Capital Preservation - Milford Asset

‘Preservation’ of capital can never be guaranteed in any investment. What can be guaranteed is having the right processes and levers in place to effectively mitigate downside risk. This overview is designed to provide clients a clear understanding of the terminology versus the reality – and why effective risk mitigation is what they really want to be sure of.

What does capital preservation mean?

‘Capital preservation’ is the common terminology used to describe the financial objectives of protecting the monetary value of your financial assets or, less often, the inflation-adjusted purchasing power it offers you. As a concept it’s often associated with the financial objectives of retired or nearly retired people who, understandably, want to make sure they don’t outlive their money. It can also apply to the idea of preserving the value of your initial investment at the same time as holding a longer-term financial objective for capital appreciation, i.e. growth.

In this balancing act between wanting growth and wanting to hang on to what you have (capital preservation), the key question is, can you have both? Taking a low-risk strategy on investments can be an answer. But the impact of time and a conservative view of risk can quickly lead to a decline in real purchasing power that most people don’t actually want as the outcome.

How can capital be preserved?

The key factor in optimising preservation of capital is understanding how to adjust a portfolio through market cycles: how to navigate the ups and downs of market movements. Active management and portfolio flexibility are the key.

Active management relies on an extremely focussed research capability across both macro and micro levels. An accurate assessment of current conditions needs timely, high quality data. The value you gain (or should be getting) with active management is, in large part a function of the depth of field research. As an example, teams like Milford’s source all the fundamental information they need, across different countries, factories, fields, shops, laboratories, boardrooms, and streets, as well as talking to experts, customers and suppliers in any chain. This ensures a constant assessment of both market conditions and specific stock fundamentals. The value key is in the analytic capability within the team. Not simply in skills and experience but also the quality and speed of processes that enable highly accurate, well-timed portfolio changes.

Active flexibility is about having a genuinely agnostic view on investments held in a portfolio. There are funds that don’t have such flexibility. As example, value style funds can be constrained in markets that favour a growth or momentum style. Another would be an equity fund that is required to remain fully invested despite severely deteriorating market conditions.

Instead, we believe funds should have the flexibility to invest across sectors, investment styles and asset classes to improve the likelihood of outperforming through a range of market conditions.

Figure 1: Example of the asset allocation shifts across the cycle created by Covid 19.

 

Maintaining an agnostic view requires an excellent process and governance framework with constant checks and balances. This includes an assessment of any potential behavioural biases of individuals in an investment team to ensure the very human side of risk identification is accounted for and managed.

Can’t you just ride it out?

Some might argue that given markets will inevitably rise and fall it is reasonable to simply ride things out – that markets will bounce back over time. To some degree this is reasonable. But also consider that if your investment drops 50 per cent in value, it has to rise back up by 100 per cent just to break even – not easy, and certainly not fast (as illustrated by Figure 2). If, however, your portfolio only sees a 20% decline against a market average of 50% then you have experienced a much more attractive preservation of capital and the recovery required to make back those (paper) losses is far less onerous to achieve, with a faster trajectory back to growth.

 

It is also really important to consider an investors time horizon. As referenced above, riding out market volatility is often not an option for pre-retirees or retirees. In a low-rate environment, achieving a return above inflation is harder to do from defensive assets alone. To meet their financial objectives pre-retirees and retirees may seek additional return by moving up the risk spectrum. For these investors, it is even more essential to choose an investment manager that actively manages downside risk associated with growth assets, like shares and property.

Another aspect of recovery following a significant decline is that some investments may simply not recover to their previous high – at which point the 100% recovery required simply cannot be achieved, resulting in a permanent loss of capital. Again, active management can work to reduce this type of risk.

Has Milford’s active management and flexible asset allocation worked?

Over time it becomes possible to track the way a strategy performs.

Figure 3: Milford Australian Absolute Growth Fund Performance against ASX200. Source: Morningstar. April 30th 2020.

 

Results like these have been delivered through the investment team’s capability, leveraging a highly tested and well-developed investment process enabling them to apply the appropriate risk mitigation levers to suit the design of each fund, for example:

Absolute-return funds

Absolute-return funds seek to deliver consistent returns over a defined period above an absolute-return objective. As example, the Milford Australian Absolute Growth Fund targets a return of the RBA cash rate plus 5% per annum over rolling 5 year periods.

With this type of fund, the most important measure of success is delivering on that objective without getting caught up in what a market index is doing. To do this, a fund needs to be flexible and leverage an agnostic approach – across style, assets held and timing to ensure optimal opportunities to buy/sell. This neutrality allows key decisions and executions to be made at the pace needed to stay ahead of shifts in conditions.

Relative-return funds

A relative-return fund is benchmarked to the performance of a market index (e.g. S&P/ASX Small Ordinaries Index) but can be actively managed with the aim to outperforming a given index. With relative funds, the levers available for risk management are typically more limited than an absolute-return fund. To overcome some of these limitations the Milford Dynamic Fund has the ability to allocate up to 20% in cash and invest in larger, typically more liquid and stable ‘mid-cap’ companies up to a maximum of 20%. These are key differentiators compared to peers in this category.

Additionally, Milford’s focus on in-depth research and face to face assessment of company management is a key risk mitigator and advantage, providing a clear understanding of each business and their drivers of performance.

This type of relative-return strategy is suited to an investor seeking a similar or higher return to the index, but with a more consistent return profile and the ability to protect some of the downside risk.

If you would like to know more about our funds or how our approach to managing risks has delivered over time, call us today.

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