We all like the value of our investments to rise. But there are times when market volatility makes it difficult for even the most skilled fund manager to prevent our investments from falling in value.
Market volatility is part of investing – are you prepared?
Source: Bloomberg and Capital Economics Research
A key determinant on how much a fund manager focuses on protection of capital, will be the ‘mandate’ or the specific purpose (i.e. benchmark) the fund will be managed to.
Managers with an ‘absolute’ benchmark will put more emphasis on generating positive returns over the business cycle ‘whatever the weather’. Whereas ‘relative’ managers are benchmarking their success on beating a specific market index, which will sometimes be a positive return and sometimes a negative return. A typical benchmark for a ‘relative’ NZ share fund would be a market index such as the NZX50. Because of their focus on producing positive returns, a manager with an absolute benchmark, will be more focussed on protection of capital in times of market stress.
A key potential benefit to many active managers, irrespective of their benchmark, is their ability to use certain tools to help protect capital or minimise loss in portfolio value during times of market stress.
What are these tools?
Outside of making sure the actual security selection is robust, allocating more of the fund to cash is a traditional move an active manager makes if they sense gloom on the horizon. This can be done by selling shares and moving the proceeds into cash or by selling index futures. Selling index futures offsets physical share holdings and essentially creates ‘synthetic cash’ to reduce risk across the fund. An index future is a financial market instrument to buy/sell a specific market index at an agreed price at some future date. Selling index futures allows the Fund to make offsetting gains, even when the value of the securities in the portfolio are falling.
An active manager may also buy put options (i.e. the option to sell a certain number of shares at an agreed price at or before some future date). These act similar to insurance contracts, helping to protect the fund’s capital if a certain market index or share price falls – by giving the ability to profit when this specific index or share price goes down. The difficult part as always, is being positioned correctly beforehand.
Market corrections happen, and can happen regularly. While these tools can aid an active manager in reducing possible losses, it’s best to accept there is no magic formula to fully limit volatility. A fund manager will generally only have a portion of their fund positioned for protection from these perceived risks in a normal market environment. At the end of the day, when seeking higher long-term returns, you need to maintain exposure to riskier assets, such as shares and property.
There have been five instances of significant falls in the MSCI World Net Total Return index since the low of the Global Financial Crisis (see below). We believe the best protection is to hold a globally diversified portfolio and get the right advice. An investor should have a plan in place and more importantly stick with it despite changing market situations. Events come and go, but taking a long-term view is a more prudent course. Staying invested makes sense, with the assistance of a skilled fund manager to help reduce volatility along the way.
Source : Bloomberg.