Dollar-cost average may be dull, but it is a good defensive investing strategy in volatile times.
Strategic investing keeps profit coming in volatile equities
I have been looking after investment portfolios in Dubai for the past 13 years, and in that period, have nursed clients through two of the world's most damaging financial crises.
Firstly, there was the dotcom crash in 2000, when the paper value of newly formed IT companies with little or no underlying substance, rose dramatically because of investor greed and unrealistic expectations. This was followed by an equally dramatic collapse over the following three years.
The second credit crisis was in 2007 and 2008, when US banks brought the financial sector to its knees by lending money to borrowers who had little or no chance of paying it back.
These were the so-called sub-prime mortgages that were converted into complicated derivatives and sold around the world to other bankers who failed to recognise their inherent risk.
The effect of these two events on equity markets was devastating, with declines of about 40 per cent in the first case and 30 per cent in the other.
Such was the negative effect on world equity markets that most of them have still not returned to the dizzy heights achieved in March 2000. What this means to the lump investor is that money invested in equity markets 11 years ago is almost certainly still sitting on a loss.
There have, in fact, been many opportunities to make money in equity markets over the past 11 years, primarily by buying stocks when markets bottomed out in March 2003 (after the dotcom crisis) and in February 2009, when they bottomed out again after the credit crisis.
If you had been investing on a monthly basis over the past 11 years, some of your contributions would have gained from these opportunities to buy at low prices. This is fine for the regular saver, but what about the poor rich man who has a large sum of money to invest? How should he cope?
One strategy is to avoid investing cash in one lump sum, but, instead, to invest it over a period of one or two years. If the markets rise, he will gain from the first tranche. If they fall, he will lose (in the short term) on the first tranche, but will gain on the second. This strategy, in statistical terms, will not produce the highest expected gain over a defined period, but it will help to reduce volatility in that period.
This strategy - called dollar-cost averaging - is a bit dull for the average lump-sum investor. If you want a more thrilling and sophisticated solution, then you need to look at hedge funds or other alternatives where performance is "independent of" (or uncorrelated with) that of equities. So, if you are losing money on your equity portfolio, there is a good chance that you could be making it on your hedge funds.
Bonds and property perform moderately independent of equities, but neither of them come close to the low correlation that can be achieved with hedge funds.
One of the most successful hedge strategies over the past 11 years (and before that) has been that of "managed futures". In this strategy, the fund manager bets on an asset value going up or down in the short term. He can make money in rising or falling markets as long as he guesses the trend correctly.
Man Investments has developed this approach very impressively with its AHL Diversified Programme, in which a computer continuously monitors price movements in nearly 200 different markets, looking for upward or downward trends that it can exploit.
The decision to buy or sell, or to go long or short, is made by the computer with no human input. The algorithm uses historical data only to predict future movement and makes no attempt to analyse fundamentals arising from economic or political change.
Because of this, and the fact that its average deal lasts for only 18 days, it is not surprising that the strategy produces performance that is uncorrelated with that of equity markets that are sensitive to such external factors.
The AHL Programme has returned an average of 15.1 per cent a year since February 1997, with only one negative year in that period. Its performance is slightly more volatile than that of equities but, on average, has been significantly higher.
In the same period, world stocks returned an average of 2.6 per cent a year and bonds 6 per cent per annum. But absolute performance is not the whole story. Because AHL offers performance that is "uncorrelated" with that of equities, adding it to a conventional portfolio will reduce overall volatility. In the three years after the dotcom crisis, for example, when equity markets fell by 40 per cent, AHL continued to rise at about 16 per cent a year.
Man Investments is currently offering a capital guaranteed product that combines its AHL Programme with a range of hedge funds available from GLG Partners. The GLG funds are managed by human beings, not by a computer algorithm, who do respond to world economic and political influences.
Bill Davey is a financial adviser at Mondial-Dubai. If you have any questions about his column or other financial matters, e-mail him at firstname.lastname@example.org