Why absolute returns matter – Sumesh Chetty

*This content is sponsored by Investec Asset Management

By Sumesh Chetty*

Investing is not a sport. The vast majority of individuals invest for a goal, which may include providing a deposit for a house, paying for a child's education or being able to retire in comfort. But these financial commitments bear no relation to the short- or long-term performance of a market index.

The advent of indices brought about greater transparency to investment markets and an increased level of accountability to those tasked with managing money. Investors had a source of reliable information – a benchmark against which to measure the performance of their money managers. But by using this measure, investors began to focus on beating the index rather than earning appropriate returns to meet their financial needs. This in turn resulted in the adoption of a relative-risk mindset at the expense of absolute risk, and has contributed to the often inappropriate use of passive strategies.

Many investors appreciate that a market index bears little resemblance to their financial goals. However, they still believe there is some merit in measuring portfolio performance against market indices, as the FTSE/JSE all Share Index has delivered real returns over the long term. But returns do not go up in a straight line, and over the short term the returns generated by a market index can detract significantly from an investor's objectives. In 2008, for example, the ALSI collapsed by 23.2%, while inflation, as measured by the South African Consumer Price Index (CPI), was 10.2% for the year. Investors whose financial objectives were linked to inflation would have been 33% behind their target for the year. 

Focusing on the risk of capital loss

Both absolute return investment managers and index-relative managers invest in the equity market, and the bottom-up stock selection process of an index-relative manager and an absolute return manager might be very similar. However, the primary difference between the two will be their definition of risk. Index investing defines risk in relative terms, typically as tracking error (the extent to which the return of a portfolio deviates from a specified index return). Absolute return investing considers the total risk of a portfolio. More specifically, it focuses on the risk of capital loss. As absolute return investors, we recognise that equity as an asset class is the primary source of generating real returns over the long term. However, when making an investment decision, the weight allocated to a stock does not depend on the weight of the stock in the index. The decision is instead based on the ability of the company to generate sustainable real returns for investors and the potential downside risk inherent in holding the stock. We therefore typically invest in high-quality companies with stable cash-flow profiles and valuations that provide a floor to potential capital losses.

The cost of a relative risk mindset

Investors have quickly forgotten the pain of the 2008 financial crisis. We believe that investors are averse to the loss of capital, but many do not realise that success relative to an index means that if the index is down 40%, one's portfolio may be down 'only' 38%. The extended equity bull market has further obscured the importance of absolute returns. But the expectation of a more volatile, lower return environment over the next ten years should increase the average investor's appreciation for absolute rather than relative returns, especially if a financial objective falls due within that period.

Financial objectives are not sympathetic to the plight of investment markets. School and university fees do not go down. The date of retirement can be delayed, or one can choose to live more frugally, but is that an outcome that should be risked by investing relative to a market index? An absolute return approach should result in a money manager being able to balance potential investment opportunities with the risk of capital loss. For the investor, it may reduce the euphoria of bull markets but it lessens the misery and uncertainty of bear markets.

• Sumesh Chetty is Portfolio Manager at Investec Asset Management.