Returning to the Stock Markets in a Risk-controlled Fashion¹

While most investors know equities have higher long-term returns, memories of the Asian Crisis in 1997 and the ‘dot com’ technology bubble of 2001 have kept many investors away from the equity markets. Absolute Return investing gives investors exposure to equities with downside protection from capital loss. This enables many professionals to get back into the market while maintaining financial peace of mind.

When it comes to investing, one can never be certain of achieving positive returns. The author has created a case study of the Cheungs*, a couple in their late 40s, who are both highly successful medical practitioners. Although Dr Alice Cheung* (a 49-year-old surgeon) had a bad experience in the past, she is inspired to return to the equity market by a sustained upswing in share prices.

Ever since she sustained a substantial loss from a technology fund investment in 2001, Dr Alice Cheung has steered clear of the equity market. She is a careful investor – putting aside funds for retirement and for the second home she has in mind.

The stock market loss changed her mind about risk in the investment markets. She sought safer asset classes for her investments thereafter.

Recently, Alice noticed that stock markets have returned to their earlier highs and she is convinced that the rising markets are based on real economics, rather than the inflated tech talk of 1999 and 2000. She wonders if there is a better way to get into the stock market again, without the same level of risk as before.

Her husband, Dr Dickson Cheung*, knows that she wants to break ground on a second home where they bought land in Australia 10 years ago. But he reminds her that they should not forget about retirement provisions.

They agree to consult their UBS client advisor, Mr Simon Lam*, for advice on how to meet both goals. Simon goes over the Cheungs’ portfolio. He highlights that the Cheungs have invested very conservatively, mainly in bonds and money market instruments. The couple decides that a portion of their portfolio should be invested more aggressively in the future, as this is earmarked for the build-the-house account.

Simon addresses the house savings issue first. He suggests that a portion of the Cheungs’ money market portfolio should be reallocated to save specifically for the house, as those investments are not cost-effective for a couple under 50 years’ old.

Alice agrees, but is concerned about re-entering the equity market. Simon explains that the financial world has developed in the past five years – with products that address the risk issue for private investors. He introduces ‘absolute return investing’, suggesting that it would meet the Cheungs’ needs at this time.

They can gain exposure to the higher returns available from equities, and still have a risk-controlled situation that provides some downside protection from capital loss.

Simon explains that portfolio managers invest in equities, but use derivatives to hedge this exposure and other uncorrelated asset classes like hedge funds to provide diversification. Together, these strategies give managers the ability to limit downside risk when markets are moving adversely. Simon then turns to the rest of the portfolio. As the Cheungs have agreed, the largest portion of their wealth remains invested conservatively to provide for their retirement.

Simon suggests that the couple reassess their risk profile for the retirement portfolio. Their investment approach is conservative for investors of their age. By avoiding the equity market completely, the Cheungs are leaving many possible returns behind. It makes sense to use an absolute return mandate to manage this portfolio, although this approach may be more defensive.

A Sensible Solution

A week later, Simon meets with the Cheungs.

Dickson is less convinced than Alice that absolute return should be applied across the total portfolio. Simon suggests that they may need to be comfortable with the absolute return concept, which is new to them. Perhaps the Cheungs should invest the house fund in a defensive absolute return mandate for the present and leave the retirement fund alone. If the experience is a success, it makes sense to alter the investment strategy for the house savings to seek a higher return, while moving the retirement fund into a defensive absolute return mandate.

For the Cheungs, the choice is clear: move the savings designated for the Australian house into an absolute return mandate and keep the retirement fund as is. Alice is prepared to use an absolute return mandate. If the equity markets keep rising, she won’t make as much profit as she would have done with a pure equity investment. However, the capital earmarked for the house won’t be as at risk as it would have been with a pure equity investment. And that peace of mind is worth quite a lot to the Cheungs.

Capital Preservation

When it comes to investing, investors can never be certain whether they will achieve positive returns. Absolute Return is designed for investors who aim to achieve stable returns independent of market conditions with a focus on capital preservation.

Paul Stefansson 
UBS

E-mail: paul.stefansson@ubs.com

* Denotes fictitious characters

Notes:

¹Important legal information.

This article is for information only and not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product or service from any person in any jurisdiction. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis.