Why capital preservation comes to the fore, when volatility is up

David Thornton

Livewire Markets

When volatility is up, capital preservation becomes key. But preserving capital is easier said than done. It needs a process that is consistent and dependable. 

"We look for a process that makes sense, that's logical, that's repeatable, that we can understand. So, the process is important to us," says David Cassidy, Head of Investment Strategy at WILSONS.

Performance is still important, though, as long as you don't get sucked into chasing short-term returns. 

"We don't obsess about the 12-month performance, but I think clearly a manager has to show at some point, they've got a process that adds value."

In this edition of Expert Insights, David takes us through the ways he positions his portfolio and manages risk during these uncertain times. 

Note: This interview was filmed on Thursday 12th of May, 2022. You can watch the video or read an edited transcript below. 

Key takeaways

  • Australia set to follow US down inflation road
  • Diversity is key amid high volatility
  • Looks past 12 month performance when assessing investment managers

Edited Transcript

What are your investors concerned about, and what do they want from their investments?

David Cassidy: I think there is a lot of concern around inflation and I think they can see the anecdotes out the window. They're often running businesses or got friends who are running businesses. And then I tell them, "Oh, well, US inflation's on the cusp of a peak." And they go, "You're crazy. Inflation's just taking off." 

I think part of that is probably Australia's been a bit late to this inflation party. US is probably ahead of the game. So, in some ways, I think there is more inflation to come in Australia over the balance of the year, but I think the market will take its lead from the US. 

As I said, if we do see this peak in US inflation in the near term, I think the market will settle down a bit, but certainly, there is a lot of concern now that inflation is ingrained in the system. I think there's maybe a little bit of that, but I think maybe people are getting a bit too worried about that.

I think, ultimately, they're worried about preserving capital and that's why we take a multi-asset approach and a multi-manager approach. We don't put it all typically in equities unless clients specifically ask for that mandate. 

So, I think having that diversity of assets and particularly having that alternative sleeve, which has done quite well for us, is something that provides some degree of comfort to clients. But at the moment, I think your average client is a bit nervous and worried about capital preservation, but that's where we think we can help them with our overall portfolio solutions.

What do you look for in your investment managers?

We look for a number of things. I think at the heart, we look for a process that makes sense, that's logical, that's repeatable, and that we can understand. 

So, the process is important to us. Performance is important, but obviously, managers and styles fall in and out of fashion. We don't obsess about the 12-month performance, but I think clearly a manager has to show at some point, that they've got a process that adds value. So, we do look at performance over various timeframes. 

We want to be comfortable with the people in terms of the continuity, and alignment of interest. So, people as well, and I guess, finally, the portfolio effect. How does the manager fit within our existing portfolio? What does it do to portfolio risk? How does it complement the portfolio? 

There might be a really good growth manager knocking on your door, but if you've already got three or four of those, it might not be the right solution. 

So, it's also that portfolio effect is the other thing we look at quite closely in terms of thinking about managers.

How do you reconcile asset allocation within and between your investment managers? 

Yeah, well, we're a multi-asset, multi-manager advisor. So, we do run that direct Aussie piece, but we also have Aussie managers, and more broadly across the other asset classes, we do tend to almost exclusively use managers or not very much.

The managers will be making sectoral decisions within their asset class, but we will be making the broader, multi-asset, asset allocation decision and controlling overall whole-of-portfolio risk through that asset allocation. 

But we basically let the managers do what they need to do in terms of those sort of intra-asset class risk, budget, allocations in terms of their sectoral bets and that sort of thing. That's really up to the manager and we'll control the overall multi-asset risk through asset allocation and manager selection, lending.

How do you measure risk, and tailor it to your investors? 

I guess we're looking at the sort of whole-of-portfolio risk in terms of the risk models that we have and the empirical volatility of the portfolios. So, I guess we look at overall portfolio volatility. We'll spit out a number. 

For a balanced growth fund that we'd run, the volatility will be seven or 8%, which is not terribly meaningful for a private client, but to give you some comparison, an equity portfolio would typically have, a pure equity portfolio, a volatility of 12 or 13. So, by mixing those assets together, we can almost halve portfolio volatility by taking a multi-asset approach.

The other way we tend to look at it is looking at your risk of a negative return in any given year, the probability. We find by blending assets, we can get a much lower probability of a negative return in any one year. 

Probably the third way is what's your maximum drawdown potential. With equities, it's rare, but you can get 50% drawdowns if you're a hundred per cent equities. And for a lot of people on the cusp of retirement or in retirement, that's just too much risk. We find once again, we can more than halve that drawdown risk in a three standard deviation type event by taking the multi-asset, multi-manager approach.

Really, the three ways there to think about risk are all related. But I think from a private client perspective, often those risk of a negative year or a risk of a maximum drawdown is probably more meaningful than just the straight volatility measure. So, that's why we sort of look at more than just straight volatility.

Learn more

WILSONS think differently and delve deeper to uncover a broad range of interesting investment opportunities for their clients. To read David Cassidy’s latest research, visit their Research and Insights.

1 contributor mentioned

David Thornton
Content Editor
Livewire Markets

David is a content editor at Livewire Markets. He currently hosts The Rules of Investing, a half hour podcast where he sits down with leading experts across equities, fixed income and macro.

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