Over the last five years we’ve seen, one-by-one, all the investments that were previously considered safe suffer substantial losses. This poses something of a challenge when building a portfolio with capital protection at its core, as there is no longer anything we could call a safe haven. This is something I’ve been thinking a lot about lately, as FE Research has several model portfolios designed for capital preservation and it is becoming much harder to find anything suitable to invest in.
It is especially difficult as the investment industry as a whole is not particularly focused on capital protection. The industry is returns-based: there are very few people who expect a big bonus for ending the year with the same amount as they started with.
Even the standard measure of risk, volatility, is gauged against expected returns. A fund that makes average gains of between 1 and 5 per cent every month would be considered more risky than one that lost 5 per cent every month, regular as clockwork.
Volatility, then, is not really suitable in this instance. Instead we’re focusing on other measures such as maximum drawdown, which measures what the largest losses have been over a given period. This is not without its flaws, however.
While volatility gives you an expected range of returns that tries to at least guess what you may experience in the future, max drawdown is purely backwards-looking and can only tell you what has happened before. Of course, plenty of things we’re expecting to happen over the next year or two haven’t happened before, like the exit from QE, for example, so max drawdown is lacking something in its predictive ability.
Additionally, we need to consider the duration of the drawdown. If on average a fund makes back a loss of 10 per cent within a week, the loss is less serious than if it persists for six months. I’ve taken to calling this measure the claw-back period, but I’m not sure what the official term is.
It also matters what context the loss is in: a 10 per cent loss at the end of the holding period, after the fund has made 50 per cent, is more tolerable than a loss at the start of the holding period, regardless of what it may do thereafter. Overshoot and correct is preferable to tank and recover.
These concerns matter less if you are running your own portfolio, but where you’re charging for your advice, investors' emotional response to seeing minus numbers in their reports needs to be considered.
Previously, there were some obvious places people parked money they were keen on holding on to: government bonds were considered a safe bet, gold was a popular choice for the super cautious and the most obvious thing was to keep it in cash and put it in the bank. Unfortunately, these asset classes now all contain considerable downside risks.
Government bonds were always considered a safe haven because it was inconceivable that the UK Government would fail to pay its debts; even under the most difficult of circumstances, it had the option of printing the money it needed to pay it back.
While this is still true today, it is also the case that government bond prices are about as high as they are ever likely to be. There is little risk of default, but the market price of a government bond is only likely to go down, thus seriously eroding capital.
The other asset class typically used for capital preservation is gold, but this too is well outside the realms of normality. Gold has been on a phenomenal run – it was $665 an ounce in July 2007, before climbing as high as $1,900 an ounce in 2011 and is currently $1,330.
Performance of indices over 10yrs
Source: FE Analytics
Again, the dynamics of gold mean it is far more likely to continue going down in price than up again. This will no doubt infuriate gold bugs, but the economics of the situation look a bit like this: gold is the ultimate fear asset – when people fear that markets are going to tumble, or inflation is going to sky-rocket, people buy gold.
These fears have peaked and, as the economy recovers, they are likely to recede further. While there is still a chance everything could collapse in on itself and gold rules supreme, it is getting less likely. Someone wanting to preserve the real value of their capital will likely be disappointed when selling their gold they bought today in a year or two’s time.
Now normally I would be espousing the benefits of diversification at this point. My general philosophy is not to get too hung up on what might happen and just build a portfolio that includes a range of funds that will each profit from a different scenario; that way, while one goes down, one goes up and so on.
Over the short-term, however, this approach isn’t likely to work as well as it should. We got a sneak preview of what the end of QE might look like last month thanks to some misinterpreted comments from the Federal Reserve.
Performance of indices over 3 months
Source: FE Analytics
The suggestion seems to be that everything is going to fall together. The money being pumped into the economy is inflating markets, so any reduction in this will likely deflate markets, causing equities and bonds to fall in unison.
At the same time, a reduction in QE will likely reduce the future expected rate of inflation, thus reducing the demand for gold as well.
On the other hand, central bankers will be planning a gradual reduction in these programmes as economies recover, no doubt hoping for a smooth transition, but that isn’t something I’m prepared to count on.
The future, then, appears to be one of high volatility and high correlation, at least in patches. Longer term, this won’t be too much of an issue, although it may still cause plenty of sleepless nights. While there are still many problems that need working out, optimism seems more rational than pessimism and growth looks to be returning.
This still leaves us with our capital-preservation problem in the short-term, however. Cash was the other obvious choice I mentioned previously, but with ultra-low interest rates, currently cash will produce a negative real return. While you’ll get back at least what you put in, once inflation has been accounted for, you’ll be able to buy less with it. Over the short-term, this erosion in spending power will likely be slight. Despite years of predictions, high inflation has been conspicuous by its absence.
The simplest solution may well turn out to be the best one: just stick to cash. While investment theory suggests a guaranteed loss of 3 per cent could be considered unfavourably compared with a 50/50 chance of either making or losing 10 per cent, for the low-risk investor, losses will always trump gains.
