Last man standing?Why there is still a need for protected investment strategies by Iain Cunningham, co-manager, Investec Multi-Asset Protector Fund |
As Investec’s Multi-Asset Protector strategy marks its 10th anniversary, we remind ourselves of the fate of the much-beleaguered IA Protected Sector. The sector was finally closed last Autumn, leading to our strategy moving into the IA Specialist Sector. The five years leading up to its closure saw the sector shrink from 48 funds with assets under management of £3.4bn to just three strategies accounting for £324m of AUM. This fall in demand was a result of many of these products simply failing to deliver competitive returns or becoming ‘cash locked’ because of the periodic volatility in equity markets and other asset classes.
Relevance remains
Despite these challenges, we continue to firmly believe in the benefits of protected investment strategies for cautious investors – particularly for those either on the runway to, or post, retirement who want to shield themselves from a significant capital loss but not at the expense of the potential for capital growth. The growing need for effective ‘drawdown’ solutions is heightened given challenging late cycle market conditions and question marks about the effectiveness of traditional defensive strategies such as government bonds.
The value of protection
So what were the orignal characteristics that originally attracted investor interest to protected strategies? While outcomes cannot be definitively guaranteed, protected strategies can safeguard investors’ capital in the event of a significant fall in the value of financial markets. Typically, these funds aim to limit losses to between 10 and 20 percent of the highest value of a portfolio. As the value of the portfolio rises, so does the protected level, progressively locking in historic gains. The aim is to limit the downside but not the upside, enabling investors to participate in rising markets.
Coping with volatility
Why have such outcomes proved so elusive to most of the managers of protected strategies? It is true to say that although the current bull market cycle has proved to be one of the longest in history, the corrections along the way have been material. The 2011 Euro crisis, the Chinese renminbi crisis in 2015 and set back in 2018 saw the German Dax Index decline by 32%, 29% and 23.5% respectively. On each occasion stock markets recovered strongly and volatility quickly subsided. Such drawdowns were particularly problematic for protected strategies that invested purely in equities but also for multi-asset approaches. Protected fund investment levels declined sharply in response to systematic protection requirements resulting from either price declines or rising volatility. As markets recovered, fund investment levels lagged, often resulting in material opportunity costs. Progressively lower investment levels and high non discretionary cash levels then weighed on potential returns. In effect the pro cyclical nature of such de-risking mechanisms forces the managers of protected funds to break one of the cardinal rules of succesful investing and sell into weakness and buy into strength. While our own approach, which actively seeks to manage risk on a contra cyclical basis, was not immune to drawdowns, these were moderate and the funds‘ performance recovered as markets rebounded, resulting in the `smoothed‘ return profile that cautious investors particularly prize.
Factors for success
So what factors do we believe can contribute to the success and longevity of a protected strategy? Firstly, we believe in maximising the breadth of the opportunity set on the one hand and diversification on the other. This led us to build the first multi, as opposed to single, asset class protected fund. This involves the ability to invest across multiple asset classes on a global basis, provided that all positions are liquid and daily traded. We treat currencies as a separate asset class, which allows us to actively manage risk relative to Sterling without constraining this ability to exploit a global opportunity set. Excessive home bias in pursuit of lower volatility unduly limits the investment opportunity set and results in lower returns over time. Currencies also offer opportunities to further diversify return sources and can play a defensive diversification role.
Secondly, we believe de-risking mechanisms should be configured to reduce portfolio risk on a pre-emptive as opposed to a coincident basis. Other approaches tended to be pro-cylical, with de-risking triggered by declining returns or rising volatility. Given that volatility tends to peak at market troughs, the consequence was that their investment levels were often lowest at the point of maximum opportunity. We, rather, believe in selling into strength and quite logically want to be a position to acquire exposure when valuations are attractive and the forced sellers have sold. Asset allocation needs to be dynamic and pro active in order to sustain a high investment level and excessive reliance on systematic protection mechanisms has been shown to be flawed.
Finally, we believe that quality of the ‘investment engine’ is critical to both generating competitive returns and, crucially, to managing risk. Focusing on using a variable risk budget and investing on an unconstrained total return basis, in our view, ensures that investors can generate long-term growth but with protection on the real value of their capital. Striking this balance is critical because many defensive investment strategies succeed in managing the downside, but this is done by accepting very modest returns, particularly after fees.
Where next for protected funds?
Although the strong returns seen this year have led many to already see 2018 as a distant memory, investors should not be complacent given where we are in the cycle. However, equally, now may not be the right time for investors to shut up shop, as its possible that reasonable returns may be available for a while to come. Therefore, we believe that well designed and executed protected strategies offer the prospect of decent returns but with a high degree of certainty of capital preservation. Nevertheless, as with all investments, we urge investors to apply caution as the recent history described above demonstrates that not all protected strategies are created equal and so the necessary due diligence is essential.
About Iain Cunningham:
Iain is a portfolio manager in the Multi-Asset team at Investec Asset Management. He is the co-portfolio manager of the Investec Global Multi-Asset Total Return, Investec Global Strategic Managed and the Investec Multi-Asset Protector strategies. He is also a member of the team’s Macro Research Group, where he focuses on the analysis of structural macro themes, as well as the FX and Rates Research Group.
Prior to joining the firm in 2016, Iain started his career at Schroders where he was responsible for the management of a number of multi-asset funds and mandates focused on dynamic asset allocation and income.
He has a BSc in Economics from Loughborough University, and an MSc in Economics and Finance (with distinction). Iain is also a Chartered Financial Analyst (CFA) Charterholder.
