We are told that Eskimos have over 20 words for snow, presumably because the are surrounded by the stuff. You could legitimately ask then why fund managers do not use more words for risk?
The word is bandied around so much in our industry, each time with a slightly different meaning, that investors are often confused as to what we mean. In our collective defence, I think this problem springs from a desire to give investors their impossible dream – relatively good returns on the way up, with absolutely no loss on the way down. This alone encompasses two perceptions of risk that deserve words of their own – relative risk versus absolute risk.
The trouble is that managers who concentrate on absolute risk usually disappoint when markets rise while the opposite is true of relative-biased managers.
Now it would be lovely to dismiss either approach as nonsense but the truth is that both matter.
Unfortunately, the real world presents no perfect way to strike the right balance (despite the claims of some fund managers). What should be done? We think the value approach to investing offers up the most effective answers.
First, forget the short term – it is impossible to consistently predict market gyrations, so ignore them and concentrate on finding good long-term investments instead. Second, look for a margin of safety by buying something cheap – it will have less far to fall if market sentiment takes against it. This offers at least a degree of protection against absolute risk.
Sterling presents a neat example of how these concepts of risk can become muddled. Recently, the trend has been for most currencies to strengthen against the pound when equities (and therefore risk appetite) are falling.
When measured in sterling, markets like Japan and the US have done well on the up days and held up well in the sell-offs. If you believe the trend is your friend, international equities seem to offer the potential for good returns with downside protection – AKA “absolute returns” or the holy grail of investment management.
Can it really be true that taking on more risk (this time from overseas currency exposure) will reduce your overall risk? Common sense tells you this cannot be true. The trend may be your friend for a while but some friends are not forever. Should this particular trend stall, or worse, go into reverse, investors who have piled into overseas equities expecting absolute returns could end up with a considerable loss.
From our perspective, good quality UK equities look a sensible option. There is enough value to realise a decent return but no risk of being cleaned out by rogue currency moves. Buyers of overseas shares, meanwhile, need to be wary of the boost that currency moves have provided this year . If they reverse, you may struggle to find the right word to describe the risk you took with your clients’ wealth.
Simon Evan-Cook is co-manager of the Premier multi-asset growth fund