How to add value and rein in risk

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How to add value and rein in risk

In a financial world that is becoming severely distorted by the actions of central banks and where lower, or perhaps negative, returns are becoming the norm, a fair question to be asked of portfolio managers is: how can value be added? 

Where valuations of some assets are at best stretched, if not outright expensive, and where periods of heightened volatility put even anaemic returns at risk, it becomes increasingly difficult for portfolio managers to justify fees that have become a higher proportion of potential returns. 

When market yields were between 4 per cent and 6 per cent, high management fees could be tolerated; but with current negative yields generating sub-1 per cent, paying the same level of fees is no longer feasible. This situation partially explains the rise in the popularity of trackers – if it is difficult to generate positive performance, let alone outperformance, then portfolio managers should at least keep up with markets at a minimal cost. 

However, market fluctuations will erode capital and here lies the true value of a good manager: being able to control risk so that the loss in value does not compromise future recovery.

A way of generating value for clients is to make sure that a client’s portfolio is always aligned to their time frame

Controlling risk on behalf of clients requires portfolio managers to initially define two things: firstly, the client’s tolerance level for losses and, secondly, over what time frame. The latter is often forgotten by both portfolio managers and clients alike. 

It is easy to lose sight of one’s time frame and get impatient when short-term results aren’t compelling enough. For example, from March 31 1998 to December 31 1999, veteran investor Warren Buffett’s performance (as measured by his Berkshire Hathaway stock price) was -16.52 per cent while the S&P 500 index was up 36.55 per cent. This represents an impressive 53 per cent difference in performance in less than two years, which tested the patience of many people. 

Just three years later, the difference in performance had reversed to Mr Buffett’s advantage, beating the S&P 500 index by 23 per cent over the period March 1998 to December 2002. While most would agree that value investing will generate returns over the long term, results can be temporarily disappointing.

On occasion, temporary can be longer than expected: over the past three years the S&P Value index has underperformed the S&P 500 by 7.22 per cent. Mr Buffett defined his favourite holding period as “forever”, but very few people have the same discipline of sticking to their elected time frame. Reasons for this may vary, although two come to mind – personal situations can change and, therefore, impact on one’s investment time horizon, and secondly with the increased use of the internet, portfolio fluctuations can be monitored in real time, making it hard to take a step back and keep a cool head when things turn sour. 

With this in mind, a way of generating value for clients is to make sure that a client’s portfolio is always aligned to their time frame. An advantage of illiquid assets is that the investment time horizon is unlikely to change and short-term volatility will not drive short-term investment decisions.

The assessment of a client’s tolerance for loss is an important part of the investment process. It ensures the tolerance for loss is in sync with portfolio behaviour and, therefore, avoids rash investment decisions at the wrong time (for example, selling at the bottom of the market when the pain inflicted is at a maximum). Secondly, it ensures that any losses are not so high that it will make recovery a lengthy and almost impossible process. In the current low-yielding environment, risk cannot be solely defined by volatility, but also by permanent or unsustainable loss of capital. 

Controlling risk has changed from ensuring that a portfolio’s composition is diversified enough, to making sure it can resist as many external shocks as possible. A reason for stress-testing portfolios rather than relying solely on diversification is to identify the primary source of losses, therefore having a better chance of controlling them. 

Another way of controlling the downside is to invest in products that have an asymmetrical payoff that will protect the portfolio on the downside while maintaining some of the upside. This will enable the manager to retain some cash while taking advantage of opportunities; for example, yield enhancement and overlay strategies. 

In summary, a combination of controlled risk management and the right investment time frame should ensure that, over the long term, investors are not disappointed and managers are allowed to create value.

Etienne de Merlis is chief investment officer at Signia Wealth