Global Equity
Investing from a
Protection of
Capital
Perspective
Greg Peacock
Presentation at Eriksens Acturial Conference
‘The Real Risk Management Conference’
The Hilton Hotel, Auckland
New Zealand Assets
Management Ltd
Level 4 General Buildings
29-33 Shortland Street
Auckland
09) 358-1517
greg.peacock@nzam.co.nz
Tuesday 25 September, 2012
Global Equity Investing from a Protection of Capital Perspective
By way of introduction it is important to explain why we’ve been asked to speak here today
Global Equity
Investing
from
Protection
of Capital Perspective
about global
equity investing
from a a
protection
of capital perspective.
NZAM vs Global Equities since Sept 1991
$7,500
$6,500
$5,500
$4,500
$3,500
$2,500
$1,500
$500
NZAM Model Portfolio
MSCI World Net Index (NZD)
This is a chart of NZAM’s performance (in orange) versus global equities over our 21 years in
business. These returns have been achieved primarily by investing in global equities with a
goal of protecting capital.
We do this by selecting the best absolute return managers globally.
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Global
Equity Investing from a Protection of Capital Perspective
Global Equity Investing from a Protection of Capital Perspective
100
NZAM 12 month rolling returns vs MSCI World NZD
90
70
60
50
40
30
20
>60%
50%
40%
30%
20%
10%
0%
-10%
-20%
0
-30%
10
<-40%
Number of 12 Month Rolling Periods
80
Return Range (%)
NZAM Model Portfolio
MSCI World Net Index (NZD)
This chart shows rolling 12 month performance for both NZAM (again in orange) and passive
global equities. There have been 241 such periods since we began in business and in 44, or
18% of those periods, global markets have delivered worse than a 10% decline. NZAM has
recorded exactly zero such periods.
Taken literally “Global Equity Investing from a Protection of Capital Perspective” is almost an
oxymoron – any investment, global, equity or otherwise by definition risks capital. There is
no free lunch, or none that’s legal anyhow, and the only way to exceed the risk free rate is
to take risk. That’s why the risk free rate is called the risk free rate!
The secret to good investment outcomes is achieving an attractive balance between the
return achieved and the amount of risk taken. Returns alone do not tell us much about the
quality of the investment decision. On the basis of returns achieved the gentleman in
Tauranga who recently won $27 million in a few minutes on a Wednesday evening seems
like an investment genius. Few though would back him to do it again.
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Global Equity Investing from a Protection of Capital Perspective
So let’s take the topic of this presentation a little less literally so that we actually have
something to talk about. In layman’s terms how is it possible to invest globally and still sleep
at night? Or, in more technical terms...
How can we achieve the best risk adjusted returns from global equities?
I guess we should first consider the merits of global equities at all from a New Zealand
perspective. I think the argument for equities as an asset class is well understood. They
provide an exposure to economic growth and over the long term as economies grow so
should corporate profits and hence equity markets.
But why global equities? The answer is diversification of risk. Recently New Zealand equity
markets have performed very well – amongst the best in the world on a risk adjusted basis
at a time when global markets have been wrestling with what are very significant problems.
But we need to recognise that New Zealand investors already have a massive exposure to
New Zealand Inc, and in a much wider sense than just their investment portfolios. They live
here, work here, their kids are here and they’d like them to have sufficient opportunities to
want to stay. For most, their largest asset is their home and that too is here in New Zealand.
We all love New Zealand and understand it but we are far from objective.
The reality is that New Zealand is a small agricultural economy very exposed to global
economic fortunes. It has just a few major industries and they are exposed to weather, the
quality of our quarantine procedures and to geological activity. In addition, the local
sharemarket is tiny (with daily turnover less than 1% of Australia’s) and poorly represents
our best industries. Having all your eggs in the New Zealand basket is just not smart.
Diversifying offshore however is smart. Most kiwis though think they’ve diversified by
investing in Australia. This has a degree of comfort in that it feels quite familiar but in a
global context it has many of the same problems as New Zealand. It’s debateable whether
this is really diversifying very much at all.
I’ve used the word ‘risk’ at least seven times already so we should be clear on exactly what
we are talking about when we use this nasty little four letter word. Risk in financial markets
is the probability of permanent loss. Unfortunately there is no way of measuring this
precisely until it’s too late and so the standard approach is to use the volatility of returns as
a proxy for risk. This is clearly a very rough approximation at best – volatility and the risk of
ruin are clearly not the same thing.
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Global Equity Investing from a Protection of Capital Perspective
Measuring risk, volatility & investor behaviour
As an aside though, if it was possible to precisely measure the risk of any prospective
investment that would be the investor’s Holy Grail, and the equivalent of an investing
perpetual motion machine could be built. The better and more thorough the analysis of an
investment opportunity, the closer it is possible to get to this goal but in the real world it
remains unachievable. In practice we also know that many of the most dangerous
investment strategies are those that seem to have very low volatility – until they don’t.
Finance companies in New Zealand are a textbook example.
Where using the volatility of returns as a measure of risk does start making sense though, is
where it intersects with investor behaviour. Volatility leads to investor stress and stress
leads to poor decisions especially with the benefit of hindsight. This invariably means selling
at or near the bottom, which then creates a permanent loss. And it also means buying at or
near the high which creates the set-up conditions for another permanent loss. So let’s just
accept for now the conventional wisdom, that volatility is the best measure we have for risk.
Remember that we are looking for the best risk-adjusted returns we can get from global
equity markets. That’s the closest we can get to protecting capital. Bear in mind also that
the only way to absolutely protect capital is to not invest at all. Now that we have volatility
as an easily measured proxy for risk we can create a mathematical way of determining the
best risk adjusted return.
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Global Equity Investing from a Protection of Capital Perspective
The Sharpe Ratio
This is the Sharpe Ratio – the ratio of the return in excess of the risk free rate divided by the
volatility of returns. It is the real return generated per unit of risk taken.
The higher the Sharpe ratio the better. A high Sharpe Ratio means high returns relative to
the amount of risk taken. Anything above 0.5 is very good and above 1.0 is outstanding over
a period of time. How does the traditional or passive approach score by this measure?
The answer is very poorly indeed.
Since September 1991 (a date of no significance other than the founding of NZAM) an MSCI
index weighted portfolio of global shares translated into NZ dollars, has returned 4.64% per
annum with a Sharpe Ratio of 0.22. We can see clearly here also the catastrophic impact of
large losses – the decline around the dot-com crash has yet to be recovered.
Global Equity Investing from a Protection of Capital Perspective
MSCI World Net Index in NZD since Sept1991
$4,500
$4,000
$3,500
$3,000
$2,500
$2,000
$1,500
$1,000
$500
$0
MSCI World Net Index (NZD)
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Global Equity Investing from a Protection of Capital Perspective
Global Equity Investing from a Protection of Capital Perspective
MSCI World Net Index in NZD since Oct 2000
$1,200
$1,000
$800
$600
$400
$200
$0
MSCI World Net Index (NZD)
Since October 2000 (a date of no significance other than it supports my argument) the
Global
Equity Investing from a Protection of Capital Perspective
return has been -3.96% per annum with a Sharpe Ratio of -0.36. A thousand dollars invested
in October 2000 is worth just $600 or so today.
MSCI The World Index since Sept 1991
$4,000
$3,500
$3,000
$2,500
$2,000
$1,500
$1,000
$500
MSCI The World Index Free - Net - (LCL)
The strength of the NZ dollar has been a major factor in these numbers. But even if we take
the currency out of the mix for now, since September 1991 global shares in local currency
have returned 6.24% with a 0.31 Sharpe Ratio. The extreme volatility is very apparent –
even more so than in NZD.
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Global Equity Investing from a Protection of Capital Perspective
Global Equity Investing from a Protection of Capital Perspective
MSCI The World Index since October 2000
$1,400
$1,200
$1,000
$800
$600
$400
$200
$0
MSCI The World Index Free - Net - (LCL)
Since October 2000 global shares in local currency have returned 0.32% with a -0.06 Sharpe
Ratio.
Global Equity Investing from a Protection of Capital Perspective
MSCI The World Index since 1969
$40,500
$35,500
$30,500
$25,500
$20,500
$15,500
$10,500
$5,500
$500
MSCI The World Index - Net
We can take this data back further – back to December 1969. Since then the return has
been 8.48% per annum with a 0.45 Sharpe Ratio. But note again the volatility.
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Global Equity Investing from a Protection of Capital Perspective
Global Equity Investing from a Protection of Capital Perspective
Looking back
Underwater Curve –
S&P 500 ex 1928
We can get even more historical context by looking at the S&P 500 where we have data
back to January 1928. Since then the annual return has been 5.31% (before dividends) with
a 0.15 Sharpe Ratio. This chart is presented slightly differently in that it is an ‘under-water’
chart. It shows the periods of time when the index is below its recent peaks.
What we see very clearly is that there have been extremely long periods of time in which
global equities deliver negative returns. Using the S&P, the crash of 1929 lead to an
extraordinary 86% decline which took 267 months (that’s until early 1955) to recover. I
guess if you were patient and young enough it turned out OK in the end!
There have been two other 50% plus declines (the smaller of the two being the recent GFC)
and the infamous crash of 1987 is only the 8th worst. So we know from history that global
equities will, reasonably regularly, deliver very substantial declines which can take long
periods of time to recover from.
This becomes a philosophical debate about the Efficient Markets Hypothesis. I have a
background in engineering where a Hypothesis is something a little dubious that remains
unproven. A proven hypothesis becomes a Law – and no-one talks of the Efficient Markets
Law. Risk, according to the Efficient Markets Hypothesis, is not having market exposure which means that holding cash is somehow risky.
So if we think back to the New Zealand market in the mid 1990s when Telecom constituted
something over 30% of the market, a traditional manager taking zero risk had a third of their
portfolio in one stock. It was widely understood at that time that to beat the market simply
meant being underweight Telecom so that those running 28% exposed to a declining
Telecom successfully outperformed. But they lost money for their clients. Their largest
position was a dog. The technical term for investing like this is madness. And yet those who
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Global Equity Investing from a Protection of Capital Perspective
were only 28% long Telecom who didn’t like Telecom believed the risk was in not being
longer! The situation in Finland with Nokia in the mid-2000s was even more extreme.
Traditional funds management must be the only global industry where the goal of most
Global
Equity Investing from a Protection of Capital Perspective
players is to be respectably a little better than average! Investment returns cannot be
allowed to jeopardise the marketing.
$18,500
HFRI Equity Hedge index vs MSCI World Index
January 1990 - August 2012
$16,500
$14,500
$12,500
$10,500
$8,500
$6,500
$4,500
$2,500
$500
HFRI Equity Hedge (Total) Index
MSCI The World Index Free - Net - (LCL)
This chart shows the performance of absolute return equity managers – the HFRI Equity
Hedge Index, in orange, versus the traditional buy and hold approach in grey.
If the markets were truly efficient this chart would be statistically possible but about as
likely as the proverbial chimpanzee composing a play by Shakespeare. This chart is
absolutely at the core of the topic – how to invest in global equities with capital protection
in mind.
To summarise so far, a passive buy and hold strategy will almost certainly generate capital
gains over the very long run but when measured against volatility the returns are meagre.
Equity markets deliver very little real return per unit of risk assumed and the time frames
don’t work in the real world.
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Global Equity Investing from a Protection of Capital Perspective
Is there an alternative? I think so.....it’s the chart above.
We are constrained somewhat in our analysis by the comparative shortness of the data but
since January 1990 a return of 12.65% pa has been achieved by absolute return equity
managers with a Sharpe Ratio of 1.07. Over the same time period passive global shares have
delivered just 4.75% pa with a Sharpe Ratio of 0.26. This chart also graphically illustrates the
wonders of compounding when large losses are avoided. So the HFRI Equity Hedge numbers
are unambiguously better but what do they represent?
HFRI is Hedge Fund Research, Inc. And the index is of investment managers who maintain
positions, both long and short, in equity and equity derivative securities. They are equity
hedge funds. The returns are after all fees and allow for survivor bias. That is, it includes the
returns from failed funds as well as the successful in the same way that equity indices do.
How do these managers generate these returns? What tools do these
managers use?
Firstly, they pay no attention whatsoever to indices and index weightings in their portfolio
construction except to the extent that they need to understand the actions of other market
participants. The largest position in their portfolio will almost certainly be the company with
the best risk/reward characteristics. That is very unlikely to be the largest stock in the
market.
The second tool is to be able to utilise cash aggressively. There is no compulsion at all to be
fully invested.
While both these tools are used in the New Zealand market, the strategies below cannot,
because the market here is too small, too imbalanced, too illiquid and does not have active
derivatives. Funds that employ these first two strategies we call Active Equity Funds. They
don’t possess the full tool kit available offshore.
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Global Equity Investing from a Protection of Capital Perspective
Funds that employ the following strategies are Absolute Return Equity managers or
Long/Short funds, a sub-set of what are widely referred to as hedge funds. Hedge funds are
not all rogues and nor are they all paragons of virtue. In this respect they are just like public
companies. For every hedge fund Madoff there’s a publicly listed Enron. Like listed equities,
most hedge funds are well managed, ethical and honest. Other than a goal of making money
rather than beating an index, they generally have two important characteristics that
differentiate them from most of their traditional peers and that are designed to align their
interests with their investors.
Firstly, the manager has the bulk of his or her own net worth invested in the fund and,
secondly, the manager gets paid via a performance fee. This means the return on capital is
paramount, gathering assets is not. In fact we have two European small cap managers in the
NZAM portfolio who are closed to new money at less than €300 mio, despite the fact that
they could raise much more money. They are closed in order to maximise the return on the
assets they do have and the performance fee component of the fund incentivises them to
do this.
Earlier this year we had our only Australian manager return our capital because he was less
than enthusiastic about his prospects in that market. This would not have happened if he
was a salaried employee at a large funds management institution. However because his own
money was in the fund he had the incentive to do the right thing.
These funds are trying to generate returns driven by their skill in stock selection and market
timing rather than just passively accepting what the market provides. That is, to use market
jargon, they seek alpha rather than beta. So we often talk about our asset class as
investment talent rather than global equities. We want manager skill to trump the market.
In order to take market direction out of the equation, or, more realistically, dampen its
effect, positions need to be taken which benefit from a decline in markets. These are short
positions, either in individual stocks or index futures.
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Global Equity Investing from a Protection of Capital Perspective
Explaining “shorts”
Short positions benefit when share prices fall but the mechanics of shorting needs some
explaining. Essentially, shorting means selling shares that are not owned. On settlement
date the buyer of these shares expects to see the holding delivered into their account. So
how does the seller do this when they don’t own the shares? The answer is that they
borrow them – usually via their broker and usually from an unknown large passive
institutional investor who is happy to receive the extra income that renting them out
generates. The aim of the short seller is to later repurchase the shares they sold at a lower.
This process provides an insight as to why short interest in a company is in fact a beneficial
thing. A short seller is almost guaranteed to be a future buyer of the stock, whereas the
owner of shares is a likely seller.
Global Equity Investing from a Protection of Capital Perspective
I’ll spend some time on shorting because it is widely misunderstood. The media and failing
companies like to portray it as a predatory exercise designed to ruin good companies. I’ll
explain why that might sell newspapers but doesn’t stand up to scrutiny. This chart is an
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Global Equity Investing from a Protection of Capital Perspective
example extracted from a monthly report that one of our funds provides to investors. Our
experience is that short positions are always considerably smaller than similar conviction
long positions, they are held for shorter periods of time and they are mainly in larger more
liquid names. It is rare for a fund to have total short positions larger than their long
positions. That is, most funds will be net long most of the time. Looking at this example the
largest long position is News Corp and it is 5.9% of the fund. The largest short position, in an
unnamed US industrial company is just 1.6% of the fund. The liquidity analysis at the bottom
shows that whilst 79.9% of long positions could be liquidated in 5 days, 97.9% of short
positions can.
Primarily all of this is because the maths of investing is upside down with shorts. When a
share is bought and it doubles, not only is that a 100% gain, but it has become a position
twice as large again - there is theoretically no limit to the gain that can be made - when it
halves there is a 50% loss but the position size has also halved and there is a limit to how
much can be lost. This naturally creates a desirable ‘cut your losses and let your winners
run’ investment style.
With a short position the maximum gain is the initial position size because a share cannot
decline below zero and the potential loss is infinite – a disastrous ‘cut your winners and let
your losses run’ style is the result. So liquidity is absolutely essential in shorting because it is
critical to eliminate losing short positions quickly. Taking huge positions in small healthy
companies and trying to drive the share price lower is a deeply flawed strategy and not one
that I’ve ever seen employed in my 20 years experience.
Benefits of shorting
There are many benefits to an absolute return manager from shorting. Most obvious is the
ability to profit from share price declines as well as gains. Nearly all managers regard their
shorts as a profit centre rather than just as a hedge. They short to make money. The second
is that the presence of short positions in a portfolio allows the manager to be more patient
with long positions. In a declining market, gains from shorts at least partially offset declines
from long holdings and this means less pressure to liquidate high conviction long positions
in order to reduce risk. Psychologically it is easier to be patient when there are some good
things happening in the portfolio.
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Global Equity Investing from a Protection of Capital Perspective
The third reason is that the process of looking for shorts makes for a better overall manager.
Analysis of companies is more balanced – the company might be a long, it might be a short
or, more likely it’s neither, but having an open mind at the outset is valuable. It is more
intellectually honest. Analysis on potential short positions also needs to be more precise
than for long positions because of the upside down maths discussed earlier. That discipline
then flows into long positions making for a better research process.
Despite this rather lengthy ramble about shorting, the bulk of an absolute return manager’s
gains come from their long portfolio. Over time shares of good companies go up and
capturing that wealth creation is what equity investing is all about. The benefit of absolute
return equity investing is the ability to capture the upside whilst avoiding the large losses
that a traditional style invariably provides.
The flexibility to short and use derivatives enables very targeted positions to be taken. For
example, let’s assume an investor likes Air New Zealand – excellent management, well
positioned versus its peers and attractively priced but in a notoriously difficult industry. A
traditional manager can’t really express this view without assuming the industry risks and so
will probably neutralise it by being at index weight. An absolute return or long/short
manager though has many options. One would be to buy Air New Zealand and to short an
industry peer like Qantas – if Air New Zealand performs better than Qantas, a gain will be
made irrespective of the direction of broader markets or the health of the airline sector. An
alternative would be to own Air New Zealand and neutralise the risk around fuel prices by
using oil futures or options. If the view was that the airline sector was OK but that wider
market risk was a concern then a short index position could be taken (if there were futures
in New Zealand). So a very nuanced and specific position can be created where the influence
of specific extraneous factors can be hedged away.
What is left is alpha – a return driven more by manager skill than unintended market
factors.
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Global Equity Investing from a Protection of Capital Perspective
Absolute Return
In practice, funds that employ this absolute return strategy are many and varied. They have
developed styles to best express their own unique skill sets. They may use shorts extensively
or hardly at all, they may take significant market risk or none at all, they may restrict
themselves to certain geographies or sectors and their means of analysing companies can
vary enormously. What they do have in common though is a goal of achieving attractive risk
adjusted returns, irrespective of market conditions, most accepting that it is easier to make
money when markets go up than down. They are also very thorough in their approach.
So in summary our approach to global equities with a capital preservation bias is to build a
diversified portfolio of absolute return managers with their own different styles so that the
correlations between these managers are modest. The goal is to achieve attractive returns
from global equity markets whilst minimising risk.
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