The importance of capital protection
- Stock markets have reached levels of valuation we have seen only in a few periods in modern financial history
- During recent market events, there have been very few places for investors hide
- Offshore cash was providing low returns, and the yields achieved on sovereign bonds were below inflation in most of the developed world’s short dated sovereign bonds
With every investment decision there is a tug of war - a battle between risk and reward, equities and bonds, dividends and growth, yield and credit, and so on.
An investor’s choice in each of these areas determines the trajectory of their investment. Traditional finance theory posits that the higher the risk an investor takes with each of these decisions ultimately determines the return he can achieve over time. As important is the degree of volatility in the investment value that can be expected.
Over the past 10 years, we have witnessed impressive growth in risk assets. Stock markets have reached levels of valuation we have seen only in a few periods in modern financial history. In fact, the graph below shows that there have only been two other periods when equity markets have been more expensive; before the Great Depression and before the Global Financial Crisis (GFC). The fall of equities after each of these periods was dramatic and we appear to be amid another one.
During recent market events, there have been very few places for investors hide. The table below illustrates this point, showing how few asset classes have delivered a positive return and capital protection year-to-date.
Looking back on recent events, there’s the temptation to think, “If only I had switched into cash sooner or if only I had switched my retirement annuity from the high risk to lower risk option, my investments would have been protected.” There are numerous people who didn’t, and one feels the pain of their decisions, but one must remember the investment landscape leading into this crisis.
Offshore cash was providing low returns, and the yields achieved on sovereign bonds were below inflation in most of the developed world’s short dated sovereign bonds. Effectively, investors had to accept a negative real yield to remain invested in these asset classes for the sake of capital protection. Holding global equities came with their rewards, which saw global stocks rise by 27% during 2019 and it would have been difficult as an investor to watch those returns from a position in cash.
Capital preservation is at the core of Pyrford International’s investment philosophy, the managers of the Nedgroup Investments Global Cautious Fund. Since 2016, Pyrford have held the view that equity markets were overvalued and consequently maintained a 25% weighting in equity believing that equity markets, and in particular US markets, were susceptible to economic shocks, given the level of earnings and dividend growth assumptions built into their valuations.
Pyrford’s positioning has shielded investors from most of the recent drawdown in equity and bond markets. It has also provided the opportunity to increase its equity weighting in the portfolio and fund investors demands for liquidity. This performance is not unexpected from Pyrford, who have performed well during periods of market crisis, having delivered robust performance in the Dot-Com bubble of 2002 and the GFC. More recently, the portfolio held up well after the outbreak of COVID-19:
Pyrford are not market timers and their investment decisions are grounded in an investment process, which they diligently apply, both when markets are rising and falling. It can often take several years before their investment case transpires and, in the lead-up, their performance can lag.
This can be frustrating for investors who sit on the side-lines watching equity markets deliver stellar performance. Overtime, however, by avoiding big drawdown events and buying equities when they are cheap, the strategy has delivered robust investment returns with capital protection.