People are frequently asked to define their “risk appetite” in investment advice assessments. Unfortunately, when most people respond, they tend to simplify the concept of risk as solely the possibility of losing their whole investment. The problem with this outlook is that risk is more nuanced and requires consideration from multiple angles. Some characteristics of risk to consider in forming a more accurate assessment include the following:
Returns fluctuating significantly (investment volatility)
The definition of risk most beloved by academics is that, assuming that two investments provide the same gain, investors should select the investment that provides the most stable (i.e. the most predictable) returns.
However, more recently, there has been increasing consensus that low volatility is not always an appropriate measurement of risk. Consider an investment which provides a very stable return for long periods of time but loses more than 90% of its value once every few decades. The stability of the returns on such an investment may be low, because it is usually measured over long periods of time and the extreme events occur so infrequently, but the investor could still end up effectively losing everything. The greater risk is, of course, that this loss occurs at exactly the wrong moment (such as just prior to retirement).
Permanent loss of capital
The short-comings of the previous definition of risk, have led others to redefine risk as the permanent loss of capital. When this definition of risk is used, assuming that two investments provide the same gain, investors should select the investment that has the lowest chance of an extreme loss.
However, this definition ignores the human tendency to react to the recent past. If an investor selects an investment which is very volatile, significant decreases in value of the investment will trigger the fear that a permanent loss is about to occur. This is likely to be the case irrespective of past experience or even current evidence that points to a potential recovery, as investors tend to focus only on information which confirms their existing beliefs. Consequently, the risk here is that investors decide to lower volatility (stop the pain at any price) by switching out of the investment at exactly the wrong moment. This behaviour then creates the permanent loss which could be what the investor was trying to avoid.
The risk of missing out on growth
This definition of risk is often ignored or only mentioned in passing when an investor’s life-stage is discussed. Most typically, investors are only reminded of this aspect of risk when they retire when they are advised not to avoid “growth” assets completely, because of the risk of out-living their investments.
However, this characteristic of risk needs to be addressed throughout an investor’s life. Research has revealed that the vast majority of investors fail to time equity markets successfully. In addition, missing only a few of the single best days in an equity market, even when investing over decades, makes a significant difference in investment outcomes. More recent findings show that missing out on just the best performing stocks, even when avoiding the most significant loss-making stocks, lead to equity portfolios producing returns that are essentially indistinguishable from that of cash.
Since risk can take so many varying forms, it is very difficult to in invest in a single product which safeguards against all of these different characteristics. Fortunately, recent changes to legislation in South Africa have made an asset class which can potentially assist in protecting against risk more broadly than traditional products available to retail investors for the first time. This asset class is Retail Hedge Fund products.
Hedge funds, in particular long-short hedge funds, offer a unique way to manage all of the characteristics of risk discussed above, for the following reasons:
Investment volatility: Hedge funds are never fully invested in equity markets and tend to hold a significant amount of cash which reduces volatility of returns. In addition, hedge funds are allowed to make far greater use of contracts with banks to insure against negative market outcomes (called “derivatives”) to protect portfolios against downside risk in equity markets than most alternative investment products.
Permanent loss of capital: Hedge fund managers assess potential investments differently from many other investors, as they are allowed to take positions (called “short positions”) which make profit from falling asset prices. As a result, hedge fund investors are constantly searching for the extreme events that lead to large losses, even for those investments where this is generally least expected. The ability to gain from such events, reduces the bias that most investors have to ignore negative information about an investment that conflicts with his/her current beliefs.
Missing out on growth: Managers of most investment products often have no choice but to move out of equity markets or specific stocks when they want to reduce risk in times of uncertainty. However, this increases the risk of missing precisely the one day or one stock that could have made all the difference for an investor. By contrast, hedge fund managers have more tools and freedom within their regulatory framework to protect portfolios against unexpected downside events. As a result, hedge funds can afford to retain equity exposure, even when the general market direction is very uncertain. Investors benefit from being invested through the cycle, but also from protection should unexpected developments occur.
As a result of the opportunities that hedge funds offer to manage risk, investors can expect a steadier performance through the cycle and, sometimes, even outperformance of the more aggressive growth mandates. Outperformance becomes more likely when uncertainty around the outlook for traditional growth assets, such as equity and property, becomes more uncertain. At 36ONE Asset Management, we believe that we are currently entering just such a period.
On the local front, despite wild fluctuations within the last three to four years, the JSE SWIX index has essentially flat since the start of 2015. When general market direction is lacking, taking advantage of changes in sentiment and gaining from negative movements is essential to improve predictability of returns. On the global front, equity markets have seen a better upward trend, but volatility has increased since mid-2016. In addition, currency volatility has made returns for SA investors more difficult to forecast. Consequently, we believe that adding a hedge fund to a balanced investment portfolio at the present juncture could be key to reducing risk for an investor.
Cy Jacobs
Co-Founder of 36ONE Asset Management
Key note speakers at the Annual GIB Investment Summit 2019 (hyperlink)
