Duncan joined Allan Gray in 2001 as an equity analyst after completing his Honours in Business Science and post graduate diploma in Accounting at the University of Cape Town. He is a CFA charter holder and was appointed a trainee portfolio manager in January 2003. As of 1 January 2005, Duncan was promoted to the position of portfolio manager and will be managing a portion of the balanced and equity portfolios of the segregated and life clients.
Allan Gray-Orbis Global Optimal FoF comment - Dec
As 2019 comes to a close, the Orbis Global Equity and Optimal Strategies are turning 30 years of age. To put performance in perspective and analyse prospects going forward, we will revisit a familiar framework that we have used in previous commentaries, in which we break returns down into three components – a risk-free rate, an equity risk premium, and the value added by Orbis, or “alpha”.
The risk-free rate is easiest to understand – the return on bank deposits or similar cash instruments. For a US dollar investor, this has averaged 3% per annum since 1990. The second component, the equity risk premium, is essentially the excess return above cash that one would expect to receive in exchange for bearing stock market risk. This premium cannot be observed directly, but we can derive it by comparing the return on stocks versus the cash rate. Since 1990, the FTSE World Index has returned 7% per annum. After subtracting the 3% cash rate, we get an implied equity risk premium of 4% per annum, which is in line with its long-term history. The final piece, alpha, is any extra return that we are able to generate through our bottom-up stock selection. After fees, this has averaged around 4% per annum since 1990 in both the Global Equity and Optimal Strategies.
Putting these components together allows us to see where the Orbis Global Equity Fund’s 11% per annum long-term net return has come from: three percentage points from the risk-free rate, four percentage points from the equity risk premium, and four percentage points of after-fee value added by Orbis. Simplistically, Optimal is designed to capture the risk-free rate and alpha without the equity risk premium. Optimal has therefore given up roughly 4% per annum, leaving a return of 3% from the risk-free rate and 4% added by Orbis for a 7% overall per annum return net of fees.
Why would anyone want to part with 4% per year? The hint is in the name – earning the equity risk premium comes with a large dollop of risk. A long-term average return premium of 4% per annum seems quite modest in the context of 15% annualised volatility and occasional drawdowns of more than 30%. By hedging stock market exposure, Optimal is designed to sacrifice some return in order to avoid highly uncertain long-term equity outcomes as well as disproportionally large annual volatility.
This has been a painful sacrifice over the last ten years. Not only has the equity risk premium delivered more than 8% per annum – more than twice its long-term average – it has done so with below average volatility. During the past decade, the risk-free rate has also been squeezed down to historically low levels. Instead of the 3% that we saw over the full history of the Strategy, it has been less than 1% over the last 10 years. Worst of all, our alpha has been poor – well below our long-term average and simply not good enough. As a result of this “perfect storm”, Optimal’s returns have been highly disappointing.
As painful as this has been for our clients – and for ourselves as co-investors in Optimal – we believe these headwinds are more cyclical than structural in nature. If we look closer at each of the components of return, we see good reasons to be optimistic that the next decade may look different from the one that has just ended.
We have no edge in predicting where interest rates will head, but we do know that the levels experienced in recent times are extremely low in the context of history – in large part due to extreme policy measures taken in the wake of the global financial crisis. But as that episode fades further into the rearview mirror, we would expect risk-free rates to return to more “normal” levels. Indeed, at nearly 2% in the US today, the risk-free rate is somewhat closer to its longer-term average.
What about alpha? While some may point to the last 10 years as evidence that markets have become more efficient and stock picking is dead, we see it differently. Our perspective is that valuation inefficiencies – often the key ingredient necessary for future alpha – have become much more prevalent since the global financial crisis and especially so over the last few years. These heightened inefficiencies often sow the seeds for future excess returns.
We appreciate that this has been a long and challenging decade for Optimal clients. As frustrating as this may be, we continue to believe that Optimal has an important role to play in client portfolios. Its downside protection may seem like a useless feature during bull markets, but it is one that should more than earn its keep when the next bear market arrives. And in all markets, Optimal provides exposure to the value that we add through stock selection. While this has also been lacklustre in recent years, we are enthusiastic about the opportunities we have identified and hopeful that clients will ultimately be rewarded for their patience.
While the Orbis Optimal SA Fund’s overall net equity exposure remained unchanged, we increased the hedging in North America, and reduced our hedging in Japan. Among individual positions, the largest addition was to a US tobacco company. The largest sale was Bayer, a German healthcare company.
Adapted from commentary contributed by Graeme Forster, Orbis Investment Management Limited, Bermuda For the full commentary please see www.orbis.com
The Fund invests in a mix of absolute return funds managed by Allan Gray's offshore investment partner, Orbis Investment Management Limited. The typical net equity exposure of the Fund is between 0% and 20%. The Orbis Optimal SA funds included in the Fund use exchange-traded derivative contracts on stock market indices to reduce net equity exposure. In these funds, the market exposure of equity portfolios is effectively replaced with cash-like exposure, plus or minus Orbis' skills in delivering returns above or below the market. Returns are likely to be less volatile than those of a foreign equity or balanced fund. Although the Fund is fully invested outside South Africa, the units in the Fund are priced and traded daily in rands. When considered in rands, returns of this foreign fund are likely to be more volatile than domestic funds with similar equity constraints.