People tend to think about risk in investments in a negative sense, focusing on capital loss, drawdown or downside risk. While this is extremely important and entirely correct, less attention is paid to opportunity cost or upside risk i.e. the risk of losing out on even better returns.
Humans are cognitively hardwired to avoid losses and the behavioral finance literature covers the topic of loss aversion, a tendency to prefer avoiding losses to acquiring equivalent gains, quite extensively. Risk aversion is also distinguishable from loss aversion and refers to our preference for outcomes with higher certainty, while our experience of loss tends to inform our approach to risk.
This relationship also highlights the difficulty investors have with probability and the trade-off between highly probable, low returns and lower probability, high returns. This is true even if the average pay-off profile of the lower probability/high return scenario is the same or significantly better.
While one would expect dispassionate, professional fund managers to be immune to these mere human frailties, it turns out that (on average) this may not be the case. However, our analysis and experience indicate that following a robust research process focused on quality assets can skew the odds in investors’ favour by balancing risk and return to create superior risk-adjusted performance.
Global Flexible Funds showed strong outperformance to early 2009…
One area where this risk or loss aversion might be most evident is in the multi-asset global flexible fund category, although we acknowledge that any broad analysis must be caveated by the disparate nature of the strategies of the funds in this category.
Chart 3: 30 years to 30 April 2021 – Total return in US dollars (indexed to 100)
Source: Morningstar and Northstar Asset Management. Date: 30 April 2021
Multi-asset flexible fund managers have a broad range of asset classes and return streams at their disposal from which to offer their investors a suitable risk-adjusted return proposition. Therefore, the full benefit of active management should arguably be available in this fund category.
From chart 3 above, it is apparent that this was very much the case in the 20 years leading up to and through the Global Financial Crisis (GFC) of 2008/9.
In fact, the average global flexible fund outperformed the MSCI World Index in both the 10 years to April 2001 (annualised total return in US dollars of 15.4% vs 10.6%) and the decade to April 2011 (5.1% vs 4.4%). Importantly, this was also achieved with less risk, as reflected in the volatility of the respective returns.
The full benefit from diversification and active management is also evident in the higher returns relative to the average large cap global equity fund and a passive 60:40 balanced portfolio of global equities and bonds.
… followed by a post-GFC malaise
While the average large cap equity fund has perennially underperformed the MSCI World Index, the underperformance from multi asset flexible funds over the past 10 years (2.7% p.a. vs 10.5% for the MSCI) stands in stark contrast to the strong outperformance in the preceding 20 years.
This phenomenon is no doubt a result of a multitude of factors. The rise of a cohort of disruptive, internet-enabled growth companies, meaningful structural shifts in market cap weighted benchmarks, and the shift into passive investing have all played a part in complicating the investment landscape and valuation of asset classes. This complexity has been further compounded by the enduring deflationary pressures arising from advances in technology and automation as well as slack in the labour market, combined with unorthodox monetary policy.
However, the experience of loss through the GFC has clearly played an important role in reducing risk appetite, resulting in significant upside risk or opportunity foregone over the subsequent 10 years.
Asymmetric returns can lead to substantial outperformance over time
If the objective of active management is to skew the likely outcome in investors’ favour by balancing risk and return, then an asymmetry in returns is required for superior risk-adjusted performance.
The Northstar Global Flexible Fund is an equity-centric flexible fund that aims to participate in most of the market’s upside, while avoiding large drawdowns, as is evident in an upside/downside capture profile of 78% vs 58% since inception¹. Modelling the target 80% vs 60% asymmetric return profile against the MSCI World Index over the past 30 years highlights the compounding effect of this simple rules-based asymmetry and puts into context the difficulty the average global flexible fund manager has faced in keeping pace with the equity benchmark.
Chart 4: 30 years to 30 April 2021 – Total return in US dollars (indexed to 100)
Source: Morningstar and Northstar Asset Management. Date: 30 April 2021
Sources of asymmetry
The desired return profile is a function of Northstar’s fundamental research process rather than an objective. The primary source of asymmetry lies in our insistence on only investing in the relatively small group of companies able to demonstrate the benefit of an inherent competitive advantage. This is evident in sustainably high returns on invested capital (ROIC) and free cash flow (FCF) growth.
We avoid companies that employ excessive leverage and/or display a high degree of cyclicality, which reduces our exposure to downside risk.
Our disciplined, probability-weighted scenario approach to valuation and the integration of fundamental risk limits and valuation into position sizing are equally important sources of asymmetry.
Before we invest, we establish proprietary Bull, Base and Bear Case scenarios, with probabilities ascribed to each, to ensure an appropriate level of risk taking. Regular review of performance and developments against these scenarios results in longer holding periods of companies with positive fundamental momentum and quicker corrective action where the Bear Case scenario plays out.
Not having to be fully invested and the Fund’s ability to diversify across asset classes are further sources of asymmetry, if informed by valuation.
Many active managers have been too risk averse
Active managers have experienced a poor decade since the GFC. Global flexible funds, on average, have been too conservatively positioned, ex-post, squandering much of the strong record of superior risk-adjusted returns established in the 20 years prior.
With signs of rising inflation and higher interest rates on the horizon, active managers face the prospect of greater dispersion in returns. Only those able to synthesise all the inevitably conflicting sources of information and opinion into a sensible and robust risk management framework are likely to achieve the appropriate level of risk tolerance to generate superior risk-adjusted returns, whatever the next decade may hold.
¹Defined as the Fund’s average participation in the benchmark’s monthly positive or negative performance. An 80% vs 60% upside/downside equity capture ratio means that the Fund returns, on average, 80% of the benchmark’s performance in months where the market moves up, and only participates in 60% of the decline when the benchmark moves down. Based on the average rolling 3-year equity capture ratio against the MSCI World Index since inception 11th January 2016 – 30th April 2021.