Issue: December 2011 / February 2012
Expert Opinion

The beauty of asymmetry

Rumbelow...managing the ‘new normal’
Rumbelow...managing the ‘new normal’
Andrew Rumbelow, chief investment officer of Sanlam Multi-Manager International, looks at why investments that deliver asymmetrical returns are ideal for current market conditions and all the volatility associated with the unnerving ‘new normal’ era

September 15 marked the third anniversary of the Lehman Brothers collapse. This ‘event’ will be remembered for many years as a defining moment of the global financial crisis (GFC) which started some 14 months prior to that fateful Monday in 2008.

At the time of Lehman's collapse, equity markets around the world had already "priced in" an element of fallout from the US sub-prime mortgage market (together with its related derivatives - please excuse the pun) as they were already some 20% off the peaks which had been achieved 12 to 15 months earlier. Judging by the markets' reaction to the Lehman news, this was clearly not enough.

While the extent of the recovery in equity markets throughout the world since markets bottomed in early 2009 can best be described as mixed, the one characteristic that has been evident across most, if not all markets, has been an elevated level of volatility.

The prospect of a protracted period of elevated volatility post the GFC was first brought to our attention by one of the international managers we interact with, namely PIMCO. During 2009 PIMCO shared with their clients their assessment that the GFC was the catalyst for a period which they termed the "new normal".

For investors, a most significant implication of being in the "new normal" environment is that the distribution of outcomes for investment returns is likely to be flatter; the tails of the distribution (those outlying events that one should theoretically very seldom experience) will be fatter (that is extreme outcomes will be experienced a lot more often than theory suggests), and the average will be an outcome seldom actually experienced.

Knowing that

  • investors are loss averse;
  • periods of elevated volatility are more likely to result in investors capitulating unnecessarily, thereby translating volatility into true risk - permanent loss of capital;
  • investors are often compelled to utilise capital to fund their "income" requirement, having to do so during times of volatility-induced capital drawdowns also results in a permanent loss of capital;

our expectation of a protracted period of elevated volatility will potentially pose numerous difficulties for the unprepared investor. Successfully navigating through this period may well require investors to give up one, or more, of their most closely-held beliefs.

Beauty is really in the eye of the beholder

By all accounts, numerous studies have been done over the years that conclude that both humans and animals are more attracted to potential partners whose physical features are more symmetrically aligned. This perhaps also explains why the words "beauty" and "symmetry" are referenced as synonyms in the thesaurus.

When assessing the relative attractiveness of investment returns, I would strongly argue that as a rule, but particularly in this period of elevated volatility, the complete opposite should apply. What I mean by this is that, as investors, we should be more strongly attracted to investment opportunities or solutions that deliver an asymmetrical return profile.

Asymmetrical returns are about finding investment opportunities or solutions where the risk / reward relationship is asymmetric, that is situations in which the potential profit / upside participation is higher than the potential loss / downside participation.

An absolute-return investment philosophy or approach is one that gives priority to capital preservation. It is a philosophy or approach which, when executed successfully, will deliver an asymmetrical return profile. By aiming to avoid absolute losses and preserve capital, even when markets are difficult, an absolute-return approach gives the power of compounding capital the best possible chance of success.

There are numerous absolute-return approaches adopted by various managers both locally and internationally. Our experience indicates that in the more traditional long-only space SA funds managers are in many instances ahead of their internationally-based peers.

With the recent changes to retirement fund regulations, we expect hedge funds and funds of hedge funds (which are absolute-return strategies) to gain greater acceptance. We also believe that more recently developed strategies which fall under the "hedged equity" banner will gain greater acceptance too.

While we expect the absolute-return approach to gain traction with both institutional and retail investors during this period of extended volatility (as pointed out in a Grantham, Mayo, Van Otterloo & Co white paper in mid 2010), the issue of "How do we measure you?" will invariably come up. We agree with their response to this question which is essentially that, given a defined target, managers should be given as much discretion as possible to deliver the real return.

In this situation, there is no easy way to judge the chosen manager or benchmark to measure them against. This may in fact be a good thing as it will force managers to be chosen on the basis of their investment process, where you trust the manager and understand the way in which your or your clients’ money will be managed.