Manager Research

We recently spent some time with the portfolio manager of the Nedgroup Investments Opportunity fund, Omri Thomas, and the rest of ABAX’s multi-asset team, including Rashaad Tayob and Matthew de Wet, for a research update. The fund had some 7.5% exposure to Steinhoff in December (through bonds and equity), which caused significant short-term underperformance against the benchmark and peers when the stock collapsed. Managers such as Coronation, Foord and Truffle all had exposure to Steinhoff, so our concern had less to do with ABAX having exposure to the share, but rather the position size within the fund. The question which arose relates to their understanding and implementation of risk, from a research and capital allocation perspective, and whether it was commensurate with the expected risk and return profile of the fund.

This fund is described as a medium-equity balanced fund (which typically has 40-60% equity exposure), with a rolling 3-year CPI+5% return target and with internal risk objectives to protect capital over rolling 2-year periods and to limit drawdowns to 7.5%. Hence, you would expect a portfolio with a moderate allocation to equities and a strong risk focus. However, the objectives in combination are actually difficult to achieve in that the CPI+5% return target is aggressive and more in line with a high-equity balanced fund, while their risk targets (capital protection and drawdown management) are more conservative.

To achieve these conflicting objectives in practice, the fund follows a multi-strategy approach that aims to generate returns from a diversified set of “opportunities” in equities, fixed interest and derivatives. Essentially, this has resulted in the fund looking substantially different to peers: Firstly, it has had a higher average exposure to equities of 60% over the last year, compared to the 48% equity exposure in Coronation Capital Plus for example. Secondly, the fund has had concentrated positions in individual “opportunities” or strategies, like the 7.5% position in Steinhoff in December or the 13.5% position in Naspers in February of 2018.   Lastly, the fund has made extensive use of derivatives to offset the higher risks.

The problem the fund faced in December was two-fold: Firstly, their research process identified several issues in Steinhoff that concerned the team, including the low taxes paid by the group and a dispute with a former joint venture partner. The team had to spend a lot of time investigating the issues to get comfortable with the share. This approach and outcome was not uncommon across managers, and while the additional level of research was warranted, ultimately it was ineffective. The question is then whether or not the position in Steinhoff was sized appropriately? ABAX’s response is that the exposure was hedged, which highlights the second problem: the risk protection was inadequate given the magnitude of the event and the exposure to the share. Using a combination of put and call options, the team constructs protective collars around the largest exposures in the fund.  They do this in order to generate significant returns from stock selection, but maintain a reasonable level of risk control at the total fund level. This results in some of the upside potential being sold to finance downside protection, typically covering the fund from the first 10% decline in a share’s price. When Steinhoff collapsed by 85% in one day, the protection was ineffective and the fund participated in all the downside below the protection.

This places significant reliance on the team's expertise in hedging and portfolio construction to moderate the fund’s risk profile in line with expectations. This has been a focal point for us since the inception of the fund:  weighing up the risk/return trade-off.

Our comfort levels in the fund, however, are supported by three factors:

1. We are comfortable with the depth of ABAX’s research process. The fund has benefitted from strong stock selection skills over time. Despite the Steinhoff issues, the fund is 1 ^st quartile over 5 years, despite short-term underperformance and one of the few funds to have achieved CPI+5% since inception.
   
   


2. Phillip Liebenberg joined the team as head of their absolute return strategy from SIM in 2017. Phillip has strong derivative and hedging skills, as well as substantial absolute return fund experience, which complements the risk management process at ABAX.


3. Their hedging strategies have been enhanced and they will now be implementing a deep hedge on any single holding over 5% of the fund, which more adequately protects against losses in large position sizes. This is a positive change to the process in our view. The positions will now be hedged as follows:
   
   

We have retained our Tier 2 rating on the fund, but with a caveat: Investor's should be mindful that this fund is substantially different compared to a typical medium-equity balanced fund. Expect more exposure to equities and larger position sizes compared to peers with active derivative management to temper risk.   Investors need to be comfortable that this approach does expose them to more ‘event risk’ than a typical medium equity fund, which should be compensated for through higher levels of return over time.