Before I delve into this editions fascinating take on my view of the idiosyncrasies of measuring risk, I first wanted to talk about risks specific to your investment in EGP.
The risk I wanted to touch on is the risk of thinking the performance in recent history can in any way be extrapolated into the future. Since March 20 2015, the benchmark we measure ourselves against has risen a meagre 0.51%, it has been a bleak period for equity investors, particularly those focused on the larger companies in our market. For the first time since the inception of the fund, the small end of the market, which is where most of our energies are applied has outperformed the larger capitalisation stocks. Such a period has given us a tailwind we’ve not had before.
In fact, the ‘Small Ordinaries’ over the same period is up 16.57%. Lest you think we chose a ‘soft target’ with our benchmark, I would remind you that since inception, our benchmark has risen 48.74% and the Small Ordinaries Total Return index has generated 1.37%. That’s not per annum, that’s 1.37% in 5 years, 6 months and 14 days. The first mention I could find on the blog of why I think the ASX200TR makes a better index is in Update 126.
Over this same period, EGP is up 39.57% after all fees and costs. This is not pointed out to boast about a performance purple patch, more as a reminder that it has been a period of uncommonly good performance. Uncommonly good insofar as you would be mistaken to expect performance of that level to be maintained.
We target 3 – 5% outperformance of our benchmark over a reasonable period (I suggest 3 – 5 years). Whilst I make every effort to do better than that, provided it doesn’t mean taking on undue risk, I would be very happy at the end of a 40 year career with the fund if I could claim to have delivered 5% annual outperformance since inception.
The risk is that the larger end of the market suddenly becomes ‘hot’ and we underperform for a stretch. I hope my fellow investors are relaxed enough about what we do and the likelihood that we will deliver sound results over time following the principles that have brought us to this point.
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On Risk:
For an investor who hopes to generate superior results over time, properly understanding the risk/reward calculation is paramount.
Many retail investors and a disconcerting number of professional investors have a mistaken model of risk and reward tucked into their investing armoury. The general view is that a situation with a potentially high rate of return must therefore have a high level of risk.
The assumption often is that because something is risky, it must therefore have a high payoff if successful, but until the probability of the risk and the reward can be modelled, as an investor, you know nothing upon which a reasonable valuation can be made. And until you can generate a valuation based on reliable inputs, and realistic assessments of outcomes, you are not investing, you are speculating.
Investment risk is critical and something that all investors should spend more time thinking about. Not just in respect of individual stocks, but when investing generally. Most people will focus almost exclusively on the upside potential for a stock’s price, or a fund manager’s returns, often with a near complete disregard for the potential value at risk, therefore overlooking the downside risk.
Where the upside is evident is where distorted thinking most often occurs. In the event of some success, for example in a mining or a biotech stock, perhaps in drilling or early-phase trials could indicate substantial investment upside. But all too often, it informs nothing of the risk that the company will be successful in delivering the mine to production, or bringing a treatment to the market. Here it is critical to remind ourselves that with investing, it is entirely possible to pay double or triple the price that a stock has historically traded at and be making a better investment decision. This (as with so much in investing) runs counter to our natural intuition, but it is absolutely true.
Investors will too often outsource their risk management too. Remember those trillions of dollars’ worth of ‘AAA’ rated CDO’s that the ratings agencies rubber-stamped before the GFC? If you don’t understand the downside risks in an investment, walk away. There are far too many opportunities that are understandable to waste time with something that can’t be understood.
The ‘Kelly Criterion’ is an enormously useful concept to understand for investors. It helps with position sizing, but obviously in order to properly dimension risk and utilise such a method, you must be able to place probabilities on the outcomes.
As a fund manager, the ideal construction of a portfolio is an especially important skill that is often overlooked. I can honestly say I have encountered plenty of truly gifted business analysts, who generate excellent ideas, but fail to generate the returns their analytical skills warrant because their portfolio management skills fall short.
Properly modelling the likely range of outcomes for the stocks you have researched and then correctly sizing your positions simultaneously maximises your returns and minimises your risk. The largest positions in your portfolio are often not the one’s with the greatest expected upside, but the lowest expected downside.
Although I don’t rate standard portfolio risk measurement tools, the fund I manage has generated good metrics in this area, our ‘annualised standard deviation’ after five and a half years runs 12.6% below the ASX200, despite our averaging only 22 or 23 stocks over the period compared to 200 for the index. Less diversification, and lower risk, that’s not what the textbooks say! The performance is most likely attributable to good portfolio management than anything else, taking as little risk as possible in pursuing decent returns.
Interestingly, the last three months have seen the fund return 18.6% while the benchmark returned 6.8% and our annualised standard deviation score deteriorated meaningfully as the high return in each of the three months lifted the measured volatility. This probably indicates part of the reason we don’t put too much faith in such traditional measures of ‘risk’, I know which of the two returns I’d rather have…
One decent traditional measure of risk is the ‘Sortino Ratio’ as it focuses on measuring ‘bad volatility’ and doesn’t punish for strong positive performance. On this measure, the strong recent performance led to an improvement in the ratio for our fund, and intuitively this makes better sense. For if we are not targeting good strong positive investment performance, what are we targeting? – Tony Hansen 15/10/2016
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|
Apr 1st 2011 |
Jun 30th 2016 |
Current Price |
Since July 1st 2016 |
Since Inception |
Annualised |
|
EGP Fund No. 1 |
1.00000 |
1.70130 |
2.04936*1 |
20.46%*1 |
153.18%*2 |
18.26%*2 |
|
37333.23 |
52006.69 |
55528.23 |
6.77% |
48.74% |
7.43% |
*1 after a 31 May 2013 dividend of 2.333 cents per share (cps) plus 1.000 cps Franking Credit, a 31 May 2014 Dividend of 7.000 cps plus 3.000 cps Franking Credit and a 31 May 2015 Dividend of 8.6667 cps plus 3.7143 cps Franking Credit and a 31 May 2016 Dividend of 6.0000 cps plus a 2.5714 cps Franking Credit
*2 calculated based on dividends reinvested
