Protecting downside > chasing return

Investors have it all wrong. In a world of zero or negative interest rates, investors are being forced to chase return. The baby boomer generation (retirees) are all chasing yield/return to fund their retirement.  No longer is cash a strategy, and as a result, many are piling into equities/property and further inflating what we believe are serious asset bubbles. 

We believe the chase for return at all cost is the wrong strategy. Instead, investors should be focusing on capital preservation. 

 As we have written about on several occasions, we are becoming extremely nervous about global markets and the economic growth outlook in the medium term. As such, we set up our fund in order to protect our investors capital by hedging (hedge fund). This simple demonstration shows the power of downside protection and how hedge funds should work to protect investors.

 A hedge fund is able to protect capital because it has the ability to short sell. Short selling allows the fund to generate profits/protect downside exposure when markets fall. This is what a hedge fund is designed to do – protect the downside! 

So, while negative/low-interest rates are forcing the baby boomer generation into risky assets to generate some return on their precious capital, they should instead be focusing on preserving capital, not chasing returns. It would be better to draw down principal to survive (or invest in hedge funds or non-correlated asset classes) than chase return/yield in what we consider an extremely overvalued and risky investing environment (paying huge premiums for high risk/low-quality assets).

As a theoretical example, the below tables show the effect on a $1m capital base through a random set of market returns across two scenarios (market return/hedge fund return). We have assumed living expenses of $75k per year and indexed to an inflation rate of 2% (growing expenses by CPI of 2%). 

The first example shows investment returns from being fully invested in the market (such as an ETF/high beta long-only fund) with the first 2 years producing negative returns (such as if the global economy goes into a recession) and the result to the capital balance over time. 

Theoretical Investor Returns from Market returns over the period. 

While a simple calculation, it demonstrates the importance of capital preservation. As you can see within 10 years this investor is out of money. This is because the initial capital loss destroyed the balance of the investable capital and spending/inflation took care of the rest. As a result, the balance of the investor's equity quickly erodes. 

Now let’s look at the returns of a hedge fund over the same period. This fund unfortunately only captures around 70% of the upside. But on the flipside captures -25% of the downside (meaning it is slightly positive during down years). Simply put, this investment protects permanent capital loss but sacrifices upside investment returns. Only 6 of the 20 years (30% of the time) were negative market returns experienced, meaning that for the other 70% of the time the fund only captured part of the upside... Yet, this strategy still significantly outperformed.

Hedge fund return over the same period.

As you can see, this investor is able to reach age 80 before they run out of money. Same market returns as the first investor, but a far better outcome because of the ability to hedge against losses. Even by forgoing the upside, they still walk away with more money due to the ability to hedge against permanent capital loss. 

Most investors always focus on generating returns, when the reverse should be true. It is far better to preserve capital and focus on managing risk to the downside than chasing returns.