With South Africa’s inflation and interest rates widely expected to rise over the medium term, and returns from most asset classes facing headwinds from relatively high valuations and slow economic growth, Prudential Investment Managers has recently been adjusting the positioning of the Prudential Inflation Plus Fund to a more defensive exposure to ensure it continues to meet its goals of producing annual returns of at least 5% above inflation, while also minimising volatility for investors who need a reliable income, according to Michael Moyle, Portfolio Manager and Head of Real Return at Prudential.
The fund, which this year won a Morningstar Award for top risk adjusted performance as “Best Cautious Allocation Fund”, is a diversified low-equity fund that is limited to holding a maximum of 40% in equity and 25% offshore (plus 5% in Africa).
“Previously it had been overweight in South African listed property at nearly 10% of the fund to take advantage of the attractive yields on offer, but as this asset class became increasingly more expensive earlier in the year, we sold down our holdings to around 6.5% so that the fund is now underweight in listed property,” explains Moyle. “We see this as more appropriate, since we believe growth is likely to slow over the medium term.” Listed property does, however, remain an important component of the portfolio due to its ability to produce above-inflation returns.
At the same time, cash holdings have risen to 14% of the fund (as of 31 July 2015), a more typical level in times of caution. The higher cash comes from the proceeds of the property sales and reflects Prudential’s belief that, with most asset classes currently relatively expensive, there are few new opportunities worth pursuing at the moment.
The fund’s largest holding, at 22.2%, is inflation-linked bonds. This also gives it a strong defensive character, providing investors with the inflation protection that is at the core of the fund. Inflation-linked bonds pay investors a yield that moves in line with inflation over time, preventing the return from being eroded as happens with nominal, fixed-rate bonds. Currently, inflation-linked bonds are around fair value to slightly expensive, which is why the fund’s positioning is neutral in ILBs, notes Moyle.
The fund’s second-largest holding is South African equities, at 20.7%, while foreign equity exposure is at 16.1%, for a total equity exposure of 36.8%, near the 40% limit for the low-equity fund category. “This positioning reflects our view that equity continues to offer the highest return potential over the medium term, so that the Inflation Plus Fund can meet and exceed its CPI+5% return target,” he says. “Our local equity holding is slightly underweight because valuations on the JSE are somewhat expensive, while foreign equities are overweight due to the attractive valuations on offer in certain countries – particularly developed markets like Germany and Italy.”
Looking ahead, investment conditions are likely to remain testing, says Moyle. Valuations of most asset classes have been at relatively high levels, while headwinds are coming from many fronts. Globally these include uncertainty around rising US interest rates, slow global growth and investor jitters over emerging markets and Greece, while locally there are concerns over economic growth, company earnings, and rising inflation and interest rates, among others. “We at Prudential expect returns to be somewhat lower from these levels going forward and would caution investors to temper their expectations over the medium-term,” he concludes.