“Our view about the perspective risk and return of the 60/40 is essentially unchanged [in light on yields widening]. We think it still looks pretty ugly,” says Rob Perrone, investment counsellor at Orbis Investments. The days of a traditional 60/40 bond equity split for a balanced portfolio have been in trouble for a while and despite government bond yields widening due to recent market volatility unfortunately this has occurred alongside heightened inflation.
Regarding the persistence of the traditional 60/40 balanced fund split, Mr Perrone says it’s like a ‘law of physics’, as in if one asset class goes up, the other is bound to go down. But he looks at famed academic Robert Schiller’s work on the subject which spans a period of 120 years and points out that Mr Schiller saw that the more usual correlation was positive. When bonds go up, so do equities and the reverse is true.
Referring back to a period in the 1960s when bonds and stocks both moved in the same direction, the driver for this was inflation, especially when it gets above 4 percent.
However, looking at the firm’s balanced fund, it does contain a mix of bonds and equities with the latter enjoying somewhat of a rally in the form of its commodity company holdings such as Shell and Barrick Gold.
Mr Perrone explains that the government bond exposure the fund has is in the form of US Treasuries are of such short duration it acts like cash. Anything long duration is in the form of TIPs, or inflation protected which in today’s market is essential. “We continue to think bonds represent basically return free risk,” Mr Perrone says ironically.
Despite the rhetoric coming from the Federal Reserve changing regarding inflation, moving from the use of the word ‘transitory’ to something that suggests that this is going to last for a long time, Mr Perrone observes that forecasts for the next couple of years suggest inflation is going to come in at around 2.2 percent.
“So, what's the market telling you? The market's telling you that to the extent that inflation is high, it'll all be sorted out,” says Mr Perrone.
He adds that while the Fed may have retired the word ‘transitory’ it’s still in the central bank’s thinking. As mentioned above, Mr Perrone thinks the inflection point which really blows the 60/40 split apart is 4 percent, so inflation doesn’t have to reach the dizzying heights of the 1970s before the traditional balanced portfolio model starts to break apart.
“You're probably going to see a big hit in equity valuations because if inflation is that high [4 percent], that's going to cause pressure, both corporate profits and the multiples that investors put on those profits. And you're likely to see a positive correlation between stocks and bonds,” says Mr Perrone.
The solution
The main tool Orbis uses in its multi asset funds is hedged equities by selling index futures. The firm screens the world’s thousands of equities for those trading at a discount to intrinsic value.
“Then what we do is short the market, hedge out some of the associated stock market exposure. And we love that because if you look back over the long term with our stock picking, that generates a volatility profile, not that different from bonds,”
A multi asset fund that generates equity like returns with a volatility profile closer to bonds might sound suspiciously like an absolute return fund but Mr Perrone says it’s more about taking less risk using “very simply building blocks”. How the fund gets to this optimum balance for investors who ‘can’t stomach’ a full risk-on equities fund can be done in any number of ways. At the manager’s disposal are equities, fixed income and commodity exposure which depending on what’s going on the macro environment can change quite quickly.
However, some positions in the fund which seem to be ideally suited to this current inflationary environment weren’t knee jerk reactions explains Mr Perrone. The fund built up its position in Shell in 2016, so has held the oil major during some tremendous downturns for the sector and Barrick Gold has been in the portfolio before the company’s merger with Randgold in 2018.
This is indicative of the firm’s contrarian style of investing. If it feels that a company is under valued but has solid fundamentals, it will stick with the stock come what may. Given recent events and the huge levels of commodity inflation, this policy seems to be one that has worked well for the firm.
The Orbis fee structure
While many fund managers are concerned with fee pressures, Orbis has an interesting solution while others are engaged in a ‘race to the bottom’.
The fund doesn’t have a fee. Sounds strange in a world where hedge funds are still desperate to cling on to their notorious ‘2 and 20’ model but Orbis will only charge clients if the fund outperforms its benchmark (net of fees obviously).
This outperformance fee goes into a pot and if the fund underperforms, this is then repaid to the client. In an environment whereby the SPIVA report delights in showing the number of active managers who fail to beat the benchmark, this structure could well be the answer to the ongoing passive versus active argument.
“It's very important that if you're going to deliver active management, you set up your charging structure in a way that incentivizes you to seek superior returns to your clients,” says Mr Perrone.
The key to this firm’s investment philosophy is its ability to change. Whereas die-hard value manager will always look for stocks that are trading at a 40 percent discount to book value, Orbis realises that those times come (Mr Perrone says now is good for deep value) but at other times the firm is prepared to pay slightly more for growth. Growth at a reasonable price, or GARP. But the difference is that investors won’t have to pay for mishaps due to Orbis’s fee structure so it seems a win-win.
