How to protect savings from market downturns

We remarked in an earlier article that the stock market predictably will fluctuate. No matter what we do, stocks go up and down. So it goes. At the moment, the equity market is particularly unpredictable with recent events such as such Brexit and Nenegate having taken place. South African equities are similarly volatile and reflect the concerns trade union trustees and their retirement fund members have about potential capital losses.

Trustees face a challenging hurdle: cash might be the safest possible option for your members, but it doesn’t keep up with inflation compared to other asset classes over the long term. Sitting in cash only on the one hand will erode your capital, but on the other hand, you could be exposed to potential capital losses in the short term if you’re invested in more risky, volatile asset classes.

So what is the best decision you can make for your retirement fund members? Phillip Mjoli, Segment Head for the Institutional Business at Sanlam Investments explains.

What can trustees do to reduce the risk of large capital losses in this environment?
Ultimately, there are two ways to withstand volatile markets. The first is by spreading risk across various asset classes through diversification. The second is protecting the investment through the use of “protective overlays” or derivatives.

Diversified asset allocation
This involves adding what we term ‘uncorrelated assets’ in a portfolio to reduce the overall risk. Asset correlation is the extent to which investments move in relation to one another during market downturns. In other words, finding a set of investments whose returns fluctuate in opposite directions from each other really helps reduce overall risk. When assets move in the same direction at the same time, they are considered to be highly correlated. When one asset tends to move up when the another goes down, the two assets are considered to be uncorrelated. This concept can be applied to a portfolio of shares, but finding a basket of individual shares with low correlation of returns between them is easier said than done, as equities tend to move in the same direction. A more common strategy is to allocate assets between the different asset classes (equity, bonds, property, cash and offshore assets) since the returns of these asset classes are generally less correlated. This way the investor diversifies a degree of risk away.

The problem with this kind of asset allocation is that during times of financial distress, markets and different asset classes tend to move together (ie, are correlated). This could cause widespread losses across several asset classes, meaning substantial losses no matter where you are invested (except cash of course, but cash does not beat inflation).

Protective overlays (derivatives)
The second option that investors could consider to reduce the risk of capital losses is the use of derivatives. This involves adding a layer of protection to an equity portfolio, which acts as an insurance or buffer against market falls. So when markets fall, your capital doesn’t fall by as much. This is called limiting ‘downside risk’ and capital is effectively preserved during market declines. Derivatives are really just a way of insuring yourself against adverse market conditions. Just as you would buy insurance for your car to compensate for an adverse event, so you would do the same for your portfolio, especially when considering the risk facing the members of your retirement fund. If implemented correctly, the derivatives also reduce the overall volatility of the portfolio – effectively making the protected portfolio less risky than one without a protective structure in place.

In conclusion:
If history is anything to go by, short-term volatility is perfectly normal in the markets. Never has this been more true in South Africa. Few investors can predict with any degree of certainty when, and by how much, the markets will rise and fall. Through the addition of a protective derivative overlay, union retirement funds can ensure members’ portfolios remain protected during market downturns while still retaining that important exposure to equity markets to provide attractive returns. This enables unlimited positive upside (potential to go up in value) together with limited downside (potential loss of capital).

Over longer periods, investors will ultimately benefit from significantly better risk-adjusted returns, as well as the added benefit of capital preservation during bear markets.