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18.09.2015

Strategies for choppy market conditions

Not only does the world go round, so too does the performance of equity markets pass through time zones like a relay baton. At some point, a market – usually a major one – breaks the pattern and counters the trend. The disconcerting part is that down markets tend to be more highly correlated than up markets.

Can investors protect themselves in global equities? No, they can't. Long-only fund strategies (that is, without short selling, options or derivatives) will perform somewhat differently in a drawdown, but all are likely to face negative returns. Funds that elect to increase cash holdings should do better than the index, but that does not indicate they are good at choosing stocks. The performance of their equity positions should be the key factor, excluding cash.

There has been one avenue with proven value for Australian investors in recent years. Unhedged global equities have given extraordinary returns and have had a very low correlation to Australian equities. But those times are probably largely over.

Therefore, it's back to which strategies can do best when equity markets are challenging. There are two approaches fund managers can take to reduce downside risk: defensive and value. Defensive leans on industries such as utilities, healthcare or real estate investment trusts. Value focuses on return on equity/assets, low debt and a firm line on the price paid for the stock.

You may question why these aspects are not always in a portfolio. If you only have these two attributes, you may have missed out on the likes of Google and Facebook, which are neither defensive nor have the metrics that meet value criteria.

Find a style that suits

This is the tough part of advising and investing. Of course, you want your funds to outperform the index, or your alternative is to use exchange-traded funds. Accepting active management and periodic deviation from the index, the question then arises: which of these investment styles suit you?

Thematic stocks can have huge potential in the long term but require fortitude to see through. These are unlikely to perform well in sell-offs or, in investment parlance, they have high beta. Many emerging markets fit into that camp as well. If you don't like drawdowns and choose a value or defensive manager, then it will be much harder to outperform the relevant index when markets rally strongly. But as long as the fund can outperform over a long time frame and in down markets, it will suit your purpose test.

When assessing a manager, the inclination is to only look at performance data. However, it's worth digging deeper into the drawdown statistics. Check if this refers to the number of times a fund has underperformed the relevant index and by how much.

Most will cite the number of times this has happened on a monthly basis. Importantly, the number of times that a fund might underperform in weeks or months will differ vastly from the quarterly or annual data.

Imagine a fund that was significantly below the index in a month, but may still have outperformed over a year. That may test your fortitude when in the rough. Therefore, the extent of underperformance in each period arguably matters more.

Some fund strategies can limit your participation during periods of negative performance. A good example is global infrastructure fund managers. There are a useful number of selections in this sector but they each tend to approach their definition of the market differently. Some adhere to the S&P Global Infrastructure Index benchmark, while others broaden their options to stocks that have fixed assets but may not fit into the specified definition. There is no right or wrong here – it all depends on what you are looking for.

Within the options a number are bounded by the performance of equities and work towards matching or beating the benchmark. Others select stocks on a long-term horizon based on cash flow generation and long-term risks. A short-term "beat the market" attitude won't matter here.

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