A couple of weeks ago I looked at How to understand the risk in your investments, and several readers had questions which I’ll cover as we consider how to make money from risk.
Many readers believe their investments are automatically protected and managed to avoid risk, but this isn’t always true.
Let’s take a simple example of diversification of risk in your investments such as your ISA or pension. We know from previous columns that the return on the best pension versus the worst pension over a 10-year period was 10 times the latter. This occurs by selecting the best funds and stocks to achieve the best returns but also ensuring you are protected by shocks to the system.
Many funds cannot do that as they do not invest, nor do they have access to, the ability to properly diversify.
Finding the balance to make money from risk
For years, investors believed that bonds and equities provided our correct exposure to risk and return with one performing in one type of market and the other providing ‘stabilisers’ if markets jolted the opposite direction. This is called negative correlation (ie where we buy ice cream shares and wellington boot shares – they are the opposite). However, as we all saw in 2020, everything was correlated, as it all nosedived.
Few would argue that the normal bond/equity spread (your pension manager puts 60 per cent in equities, and 40 per cent in bonds and they balance each other out) provides the best basis for growth in the current financial markets, but many aren’t even offered these options, because most managers do not have that expertise.
Hedging, or, protecting against risk, is when you buy the aforementioned ice cream shares alongside a welly boot company’s shares, to use a metaphor. In normal conditions they might both be fine, but if there is a heatwave or extended cold spell, while one will suffer, the alternative outperforms off Newton’s law of physics – for every action there is an equal and opposite reaction.
And so, we need to look for alternative assets to the old style 60/40 split. As mentioned before in this column, we have held an asset that paid out every time we had large volatility in the markets. That is an example of alternative assets. In normal conditions, the investment pays nothing, but when markets are hit with high volatility, they pay a healthy return.
For example, in March 2020 when things just went a little nuts, in just one solitary day, the S&P 500 was down 1.68 per cent, Russell 2000 down 2.17 per cent, Wilshire 5000 down 1.78 per cent, but the hedge BH Macro was up 0.37 per cent. That’s in just one day of volatility. In a year or financial cycle these numbers make a huge difference. There are few managers with easy access to the above holding as a hedge, or ‘stabiliser’.
The same can easily be said of other alternative assets such as commodities, agricultural exposure, and precious metals, none of which are bonds or equities.
Alternative diversification of risk
Two other key alternatives offer balance. The easiest to explain are ‘economic rents’ for items that provide security of capital, so funds that bought into prime student economy funds when markets went crazy and no-one was going to university during lockdown, would have bought an absolute bargain. Other obvious economic rents are alternatives like wind, solar and infrastructure.
Added to this as a balance, are strategies that hedge against risk and these can be taken with small elements of your overall portfolio by a fund manager that effectively throw out stabilisers to protect your investments in stormy seas.
Space prohibits their full explanation, but key hedging strategies like short term trading (not normally seen in mainstream investment portfolios), trend following, merger and statistical arbitrage, as well as global macro views, are vital in the new economic world we are currently moving through.
I’ve mentioned previously the ability for an investment trust to take the opportunities to gear (borrow) when other property funds are being forced to sell, thereby buying their property at fire sale prices, only to sell it back to them later at a premium.
Trust me on the expertise required in this arena and it is few and far between, let alone the colossal research required in the background.
If you have been seeing that your capital is just following the market up and down expensively, consider a review of who invests it. For an investment review, you can call Peter’s team at 01872 222422, email [email protected] or visit wwfp.net.
Creative ways to make money from risk is the latest weekly column from Peter McGahan exploring how best to manage personal investments for more content like this visit our Finance channel.Tags: Peter McGahan Last modified: September 7, 2022