The Beauty of Prudential Balanced Portfolios

Pension funds typically invest their moneys in prudential balanced portfolios, multi-asset portfolios where either the fund or its investment manager/s determine from time to time how much will be invested in which global market and how much will be invested in equity, property, bonds and or cash, to mention only the main asset classes employed by pension funds.

The difficulty is that one is dealing with future uncertainty. Decision makers consider the relative risk-return profile of various asset classes and of specific securities. Various models agive the risk-return profile of prospective securities, such as top-down analyses, where the economic environment and its expected impact on the different asset classes is considered, or bottom-up analyses where specific companies and other securities are analysed, or a combination of top-down and bottom-up analyses.
The reason for profiling risk versus return is that managers want to optimize the ratio. If two shares for example are expected to produce the same return over a given period but the risk of share A is higher than the risk of share B, the decision maker would rather purchase share B than share A. A higher risk would reduce the probability of achieving the expected return.
The table below shows the asset allocation of the average prudential balanced portfolio at 31 March 2015, and the return of each asset class to June 2015:
Quarter to June 2015
Asset Class Allocation % Return %
Equity 60.4 – 0.8
Bonds 13.4 0.3
Property 16.2 – 3.5
Cash 3.6 1.5
Other 6.4 n/a
Total 100

The actual return for the average prudential balanced portfolio for this quarter was 0.4% (best 1.8%; worst – 0.3%). The average manager and the worst performing manager have both thus outperformed all asset classes except cash for the latest quarter.
Year to June 2015
Asset Class Allocation % Return %
Equity 61.5 8.5
Bonds 14.4 8.9
Property 15.7 31.7
Cash 3.2 6.3
Other 5.2 n/a
Total 100

The actual return for the average prudential balanced portfolio for the 12 months was 10.2% (best 14.9%; worst 6.4%), outperforming all asset classes except property for the 12 month period.
This shows last period’s winning asset class is unlikely to also be this period’s winning asset class. It also shows that spreading one’s investment between the different asset classes is outperforming most asset classes. This of cours does not take into account what happened in offshore markets and the foreign exchange rate movements.
Looking at foreign exchange rate movements, the Rand depreciated by 12% against the US Dollar and by 5% against the Pound Sterling while appreciating by 7% against the Euro.
Looking at the performance of prudential balanced portfolios relative to the local equity market (JSE Allshare Index), where equities are typically the preferred asset class with the highest expected returns over the long-term, the following table also reveals interesting results for periods to 30 June 2015:

Period to June 2015 Equity Return % Average Fund Return %
3 months 0.7 0.4
6 months 4.1 6.0
1 year 1.7 10.2
3 years 15.4 17.2
5 years 14.6 15.5
10 years 13.9 14.7
15 years 13.5 17.1

It shows that over all periods in the table, the average prudential balanced portfolio outperformed the JSE Allshare Index. Most local individual investors will find it very difficult to achieve the returns that the average prudential portfolio has achieved. There are a number of clues that indicate the US economy is on the mend.
US GDP is on a steady upward trend:. Housing starts and housing permits are on an upward trend: Unemployment is dropping sharply while the non-farm payroll is improving. Consumer sentiment is on a steep incline. But inflation is stubbornly moving sideways.
In the light of this, there is a high likelihood of the Fed raising interest rates possibly this year still. When this happens there is a fair likelihood that equities will move sideways or may even turn down, while bonds and property are likely to produce negative returns, leaving only cash as the asset class that will offer positive returns.
From a top-down perspective, this does not offer any exciting investment opportunities in any particular asset class for the next year or two. The near to medium term will thus require one skill above all, which is stock picking based on bottom-up stock analysis. Prudential balanced portfolios are affording their managers the opportunity to move between asset classes as they see opportunities or threats and if the portfolio manages to outperform the equity market, as the average manager has consistently been able to do, any investor should be reasonably comfortable that his investment is looked after better than what he would be able to do himself in most probability.
Our investment view remains unchanged
The local investor should invest in equity and property in preference to fixed interest assets, talking only about conventional asset classes. Stock picking should prove to make the difference in returns and will be a prerequisite for out-performance of a portfolio. Turn down your return expectations, focus on inflation and aim to outperform inflation rather than aspiring for high absolute returns as these will not be achievable without taking significant risks.
The expected upswing in consumer sentiment over the next year or two, is likely to be preceded by an upswing in commodities and to be followed closely by and upswing in financials. A soft Rand and a depressed local economy suggest that the investor should continue to diversify offshore. Lowly geared Rand hedge shares should benefit from increasing interest rates and improving consumer sentiment in developed economies.
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