Investors across the board seem more willing to give up potential upside in favour of the greater stability and better night’s sleep offered by focusing on capital protection and limiting drawdowns. As Tom Joy, director of investment at the £5.2bn Church of England Commissioners’ endowment fund says: “We care much more about not underperforming in a down market than underperforming in a strong up market.”
The continued shift towards more diversified strategies, including hedge funds, multi-asset and diversified growth funds, which are designed to provide flexibility to adapt to the market environment while offering protection from downside risk and the potential for significant upside, speaks to that notion because of their greater ability to cater to short-term risks and opportunities.
Stay nimble
The hedge fund industry has seen more than $20.4bn inflows in the first half of 2012 alone, according to figures from Hedge Fund Research. The nimbleness of hedge funds to adapt to changes in the short-term environment has demonstrated the extent to which there is prudence in doing so in a politically- driven and manipulated market.
In June and July a large number of hedge funds had been short the euro and were very negative in their outlook. Yet come September, which saw a significant uplift in markets and sentiment on the back of Fed and ECB actions, hedge funds also fared well. The HFRX index was up 0.82% for the month to 24 Sept, suggesting many had been able to effectively adapt their positions.
Standard Life meanwhile has seen its multi-asset Global Absolute Return Strategies (GARS) fund portfolios swell by more than £3.3bn in the first half of this year to over £17bn in AUM from more than 500 institutional clients. Blackrock has enjoyed around 15% growth in its diversified growth assets so far this year, having grown at over a 30% compound rate for the last three years.
John Dewey, managing director within Blackrock’s Multi-Asset Client Solutions team, says: “It is important to be more opportunistic and flexible in a volatile environment. Part of risk management is about being able to respond quickly by being in a position to rapidly put a view in place and then take it off when the market changes.”
Flexible friends
In a market that is increasingly driven by news and data flow on a weekly basis, it is more difficult to take a medium or long-term view. “While people want to stay true to their investment philosophy,” Spenner says, “being too rigid can be costly. Even if they have the long-term fundamentals right, funds have to be careful not to lose their long-term value potential by repeatedly losing out in the short term.
“Overall, many investors have shrunk their time-frame,” Spenner continues. “Pension funds and endowments post-2008 are more constrained as none can afford to do otherwise due to their liability structure. It is prudent to be more trading-oriented in a risk on/risk off environment. It would be silly to try and fight the markets.”
As long as volatility and uncertainty prevail in the markets, paying greater attention to short-term risk looks like prudent behaviour given the damage that compound losses can cause to investors’ long-term performance potential.
The plague of prudence
Prudence, particularly if similarly executed by many investors, can of course lead to plague. Risk management and tighter controls on volatility can also have a significant downside. With so much of the market following similar risk management policies and employing similar tools, the degree of whipsaw in markets becomes increased, exaggerating the volatility investors are trying so hard to avoid.
Risk has become commoditised to the extent many investment managers’ policies operate in very similar ways, within similar tolerance bands and triggered to buy and sell at similar points. As a result, larger swathes of money move in the same direction at the same time, effectively increasing the sharpness of swings as they occur.
This raises two concerns. One, it increases correlations between assets and exacerbates the volatility investors are trying to avoid and, two, it can severely limit upside potential. Both factors increase the danger of compound short-term losses eating away at long-term gains.
“It’s great not to lose money,” International Asset Management chief executive Morten Spenner says, “but you also have to generate some returns. You can’t just switch to avoiding short-term losses – you also need long-term gains and that has been missing in some cases.” The problem is that typically, investors don’t get the chance to put enough risk on at the appropriate times in a risk on/risk off environment.
In fact, not only do investors risk losing out by selling at fire-sale prices, it may also prevent them from buying at the most opportunistic time.
Humayun Shahryar, chief executive of macro hedge fund Auvest, says: “Investors who redeemed in a panic during the financial crisis lost money and that lesson has still not been learned today. In a volatile world to expect consistently low volatility of returns is irrational and dangerous as it is telling managers to get out of the market just as things are getting interesting. You can’t expect not to lose money and still be an investor in today’s world.” (It is worth noting, that Auvest enjoys the stability of locked-in assets as clients are effectively forced to ride out any short-term performance volatility).
Ironically, as the market increasingly acts in synchronised prudence, that creates a plague by exacerbating unwanted volatility and limiting upside, to the detriment of long-term potential.
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