28 July 2021
There are several ways to put cash to work productively, produce better long term, risk adjusted returns and participate in markets more safely than simply betting on markets going up. Here we highlight five approaches you can use to keep your portfolio downside risk low. We explain why it matters and why many common investment approaches are suboptimal and don’t manage risk well.
Why does it matter?
From the point of view of many investment managers, index investors and advisor portfolios, managing investor risk isn’t that important. The aim is simply to benchmark to equity indices, aggregate assets, make as much money as easily as possible when the going is good and blame the market when things turn sour. Indeed, from their business point of view this works because most of the time the markets are going up and most people invest in managers only when the going is good. This investor behavioural flaw enables the easy aggregation of assets e.g. by making the paper’s top performers list in any one year. Hence, if the markets go up 3 years out of 4, and the returns are an impressive looking +20%, +20%, +20%, -20%, then that creates a great outcome for the manager. Indeed, from the point of view of a typical client, they may even think that looks like a great return. But is it really? Is it actually in your best interests, or even what you want?
Here’s the problem. It is not anywhere near as great a return as it seems as I’ll demonstrate. Why are the returns not great, even if you manage to stay invested? Here we turn to one of the wonders of the world, which is the rule of compounding. The actual return you would make with the above impressive looking numbers – lots of 20s – is a relatively modest 38.2% over 4 years and an annualised or compounded return of just 8.4%. As you’ll appreciate, this is far removed from the 20% annual returns that are reported by the manager most of the time. Furthermore, this type of return stream often results in even worse performance for clients who routinely buy high into these managers and assets (like now, sometimes with borrowed money) and sell low (during the next market fall), creating even lower realised returns for themselves.
When you’re investing your own family money and are interested in acting in clients’ best interests, as we are, then you are much more interested in maximising the compounded return over time rather than a single annual return. This is very different from tracking a bipolar market up and down especially when it falls. The most important step to achieve higher compounded returns is to avoid big downside losses like -20% or more. Big losses destroy years of strong returns, usually require years to recover from and leave your portfolio far behind those which haven’t experienced big losses. Interestingly even a seemingly uninspiring return stream of 15%, 15%, 15%, -5% leaves your clients with a better result – closer to 10% compound – than the more volatile 8.4% of that provided by the more impressive looking series of 20% returns above.
In short keeping downside risk low improves your wealth creation. It also improves your actual investment journey as you need not experience the pain of large losses and we know most people dislike large losses much more than they like big gains. While the return stream may not look quite as sexy, your investment result is unequivocally sexier over time despite (and in part because of) lower risk. This is what outcome based and client aligned absolute return investment management aims to provide. Unlike the buy and hold conventional index or pretend active investing approaches, absolute return and outcome based investing is hard to replicate yourself and implement well and hence worth paying for. This is particularly true when the manager backs themselves to achieve good results through offering low base management fees with performance fees dependent on absolute returns or actually making money for clients. You don’t want to pay much or anything for a manager to lose you money, which is addressed by only investing with managers aligned to making you positive returns, rather than market returns.
It is quite easy to track market returns, but much harder to achieve good returns with modest downside from a diversified portfolio. Relatively few investment managers hence even attempt it. As we have shown, however, the latter are much more aligned with investors’ best interests and less likely to be paid high fees for getting lucky with a concentrated single asset class portfolio.
We have demonstrated why risk management matters to produce lower risk outperforming portfolios through a full cycle. Now let’s outline some of the ways to reduce downside risk while still enabling good upside:
1. Diversify your asset classes
Many say they’re diversified and indeed if you own more than 1 position, you are diversified to a limited degree. But sufficient diversification relies upon much more than simply adding another correlated Australian stock or equity fund.
Commonly understood by diversified managers is the concept of diversifying into different asset classes. However, diversification for its own sake in a static way is suboptimal and valuation needs to be considered. Government bonds are an obvious option which are still heavily used. They offer potential diversification benefits in some environments and were attractive historically, but currently offer inadequate yields and may ultimately become more of a trading asset than a long-term hold. Other asset classes worth considering selectively include commodities, precious metals, and selective corporate bonds including hybrids. Cash is also an obvious option albeit one with inadequate returns today that is best used only for shorter term needs. It is also becoming difficult currently to find value in quality corporate debt.
Many Australians are already overweight property and are hence advised to preference managers that minimise or exclude property (and even the leveraged property plays like banks). Equity subsegments offer some potential for modest diversification and even potential upside (e.g. especially if you can find a superannuation fund willing to pay up with others’ money for an asset like Sydney Airport, so they can delist the asset!)
2. Diversify your underlying risks
Diversifying your underlying risks or drivers of return is a less obvious and arguably more important risk reduction tool than simply diversifying asset classes. It is much more important today to recognise this because there is a common policy risk to most asset classes arising from the particular yet extraordinary circumstances in today’s markets. Incredibly generous monetary and fiscal policy has driven most asset classes up to extremely high valuation levels. They will hence all likely fall together also at any hint of policy withdrawal and hence their returns are likely correlated. This risk may be crystallised because of growing inflationary instability and growing recognition about the instability and inequity created from excessive central bank and government interventions.
Diversifying underlying risk drivers in a portfolio can be achieved by understanding the underlying fundamental risk drivers of different investments e.g. are they interest rate dependent? You then ensure your portfolio spreads risk and is not overly subject to a single risk factor such as interest rates going up and hurting equities, property and bonds simultaneously. Superior portfolio construction can ensure that investments can be weighted depending upon their contribution to portfolio risk rather than their individual risk alone.
One of the best ways to diversify your underlying risk is allocating meaningful weightings to alternatives and active managers to a portfolio. Genuine alternatives and active managers should introduce more diversifying return streams which are more idiosyncratic and more skill and manager dependent than traditional investments. This is a good thing if your managers are actually good and highly desirable if markets are expensive and lack true resilience and diversification (as they do now). Being more active and alternative should lower your overall portfolio risk and risk of loss. An example of doing this includes allocating to low correlation long short funds rather than long only funds alone.
3. Avoid “crowded” and risky investments
Sometimes it is what you avoid doing which is most beneficial. The most promoted and popular and best performing investments in the world often become the worst. Just months ago, the most searched for investment in the world was the perhaps aptly named Dogecoin before its >70% fall from grace. Naively following the crowd and doing what others do is very common approach these days (even among professionals) but risky, even if it can feel comfortable at the time. Buying what Wall Street or the media is selling as cheap and easy often ends in tears. Concentrating your underlying investment risk in overpriced assets by buying and holding mantras such as index investing is also well overdue for some pain. Clearly there is plenty of risk in crowded investments even in and perhaps because of a bull market.
Being researched and contrarian and value orientated is likely to work better at protecting capital in more volatile market conditions.
4. Dynamically Manage Portfolio Risks
Dynamically managing portfolio risks in a forward looking way based on top down and bottom up insights can add a further degree of sophistication to your risk management. Position size can be changed in accordance with conviction and the opportunity set and/or positions can be removed when no longer prospective or additive to the overall portfolio. A disciplined research process and money management may establish whether company and market changes provide opportunity or may negatively impact and hence address these risks prospectively before damage is done.
5. Buy insurance to further protect your portfolio
Buying options to hedge out risks and protect downside can help remove some downside and protect you from the worst of the tail risks. Given insurance options can degrade quickly and be costly, it is best to buy only what you need, be disciplined and select your underlying securities and timing of insurance purchases carefully. Options, however, provide tremendous flexibility to rapidly change the underlying exposures in a portfolio with limited capital at risk. We like puts over major indices and ETFs, put spreads and VIX calls which hedge against rising volatility. Shorting can also be used selectively to provide portfolio protection and profit from downside moves in markets and stocks.
Buying markets, holding and hoping is a risky strategy in risky markets. Naïve backward-looking approaches and those which predominantly serve the manager won’t always work as well as they have and are unlikely to produce optimal results over time. Cash isn’t the only option to protect against market downside and is a poor long-term option.
There is much investors can do to produce better active and outcome orientated portfolios which are aligned to their actual goals, produce better compounded returns and as importantly protect against the building risks in today’s equity, bond and property markets. There are many ways to manage risk in portfolios which you can consider; we like and routinely use many of these in combination.
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