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How to manage risk during times of uncertainty

Sep 26 2017 11:18

Where many investors define risk as the volatility of returns, or the risk of looking different, Allan Gray’s focus is always on avoiding permanent loss of capital. 

However, the risk of capital loss varies considerably between unit trusts and generally, for a higher risk of loss, you should expect a higher long-term return from an investment.

“When choosing a unit trust, you need to balance the return you require to meet your objectives, the risk of loss you can afford to take, and the risk of loss that you are comfortable with. 

This may involve a tough trade-off between your objectives and your comfort with risk.

But it is better to make a considered decision at the beginning and to stick with it than to be surprised later and shaken into disinvesting at the wrong time,” says Claudia Del Fante, business analyst at Allan Gray.

“Once you are invested, your unit trust portfolio managers will be working hard on your behalf to manage risk and return within the fund, and your job is to give your investment the time it needs to deliver on your plan,” she adds. 

The risk and return conundrum

Investors would all prefer high returns with no risk, but as the economist Milton Friedman famously liked to say: “There is no such thing as a free lunch.” 

In theory, the more risk you take, the higher the expected investment return, but more risk also means a wider range of possible outcomes. 

So if you choose an equity fund, you can expect to achieve a higher return over the long term than in a balanced fund, but you should also accept that there are periods when this does not occur.

Radhesen Naidoo, business analyst at Allan Gray, explains that the first part of the portfolio manager’s job is to invest in securities that individually offer the best trade-offs available between risk and return.
 
“Allan Gray’s investment philosophy is to invest in a basket of assets that are trading below what they are intrinsically worth, and to be concerned with the risk of losing capital and not the risk of being different. 

Our portfolio managers combine many individual investments, each driven by different risks and opportunities, into unit trusts, managing the overall risk of loss and upside potential in each. 

Focusing on fundamental business risk and not the latest share price action may result in short-term periods of underperformance, but we believe that excessive focus on short-term volatility can be distracting and ultimately detrimental to long-term investment returns,” he says.

To illustrate how this works, Naidoo explains how risk is managed in the Allan Gray Balanced Fund, which, since inception in October 1999, has delivered on its objectives and outperformed its benchmark without taking on greater risk of loss.

“The fund is constructed using a bottom-up investment process. The portfolio managers build the portfolio from a blank sheet of paper, based on the relative attractiveness of individual securities across various asset classes. 

Each individual security goes through an extensive research process to assess the expected return over a minimum four-year term relative to downside risk. 

Every individual investment idea is competing for a place in the portfolio. The asset allocation is the result of the extent to which individual securities are found most attractive relative to one another,” Naidoo notes. 

During periods where valuations move to extremes, the asset allocation can be more dynamic to protect investors and take advantage of the opportunities presented.

While investors could construct their own portfolio, a balanced fund hands over the decision of choosing between different asset classes and securities to experienced professionals.

“In December 2015, during the Nenegate debacle, South African banking shares sold off sharply while rand-hedge shares, such as British American Tobacco (BAT), performed relatively well. 

We had to decide whether to reduce exposure to the rand hedges and take advantage of the cheaper price of banks. 

“Meanwhile, selected resource shares had also become attractive as their prices fell in rand and US dollar terms, as commodity prices and the rand weakened.

At the same time, investing in government bonds offered investors a guaranteed nominal return of 9% over 10 years. 

This gives you a sense of the complex decisions investors may face,” says Naidoo.

Purchasing assets at prices below their true value provides a built-in level of capital protection for long-term investors, as bad news is already priced in, and increases the potential for future returns.
 
“Our focus on absolute risk and protecting capital has enabled us to grow our clients’ money and truly benefit from the power of compounding over the longer term,” says Naidoo.

Stay the course

Del Fante explains that for fund managers and professional investors alike, it is especially important to stay focused on long-term investment goals and not to get distracted by short-term noise when things are uncertain.
 
“Avoid the temptation to try and time markets, as this increases the likelihood of permanently destroying value,” Del Fante concludes.

This article is from the September 2017 edition of FundFocus, which appeared in the 21 September edition of finweek. Buy and download the magazine here.

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