Edition: June / Aug 2017

How to protect capital and beat inflation

Use absolute-return investment strategies to navigate the current climate of increased volatility and risk, suggests Natasha Narsingh,
head of Absolute Returns at Sanlam Investments.

Retirement fund trustees have to meet challenging goals; above all, to achieve the highest possible rate of return for fund members while limiting downside risk and volatility of returns. Yet in the current climate of increased volatility and lowered return expectations, reaching these objectives has become increasingly difficult.

So how do institutional investors meet the return objectives of fund members without exposing them to substantial risk of short-term capital losses?

Where capital protection is a priority, many trustees have begun to accept that they must be willing to re-examine their investment strategies and investigate more tactical ways to achieve their investment goals. Increasingly popular is the absolute-return strategy.

In absolute returns, we have two distinct goals. One is capital protection over a rolling 12-month period. The other is delivery of an explicit real-return target over a typically three-to-five year period. This is fundamentally different from the usual benchmark-cognisant type funds that are measured relative to a particular index, or even against funds that use peer groups as benchmarks.

In our absolute-return space, we have to meet an explicit return hurdle over and above inflation. The essence is to achieve inflation-beating returns at minimal levels of volatility.

High priority is given to minimising capital losses, so the idea is to have both a capital-protection and a real-return mindset. Absolute-return strategies also generate an “asymmetric return profile” i.e. higher and more positive returns, lower and fewer negative returns. The key is a dynamic risk-management process that limits the probability of large portfolio losses.

A typical asymmetric return profile illustrates that participation in the upside is roughly two-thirds greater than participation in the downside.

Source: Sanlam Investments, 2017

Asymmetric returns are also useful in behavioural finance. They limit the likelihood of irrational investor behaviour by creating a smoother returns experience. Behavioral finance indicates that investors feel the pain of loss twice as much as the joy of gains, triggering reactions (such as irrational fear) which may lead to investors making poor decisions.

Narsingh . . . specific goals

Defining risk in absolute
(rather than relative) terms

Achieving sustainable, positive absolute returns is the result of taking and managing risk wisely i.e. an active risk-management process where risk is defined in absolute terms and changes in the marketplace are accounted for. A properly executed active risk-management process should yield an asymmetric return profile i.e. more and higher returns on the upside, fewer and lower returns on the downside.

Risk management in an absolute return context is driven by profit and loss, rather than market benchmarks. This means that risk is defined against an absolute yardstick where the return objective is to generate a positive compounding of capital while the risk-neutral position is capital protection.

However, in a relative-return context (such as benchmarking and indexing), risk is defined, perceived and managed as ‘tracking risk’. In this context, the investor is exposed to both upward and downward swings in the asset class.

How we protect capital for our clients

Although we draw on several tools, essentially there is a conservative application of our pragmatic value philosophy, together with the use of protective strategies or derivatives.

We look at relative valuations across all asset classes to support our dynamic asset-allocation decisions. Our equity valuations, driven from bottom-up stocking picking, are key to determining the parameters of our protective structures.

This combination of derivatives, with a fundamental valuation underpin, acts as a protective structure (or hedge) against equity-market falls. It aims to achieve the highest possible rate of return per unit of risk taken, while minimising the risk of capital losses on a rolling 12-month basis.

We operate dynamically across all local and offshore asset classes. These include equities, nominal bonds, inflation-linked bonds, cash and listed property to adapt to relative market valuations.