From January 2023 we’ll be making some small changes to the Lighthouse Global Equity Fund’s portfolio structure.  

The Fund’s portfolio structure and investment activities are very prescriptive and strictly follow a set of disciplined processes.  We’re changing one of those processes.  This is the first change to these processes in 7 years.

We’re not changing the Fund’s investment philosophy.  The Fund will still invest in global equities, with a strong growth focus.

We’re not changing the Fund’s benchmark index.

We still expect to achieve the same long-run performance.

The Fund will no longer invest in options.  Historically the Fund has invested about 6-8% of its Net Asset Value (NAV) into long-dated call options.  We’re removing the options strategy.

The place of the options in the Fund’s portfolio will be replaced with more large market-cap growth equities.  So, the Fund’s portfolio will be wholly large market-capitalisation growth stocks.

With this change we will slightly raise the overall leverage limit the Fund can operate to.  The options strategy held significant cash holdings that we will now deploy rather than continue to hold as cash.  Because of that we will raise the Fund’s overall leverage limit from 20% of NAV to 30% of NAV.  But note that this is a limit and not a level we expect the Fund to operate at.  We expect the Fund’s actual leverage to average 10-15% of NAV over time.  In practice, the Fund’s effective leverage is reducing, as the options have characteristics of leveraged equities.

Some investors are uncomfortable with options, and we want to remove any impediment to them considering an investment in the Fund.

The Fund’s options strategy has returned on average over 40% pa for the 7 years we’ve been using it, even with about half of its portfolio allocation held as cash.  So we’re not removing it for performance reasons.

What Effect Are These Changes Expected To Have?

We expect the Fund’s monthly volatility will reduce.  That feeds into the calculation of the Fund’s “risk indicator”, which is required by the Financial Markets Conduct Regulations 2014, but we expect the Fund to continue to rate as a “6” on that risk indicator.

The Fund’s ultimate capacity will rise materially.  Every investment strategy has a capacity limit beyond which performance will erode.  The options portfolio was the limiting factor on the Fund’s capacity limit.  With these portfolio changes the Fund’s capacity limit is now high enough that we are unlikely to reach it.

Importantly, we don’t expect these changes to reduce the Fund’s long-term returns. The research and testing we’ve done in connection with these changes suggests the Fund’s 5-year returns with the new portfolio structure should be at least as strong as could be achieved under the current portfolio structure including the options.

From January 2023 the Lighthouse Global Equity Fund will replace its current options holdings with a broader mix of large market-capitalisation stocks.

Some investors feel nervous with options, and we want to remove any impediment to them investing in the Fund.

The Fund will also modestly increase its overall leverage limit from 20% to 30% of Net Asset Value. 

We expect these changes will reduce the Fund’s monthly volatility but not reduce the Fund’s long-term returns.

Every fund manager has a “house style” that reflects their investment philosophy.

On one level some fund managers will choose to invest in equities, some in bonds, some in other asset classes.  Some equity managers will prefer passive investing, others active management.  Some of the active managers will target income, some value, others growth.  And so on.

On another level their investment philosophy will influence what factors they think will deliver successful investments.  Some of those factors might be financial metrics such as profitability, or dividend yield.  Others might be factors like how long the manager is prepared to hold any investment (Are they a short-term trader?  Or a long-term investor?), or how much uninvested cash they prefer to hold.

All these things add up to an individual house style that will strongly influence the fund manager’s portfolio – what they buy, how long they hold those investments for etc.

In parallel to this the financial market has a cycle of its own, where it progresses through bull periods and bear periods.  From troughs to peaks and back to troughs again.  This is driven by economic, financial and demographic effects that are outside the control of any fund manager.

The challenge then for each fund manager is to develop and optimise their house style so that it delivers the best outcomes across the full market cycle.

There will be periods in that market cycle that will align with a fund manager’s “house style”, and other periods that will be a headwind to that house style.  We’re not aware of any fund manager whose style is optimal at every stage in the market cycle.  So each fund manager has to accept there will be times when they under-perform the market, and other times when they will out-perform it.  They need to optimise their style across the whole span of the market cycle.

But when we say “best outcomes” and "under-perform" and "out-perform" we need to interpret that in light of what is the objective of the fund manager’s investment philosophy and house style.  Is the fund manager optimising for the highest returns across the cycle?  Or the lowest volatility?  Or minimal drawdowns?  Or some other metric?

You will see the effect of each manager’s house style in their long-run performance.  In any given period you will find some fund managers appear to do well (perhaps because it’s a time where the market cycle aligns with their house style), while others appear to do less well (perhaps because it’s a time where the market zigs while their house style zags).  But that short-term variability levels out over periods of 5 years or longer, and so you get to see the inherent performance of the fund manager’s house style.

We strongly believe that each house style has an inherent long-run rate of return.  You will see that inherent long-run rate of return in these 5-year (or longer) average returns [1].  

Similarly, each house style has an inherent level of volatility, and maximum drawdowns, and so on.  Again, you will see that inherent performance over 5-year (or longer) periods.

At Lighthouse Funds our investment philosophy has three parts:

We will only invest in highly profitable, conservatively run companies whose shares have deep liquidity, and

We believe that within that universe there will always be a small set of companies who have strong medium-term growth, and

We need to be patient investors to allow that medium-term growth to come to pass. 

This investment philosophy and house style is consciously optimised for achieving strong net returns.

We believe the inherent long-run rate of return of our house style is a little over 20% pa.  You can see that in the return profile across different hold periods – the average return across a range of hold periods is pretty consistent at about 20% pa, and as the hold periods get longer the spread of the returns tightens closer around that inherent long-run rate of return.

But, we acknowledge and accept that our house style will be more volatile than other alternative styles might be (that said, we don’t believe that volatility is risk).  And we accept that our style will under-perform the market something like 1 year in 4 or 1 year in 5 - we accept there will be periods where the market cycle doesn't align with our house style.

Those short-term losses are the price you pay for the long-term gains.  To get high returns over the long-run you need to accept there will be short-term periods with losses.  The long-run gains are despite those short-term retreats.  The 20-ish % pa long-run returns include the periods, such as the last 6 months, where the Fund trails the market. 

(Note that the flip-side of this is also true … if you want low volatility or protection from drawdowns then you will have a portfolio that underperforms in the bull markets).

The Challenge For You As An Investor (Or Potential Investor)

The relevance of all this to you, the investor, is in three steps.

Think carefully about your objectives, your investment time horizons, and your financial and emotional tolerance for volatility, drawdowns and so on.  It may be helpful to talk these through with a financial advisor, who will be trained in how to help you consider these things.

Look for a fund manager (or managers) whose house style aligns with your objectives and tolerance.  If you want strong returns over a 5 year or longer horizon then look for a fund manager with strong 5 year returns.  If you need low volatility then look for a fund manager whose style aligns with that, et cetera.  If you were shopping for a car to suit a young family with several children you’d likely buy an SUV, not a 2 seat coupe.  In a similar way, look for a fund manager who’s aligned with your needs.

Be patient.  Accept that there will be periods where both your investment objectives and your chosen fund manager’s house style will be out of step with the market’s current mood.  And remember that there’ll be other periods where that fund manager's house style over-delivers.  One of the biggest keys to successful investing is managing your emotions during those times when your objectives are out-of-alignment with the market.  It won’t stay that way for ever – it probably won’t even stay that way for long.  That’s just the market cycle at work.

[1]  Equity markets tend to have about one losing year in four or five, so a five year average return should span both bull and bear market periods.  Major market peaks and crashes are a bit more occasional, but over the long-run don’t move these long-run averages much.

Every fund manager has a "house style" that reflects their investment philosophy and that shapes their portfolio and their long-run performance.

No fund manager's house style will be optimal at every stage in the market cycle, but fund managers will tend to optimise their style across the full market cycle rather than for different stages of it.

Look for a fund manager whose house style aligns with your own long-term objectives, and your tolerance for volatility, drawdowns etc

Investing in the share market is emotionally trying.

As we write this, in early-2022, the major global indexes are abruptly off their recent highs.  The mood of the market has swung strongly bearish - in fact surveys of investor sentiment are as negative now as they were in March 2020, which seems scarcely credible when you think back to March 2020.

Investors in our Lighthouse Global Equity Fund have seen larger falls than those of the indexes.  The fund has a very clear strategy that is different to the market-as-a-whole.  History shows that that different strategy delivers higher long-term returns than the market does.  But there are times when your different will be out of step with the market and this is one of those times.  We expect and accept that because we’re focused on the long-term returns.

But we know these times in the market are emotionally trying, so we thought it would be useful to talk through three truths of investing in equities. 

Short-Term Losses Are The Price You Pay For Long-Term Gains

Over the long-run the share market offers strong returns.  Across the last 5 years our benchmark index, the MSCI All Country World Index, has averaged nearly 15% pa in New Zealand dollars.  In the same timeframe our Lighthouse Global Equity Fund has averaged more than 25% pa.  That’s the sort of story we’re all here for as investors.

But in the short-term the share market will have deep retreats.  Like we’ve seen recently.  They’re not rare - you should expect that every year the market, and your investments, will have a significant pullback, that every second or third year it will have a correction, and that every six to ten years it will have a crash (1).

Truth #1 = To get high returns over the long-run you need to accept there will be losses in the short-term.  The short-term losses are the price of admission.  The long-term gains are despite those short-term retreats.  

There’s a chart in JP Morgan’s excellent “Guide to the Markets” that shows this clearly.  

The grey columns show the annual return for the S&P500 for each calendar year since 1980.  The red dots show the extent of the largest decline, or retreat, in each of those years.  Over the 42 years covered in the chart the S&P500 has averaged 9.4% pa (in US dollars).  But that’s despite declines each year that averaged 14%.

Investing for long-term returns requires the fortitude to stomach short-term setbacks.

Most Of The Time Your Investment Will Be Below Its Highs

Given this Fund’s strong long-term returns you might think it’s normal for most days to lift higher and higher.  Not so.  Not even close.

This Fund began on the 31st of March 2016.  In the 1,530 business days since then the Fund’s unit price has set a new high on just 186 of them.  So all of the 25% pa net return across nearly 6 years was generated on just 12% of the days the Fund has been in place.

For the other 88% of the days the Fund was below its most recent high point.  On average, across time, the Fund has been about 6% below its most recent high.

When we chart the Fund’s distance from its most recent highs it looks like this.  

These charts are likely a little confusing so let us explain what it shows.  If the purple line is touching the top of the chart then that’s a day the Fund’s unit price hit a new high (so when the Fund is 0% off its most recent high).  If the purple line is below the top of the chart then that’s when the Fund’s unit price has dropped below its most recent high.  You’ll see the Fund spends most of its time below the top of the chart, or in other words it’s below its most recent high – that’s the "88% of the time" statistic we just mentioned.  For this Fund the longest gap between new highs was 38 weeks, or 9 months.  And the slowest recovery from the bottom of a big drop was 25 weeks, or 6 months.  

Truth #2 = Most of the time your investment will be lagging its high point.

Truth #3 = Your investment will return to new highs in the future, typically quite quickly.

It’s Not Only This Fund That Shows This Pattern

This isn’t the case with just this Fund - the chart looks fundamentally the same for each index and for most individual stocks. That is the reality of equity investing - your investments will spend a lot of time notionally “under water” but they will recover.  Equity markets have a strong upward bias and they deliver positive long-run returns.

Amazon listed in May 1997 at about US$1.70 per share (when we adjust for share splits since then).  Now, in February 2022, Amazon’s shares are worth about US$3,100.   That’s a return of more than 35% pa across almost 25 years.  We’d probably all like to find a DeLorean time machine, go back to May 1997, and load up on Amazon shares in the IPO.

But the “Percent distance from most recent high” chart for Amazon looks like this:

In the aftermath of the 2000 dot-com crash Amazon’s shares fell by 94%.  Very few investors could calmly tolerate that level of crash.  And it took 10 years - from November 1999 until October 2009 - for Amazon’s shares to recover and post a new high above its 1999 level.  Amazon’s shares have hit new highs on only about 12% of the days since Amazon listed - so across time Amazon’s new highs have been about as rare as we find they are with this Fund.

And even today Amazon’s shares are more than 15% off their most recent high, which was in July 2021.

But still … 35% pa for almost 25 years. 

Likewise, if you’d held Apple shares since its IPO you would have travelled through six different periods where Apple’s share price was more than 50% below its most recent high, with a worst drawdown of 82%.

Truth #1 = The long-term gains are despite the short-term retreats.

Truth #2 = Most of the time your investment will be under its most recent high.

Truth #3 = But your investment will rebound to make new highs in the future.

Successful investing relies on being patient and managing your emotions.  The hardest aspect of managing your investing emotions is learning to ride the market’s turbulence.  

When the market is dropping to significant lows the human emotional reaction is to sell.  That’s why “Buy low, sell high” is a beguilingly simple maxim, because while your head will recognise the logic of that phrase at the times when it really matters your emotional state will make doing that logical thing hard.

But history shows those occasional lows are great entry points, and bad exit points.  This Fund’s slowest bounce-back was 6 months to regain a 25% loss.  So an investor who added money at that low made 33% in 6 months. 

Meanwhile panicking and selling at that low point just means you are locking in that loss.  

There’s various definitions used to describe different levels of market fall.  We use “pullback” to describe a fall of 10%-20% from the most recent high, “correction” where the fall is 20%-30% from that most recent high, and "crash" where the fall is more than 30% .

To get high returns over the long-run you need to accept there'll be periods with losses in the short-term - it's the price of admission.

In fact most of the time your investment will be under its most recent high.

But your investment will return to new highs in the future, typically quite quickly.

At the moment the two dominant influences on global share markets are the ongoing Covid pandemic and forecast rising interest rates.  We don’t have any insight into how and when Covid will resolve itself but we have some pragmatic thoughts on interest rates and their impact on share markets.

The particular interest rates we’re focusing on here are the rates paid on Government bonds.  These are called “risk-free rates” because reputable governments are expected to always honour their debt obligations so there’s supposedly no risk in lending them your money.  These risk-free rates, especially the interest rate on 5 to 10-year Government bonds, are one of the inputs into company valuations.  All else being equal if these interest rates rise then share prices fall, and if these interest rates fall then share prices will rise.

Central banks strongly influence interest rates through where they set the overnight cash rates (which in New Zealand we abbreviate to OCR).  All interest rates, for borrowing and for investment, from private companies and from governments, anchor back to these central bank cash rates.  This gives us what’s called the “yield curve”, which is the profile of how these interest rates change as the term of the debt gets longer.  For example here’s the yield curve on US government bonds at the beginning of January 2022.

As the term, or duration, of the debt gets longer so the interest rate gets higher.  That’s an important relationship we’ll come back to later.

The central banks primarily set the overnight cash rate in response to inflation.  Typically a central bank is mandated to maintain inflation within a set range.  For example the Reserve Bank of New Zealand is mandated to maintain inflation between 1% to 3% pa over the medium term (1).  

Simplistically … when the central bank raises the overnight cash rate the longer-term rates also rise, in order to maintain the upwards slope of that yield curve.  Those higher long-term rates in turn stifle economic activity.  Borrowers (for example mortgage holders) face higher interest rates so have less discretionary income to spend.  Companies face higher financing costs, so they tend to defer investments.  And the currency rises, which is a headwind for exporters and makes imports relatively cheaper, both of which further weaken the local economy.  The overall effect is to take excess heat out of the economy, which will temper inflation.

That’s not without cost.  People feel poorer.  The labour market gets hit because companies are less likely to take on new staff, and in fact are more likely to shed staff.  Economic growth slows.  This isn’t a surgical process – all aspects of the economy are hit, not just the over-heated parts.  So it’s a crude-but-effective measure that has a lot of collateral damage.  It’s somewhat like a doctor saying they’ll cure your fever by strangling you rather than giving you paracetamol.

And it’s not without risk.  If the central bank overshoots and raises the overnight cash rate too high (over-strangles the patient) then the risk of an economic recession rises.  That risk is heightened because there’s a lag between the central bank raising rates and the inflation ebbing.  History suggests that lag often provokes central banks into over-tightening.

So Why Might Central Banks Raise Rates In 2022?

Mainly because inflation has risen markedly in the last twelve months, well above the levels in central bank mandates.  That inflation has several drivers, including:

Demand has rebounded from Covid faster than supply,

This has been compounded by supply chain disruptions, which had been slowly resolving but are now re-occurring because of the number of people isolating from Omicron infections,

Geopolitical tensions have significantly raised the cost of oil and natural gas,

The pool of people available for work has reduced post-Covid … immigration is lower, some workers have voluntarily left the workforce, some workers are having to care for children locked-down from schools, and sadly some workers have died … so companies are having to compete harder for staff which is driving pay raises.

So central banks are eyeing their inflation mandates and preparing to raise interest rates.  Note though that raising interest rates won’t magically unblock logistics chains, or resolve geopolitics, or whistle up a lot of new workers.  But it will stifle demand to a lower level that the constrained industry and labour market can comfortably supply.  They're strangling the patient.

Trading banks will also lobby for higher interest rates, because it gives them room to increase their Net Interest Margin (NIM), which is a bank’s main source of revenue.  Trading banks’ self-interest is served by higher interest rates.  In the last week JPMorgan in the US suggested the Federal Reserve might raise their cash rate by nearly 2% pa, and here in New Zealand the ANZ’s economists floated the idea that the OCR could reach 3% pa.  They want higher interest rates because it's good for their business.

And central banks also won’t mind nudging cash rates higher because it then gives them room to lower them again in any future recession.  At some point in the cycle the central banks need to re-load their stimulus guns, in preparation for the next crisis.

But Why Might Central Banks Not Raise Rates In 2022?

We think there’s two practical and one political reason why central banks might not raise rates as much as many commentators are forecasting.

Firstly, despite the recent inflation Covid is still with us and there are likely to be further disruptions to our economies in 2022.  That suggests central banks should still err towards being stimulatory not punitive.  Remember their inflation mandate is “over the medium term” – they can tolerate another six to twelve months of “wait and see” time while Covid (hopefully) properly clears.

Secondly, and importantly, because they will need to be cautious about inverting the yield curve.  That’s when the interest rates on longer-term debt end up lower than the interest rates on shorter-term debt, so that yield curve chart we showed above would change to be flat or sloping downwards.  An inverted yield curve is seen as the strongest predictor of an imminent economic recession.

Remember central banks can only change the overnight interest rate – the very left-hand end of that yield curve chart.  That does influence the longer-term rates, but so do a lot of other factors.  At the moment there’s still a lot of money looking for attractive investments and that wall of money puts a strong lid on the interest rates on longer-term (10 year and longer) bonds.  With that heavy lid on long-term rates raising overnight rates aggressively could quickly invert the yield curve and set the scene for a recession.

Thirdly, because it’s politically expedient to run “hot” inflation at the moment.  Covid has left governments owing significantly more debt.  Those governments will be happy to inflate some of that debt burden away so will likely prefer inflation to remain at higher levels for a few years.  Just don’t expect them to say that out loud.

Firstly, we expect central banks to talk a big game.  Plan A will be to threaten to raise rates, in the hope that will achieve some of the central banks’ objectives without them actually having to do anything.  That’s exactly what we’re seeing already in the US – rates are rising before the Federal Reserve has really moved.

Secondly, we expect a few sharp interest rate rises through the first half of 2022.  Central banks will want to try to dampen inflation early, before it becomes a repeating spiral.  And they will want to be seen to have backed up their public statements.  Two or three 0.25% pa rate rises will convey the message that they are taking this seriously, but will still leave rates at historically low levels and shouldn’t threaten the yield curve.

But, thirdly, we expect central banks to be cautious after the first few rate rises.  We expect that rate rises in the second half of 2022 will rest heavily on whether Covid is truly behind us by that stage.  To us talk of four or more rate rises through 2022 is rhetoric that would need a material improvement in the public health situation to come to pass.

We’ve been interested to see the equity markets panic over interest rate rises and stimulus wind-downs, but at the same time see the bond and foreign exchange markets remain relatively calm, and the price of classical inflation hedges like precious metals stay flat.  To us that suggests the equity markets are over-reacting.  Again.

We do expect to see interest rate rises through 2022, but even a 1% pa rise in overnight rates shouldn’t have an undue effect on the share price of companies that are growing their earnings at 15-20% pa and that have pricing power that allows them to pass on inflation and maintain their margins (2).  Where we would expect to see a stronger impact would be in the share prices of “bond-like” companies such as utilities and commercial real estate, where the growth is lower and bonds are an easier substitute investment.

So if, through 2022, the companies the Fund invests in were to grow their earnings by 15-20% pa, but see their share prices only rise by 10% or so, then that wouldn’t surprise us.  But at this point we don’t see the rationale for a collapse in their share prices because of inflation or interest rates.   

Note that there’s several different measures of inflation, and “medium term” is a little vague.

For the corporate finance geeks … think back to the CAPM formulas for the cost of equity.  If the 10-year risk-free rate rises by, say, 0.75% pa then yes all else being equal that will raise Ke, but not by very much.  If Ke goes from, say, 9% pa to 9.75% pa then that will reduce the equity valuation, but not as significantly as the recent market movements would imply.  (Yes, there’s also the forecast free cash-flows to consider, but that would take too long to really get into here).

Equity markets expect central banks to raise cash rates significantly in 2022, to counter inflation

Rising interest rates impact on equity valuations, and so markets are falling on the expectation of higher interest rates

We expect interest rate rises, but think practical constraints will limit their number and extent

Recently we set out how we think about risk:

There are two dimensions of investment risk.

There are two levers you can use to help manage that investment risk.

The two dimensions of investment risk that we outlined in that recent piece are:

The risk of permanent loss of capital, and

The risk of underperforming your target return or benchmark.

All of the other “risks”, including the risks we have to list in our formal fund documents, are just sub-sets or causes of those two over-arching risks.

Now in this piece we’ll look at the two levers you can use to measure and manage that investment risk.  Then in a later piece we’ll look at some of the behavioural, or emotional, aspects of managing investment risk.

Managing Risk Is About Balancing Time And Probability

Essentially risk is about uncertainty.  Riskier investments are the ones where your investment has a range of possible outcomes spanning from good to bad, and you’re not certain what eventual future outcome you’re going to end up with.  

We handle uncertainty – in many areas of life, not just in investing – using probabilities.  So we need to think about what are the probabilities of these different possible outcomes?  And do those probabilities change over time?

We mainly think about risk in terms of probability distributions – specifically the probability distribution of the fund’s historical returns.

You’ll be used to how funds post annual return numbers, which are simply the “through 12-months return” calculated at the end of the fund’s financial year.  But we can calculate the “through 12-months return” every day and so for this fund we have over 1,200 individual “through 12-months” data points from both bull-ish and bear-ish periods.  With a sample size that large we can arrive at the probability distribution of the Fund’s returns with some confidence.  What we find is that the distribution of these “through 12-month returns” fits to a bell curve (1), and the shape of that bell curve gives a simple visual picture of the Fund’s risk and return profile.

For our Lighthouse Global Equity Fund the probability distribution of the “through 12-month” returns is:

Let's mark-up that diagram with a few notes that highlight risk and return.

Based on the historical performance – in the historical conditions – the fund has about a 6% probability of losing money in any 12-month period.  We expect that will be understating the true risk of a losing year because the period we’re measuring across has been a good one in the markets.  As, if, and when we pass through the next deep market correction these probabilities will shift and that probability of a losing year will rise.  But the method, or approach, we’re using to think about it won’t change (2).

Now let’s overlay the equivalent bell curve for our benchmark index, the MSCI All Country World Index (the ACWI).

The bell curve of the fund’s returns is wider, or flatter, than for the ACWI, which tells you that the fund is more volatile than the ACWI.  The standard risk indicator, which measures volatility not risk, rates the ACWI a 5 and this fund a 6.

But the proportion of the ACWI’s bell curve that’s to the left of the 0% line (to the left of the vertical axis), is actually the same as for the fund.  Both have about a 6% probability of a losing year.  So despite the fund being more volatile the numbers suggest that in terms of the risk of permanent loss of capital the fund is no riskier than the ACWI index.  As we’ve said before, volatility is not risk.

Where the fund’s wider and flatter bell curve shows a difference is that the fund is more likely to have strongly positive returns than its benchmark index might.  The two bell curves suggest that the ACWI will rarely deliver a 40% return in any 12-month period, but meanwhile it’s quite possible for the fund to return 40%, or more, in a 12-month period.

So comparing these two bell curves suggests the fund is more volatile than its benchmark index, but that volatility is concentrating towards the upside, and in fact the fund’s risk of a losing period is about the same as for the index.

There’s more insights to draw from these probability distributions, but we’re trying to be brief so we’ll come back to those in a later piece.

Share markets have periods where they lose ground.  History shows that in more than half of all years the S&P500 will have a drawdown of at least 10%, and in about one year in five it has a drawdown of more than 20%.

Yet equity markets’ long game is consistently positive.  This Fund hasn’t had a 2-year period where it lost money.  It hasn’t had a 3-year period where the annualised return wasn’t in double figures.  

So investing in equities means handling periods where your investment goes backwards, but the odds of positive returns improve as your time horizon lengthens.  Essentially, the shorter your time horizon the higher the probability you will experience losses. And the longer your time horizon, the higher the probability you will experience gains. 

So when we consider the possibilities of losing money, or of underperforming we need to ask “Over what time period?”   We wrote earlier about how to think about investment timeframes, and you’ll see from that piece that our thinking on investment horizons links back to these questions of risk.   They’re two sides of the same coin.

This chart shows how the probability distribution – the bell curve – of the Lighthouse Global Equity Fund changes with longer and longer time periods.

The lightest shaded bell curve is the one we showed earlier – it’s the distribution of the fund’s returns for 12-month hold periods.  A meaningful portion of that bell curve lies to the left of the vertical axis, which says we should expect some 12-month hold periods to lose money.

But as the hold period lengthens (indicated by darker and darker shades of blue in the chart) the probability distribution narrows and becomes peakier.  The long-run returns are more consistent and certain – they’re less risky.  Little or none of those bell curves lie to the left of the vertical axis – the risk of permanent loss is reducing quickly as we hold for longer periods.

What this chart highlights is that risk is linked to time.  The shorter your hold period the riskier your investment will be. Patience is one of the best tools for managing risk.

No doubt you’ve heard the standard proviso that “past performance is no guarantee of future performance”.  

It is true the future might not be the same as the past, so yes a high probability for success based on historical returns is no absolute guarantee.  But what is a better alternative measure for weighing risk and return?  Volatility is a poorer and less relevant measure of risk, and if you truly think the future could be different from the past then who’s to say the future volatility won’t be materially different to the historical volatility?  Why is the historical volatility any better a predictor of the future than the historical investment returns?

We try to be pragmatic.  Every fund manager has their own individual investment style.  Every investment style has an inherent rate of return and an inherent risk (or probability distribution) of permanent loss or underperformance.  We believe the best way to see that inherent rate of return and level of risk is by looking at that fund manager’s 5-year, or longer, historical investment returns.

(1)        We could talk about – and will cover in a separate piece – multi-modal distributions, and skew, and “fat tails”, and so on.  We’re nerdy enough to get into that stuff.  But we’re also trying to make these pieces accessible too.  The fit to a bell curve is very good, so although it’s a slight over-simplification we’ll use it in this piece because most people will be familiar with normal distributions.

(2)        These charts are based on the audited returns from our wholesale and retail funds since 2015.  But if we look over a longer history of investing with this approach we estimate the risk of a losing 12-month period will be about 10% over the full market cycle, or about 1 year in 10.

Investment risk is fundamentally about the uncertainty of the future outcomes

We usually manage uncertainties using probabilities

But these probabilities change depending on our time horizons

Risk can be a difficult concept to construct a clear framework about, but without such a framework it can be hard to think about how best to measure and manage risk.

There are two dimensions of investment risk,

In this piece we'll set out how we think about the two dimensions of investment risk, and then in our next piece we'll look at the two levers you can use to manage the investment risk.  Then in a later piece we'll also look at some of the behavioural, or emotional, aspects of managing risk.

First and foremost investment risk is the possibility that you might lose some or all of your capital. 

Immediately we find ourselves dealing with the fundamental truth of investment risk … it’s all about uncertainty.  Clearly if you knew you were certainly going to lose money then you wouldn’t invest, but instead it’s that you expect to make money on your investments but you recognise that’s not certain and that there is a possibility of losing money.  Or, if you look at it from the other direction, if you knew exactly how your investments were going to unfold then there wouldn’t be any risk.  So the pithy summary is that riskier investments are ones where there is more uncertainty about the outcome.

There are many ways an investment could lose money.  It could be that circumstances unfold in an unexpected way in the overall market (for example shifting economic fundamentals) or in an individual company (for example new competitors, or regulatory changes, or even criminal behaviours inside or outside the firm).  That wide spectrum of possible causes and fault lines is one of the main reasons investors get overwhelmed and confused by “risk”.  But distil it down and the essence is that these are all variations on the primary risk that you might lose some or all of your invested capital.

Second, The Risk Of Underperforming Your Target Return Or Benchmark

Investment risk is also about the possibility that you might not reach your investment target.  

It could be that you need a certain level of return to finance your needs and objectives, and a prolonged period of underperforming that required return will have serious financial implications for you.  We fear this is an under-appreciated risk in KiwiSaver in particular, where there’s a lot of focus on fees but not on long-run net returns after tax.  

Parallel to this is the risk of underperforming your benchmark return.  Fund managers feel this acutely, and it’s why many equity funds are constructed as quasi-index funds – to minimise underperformance risk.  The difficulty here is that if you want to get an above-market return (what’s referred to as “alpha”) then you have to do something that’s different to the market, and that will entail you’ll also have periods of underperformance too since no investment strategy or style can be perfect all the time.

You Need To Balance Between These Two Risks

Note that there’s a tension between these two investment risks.  If you tilt towards “safer” investments in order to reduce the risk of permanent loss then you may increase your risk of under-performance, and vice-versa.  So the challenge is to balance your portfolio or fund between these two competing pressures. 

No one promised this would be easy or cost-free.

There are two simple elements to investment risk … the risk of permanent losses, and the risk of underperformance.  All of the other “risks”, including the risks we have to list in our formal fund documents, are just sub-sets or causes of those two over-arching risks.

At heart both these two investment risks speak to the uncertainty of investing.  Not surprisingly then the levers we can use to help understand and manage investment risk flow from how we manage uncertainty.  We’ll cover those in our next piece. 

A Few Quick Thoughts On Investment Risks In Other Asset Classes

We run a fund that invests in listed equities, and so much of this discussion is in the context of how listed equities behave.  But the same two fundamental investment risks apply across all asset classes.

For example, many New Zealanders have invested in residential property.  There’s a perception that these are low-risk investments but they still entail the risk of permanent loss of capital (some causes of which can be insured against, such as fire, but other causes can’t be, such as leaky homes or regulatory changes) and the risk of underperformance (there are different returns between cities and suburbs, and even property by property).

Investment risk is fundamentally about two things ...

The Product Disclosure Statement (PDS) for every managed fund will show a “Minimum suggested investment timeframe” – it’s a statutory requirement for every PDS.  In the PDS for the Lighthouse Global Equity Fund we recommend investors have an investment timeframe of 5 years.  Firstly, because that’s the investment horizon we try to target with the Fund’s investments and, secondly, because we believe that over that length of time you’ll receive the “true” return for the Fund’s strategy and style.

But how should those investors think about their hold period?  We think there are two pragmatic questions that help inform investors’ thinking.

Firstly, How Long Do You Need To Invest For To Avoid The Risk Of Losses?

There’s a chart in our earlier piece on “Focusing on what really matters” that highlights an important concept:

Some explanation - this chart shows the worst, average and best returns we've seen across  more than nine years of investing using the Fund's investment strategy (1).  If you look just at the dashed red line, for the “worst ever period”, you can see the Fund’s worst ever 1 year period was a 15.8% loss, its worst ever 2 year period was a slight loss, but its worst ever 3 year period was still a positive return.

We think investment risk is all about managing, and ideally eliminating, the probability of permanent loss (we’ll write more on this shortly).  So this chart says that if your investment horizon in this Fund was to be only 1 year then there is a possibility you'll incur a loss (to be more precise we calculate the possibility of any rolling 1 year period having a negative return at about 14%), if your investment horizon was to be 2 years then there's still a small possibility of permanent loss (so far just one rolling 2-year period across 9 years), but if your investment horizon is longer than 2 years then, at least historically, we've not seen permanent losses.

So based on this information we recommend that the shortest period an investor should consider for an investment in the Lighthouse Global Equity Fund is 3 years, in order to reasonably expect you shouldn't incur a permanent loss on the investment.  And on the basis of the analysis outlined here we still feel comfortable recommending investors have a longer 5 year horizon.

Secondly, How Long Do You Need To Invest For To Ensure You Beat The Benchmark Return?

The Lighthouse Global Equity Fund’s benchmark index is the MSCI All Country World Index (ACWI), net in New Zealand dollars.  Our objective is not only to beat that benchmark, but to beat it by at least 2% pa.

So if we compare the Fund’s returns with those of the ACWI then we see the Fund’s probability of beating the ACWI has been (2):

What this analysis shows is that, historically, as long as your investment timeframe was at least 30 months long then there's been a 95% likelihood you would have received an investment return that was better than the ACWI benchmark’s return. 

And, similarly, by the time you get to 36 month hold periods or longer then the Fund is beating our “ACWI + 2% pa” goal more than 90% of the time (eg in more than 90% of the rolling 30 month periods).

But if, for example, your investment timeframe were to be as short as 12 months then the Fund has beaten the ACWI in only 74% of those rolling 12 month periods – which means you would have had about a one-in-four probability of underperforming that ACWI benchmark.

So based on this analysis we'd recommend that investors should consider an investment timeframe of at least 30 months for an investment in the Lighthouse Global Equity Fund, in order to reasonably expect they should receive a return that beats our benchmark index.  And we'd feel more comfortable with an even longer hold period in order to increase the probability of the returns exceeding our hurdle.  We think that lines up with our recommendation in the previous section that investors have at least a 3 year investment horizon for an investment in this Fund.

We recommend that when investors are considering investment timeframes – for any investment – they consider the risk of permanent loss and the risk of underperformance.  Those two factors are useful guides to how long a commitment you should make in order to ensure short-term volatility doesn’t harm your returns.

For the Lighthouse Global Equity Fund we interpret those two factors as pointing investors towards an investment horizon of at least 3 years, based on the historical experience.  We acknowledge there’ll be investors who have good reasons to invest for shorter periods, but we need to point out that the investment risks are higher with those shorter timeframes.

Note that you can do this same analysis for any fund where you can get a long return history (for example, monthly returns for at least five years).  Note too that these numbers are as at the end of April 2022 and they may move around a little over time as the Fund and the market go through different periods.  But we believe the principles and the approach set out here are a pragmatic way to frame your investment choices.

(1) This is the nine and a bit years from 31 March 2013 to 30 April 2022.  From March 2013 to March 2016 we trialled and proved this strategy using private money.  We don't use the results from this period in our marketing because they are unaudited - but we are including them in this analysis here because they include the worst return periods we've seen with this strategy to date and so provide the worst, or most conservative, results in this analysis.  Then from March 2016 to March 2021 this strategy was used in a wholesale fund, with audited results.  And from March 2022 this strategy is also employed in our retail unit trust PIE, which is also audited.

(2) This analysis draws on the same nine and a bit years of investment returns and ACWI performance from 31 March 2013 to 30 April 2022.  Again we are including our trial and test period because that captures the worst period of results for the Fund's investment strategy and provides the worst case results in this analysis.

We believe there are two pragmatic questions to inform investors' decisions on their investment timeframes

How long do you need to invest for in order to avoid the risk of permanent loss?

How long do you need to invest for in order to avoid the risk of underperformance?

Our monthly update for August 2021 is now available.

August was a modest lift for the Fund.  Markets (understandably) are struggling to determine whether the Covid pandemic is beginning to fade, or has entered another prolonging phase.  That favours traditional and defensive sectors such as banking and industrials, which the Fund is under-weight in because they don't offer the levels of growth we seek.  But we are focused on the 3-5 year horizon not just this month. Meanwhile stocks we like are available at a discount.

Markets are still struggling to establish a clear direction, particularly with Delta rampant

We've been thinking

Changes

House styles

Sadly market falls are normal

Of inflation and interest rates

Two levers for managing risk

What risk really is

How to think about investment timeframes

Looking back on August 2021

Focus on what matters - Part 2