SFCS Insights discusses Protection Strategies
|February 21st, 2010||
|Contributed by: Claude Bovet, SFCS Capital|
|The following is an article describing an investment approach that provides true downside protection to investment portfolios whilst maintaining upside performance – what we call Protection Strategies.|
Risk is a universally understood concept. However, there is not just one type of risk that affects investors, there are many. And any one of these types of risk will become the primary one driving markets and investor reactions at any given time. In the bullish decades of the Eighties and Nineties, substantially defined by measured yet steadily rising markets during the early years and culminating in the euphoric stampede to towards technology and the internet, investors, conditioned to “buy the dips” within the framework of a buy-and-hold mentality, focused on volatility as the primary measure of risk. However, in the far more wildly bullish, credit-driven ecstasy following the tech collapse of the newly-minted millennium, opportunity loss took over as the key operating risk measure. This type of euphoric risk measure, originating as it was from a rush to not miss out on the money grab, was, nevertheless, quickly and mercilessly displaced in the sharply declining markets of 2008 by a much more fundamental, fear-driven measure of risk, the risk of loss. If 2008 was the test of our defensive measures, what was the effectiveness of diversification as the primary and universal risk tool?
Diversification (a neat word that summarizes the old adage of “never put all your eggs in one basket”) is often touted as the solution for mitigating the risk of loss. There are, however, at least two problems with diversification that are either ignored or not readily understood by investors:
1) In a crisis, markets will inevitably correlate to one as risky assets are sold in exchange for the perceived safety of government bonds and cash
2) Globalization and the pervasiveness of the media have created an inter-connectedness of information flow that serve to instantaneously transmit shocks throughout the system
Diversification does have its benefits, of course, both as a means to reduce your reliance on a few, concentrated bets and as a way of ensuring that you catch an opportunity not necessarily immediately discernible (this is called keeping your feelers out). But as your sole line of defense it may prove as effective as the Maginot Line.
There are other, better solutions that can and frankly should be added to your defensive arsenal. Hedging is an obvious candidate. Dynamic investing is another. Both of these investment styles are signature techniques of the hedge fund industry and we believe should be the core of any investment portfolio. However, there is another technique that we have developed to augment a portfolio’s defensive measures, what we call “Protection Strategies”. Let me elaborate.
A multimanager hedge fund portfolio by definition utilizes both hedging techniques and a dynamic investment process. Hedging necessitates an offsetting position against an investment. For instance, a long/short equity hedge fund manager will typically sell short the weak company in an industry to offset an investment in the perceived leader of that industry. The objective of this transaction is to capture the returns available from the outperformance of the strong company versus the weak company. A benefit is the removal of market risk (the performance of the broad equity market) from the investment and thus an overall reduction in risk. Another manager might short a basket of representative stocks against his long portfolio of companies he expects will be the winners.
Dynamic investing is what hedge funds are really all about. In a nutshell, investing dynamically means to invest actively and in all types of securities in order to profit from ever-changing market conditions. This is achieved by investing directionally (going long, selling short); by short-term discretionary trading; by using systematic and quantitative investment processes that seek to capture opportunities available through the analysis of price and fundamental factors; by seeking to profit through the arbitrage of pricing anomalies in related securities; by placing bets on market movements through the analysis of global macroeconomic and political factors; too name a few. Investing dynamically means using whatever tools and processes are necessary to profit from all types of investment opportunities – it means being unconstrained, adaptive and proactive.