The Efficient Frontier
In the realm of investment portfolio construction, the Efficient Frontier is a crucial concept that helps investors optimise their portfolios. In simple terms, the Efficient Frontier is a graph that shows the best possible return you can get for a given level of risk. Imagine plotting all possible combinations of investments on a chart, with risk on the horizontal axis and return on the vertical axis. The curve that forms the upper edge of this plot is the Efficient Frontier.
Portfolios that lie on this curve are considered “efficient” because they offer the highest expected return for a specific level of risk. Conversely, any portfolio below this curve is considered “inefficient”, as it does not offer adequate returns for the risk taken. By selecting portfolios on the Efficient Frontier, investors can maximise their returns while minimising risk.
Simple South African Efficient Frontier
In the chart below, we have plotted the most popular Association for Savings and Investment South Africa (ASISA) fund categories. As expected, the portfolios with a higher equity allocation have a higher volatility than those with a lower allocation.
If we take a very simple portfolio example that only comprises an allocation to a Multi-Asset High Equity CIS Fund, the investor has a portfolio that, at the time, is suitable for their needs and meets their investment objectives.
Now what would happen if these investment objectives should change? These changes could be a shift in the overall view of market conditions (such as changes in interest rate cycles), specific upcoming events (such as general elections) or they may even be a change in the individual investor’s personal circumstances (such as job loss, early retirement, emigration, etc).
Usually, to effect these changes, the portfolio would have to be adjusted to something more suitable and this would then involve a sale of their current portfolio holdings into something more suitable (for example selling the Multi-Asset High Equity CIS holding and purchasing a Multi-Asset Low Equity CIS holding).
Trading out of one fund into another fund could lead to significant tax implications, as well as additional costs. Other considerations are when to trade and for how long will this new portfolio be suitable.
There may be times when more risk can be tolerated if higher returns are sought after (for example, selling a Multi-Asset High Equity and purchasing a General Equity Fund).
Absa fund-linked solutions
Financial advisors can use Absa Bank issued notes to effectively change the exposure of their client portfolios without having to physically transact CIS funds.
The Absa fund-linked solutions (FLS) note has the following features:
- Total return note (no distributions)
- Advice-led, where each investor gets their own note
- Portfolios can be managed on a bulk basis
- Available via LISPs
- The CIS units belong to Absa and Absa will provide the performance of these holdings via the performance of the note
Several strategies can be implemented on the reference portfolios:
- Delta 1 – model portfolio constituents. This is the default or starting strategy, where a blend of CIS exposures is chosen by the financial advisor. These funds must come from an Absa approved fund list (there is a due diligence process for new funds to join this list). Automatic rebalance of model portfolio can be implemented for example, every six months or when weightings drift more than an agreeable amount.
- Risk management – setting a volatility target. A suitable volatility target will be set over the Delta 1 portfolio. When volatility is higher than the desired level, the strategy will dis-invest a certain amount of the Delta 1 portfolio into a cash-like investment. When volatility settles and drifts below the target, CIS exposures will be re-invested. The total volatility of the CIS exposures and cash-like instruments will always be at or below the target.
- Protection – preserving values. There are two types of protection: term-based, which sets a minimum value of the portfolio over a set term (for example, 95% of current value for the next five years). This can allow for loans to be taken out using the protected portfolio as collateral without the necessity for any asset top-ups or additional cash flows. Continuous protection can also be applied on the portfolio locking in a minimum value that increases as the portfolio reaches new high values (trailing stop loss). This results in a known upfront maximum loss on the portfolio (for example, an 85% protection value results in a maximum loss of 15% on the portfolio).
- Leverage – obtaining more exposure than the nominal value. Applying leverage on the portfolio during specific positive market phases can enhance portfolio performance. This extra exposure is obtained by additional funds borrowed from Absa and then applied to purchasing additional CIS exposures in the model portfolio.
How to use Absa FLS to move along the Efficient Frontier
Using various strategies, we can effectively turn a specifically risk targeted portfolio into another risk profiled portfolio without having to effect a transaction. Looking at the chart below, we can see different points along the Efficient Frontier that are achieved by using various strategies just on the Multi-Asset High Equity CIS Fund (shown in orange). There is no need to trade funds to achieve a similar risk/return profile. These strategies are highly flexible which means that movements along the Efficient Frontier can be implemented with ease and without fear of triggering potential gains as, remember, the performance assets belong to Absa and the investor hasn’t traded the note.
To approximate a General Equity Fund’s risk/return, we apply a combination strategy with Leverage strategy of 1.7x Exposure (E) with a Risk Managed Volatility target (V) of 20 on the Multi-Asset High Equity Fund which gives a slightly higher return for lower risk than a straight allocation to a General Equity Fund.
To approximate a Multi-Asset Low Equity performance, a Continuous Protection strategy with a protection level of 85% on a Multi-Asset High Equity Fund with no leverage (Exposure (E) of 1x) will result in a slightly higher level of volatility for a higher level of return than a direct allocation to a Multi-Asset Low Equity Fund.
Conclusion
Subject to each investor’s own constraints (eg taxation, levels of free assets, risk tolerance, etc), the primary objective of investing is to maximise return subject to the minimum level of risk for that return. We think there is a role for Absa’s FLS strategies to improve outcomes from what investors have traditionally known to be true.
It is now possible to move up and down the Efficient Frontier when investment circumstances change but, more importantly, many Efficient Portfolios can be created by using the same building blocks. Now imagine what could be achieved when additional building blocks with FLS strategies are placed upon them.
