Preservation, protection and growth – questions answered

March 2009

BY STEPHEN ROBERTS

Do preservation and protection always come at the cost of growth – are there ways to achieve both?

In investments there are no free lunches. It is conventional wisdom that over the long term equity, as an asset class, provides superior returns to other traditional asset classes like bonds and cash, but with greater cost in terms of greater volatility (risk). The requirement to preserve and protect implies a need to reduce exposure to the volatility which exposes the investor to the possibility of negative absolute or at least negative real returns. This is typically achieved by altering the return profile of equity using derivatives (capping the upside in return for protecting the downside) or providing access to some form of balance sheet to smooth the bad times. Both of these must be paid for in some way and represent a cost.

The achievement of preservation, protection and growth is a function of the investor’s time scale. The shorter the timeframe, the more the investor has to give up to achieve the multiple objectives. Demand for preservation in real terms (i.e. growth in excess of CPI) and absolute capital protection in any one year period, forces the investor’s overall return expectation to migrate to a cash-plus profile.

What are the various products available for investors looking for preservation and protection?

The plethora of “absolute return” products on the market that promise some form of preservation and protection suggests there is no shortage. However the sobering experience of our market in 2008 and continuing in 2009 has exposed the reality that relatively few absolute return products offer capital protection, never mind preservation in real terms, in a sustained declining market scenario. Even some of the insurers’ smoothed bonus products have bowed to the chilling blasts of negative equity returns and widening credit spreads. There are relatively few genuinely “cash-plus” focused absolute return funds.

What should one expect and know about cash-plus solutions?

The sobering experience referred to above is likely to prompt investors to demand the types of product where a key underlying objective is, at a minimum, capital protection and preferably growth in real terms in every year. Taquanta Absolute is one such product.

How much should be preserved and protected and how much can be invested into a ‘higher risk’ asset class or investment?

Much depends how cheap various asset classes are and therefore on their expected returns. However, in general, our analysis suggests that to ensure as a minimum capital protection and grow the asset base in real terms over short term horizons net equity exposure of less than 15% is advisable, assuming the manager has sufficient diversifying and value adding strategies to ensure the growth imperative.

When is it time to protect and when is it time to look for growth?

An investor’s perspective is determined by their individual risk appetite, time horizon and liquidity requirements. From a market perspective the time to start looking for protection is when it appears to be counter intuitive in terms of the preponderance of “good news” in the market. Likewise the time to start taking more risk is when the market is depressed. At Taquanta this expresses itself as a contrarian strategy so, as an example, when the market value against the trend earnings (not current earnings) is over inflated, we will look to protect our clients’ wealth. Conversely when the market value against trend earnings is deflated we believe it appropriate to add risk to portfolios (increase the opportunities for growth).

How much of the current need for preservation is based on investment principles and how much on emotion?

Preservation of investment values in real terms is correctly a primary investment objective. Investors are notoriously badly wired to be successful investors, being driven alternately by the twin emotions of fear and greed – the very drivers that create market cycles. They naturally end up wanting to emphasize protection when in hindsight they would have been better staying exposed to what appears to be a risky market. In the current market, investors are understandably running scared and focusing on preservation or at least some form of protection. The tension can be resolved to some extent by investment in an absolute return fund with a genuine “cash plus” process which embraces some form of contrarian equity exposure strategy.

Is the need for preservation overriding any long term goals?

 

There is always a risk that people protect when the worst is over, yet it is not at all clear that the worst is over. Again where the primary objective is the protection and preservation of capital in real terms a genuine “cash plus” approach should meet this objective. Where investors are willing and able to sustain investment loss for periods of greater than a year strategies that emphasize exploiting the equity risk premium are more appropriate (assuming that equity is either fairly or ideally under valued).

 

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