North Star
Registered User
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Good afternoon Dan,
You have got some very insightful feedback and firmly held viewpoints to date which is always a good start when trying to make an informed decision. I would like to offer a slightly different perspective. I apologise in advance for a long winded reply ....
Firstly in relation to your friend and investment advice, when dealing with clients and their investments we are firmly in the realm of behavioural finance i.e its difficult to separate the emotions and fears either rational or irrational that are associated with investment gains and losses. Your friend sounds like lots of clients we have, who were happy to earn 4-5% on long term bank deposits for investments and pension/ARFs etc and as they have gradually matured, they are now facing a challenge to try to deliver reasonable returns with a limited risk to their capital. ( They may not have realised it at the time but as events in Cyprus proved, bank deposits were never risk free ). Stephen is right in when he is saying that you cant examine risk appetite and loss tolerance re the ARF in isolation. An overall/holistic approach is important. Your friend needs to quantify the level of return required over the medium term to meet his/her financial objectives. They may well be making an equally serious mistake of not running enough risk, depending on their circumstances. Though I accept that if they have sufficient assets they may have no need to take on investment risk. For this purposes lets assume that your friend needs a 3% real return per annum after all costs.
Based on what you have said it appears that for your friend the marginal utility of a unit of gain is not equal to a marginal utility of a unit of loss, i.e they would be more concerned with a €100k loss compared to being satisfied with a €100k gain. If this is correct or confirmed by your friend we need to take this into account when looking at investment options. We would try to where possible moderate the downside risks even if that meant sacrificing some of the upside potential. We would advise your friend to avoid capital protected products even though they may seem alluring on a first viewing. There are plenty of threads on AAM which will explain why we hold this view.
In terms of investment styles and approaches, we arent champions of any one approach at the expense of all others i.e we can see the merit in low cost passive strategies, active mangement where it has a good track record in adding value and also some Absolute Return strategies. Costs do matter and we always look at net returns i.e after all costs when evaluating options. ( I will address the Absolute Return specific items later ). You can diversify across investment approaches as well as across asset classes. In our view valuations also matter, not as any timing indicator but a determinant of probable/potential future returns, so yes we confess that we bring our own bias to the table by liking a GMO type approach to investing
As risk and return are inextricably linked we need to see how we can get your friend at a position where they are more 'comfortable' taking on risk to deliver the required return with the associated risk of loss. We find that once clients have a reasonable profit buffer, then they are more comfortable with downside risks. Back to behavioural finance again, giving up some profit doesnt seem to hurt as much as losing part of your original capital, even if to many that is illogical. Therefore for your friend we would start with a very defensive approach and gradually step into higher risk/return levels as a profit buffer has been built up. This takes discipline and time, and in a rising market will sacrifice some upside potential. As bond yields and cash instruments are so low, we find that there is good reasons to use an Absolute Return approach as 'defensive asset' to help build up a profit buffer. We are concerned that bonds/fixed income are extremely expensive and the traditional 60% equities and 40% Bonds portfolio will struggle to meet historic return patterns and will show higher correlation than previously experienced. I could well be wrong but I have to call it as I see it.
Lets assume over time your friend has now built up a modest 10% to 15% profit buffer( taking income drawdowns into account). We can now explore a more balanced long term investment strategy along the following lines assuming that your friend doesnt have the inclination to directly hold a portfolio of equities and will favour a diversified ETF or fund strategy;
Some may view the above as too adventurous for a 3% real return agenda but I am taking into account that it may take some time to build up this exposure. If more suitable defensive assets were available to meet the return agenda then we can scale back the higher risk/return allocations.
Specific issues re Absolute Return strategies as Hedge funds and associated risks for retail investors
You have got some very insightful feedback and firmly held viewpoints to date which is always a good start when trying to make an informed decision. I would like to offer a slightly different perspective. I apologise in advance for a long winded reply ....
Firstly in relation to your friend and investment advice, when dealing with clients and their investments we are firmly in the realm of behavioural finance i.e its difficult to separate the emotions and fears either rational or irrational that are associated with investment gains and losses. Your friend sounds like lots of clients we have, who were happy to earn 4-5% on long term bank deposits for investments and pension/ARFs etc and as they have gradually matured, they are now facing a challenge to try to deliver reasonable returns with a limited risk to their capital. ( They may not have realised it at the time but as events in Cyprus proved, bank deposits were never risk free ). Stephen is right in when he is saying that you cant examine risk appetite and loss tolerance re the ARF in isolation. An overall/holistic approach is important. Your friend needs to quantify the level of return required over the medium term to meet his/her financial objectives. They may well be making an equally serious mistake of not running enough risk, depending on their circumstances. Though I accept that if they have sufficient assets they may have no need to take on investment risk. For this purposes lets assume that your friend needs a 3% real return per annum after all costs.
Based on what you have said it appears that for your friend the marginal utility of a unit of gain is not equal to a marginal utility of a unit of loss, i.e they would be more concerned with a €100k loss compared to being satisfied with a €100k gain. If this is correct or confirmed by your friend we need to take this into account when looking at investment options. We would try to where possible moderate the downside risks even if that meant sacrificing some of the upside potential. We would advise your friend to avoid capital protected products even though they may seem alluring on a first viewing. There are plenty of threads on AAM which will explain why we hold this view.
In terms of investment styles and approaches, we arent champions of any one approach at the expense of all others i.e we can see the merit in low cost passive strategies, active mangement where it has a good track record in adding value and also some Absolute Return strategies. Costs do matter and we always look at net returns i.e after all costs when evaluating options. ( I will address the Absolute Return specific items later ). You can diversify across investment approaches as well as across asset classes. In our view valuations also matter, not as any timing indicator but a determinant of probable/potential future returns, so yes we confess that we bring our own bias to the table by liking a GMO type approach to investing
As risk and return are inextricably linked we need to see how we can get your friend at a position where they are more 'comfortable' taking on risk to deliver the required return with the associated risk of loss. We find that once clients have a reasonable profit buffer, then they are more comfortable with downside risks. Back to behavioural finance again, giving up some profit doesnt seem to hurt as much as losing part of your original capital, even if to many that is illogical. Therefore for your friend we would start with a very defensive approach and gradually step into higher risk/return levels as a profit buffer has been built up. This takes discipline and time, and in a rising market will sacrifice some upside potential. As bond yields and cash instruments are so low, we find that there is good reasons to use an Absolute Return approach as 'defensive asset' to help build up a profit buffer. We are concerned that bonds/fixed income are extremely expensive and the traditional 60% equities and 40% Bonds portfolio will struggle to meet historic return patterns and will show higher correlation than previously experienced. I could well be wrong but I have to call it as I see it.
Lets assume over time your friend has now built up a modest 10% to 15% profit buffer( taking income drawdowns into account). We can now explore a more balanced long term investment strategy along the following lines assuming that your friend doesnt have the inclination to directly hold a portfolio of equities and will favour a diversified ETF or fund strategy;
- Lower cost globally diversified equity exposure
- - Exact percentage to be determined by max drawdown ( reasonable worst case ) figures your friend is comfortable with - lets say 30% of ARF
- The objective is to buy and hold this through all market cycles
- We suggest looking at Dimensional Fund Advisers (DFA) or Vanguard for ETFs
- Whilst no one can time markets, when moving from cash to this 30% holding as we have a value bias we would like to enter this portion when it is supported by favourable valuations ( which will annoy the efficient market disciples)
- Smaller companies is the sector where active management has a higher probability of adding value after costs, maybe as a side effect of the swing to passive investing, which leaves an opportunity for stock pickers to add value
- This sector has a long track record of superior risk return characteristics which isnt to say it outperforms all the time, but over the medium to long term its track record is appealing
- As above ideally would like to step into this gradually in a favourable valuation environment even if that takes time.
- Allocation up to 20% if built up gradually
- This includes Absolute Return type funds, and if/when rates start to normalise will also include cash, bonds, corporate bonds, gold etc in small allocations
- The objective is to produce reasonably stable but modest returns with lower correlation to equities
Some may view the above as too adventurous for a 3% real return agenda but I am taking into account that it may take some time to build up this exposure. If more suitable defensive assets were available to meet the return agenda then we can scale back the higher risk/return allocations.
Specific issues re Absolute Return strategies as Hedge funds and associated risks for retail investors
- We have and will probably continue to recommend some Absolute Return type funds, and our clients employ us to in effect do their due diligence work for them
- There is no alchemy and no risk free return, these type of funds replace asset class risk with investment manager risk and as Sarenco says you can diversify across several managers to mitigate some of this risk
- In a previous life I have 20 years capital markets trading experience and would be at least quite familiar with the type of strategies used
- Whenever we give a client a written recommendation we take on a regulatory and ultimately a legal risk and we are very conscious of this. We take our responsibility to clients seriously.
- We have reviewed various Absolute Return Funds including Std Life GARs fund. In fairness to Std Life they were good in granting me access to fund mangers in private meetings here and in small group meetings in Edinburgh where we could ask as many questions as we felt were required to be satisfied with our due diligence
- Jim raises some very good points re LTCM type risks, and we have and continue to be aware of these risks
- As the guys say Macro driven hedge funds can often work in crowded trades and be exposed to extreme volatility when the market thins and there is limited or no liquidity. There have been several episodes where Macro Hege funds have been hit by this crowding effect e.g the 2008 bear maket, the correction in 2011, JP Morgan 'London Whale' in credit deivatives and perhaps even this summers correction. During all these episodes GARS performance was much more stable than the average 'Balanced Managed Fund' available to Irish retail clients
- We take some comfort from this historic performance under stressed conditions
- In addition the GARS appoach to having 30 to 40 different strategies hopefully mitigates some of the risks Jim mentions
- The other factors which also provide comfort are the daily liquidity, the fact that there is no bonus payable for beating a hurdle target, an element of risk sharing via Std Life investing their DB pension in the fund, the lower costs compared to hedge funds, the strong investment team and the risk management delivered to date
- Our primary concern would be if corelations all move to 1, but in that scenario we would expect all risk assets to be hit
- To conclude, there is no risk free return or investment panacea but our opinion is that some Absoute Return funds are worth considering as clients would be in general be satisfied IF a cash plus 5% can be dlivered with lower volatility. We fully accept that others are free to disagree.
- Apologies again for length of reply All the best Vincent