Speaker 0:
Hello and welcome to this fund fit session. I'm joined today by Lawrence Pretorius, head of fixed income at Matrix Fund Managers. Jacques De Place, chief investment officer at Graphite Advisory and Investments, as well as Stephen Hall, director and founder at Hens Forward. A graviton partner. Welcome to you all. Thank you.

Speaker 0:
So today we're discussing income funds. Lawrence, I'm gonna kick off with you. What do income funds typically seek to achieve? And what is the value proposition of income funds? Considering the current macroeconomic environment,

Speaker 1:
why does it have to start with me to, um, I I'll I'll give you a bit of a long winded answer to that. I hope we have sufficient time, but first of all, I'd say

Speaker 1:
and I'd be curious if the other gentlemen agree with me on it or not. But South Africa is experiencing a risk rewriting at the moment. Um, and it's a negative risk rewriting

Speaker 1:
the purchasing power of our foreign purchasing power of our currency is deteriorating or the rand depreciating. Our equities are trading arguably at historical relative low valuations. In other words, if you look at the multiples that we are trading relative to developed markets relative to peer groups. Our bonds are delivering you six plus percent real return, so they are cheap.

Speaker 1:
And, you know, arguably a lot of this re rating is, as a consequence of lack of growth, sustainable growth, growth prospects, um, potential growth, per capita growth declining. So it is a negative growth story. Um, and that in itself again puts debt sustainability with a big question mark around that, um and and broadly speaking, you know, we find ourselves solidly in junk bond status. Um,

Speaker 1:
and the question is whether we are moving back towards an investment grade in terms of country risk premium or whether we are deteriorating further to a single B rating which would put us amongst the Cook Islands,

Speaker 1:
Rwanda, Uganda, et cetera. It's shocking to actually realise, um, so so that long winded sort of preamble. Um, what I just want to highlight is when you're facing these risks and particularly you have a current account deficit that's structural of nature as well. Then you're facing a central bank. Um, like the That's very orthodox, very conservative. And it's my opinion that over time, on average, forget about the cyclicity associated to it. but on average,

Speaker 1:
which we are probably going to maintain something like a 2.5% positive real risk premium in policy setting. That means if we are successful to get inflation down to four and off, we will probably have interest rates around about 7%. If we can't get it down to four and we are over around five, which happens to be our sort of base case, then we probably reduce interest rates to 7.5 from the current eight and a quarter. So we are talking about minor, sort of on average

Speaker 1:
interest rate cycles and and definitely this sort of strict 2 to 2.5% risk premium. And while that is important, income funds rely a lot on the money market, and

Speaker 1:
the money market generally gives you something between 50 100 basis points additional yield relative to where your policy setting is. So it would follow that if you have a 2.5% positive real policy setting and a money market 50 to 100 above, then most income funds that's worth they sold should give you an inflation plus three type of return. Now,

Speaker 1:
you know, you ask what's the importance of of income funds? I would say

Speaker 1:
you know, an inflation plus three. the old adage is that bonds and inflation plus six is starting to crowd out equity investment because your traditional equity risk premium is 6 7% and now you can get it out of bonds and you can get it at all the volatility of equities. But in a way, cash or the money market is also crowding out equity investment and bond investment because your associated to cash is a fraction of a quarter to 1/5 of that of bonds. So in my mind,

Speaker 1:
you know, the the the sort of stable income funds and the money market in itself is going to become and and currently is already a very dominant and prevalent driver of of, of stable, real returns. And any asset allocation decision has this high hurdle almost that it needs to to beat in terms of volatility, adjusted return. So, you know, I think inflation plus three, with very little volatility is, is is is a very relevant, uh, investment. And

Speaker 1:
sorry if I take a lot of time, maybe what I will also say is we all tend to believe that time smooths away volatility. Jacque and myself had a discussion now on it as well, and I think he holds some different views on it. But, um, you know, volatility is your biggest enemy when you need to make investments and when you need to make withdrawals. And the risk of volatility is the risk of making a mistake by investing at the wrong time and and and

Speaker 1:
and and withdrawing at the wrong time. So, you know, the sort of stable real return of 3% I think

Speaker 1:
is going to maintain its its importance. Um, in terms of of, of stable, real return drivers?

Speaker 0:
Absolutely. Thank you so much for providing that macro macro backdrop. Um, Lawrence. So now, Jacque, then, um, how would DF MS such as such as graphite, then typically make use of income funds such as these that are offered or such as the ones that, um, Lawrence is gonna tell us about a little bit later in your solutions And what drives the decision of which manager to employ

Speaker 0:
both from a quantitative and qualitative perspective, I guess, Firstly, you know, not all fixed income funds are are equal, and they fulfil different roles, I think, in in different portfolios in different economic environments. So the the sort of lower risk, um, shorter term focus fund, like the the Matrix Stable Fund, would play a role in the more cautious portfolios. So if you're running,

Speaker 0:
uh, a cautious multi asset portfolio or a low equity fund AC a category or AC P I plus three. as Lauren said, You know, it's it's offering very good real yields, and it would form the core of that type of portfolio. You know, it would provide consistency, uh, of return, low volatility and reduced drawdown. Um, so it's a very important building block if you follow a building block approach. Um, if using

Speaker 0:
multi asset portfolio is obviously, um, you know, it might fulfil a role as more as a satellite, but for us, as as a building block, it would form that core base for us. Um, and it's quite an important building block for us, you know, not only in forming a foundation. It also provides a significant cost advantage for us. So picking specialist managers,

Speaker 0:
uh, in in the different asset classes. Paying the appropriate fee for those classes, uh, is significantly cheaper than using a balance fund, which would incorporate similar strategies. Um, to what Lawrence would. But there you might be paying 1.5% for for cash or cash. Um, type of products. Um,

Speaker 0:
in terms of selection of the the funds. Um, you know, for us, it starts, I guess, like most people with the numbers, um, and, you know, we run a very quantitative approach to determine what funds we want to look at in more detail. Um, that doesn't mean we look for the highest returning fund.

Speaker 0:
Um, for us, it's about consistency and performance. So we're looking for managers or funds that rank very consistently versus their peers and versus their benchmark. Um, And then we also looking for the type of volatility that they produce to get those returns. So what type of drawdowns do we get? When do they perform and when When do they struggle? Um, which gives you a lot of insight into the type of risks that they're taking.

Speaker 0:
Um, once we we found a fund that meets those type of criteria, you know, then we'll move on to the next stage of actually meeting with the management team and again for us. There's nothing to replace experience. Um, we're looking for well established, very experienced team with consistency, uh, in in actually managing the fund. Um, there's a lot of funds in in South Africa. But what we do find,

Speaker 0:
um, is that some of the funds have got long track records, but they might have been run by four different teams over time. The current team is actually not as experienced as you might think for the size of the investment house. Um, so

Speaker 0:
we've known Lawrence in the team for a very long time. Um and you know, it gives us a lot of comfort to know that they've been through multiple cycles, um, and understand the risks inherent in in fixed income. Um, and that's the type of manager we would like to to approach and use in our portfolio. Thank you very much. Shack.

Speaker 0:
Um, Lawrence, I'm gonna take it back to you. Perhaps you can just quickly give us a broad overview of the funds of the income funds that, um, matrix offers. Um, and perhaps the, um, investment objectives of each.

Speaker 1:
May I first say thank you for that endorsement. Understanding fixed income.

Speaker 1:
Um, thanks, Larry. Yes. Um, maybe I should make the point first that we at Matrix started as a hedge fund manager. Effectively, we we do manage a quite a prominent fixed income hedge fund. We've been managing that since 2008.

Speaker 1:
Um, it is certainly on the higher end of the volatility spectrum. We managed to, uh, deliver over the last 13, 14 years, Uh, a cash plus 9% annualised return net of fees. Um, and and, you know, we're proud of that, but that is certainly a very different, you know,

Speaker 1:
different. Uh uh, point on the on the risk return spectrum. But why I mentioned that is that's a 13 14 year track record. And what's always been very important to us in that fund is the cash management aspect to it. So it's essentially a pot of cash and then forward exposures that we take in a leverage format in each fund. So So you know, essentially, we've been trying to sweat our cash as efficiently as possible, and we've been reasonably successful at that.

Speaker 1:
So we launched um based on that same principle and leveraging exactly of our experience what we've done there in 2018, the Stable Income Fund, which is a short term interest bearing fund. Um, our objective there has been to outperform the ST E composite by 100 basis points. Um, we have actually managed over the last five years to outperform ST EE composite by in excess of 200 basis points, I think 220 or 230. Um,

Speaker 1:
and we also, uh, outperform the median of multi asset, um, income managers as well as short term interest bearing managers by about 100 and 50 basis points on an annualised basis. So I'd say, you know,

Speaker 1:
to date, we've been doing something right. Um, I'm proud of the track record, and and And if there's one defining, you know, maybe one important defining characteristic is unlike a lot of other stable funds, we don't employ credit in our portfolio construction. That's not

Speaker 1:
say there's not a place for credit. That's not our strong point. Uh, our strong point is to, uh, assess the money market versus monetary policy. The fixed rate duration curve. Uh, versus fiscal policy. Obviously, um, the inflation curve versus inflation prospects and, uh, bank senior debt, Uh, and particularly floating rate debt. And it's also an interplay between those four drivers. And I would say,

Speaker 1:
you know, if you were to look at our fund at any point in time, it probably yields you 30 to 40 basis points higher than the sty composite, but it results in an outcome that's 200 basis points above. So it means that on balance, we rely a lot on asset allocation or mixing those drivers of return up appropriately.

Speaker 1:
And with the success that we've achieved and by popular demand by quite a few of our clients, we've been persuaded to launch a multi asset income fund now as well. Based on the stable income architecture and broadly speaking, it would follow the same sort of investment process. It won't be reliant on credit. It will have more, um,

Speaker 1:
degrees of freedom, so to speak, in terms of asset allocation and and duration decision. Probably run on balance a slightly higher duration, but it's not a statically higher duration than necessarily in the in the stable

Speaker 0:
income. OK, thank you, Lawrence. Um so Stephen I want to bring you in here. Do you think perhaps there's a misconception that clients select income funds purely for a steady liquidity stream?

Speaker 0:
Yeah, definitely. Um, I think when when we look at, you know, from clients perspective, clients look at risk in terms of volatility risk. So the risk of their money going up or down. Um, but they are Actually, there are other types of risks that that that we need to take into account as well. One is inflation risk. Um, you know, is your money outpacing inflation? Um, two, liquidity risk in terms of, you know, do you have access to money at the at the right time

Speaker 0:
and then the fourth one capital adequacy risk. So do you, you know, does your money is it gonna sustain your lifetime? So, yeah, people look at risk and and they don't want to lose money, but they forget that their money actually has to serve a purpose. And it has to get them to a point in time. And they shouldn't just be looking at volatility risk. They need to make sure that their their funds are outpacing inflation and that it's gonna last and yes, available when they need it. OK,

Speaker 0:
so So just to add to that, um, I think you know one of the problems. If you only look at income funds, as is providing you an income, you miss a lot of the other risks. Um, and I guess some of the advantages as well. So definitely income funds. If you move up the spectrum, uh, can provide you with significant capital gains. But the flip side is you can suffer significant capital losses. You know, anyone that was invested in US government bonds last year,

Speaker 0:
um, you know, would have experienced 30 40% drawdown. So, um, yeah, you You shouldn't just be looking at What am I getting as a yield you should be thinking of. What are they investing in to get that yield? Um, the other,

Speaker 0:
you know, problem. If you're just looking at yield is you might miss the correlation that you are picking up in the very moment that you're looking to diversify away your your your risks and specifically, you know, uh, if you think about equity, you might be nervous of equity markets at the moment, you know, the world is in a tricky place. Growth is slowing. Despite valuations, For example, you might say

Speaker 0:
I actually want to park my money. And as Lauren said, You know, you're getting very good, you know, real yields. It sounds like a great opportunity to earn 9% 10%

Speaker 0:
but one you could pick up duration risk, but two, you could actually pick up credit risk, which in essence, is just another form of equity risk. And I think if you don't spend the time to look at the income funds that you're buying,

Speaker 0:
you can pick up, you know, securitizations. You can pick up equity link notes, which in essence, are another form of of equity risk. And suddenly your equity or your income fund could suffer a drawdown and not provide you with that capital protection that you're looking for

Speaker 0:
for at the very moment when you you need it. OK, OK, thank you very much. So then, Lawrence, it sounds to me. Then, on the stable income fund, you mentioned that you take no credit risk. Um, currently, uh, but then how would you manage the duration in this fund to ultimately outperform when interest rates are changing?

Speaker 1:
Yeah, just to, uh, clarify the no credit risk. The credit, I guess, is in the oil of the beholder as well. But our our, um, credit risk is limited to government, uh, government debt, government bonds, in other words, and money market instruments and, uh, the top four banks, senior debt and with the emphasis on senior debt rather than down in the in the credit spectrum, Um, so it is very light on credit risk, um, so to speak. Then, um so

Speaker 1:
you know, again, we we are allowed by the category itself to run up to a two duration. That's our maximum limit in in the stable income fund.

Speaker 1:
For those you know to maybe just try and put that into understandable terms. That means if there's 100 basis point, parallel movement in interest rates up or down, then the fund, if it were to run at 2% would suffer or gain a 2% gain or loss as a consequence of that risk. On average, we actually quite cautious and run closer to a year.

Speaker 1:
We have been at two years as well. We are currently at half a year. We are a little bit concerned around additional bond supply, a deteriorating fiscal outlook. Only locals subsidising government's deficit and moving out of coupon season as well. But we are not scared to increase that duration either if we've been wrong or if we've been right

Speaker 1:
and and and again, you know, our Enhanced Income Fund, we'd have a faster twitch in terms of the the swing in duration, and we'd probably move up to about a three duration, uh, as as a maximum, albeit that it's allowed to get up to four duration. Duration

Speaker 1:
is an important driver. But again, I would highlight that it's not only duration that, you know, getting duration right. That's driving excess returns. It's actually getting asset allocation decisions. Right? Which has some implication on duration from time to time.

Speaker 0:
OK, thank you very much. Um so, Jacques, I'm gonna bring you in here, and then we're gonna close off the session. Um, with Steven,

Speaker 0:
I'd like to understand, then, at the solutions at graphite. What types of solutions would the Matrix stable income fund ideally be be appropriate for? I know you mentioned that you use it as a as a core, almost like a building block. Um uh, purpose, should I say? But what decisions do you

Speaker 0:
take whether to overweight or underweight? Um, an allocation to the to the stable income fund again. I think it depends on on the risk profiled fund. So it would be a different answer for a cautious or a low equity fund to to a high equity or balance mandate.

Speaker 0:
So, for example, in a balance mandate, it might be more of a parking bay for us. Um, you know, particularly if we are bullish on other assets, we might use it as a cash plus type of of offering to to house a portion of the assets while we look for better opportunities. Um or and that might be that we switch some of those assets, for example, into

Speaker 0:
a higher duration bond fund. Um, so you can't again, you know, use one fund for all solutions. Um, the average balance fund, at the moment, their fixed income carve out has probably got a five or six year duration. So if you're trying to replicate in a building block approach what the average balance fund in South Africa does at the moment,

Speaker 0:
you wouldn't use the stable fund as as your core. Um, however, in a different environment, if rates, for example were were going up still, um, you know, it might form a much bigger portion in that, you know, managers wouldn't be taking We wouldn't be looking to take a much higher duration.

Speaker 0:
Um, however, in a a more cautious low equity, uh, solution. This would be something that you would have in the portfolio, I guess, through all market cycles, um, you might tilt and take on more credit risk if you were particularly bullish there,

Speaker 0:
Um, and the spreads had widened. Um, but I don't think that's the case at the moment. You know, I think Florence gave you a good feel for the the the economic environment in South Africa. You know, you don't need to take that additional risk. Absolutely. Thank you very much. A So Steven. I just want to understand, then as well would, um, for a stable income fund.

Speaker 0:
What are the specific considerations that clients as well as advisors would need to take into account when looking to allocate or increase an allocation toward, um, a stable income fund or income funds in general? And, um, what are the unique benefits that they would provide in a client's portfolio.

Speaker 0:
So it's It's a horses for courses approach, Um, and hence forward we look, we follow a lifestyle financial planning approach so there might be three particular reasons, or or scenarios where clients might find themselves in income funds or or an allocation to income funds, and it really depends on their circumstances. So we would start off to really try and understand what their clients income and capital requirements are over their lifetime. Uh, based on the resources that they have at hand,

Speaker 0:
we would. It's a mathematical calculation to determine what type of return they need. You know if they need a high return, because they don't, you know, have enough assets. Well, then you need more growth assets. If you need a lower return because you have enough assets or your your your expenses, your lifestyle expenses are low. Then you can afford to take less risk.

Speaker 0:
Once we understand what the mathematical calculation is, we can then unpack risk. We spoke about the different types of risk early on, and once clients are comfortable with that level of risk, then you know we've got a strategy so what we would do, we would look at. We look at four types of assets. Either business assets, which are clients ability to earn an income or a business that's generating an income.

Speaker 0:
Um, life style assets, your home, your car, your house. You don't really regard them as investments. A lot of the space where we we we play in, is around the lifetime asset. So income funds come in, uh, they play a big role in there. Those are the type of investments retirement funds that are designed to generate an income when you are no longer working. So the rules around that are to try and minimise risk. And, uh, you know, not take that kind of volatility.

Speaker 0:
Um, and to make sure that you have enough money for your lifetime. So it might be in that instance in retirement funds living in US that clients don't need to take much risk. So part of a building block approach there might be an an inflation plus two type of strategy, um, and and that's where the income fund will come in. And that sort of retired client,

Speaker 0:
then, once you have enough money in those lifetime assets then the rest of your assets are are surplus. So you you could you could go put it on black or red. You know, you could afford to use it. You could use it for future generational wealth creation.

Speaker 0:
Um, what we do is we find a lot of our retired clients have money in that space, and they like to just leave it in the bank. They like the money market. They like to know that there's no we're talking about that risk. They don't want to lose this money. Um and so the play there, I mean, the the the terms that cash is king. There's a term that cash is trash. And you know, when you're taking into account inflation and taxation, you got to look at your after tax. And after inflation, there's real returns. What are you actually getting?

Speaker 0:
In a lot of cases, you know you're going backwards, and so it's an enticement to to take clients just up that risk spectrum. You know, one step up cash like returns, or what do you call cash plus returns? Yes, there's volatility. It's not their immediate money in terms of that liquidity space that they need access to it. It's money that they could possibly use in 12 months or or longer. So that's

Speaker 0:
in that space. And then maybe the third one is kind of like a a situational type of client where they've sold the property. They don't They're not gonna use that money straight away. They can take 12 months. Uh uh, or longer they might be building. They might need the access to their money in sort of 12 to 18 months. Those are the type of clients who want slightly higher return than cash. They're looking to minimise taxes slightly because of the different, uh, assets that you can use in that income fund.

Speaker 0:
And they can afford to take a little bit of risk, but they want a high, high, higher yield. So those are kind of the three scenarios that that we would look at it. But I think I guess part of our job and these guys are the clever guys, how they engineer it and make it work.

Speaker 0:
But part of our our job is to actually educate people because there are a lot of these misnomers out there. Um, you know, when we do modelling uh, we show people if you if you leave your money in cash, you actually you're gonna run out of money to talk about that capital adequacy risk so you can do what you like, but the consequences of that So for us is trying to to to to not do what clients think that they want to do. We try to show them scenarios that that can, you know, that will sort of outplay what they want to do

Speaker 0:
and give them the opportunity to make the right decisions. OK, so then perhaps, um, just to understand, then, in what market, um, environments. We'd start seeing a lot more interest in stable income funds. Perhaps Now, with the higher interest rates, um, loans, you are seeing a lot more flow coming into the stable income fund. What about the Enhanced Income fund? And

Speaker 0:
what What's determines the the the flows. You know, could I make a comment on on on Absolutely. What we also like about income funds is because, you know, uh, people like Lawrence have got their finger on the pulse. They have access to data, they seeing what's going on the market. They know,

Speaker 0:
you know, as momentum is shifting and changing when they need to be moving between those flexible asset classes. We don't in, in, in, in a financial planning world with clients, it's a it's a lot more difficult. And we we feel a lot more comfortable handing it over to those sort of flexible managers who who can take advantage when you know and and get some upside yield when the opportunity arises. And

Speaker 1:
Chloe, my quick answer would be that, you know, inflation plus three is a very common mandate out there. Um, and Inflation Plus three has been quite demanding to meet for many managers in many different products. Um, particularly low and medium equity mandates, um, multi asset mandates, as you guys would know as well and if you can, to to put it simply, I think clients are sometimes getting a bit fed up as well, with not getting that inflation plus three outcome. So,

Speaker 1:
you know, hence the large allocations that we've seen to income funds and to our sort of introductory remarks or more introductory remarks, I think inflation plus three is here to stay in income funds, and it's stable inflation plus three

Speaker 1:
and you know, I would continue to see that as a very favourable place for all the right reasons mentioned, you know, achieving inflation plus three. Because I think inflation plus three is going to be achieved for a prolonged period of time, given this policy setting over inflation that certainly we are expecting. Ok,

Speaker 0:
well, I think that that brings us to a close for the session.

Speaker 0:
I really enjoyed, uh, unpacking income fans with you gentlemen. Thank you very much for sharing your insights. We appreciate your time.

Speaker 1:
Thank you.