Putting losses in context

March 14, 2019 in Attribution



Putting losses in context

Andrew Colin

Flametree Technologies

As an (occasional) student of military history, I was interested to read of the recently released account of the sinking of HMS Sheffield. The Sheffield was one of the early casualties in the Falklands War in 1982; it was sunk by an Argentine Exocet missile with the loss of 20 lives, and sank.

The sinking of the Sheffield was widely reported and was seen by some at the time to be indicative of wider failings within the Navy, which may have been why the official account of the sinking was only released in 2017.

But what was the context of the sinking? Let’s look at a similar issue that I met recently in a quite different area.

A fund I was working with had significant exposures to fixed income (FI) assets over a period in which rates generally rose. After a period of four years positive returns, the FI returns had retreated quite badly, and my first question was why the managers had not reduced either their exposure to FI generally, or the duration of their fund, which would have made its returns less sensitive to adverse interest rate movements.

I dug deeper and found that the losses were not the whole story. The FI made up part of a superannuation fund that also had holdings in equities, unlisted assets and infrastructure.

The important point here was that the managers of the fund were acutely aware of sequencing risk. This is the risk that if the member chose the wrong point in time to retire and move their investments into safe assets, the amount available would vary quite considerably from year to year. In the aftermath of the GFC, there were cases of some members having to work well into their expected retirement age to make up the deficit.

The managers of the fund particularly wanted to guard against this recurring in future. They decided that the best solution was to invest in strongly uncorrelated assets. In years where equities showed a 15% return, the fund might have showed a 8% return due to underperforming FI assets. But in years when equities fell, the fund still showed consistent return of around 6%, massively outperforming their rivals.

This particular fund used leveraged bond futures to ensure that the risks of the FI and equity sectors could offset each other. So the negative returns of the FI assets were explicable after all. They arose as a result of the fund’s hedging strategy to even out returns over time. Just as the Sheffield acted as a picket (a vessel at the edge of the fleet) to protect the much more valuable aircraft carriers and the QE2 at the centre, so the FI holdings were in place to defend the fund’s overall smooth returns. Both were successfully doing their job.

An interesting object lesson for me, and a reminder that in the investment world, not all losses are equal.

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