How to protect capital and beat inflation
Use absolute return investment strategies to navigate the current climate of increased volatility and risk.
Retirement fund trustees have to meet challenging goals— above all, achieve the highest possible rate of return for their members while limiting downside risk and volatility of returns. Yet in the current climate of increased volatility and lowered return expectations, reaching that objective has become increasingly difficult. So how do institutional investors meet the return objectives of their members without exposing them to substantial risk of short-term capital losses?
Says Natasha Narsingh, head of Absolute Returns at Sanlam Investments “In the current environment where capital protection is a key 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”. An increasingly popular investment strategy is the absolute return strategy.
Explains Narsingh, in absolute returns, we have two very distinct and specific goals that we aim to achieve for our clients, one being capital protection over a rolling 12 month period and the other being the delivery of an explicit real return target over a typically 3 to 5 year period. This is fundamentally different from the usual benchmark-cognisant type funds that are measured relative to a particular index or even versus the funds that use peer groups as benchmarks. In our absolute return space, we have an explicit return hurdle over and above inflation that needs to be met.
Here 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 real return mindset. Absolute return strategies also generate what is called an asymmetric return profile, ie, higher and more positive returns, lower and fewer negative returns. The key to this is a dynamic risk-management process that limits the probability of large portfolio losses.
How we protect capital for our clients
Although we draw on several tools in our investment toolkit, essentially this is a conservative application of our pragmatic value philosophy, together with the use of protective strategies or derivatives, explains Narsingh.
At Sanlam Investments, we look at relative valuations across all of the asset classes to support our dynamic asset allocation decisions. Our bottom-up driven equity valuations in particular are key to determining the parameters of the protective structures we put in place. To ensure maximum certainty in outcomes, we use these fundamental equity valuations to aid the levels and the magnitude of the derivative overlays in achieving explicit downside protection for our funds. This combination of derivatives with a fundamental valuation underpin acts as a protective structure (or hedge) against equity market falls, aiming to achieve the highest possible rate of return (per unit of risk taken), while minimising the risk of capital losses, over a rolling 12-month basis.
We operate dynamically across all asset classes, both local and offshore, including equities, nominal bonds, inflation-linked bonds, cash and listed property to adapt to relative market valuations.
Asymmetric returns are also extremely useful from a behavioural finance point of view, concludes Narsingh. They limit the likelihood of irrational investor behaviour by creating a smoother return experience. Investors feel the pain of loss twice as much as the joy of gains, triggering reactions (like fear) which may lead to poor investment decisions.
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