining different types of “building block” funds. Once more, balanced funds – or asset allocation funds like our Global Flexible Fund – have become unpopular. However, we believe many investors – such as the clients in this fund – may well come full circle back to seeking a cost-effective and sensible one-stop shop for their wealth preservation needs.
By the end of 2019, since its launch in 2003, the RECM Global Flexible Fund had grown by 5,2% in real terms per annum, slightly behind its benchmark. After the coronavirus-induced market crash of March 2020, this has reduced somewhat to
4% above inflation per annum – still a healthy compound annual return. If you’d invested R100 at inception, today, 17
years later, your investment would be worth R400.
PART II: How the Fund is positioned for the future
As promised, in the second part of this letter I want to deal with the future. Given the market (and political uncertainty) that I spoke about earlier, how is the Fund positioned today? And more importantly – what is the reasoning behind this positioning?
Looking at history and the lessons gleaned offers some context for my thoughts on positioning. As George Santayana famously said: “Those that cannot remember the past, are doomed to repeat it.”
About a year ago, Morgan Housel wrote an insightful article on the lessons we can learn from history. These lessons have broad, universal applicability, so they are worth repeating here. Also, they can be used in order to get a sense of what we can know and can’t know about the future. In preview, we don’t know very much about the future at all. And this knowledge – that we don’t know much about the future – is key to how we position the Fund to achieve its aims.
Housel specifically mentioned 5 valuable lessons from history:
Lesson #1: People suffering from sudden, unexpected hardship are likely to adopt views they previously thought unthinkable.
So, be prepared for surprising things to happen. What exactly, I don’t know. How many of us expected negative interest rates? How many of us expected the oil price to trade at minu s $40? The message is clear – expect the unexpected.
Lesson #2: Reversion to the mean occurs because people persuasive enough to make something grow don’t have the kind of personalities that allow them to stop before pushing too far.
The kind of personality willing to take enough risks to earn outsized returns is generally not compatible with the kind of personality willing to shift everything into money markets once they’ve made enough money. They’ll keep taking risks until those risks backfire. For the same reason the Forbes list of billionaires has 60% turnover per decade, the same fund isn’t always at the top of the performance charts. If a fund you own has recently shot the lights out, it would be a good idea to understand why.
So which strategy should be implemented in the Global Flexible Fund? We don’t know.
Here are better questions: Should we put all our eggs in one basket? (No.) Should we aim to have different parts of the portfolio respond to different possible future outcomes? (Yes.)
Lesson #3: Unsustainable things can last longer than you anticipate.
How long can value’s underperformance last? We don’t know.
Cliff Asness from AQR has examined the situation, and found that it’s not different this time. In his words: “Good investing isn’t about sure things and certainly rarely about precise timing. Good investing is about being on the right side of the odds and sticking with good strategies. We think the medium-term odds are now, rather dramatically, on the side of value, with no “this time is different” explanation we can find.”
However, identifying that something is unsustainable does not provide much information on when that thing will stop. If enough people believe something is true, unsustainable ideas can gain durable support. Value has been underperforming for ten years now. The difference between “That looks unsustainable so I don’t want to be a part of it,” and “That looks unsustainable so I’m going to bet that it will end by Q1 2020” is enormous. In the Global Flexible Fund, we prefer to think in terms of the first option.
We remain committed to the value investing philosophy in managing the Fund.
Lesson #4: Progress happens too slowly for people to notice; setbacks happen too fast for people to ignore.
There are lots of overnight tragedies. There are rarely overnight miracles. Growth is driven by compounding, which always takes time. Destruction is driven by single points of failure.
When will the Fund come into its own, after enduring an especially tough first quarter of 2020? We don’t know.
But if we continue to position the Fund tilted towards prospective high return situations (e.g. value, small cap, emerging markets) and away from prospective low return situations (e.g. large cap growth, indices, high quality franchises), we are stacking the odds in favour of a good outcome from this point.
Lesson #5: Wounds heal, scars last.
After recessions, economies heal. Markets recover and past mistakes of businesses are forgotten. But although they might heal, these events leave scars, and change behaviours in many unpredictable ways.
We can see and measure just about everything in the world except people’s moods, fears, hopes, grudges, goals, triggers, and expectations. That’s partly why history is such a continuous chain of baffling events and always will be. And that’s exactly why it is so hard to predict the future, and foolish to build a portfolio based on one particular expected outcome.
In managing your hard-earned money, we are not paid to predict interest rates, economic growth rates or exchange rates. Fund managers will seldom admit it, but we have the same ability to forecast these variables as our clients have – none of us truly has a consistent edge here.
Rather, our job is to build a portfolio that can withstand adverse outcomes and benefit from positive outcomes – all from different sources. All of which are hard to predict a priori.
So what will the future look like after the coronavirus is over? What will markets look like? Which assets will do best during and after?
Again, we don’t know.
It is clear that Morgan Housel’s 5 lessons from history teach us that we know very little. But that doesn’t mean we are helpless. What we can do is identify negative risks that can destroy wealth, and hedge against them by buying assets that protect against such risks. We can also identify positive risks that have the potential to grow wealth, and buy assets that stand to gain from these risks.
Despite not knowing how, when or even if all these risks will materialise, we can put together a “tardigrade” portfolio: a portfolio that tilts towards opportunity, and away from risk.
These are the opportunities today as we see them:
1. Value. Value is a strong long term strategy, currently priced at its cheapest ever. None of the stories that say “things are different this time” hold much water. The Fund is strongly aligned with value at this time. The 55% equity exposure in the Fund is all-in value.
2. Emerging Markets. Emerging markets are undervalued, having been hardest hit by the coronavirus fall -out. We think they will recover, and the Fund has a decent allocation to emerging markets, both via its direct holding in SA assets (23% of assets) as well as via holdings in Russia, Asia and Latin America which add up to 9% of the global equity. So overall, the Fund has just less than 30% exposure to emerging markets.
3. Small cap. Small companies have also underperformed, and are cheap. We think there is good long term potential here. Around 12% of our global equities is invested in small caps, and around 60% of local equities. In total, that adds up to just over 12% exposure to small caps in the Fund.
4. Oil. Oil is trading at historically low levels, with massive production cuts happening. If and when economies start to recover, it will be hard to turn the switch back on. This could perversely lead to a spike in the oil price. We own some unlevered oil companies, but still only at less than 4% of the portfolio. Where we get the opportunity, we would probably want to build up this part of the Fund’s exposure.
These opportunities are somewhat correlated in that they are likely to do well together, or do poorly together. So far this year, they have done poorly together. That is why the Fund holds cash and gold to diversify risk – and as an insurance policy against bad things happening.
The Fund currently has 45% in cash, most of which is held offshore, in a mixture of US dollars and British pounds. The Fund also has exposure of 10% to gold and other precious metals.
There are many risks out there. Here are a few of them:
1. Deflation. The spread of the coronavirus, and government ’s policies to combat it have meant a severe downwards adjustment to aggregate demand. By its very nature, this is deflationary. Bond yields globally are at historically low levels – many countries even have negative yields – reflecting this reality. We think cash – held in undervalued, potentially strong currencies – is a good measure to counter deflationary risk.
2. Inflation. Conversely, inflation could be a longer term threat, as governments print money to combat the lockdown – induced economic slowdown. Supply chains could also come under pressure, further aggravating inflationary forces. Gold is our main defence against this risk, but we also own some inflation-linked bonds. If the short term deflation risk perception increases, pushing out the spread on inflation linkers, we could accumulate even more of them.
3. Indices. Indices are becoming ever more concentrated as large cap growth companies continue to outperform, at the expense of almost everything else. This is basically the converse of the opportunities mentioned above, so we have no further specific strategy here – but it is worth keeping in mind, as pressure from clients to index more and more of their funds keep building.
4. Volatility. Uncertainty breeds volatility, and we live in even more uncertain times than normal: oil prices collapsing to negative levels, stock markets moving up or down by over 5% a day, are all signs of this uncertainty. To counteract this, we have a small position in companies that mine, invest in or otherwise vacillate trade in cryptocurrencies. We think this could prove to be a valuable hedge against undue volatility now and in the future. The position is very small – less than 2% of the Fund. But we think of it as a small insurance premium, with a big potential payoff, which only pays out when needed most. And like all other insurance policies, we hope it doesn’t pay out at all.
In a nutshell, the RECM Global Flexible Fund is a portfolio whose job it is to help you sleep at night, but still love the market – with all its attendant volatility.
Thank you for your trust in allowing us to manage a portion of your capital.