Our monthly update for November 2021 is now available.

The fund was up strongly in November, as markets shrugged off earlier concerns about corporate profits, inflation and interest rate rises.  But that trend started to reverse in the last few days of November as fears of the Omicron Covid-19 variant and a more hawkish Fed brought the market's fear back to the forefront.

Our sense is that fear is still the dominant emotion in equity markets right now.  That mainly manifests itself in quick and sudden reversals at even the hint of bad economic news (or even anything other than stellar economic news).  But it also manifests itself in FOMO (fear of missing out) as well.  It feels very reminiscent of late-2018, which was the last time the Federal Reserve began to taper its economic stimulus and look to raise interest rates.  Maybe the only thing we learn from history is that we don't learn from history.

Economic and business news in November gave growth stocks a lift

But we still feel that fear is the dominant emotion in markets just right now

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

Our monthly update for October 2021 is now available.  The earnings announcements for the July-to-September quarter indicate that corporate profits have stayed robust despite the fears of inflation, although supply chain issues are still a drag on many companies.  The reverse side of that supply chain issue though is that there seems to be strong consumer demand, which is an opportunity in the coming months.

Month-to-month volatility remains the key feature at the moment

Although, to be fair, few people complain about upwards volatility

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 ...

Our monthly update for September 2021 is now available.  And since September marks the end of the first half of the financial year we've also provided some extra commentary looking back over the last six months.

Just right now this market reminds us of a learner driver stuck at a busy intersection.  There's lots of inching forwards and backwards, and lots of switching from the accelerator to the brake, but really we aren't going anywhere.  That lack of conviction in any direction has seen share prices sag to a level set by opportunistic buyers.  

We saw a similarly moribund market in late-2018, where markets slid through the last quarter only to roar away once the fears ebbed at the start of 2019.  We expect a similar dynamic here where eventually the gloom will lift and markets will bounce back, but it's not yet clear just what event will break the current spell.

September often returns a loss, and September 2021 was no different

The market is grappling with a "wall of worries", with fear and nervousness dominating

Markets go through these phases - most recently in the last quarter of 2018

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 five 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.

While that is our recommendation we appreciate many investors will want to work to shorter investment periods than five years.  So 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:

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 6% loss, but its worst ever 2 year period was still an 11% pa 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 is only 1 year then there's 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 6%), but if your investment horizon is at least 2 years then, at least historically, there’s been no risk of permanent loss.

If we zoom in to get more detail on those “less than 2 year” hold periods we see the Fund’s worst ever returns across different hold periods have been:

The solid line shows the actual historical experience, which is a bit lumpy, so the dashed line is a smoothed trendline to help interpret the data.  What this analysis shows is that, historically, if you invested in this Fund for at least 17 months then you would have always had a positive return – that even the worst ever 17 month period gave a positive return and avoided permanent loss.  

So based on this information we’d recommend that 17 months should be the shortest period an investor should consider for an investment in the Lighthouse Global Equity Fund, in order to reasonably expect you shouldn’t lose money on the investment.

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 is:

What this analysis shows is that, historically, as long as your investment timeframe was at least 22 months long then you would have always received an investment return that was better than the ACWI benchmark’s return.  Expressed another way, in every rolling 22 month (or longer) period the Fund beat the benchmark return.  

And by the time you get to 24 month hold periods then the Fund is beating our “ACWI + 2% pa” goal 98% of the time (eg in 98% of the rolling 24 month periods).

But if, for example, your investment timeframe is as short as 9 months then the Fund beats the ACWI in only 74% of those rolling 9 month periods – which means you have about a one-in-four probability of underperforming that ACWI benchmark.

So based on this information we’d recommend that investors should consider an investment timeframe of at least 22 months for an investment in the Lighthouse Global Equity Fund, in order to reasonably expect they will receive a return that beats our benchmark index.

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 22 months.  We acknowledge there’ll be investors who have good reason 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 August 2021 and they may move around a little over time as the Fund and the market go through different periods.  But we believe the principles set out here are pragmatic guides to your investment choices.

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

The main directional options are "pandemic", "recover" and "unsure" ... and right now it's unsure

In part 1 we urged readers to focus on net returns after tax - because that’s what you, the investor, get to keep.  And we pointed out that focusing on the differences in fees is mis-directed because any difference in fees between managers is very small compared to the differences in their gross (pre-fee) returns.

In this part 2 we want to show why it’s important to focus on medium to long-term net returns rather than just the last month or year.

Every investment manager has a style and a strategy – it’s the way that they think about finance and investing and it guides and shapes their investment choices.  Some managers are very conservative but others are more aggressive, some have concentrated portfolios while others have very wide portfolios, and so on.  We believe that each style and strategy has an inherent level of return, and that you will see that inherent level of return across the long run.  

But in the short-term there will be times when any given style outperforms, and other patches where it underperforms.  The market is constantly moving and the changing conditions align, or not, with certain styles of investing at different times.

In engineering there’s the idea of a signal-to-noise ratio.  The signal is the information you want, and the noise is the background interference.  We’re all familiar with signal-to-noise ratios in the real world, from trying to tune a radio to a particular station.

There’s a signal-to-noise ratio in investing too.  The inherent level of return of the manager’s investment style and strategy is the signal.  For you the investor that is the information you want to understand.  But the noise is the short-term volatility – the little good and bad patches as the market briefly aligns, or not, with each strategy.

So how can we best tune out the noise and discern the signal?

Look At The Net Returns Over 3-Year And 5-Year Hold Periods

If you want to see how effective a fund manager’s style and strategy is then you need to look at their fund’s net returns over long hold periods.  Shorter hold periods have a lot of noise, but that fades away as you look at longer timeframes.

You can see this in the chart below.  The chart shows the Lighthouse Global Equity Fund’s best, worst and average returns across hold periods from 1 year to 5 years.  The purple line in the middle shows the average returns per annum and you’ll see it’s pretty consistent across the range of timeframes.  That is the signal you’re trying to discern.

But if you look at the shorter periods, like 1- or 2-year holds, then there’s a wide range between the best ever and worst ever returns.  That “noise” makes it hard to discern the signal.  You could look at the annual (1-year) returns for each of the last five years and they’ll be spread across that range, making it less than obvious what net returns to reasonably expect.

However, once you get to 3-year periods and longer that spread between the best and worst ever periods has narrowed and by the time you get to the 5-year numbers the range is pretty tight.  The wide variability you see from year-to-year has been squeezed out and what’s left is a clearer picture.

Summing Up – Focus On Net Returns Across 3-Year And 5-Year Periods

When you’re selecting funds to invest in look at their average net returns across long periods.  That is the most reliable indicator of what you, the investor, are likely to receive if you invest with them.

The size of the fees is a distraction.  You get to keep the net returns after tax.  The small differences in fees between managers (realistically 0.5% pa at most) are overwhelmed by the big differences in gross returns between managers (typically at least a 5% pa range between the best and worst performers).  Focussing on fees is being penny wise, pound foolish.

But when you look at net returns prioritise the 5-year average net returns.  Across that sort of timespan the fund manager’s good and bad patches have balanced out and you’re starting to see the inherent performance of their style and approach.  That will be the best guide of the net return you are likely to receive from that fund manager if you invest with them.

Focus on net returns after tax - that's what you get to keep

The best measure of net returns is the 5-year average

Across a 5-year period the manager's good and bad periods balance out and you see the inherent performance of their style and strategy

Our monthly update for July 2021 is now available.

Historically July has always been an "up month" for the Fund.  There is a slight seasonality to financial markets, largely driven by quarterly earnings seasons and key tax dates, and that seasonality tends to give July a bit of a tailwind.  This July continued that historical trend but at the same time this is still an unsettled market that is prone to daily volatility both up and down.  Financial markets are still trying to perceive whether we're out of the Covid woods yet or not, and any given day can bring either positive or negative developments on that story, which then in turn drives the market's mood.  We expect this nervous and directionless state to continue for several months yet.

Historically July has been a reliable "up month"

At the moment markets are struggling to settle on a direction

Our monthly update for June 2021 is now available.

June was an extremely strong month, with the Fund up 19.8% (net, after fees and expenses).  That saw the Fund bounce back from May's loss and post a net return of 7% for the first quarter of this financial year.

We don't look for, or expect, or want, quite this amount of month-to-month volatility but sometimes it's what the market delivers.  But if you have a longer investment horizon (and we recommend investors in the Fund think in terms of a three to five year investment horizon) then this short-term volatility does just become noise and the signal (the annual returns) becomes clearer.

This was the Fund's best ever month, in over five years of operations

But it needs to be seen in context with the last few months on the markets

Our monthly update for May 2021 is now available.

May was a very challenging month.  None of the companies the Fund is invested in appeared to be under-performing, but the market took exception to the types of companies we look for.  We have seen months like this a few times in the five years we've been running funds with this investment strategy.  While we don't seek or welcome months like this we do see this is the corollary of using a strategy that is intentionally different from the market.  Most of the time our different is an advantage, but occasionally it hurts you if the market zigs while you zag.  

The main narrative in the financial media has been about inflation concerns.  We don't find that compelling because other inflation-sensitive assets (for example long-term bonds and gold) haven't moved noticeably.  

We have heard one other narrative that is interesting, and is more plausible.  The United States has a lot of "defined benefit" superannuation schemes.  These schemes have been in financial jeopardy as their members' life expectancy has got much longer than expected when the schemes began - basically the schemes' liabilities far outweigh their invested assets.  But the strong returns from growth stocks in the last year has brought those schemes back towards balance.  (And, macabrely, at the same time the high Covid death toll in the United States has reduced their liabilities).  We hear that many of these schemes have been heavy sellers of growth stocks in the last few months as they look to lock-in this windfall moment where they have their assets and liabilities back in balance.  That explanation fits what we're seeing in the market better than the inflation story does.

Our history suggests that the Fund recovers quickly from these unexpectedly bad months.  We still have a positive outlook for the immediate future.

We've had a few months like this in the last five years, but they are (thankfully) rare

If you want to beat the market you have to do something different, but sometimes different will perform worse

There's a lot of attention paid to fund management fees, with both regulatory and competitive pressure to keep fees low.  The implication is that lower fees will result in higher returns to investors, but fees are just one of the inputs in determining the returns you will receive as an investor.  

What really matters isn’t fees but net returns after tax – because that’s what you, the investor, get to keep.  In particular what matters is net returns after tax over medium- to long-term horizons.  Any fund manager (even us!) can fluke one good year, so you should focus on their average net returns after tax across two year, three year and five year periods.

It seems the accepted wisdom is that the only difference between competing funds is their level of fees, and so lower fees will result in higher returns to investors.

That may be true within directly comparable passively managed funds – if you have two competing NZX50 index tracking funds then yes the difference between their fees will be important.  But other than that narrow situation the other differences between funds will overwhelm the relatively small differences in fees.

Base fees can range from as low as 0.1% pa for large passively-managed funds through to as much as 1.5% pa for some actively-managed equity funds, but most funds have base fees in the range of 0.6% to 1.1% pa.  So the difference in base fees between two ostensibly comparable funds is likely no more than 0.5% pa.

But the difference in gross returns between funds, even within the same asset class, can be much higher than 0.5% pa.  MJW’s excellent quarterly investment surveys show you the gross returns, before tax, for about 200 investment funds and for all the KiwiSaver providers.  Their most recent survey, for the March 2021 quarter, shows variability in 5 year gross returns of:

Pragmatically, the differences in gross returns due to differing fund manager styles, strategies and execution will almost certainly outweigh any small differences in their fees.  Basing your choice of a global equity fund on a 0.5% pa differences in base fees seems mis-directed when there’s a 13.0% pa difference in gross returns between the best and worst managers.  Our grandparents generation used to call that being “penny wise, pound foolish”.

Added to which there can be material differences in the effective tax rates between funds too, as different portfolio compositions lead to different levels of taxable income.  A 28% PIR investor may easily find that the difference in the tax they would pay on two apparently comparable funds can equate to more than 1% pa.

Comparing only fees is appealing because it’s simple, but a focus only on lowest fees won’t capture these other factors.  But the differences in gross performance, in fees and in tax are captured when you compare funds on the basis of their net returns after tax.  

Yes, when you’re evaluating a fund it is important to weigh the net returns after tax against risk.  We recognise judging returns against risk is hard, especially given the limited information investors can access.  We’ve written a little about risk already, and will write more about how we measure and weigh risk.

But, as a general guide, funds within the same asset class (for example, all New Zealand equity funds) will tend to have broadly the same investment risk profile.  They may have different weightings to individual stocks or sectors, but an adverse event in any one stock should be softened by the fund’s diversification while the significant events (for example the 2008 Global Financial Crisis) will tend to affect an entire market and impact all funds in that asset class to a similar degree.

Any differences in fees between funds are quickly overwhelmed by differences in their investment performance

It is proper to weigh those net returns through a risk vs return lens

In part 1 of this piece we outlined that managed funds in New Zealand have to show a standardised risk indicator, which is a number from 1 (low risk) to 7 (high risk), and is calculated from the volatility of the fund’s monthly returns.  Now in part 2 we’ll highlight three aspects of why volatility has limitations when evaluating risk.

Firstly, volatility calculations are disconnected from whether your investment is increasing or decreasing in value – even though risk is about the possibility of losses.  Imagine a $1,000 investment that increases in value by $20 every month.  After 5 years you’d have $2,200, and an average return of 17.1% pa.  On a chart that looks like this:

Investment one - You receive $20 every month

Now imagine you have a second investment, where a $2,200 investment decreases in value by $20 every month.  After 5 years you’d have $1,000, and an average return of -14.6% pa.  On a chart that looks like this:

Investment two - You lose $20 every month

Here’s the thing … both investments have essentially the same volatility (1.07% for the green line and 1.04% for the red one).  So the risk indicator would say these two funds are equally risky, even though that’s not the common sense interpretation.

So now imagine you have a third investment.  It’s just like the first one, except that it increases in value by $40 every month not $20.  After 5 years you’d have $3,400, at an average return of 27.7% pa.  On a chart that looks like this:

Investment three - You receive $40 every month

Except … the volatility of this new investment is two-and-a-half times that of our first investment (2.46% for the blue line).  So it’s “riskier”.  Even though common sense suggests it’s the best investment of the three and that it doesn’t appear to have any higher risk of losses than investment one.

Secondly, investors don’t actually care about a lot of the volatility they experience.  No one complains when the value of their investment rises, but that’s volatility.  Generally what concerns investors is downside volatility, which is the volatility you experience when prices are falling.  There are ways to measure downside risk, such as downside deviation, Sortino Ratios or maximum drawdowns, but those aren’t the calculations the risk indicator is based on.

Thirdly, low volatility is not the same as low risk.  At the time of the 2008 Global Financial Crisis many New Zealanders had investments in debt (bonds) or mezzanine securities (such as preference shares) issued by finance companies.  In most cases these finance companies continued to meet their scheduled interest or dividend payments right up until the point where the finance company declared insolvency and much or all of the investors’ capital was lost.  In risk indicator terms these investments were low volatility, and hence low risk, but clearly that turned out to not be the case.  There are many dimensions of risk other than volatility, for example liquidity risk and counter-party risk, but the risk indicator doesn’t capture those.

But that’s enough about the risk indicator.  In our next pieces on risk we’ll look at what we think risk really is, and how we track it here at Lighthouse Funds.

Volatility measures don't take into account whether your investment is going up or down

No one complains when investments rise (volatility), only when they fall (also volatility)

And just because an investment has low volatility doesn't mean it is low risk

Our monthly update for April 2021 is now available.

Financial markets are a little unsure of themselves at the moment, with conflicting positive and negative aspects of the economic recovery from Covid-19 driven downturns.  Typically what happens in these sorts of directionless times is that markets get panicky, with a "sell now and worry about the facts later" kind of mindset.  We're seeing a little of that right now.

The Fund was down 0.79% in April (net, but before investor tax).

The Covid recovery economic news is positive, but is leading to unusual short-term gyrations.

Quarterly results announcements have been positive but share prices have dropped, for now.

Managed funds in New Zealand have to show a standardised risk indicator, which is a number from 1 (low risk) to 7 (high risk).  You’ve likely seen it in fund documents and websites.  It was first developed in Europe in 2010 and then adopted in New Zealand in 2015.  But what really is it measuring?  And can it help you manage your investment risk?

The risk indicator is a simple tool that measures the historical volatility of a fund’s returns.  Volatility refers to how dramatically the price of an investment may change – if the price moves widely then we consider that investment has high volatility, but if it maintains a relatively stable price we say it has low volatility.  

Think of volatility as being a measure of how steady and predictable a fund’s returns are (or not).  A fund that invests in term deposits would have steady and quite predictable returns each month and so its volatility would be low.  But a fund that invests in listed equities will rise and fall with the sharemarket, so next month’s returns could be quite different to last month’s, and so its volatility might be high.

The risk indicator is calculated off the fund’s monthly returns over the last five years.  Without wanting to trigger bad memories of high school maths the risk indicator is the annualised standard deviation of those 60 monthly values.  The number you calculate is a percentage, and then that percentage will map into one of the seven risk classes.  For example, if the volatility was, say, 11% then that would be risk class 5, which is for percentages from 10% to 15%.

The attraction of the risk indicator is that it’s easy to calculate.  It was developed by academics, and generally academics like to be able to reduce complex ideas like “risk” into a simple measurement.  Whether that’s useful or not.  

As investment practitioners, rather than academics, if we search for a practical application of the risk indicator then it is true that investors do have an emotional reaction to some volatility.  If prices rise rapidly then that’s volatility, but generally we’re happy about it.  But when prices fall rapidly, which is no different in terms of the maths behind the risk indicator, we all find that stressful.  So perhaps the risk indicator is an indication of the level of emotional stress an investment might place on you.

But risk is a very complicated idea with multiple dimensions, and volatility isn’t one of the significant ones.  In part 2 of this piece we’ll highlight some aspects of why the risk indicator is limited, and then later we’ll write about some of the ways we evaluate risk.

New Zealand investment funds have to show a risk indicator, which is a number from 1 to 7

The risk indicator measures volatility, which is the extent to which prices move up and down

But risk is a complicated idea, and volatility is not a significant element of risk

We expect the main reason why an investor would choose to invest in the Lighthouse Global Equity Fund is our track record of investment returns.  

We expect to deliver above-market returns and historically the Fund has delivered about 1.75x the returns of the major indexes.  Across the five years from 31 March 2016 to 31 March 2021 the Fund’s average return, after fees and investor taxes, has been:

We think these returns are probably a slight overstatement of the Fund’s long-term performance.  This fund has evolved out of our own personal investing, and from that we can derive performance figures back as far as 2010.  The average return across that eleven year period is a little lower than the five year averages shown here (22.0% pa vs the 23.3% pa shown here for the 0% PIR, so about 1% pa to 1.5% pa lower).  But we should allow for the occasional market crash (such as 2001 and 2008) and that would likely trim a further 1.5% pa off these average returns.  

Of course we need to add the standard disclaimer that past performance is no guarantee of future performance – that’s true, and fair.  But we expect that the features we look for in the companies the Fund invests in should be enduring into the future.

Where that strong performance helps investors the most is across the medium to long term.  We recommend investors in the Fund have at least a five year investment horizon – that allows both the investor to better navigate the year-to-year volatility in returns, and for the performance to compound over time.  If we consider how a $10,000 investment might grow in five years and in ten years, at a range of different average post-tax returns we see:

We’re focused on helping our investors reach their financial goals faster, and we see these strong investment returns as how we deliver on that objective.

We expect investors will choose us because of our track record of investment returns

The last five years have been rosy, but we expect the long-run average will be about 3% pa lower than across these last five years

Patient investors with longer time horizons will benefit from those higher returns compounding

There are a few dimensions to how we think about which investors the Lighthouse Global Equity Fund might suit.

Firstly, the Fund has a growth focus, and so should suit investors who are looking for higher returns over the medium to long-term.  The Fund targets returns, after fees, that are at least 2% pa above the return from the MSCI All Country World Index.  Over the last five years (from March 2016 to March 2021) that target rate of return has averaged 14.5% pa, in New Zealand dollars.  To date we’ve comfortably beaten that target rate of return, but there’s the usual proviso that past performance is no guarantee of future performance.

Secondly, the Fund invests in global equities, and so should suit investors who are looking to include some exposure to global equities in their portfolio.  Although the Fund invests in equities that are listed on the major United States exchanges in practice that captures both United States companies that have global operations and also large companies from outside the United States that list there because of the depth and status of those markets.  

These same dimensions also help to highlight which investors the Lighthouse Global Equity Fund might not suit.

The Fund is unlikely to pay scheduled distributions.  Investors who are seeking a regular income can still receive that by periodically selling down their investment in the Fund, which is quite straightforward, but we don’t expect the Fund to pay a dividend.

The Fund will also likely prove to be more volatile than other funds that predominantly invest in assets such as cash, bonds or property.  Share markets are very liquid, and their prices reset quickly to take into account new developments and news.  That’s great when the prices are going up, but can be emotionally testing when the markets are going through their occasional falls.  It can also be problematic for those investors who need to know they will have a very specific amount of money in the near-term.

But if you’re an investor who’s looking for attractive long-term returns, or wants to increase their exposure to the global economy, then talk with your financial advisor about whether an investment in the Lighthouse Global Equity Fund might suit your portfolio.

This fund should suit investors who are looking for growth

And investors who are looking for more exposure to global equities

It’s unlikely to pay distributions, but investors can easily make small regular withdrawals

Welcome to Lighthouse Funds! We’re likely a new name to most potential investors and so we thought it’d be useful for us to provide a bit of background to how we got here.

Lighthouse Funds has evolved through three phases.

The first phase began more than 20 years ago, in the investment approaches and philosophies we’ve been using for our own personal investments. So Lighthouse Funds traces its history back to the methods we developed to help us invest our own money.

The second phase began at the start of 2014, when Lighthouse Funds’ opened its first investment fund so that others could invest alongside us.  That fund was what’s termed a wholesale fund, which means it was only open to investors who qualify for certain exclusions in the Financial Markets Conduct Act 2013.  For example that might be investors who are investment businesses or are investors with very large portfolios.

In April 2016 we replaced that fund with an improved version, which we called the Lighthouse Accelerated Growth Fund.  But still a wholesale fund only available to wholesale investors.

Now, in April 2021, we start our third phase.  We’ve repackaged the Lighthouse Accelerated Growth Fund into a new vehicle – a unit trust PIE that anyone can invest in.  There’s a slight change of name too, to the Lighthouse Global Equity Fund, which just makes it clearer what the fund invests in.  But we’re still using the exact same investment approach that we’ve proven over the last five years.  So this may be a new fund entity but it comes with five years of track record and established relationships with our custodians, brokers and so on.

We’re looking forward to engaging with the bigger audience of investors, advisors and other partners that a retail fund can talk with.  We’ll post our thoughts here on our website, and on Facebook, LinkedIn and other channels.  Hopefully we’ll also get to meet many people in person too – one of the things we liked about the wholesale funds is that we could maintain a personal link with each investor and we’re looking to see how we can maintain that connection with this retail fund.  

We've been thinking

Looking back on November 2021

Two levers for managing risk

Looking back on October 2021

What risk really is

Looking back on September 2021

How to think about investment timeframes

Looking back on August 2021

Focus on what matters - Part 2

Looking back on July 2021

Looking back on June 2021

Looking back on May 2021

Focus on what matters - Part 1

The risk indicator - Part 2

Looking back on April 2021

The risk indicator - Part 1

Why us

Who this fund might suit

Welcome

From 2016 to 2021