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How do you limit your downside?

28062018 downside

How do you limit your downside?

We recently met Frank and Vanessa, two hypothetical investors in global equities but with very different performance over a two-decade time frame. Frank turned a million dollars into $4 million, but in the same time Vanessa’s account grew to $11 million – all by avoiding the handful of down years in global equity markets from 1997 to 2017. So how can you limit the downturns when investing in global equities?

One such solution to the problem is simply to own less equities (or less equity exposure). This can be achieved in two ways which for our purposes move on average in similar ways. Firstly, an investor might decide to place a portion of his or her wealth in equities, let’s say just 40 per cent, and the rest in cash, the remaining 60 per cent. Alternatively, an investor might just choose to invest all his money in a “low-beta” equity portfolio, where the broad index of stocks might only be 40 per cent sensitive to market movements for example.

In times when the equity market falls either version of the “40/60” portfolio described will only fall four-tenths of the market’s fall. So take those years in the early 2000s by way of example, where equity markets fell almost 20 per cent in any given year (the red outlined bars in the chart below). In such a year our “40/60” portfolio would only be down 8 per cent – much better than the market, and saving the investor from another 12 per cent downside. Good job!

The last 20 years of global equity returnsScreen Shot 2018-06-28 at 10.02.45 am

Source: MGIM

The rub is on the way up. In the half-dozen or so years where the market runs up at least 20 per cent our “40/60” will only achieve four-tenths of the gain, or 8 per cent. Even though we avoid the majority of the brunt of the bad times we also don’t get to join the party in the good times, of which there are many more (as you can see by the bold red bars) and a key driver of wealth over time. In fact, all we have done is dampened yearly volatility. All up following this strategy over the 20-year horizon shown would see a million dollars turn into just $2 million. Even Frank would be having a laugh at us.

What we are looking for is a strategy that has the demonstrated ability to pay off “asymmetrically”. That is, we get less of the “downs” while capturing more of the “ups”. Take a look at the following chart.

Annual return comparison: global equities, Montaka and a low-risk exposure portfolio*

Screen Shot 2018-06-28 at 10.07.16 am

Source: MGIM 

The black bars show the returns of the global equity market over the last 3 years (less one month) broken into two one-year periods ending June 30 2016, 2017, and an eleven-month period ending May 31 2018 (we will be able to make this a full year in less than a week from now). You can see that the market was down in year 1, then strongly up in years 2 and 3. In total the market returned around 29 per cent over this period.

Now look at the red bars. They show the returns for our Montaka strategy in each period. You should notice that when the market turned down in year 1, Montaka not only avoided the dip, but actually made a tidy profit. Then in the next two years, Montaka was able to “run with the bulls” as they might say on Wall Street – and even nicely outperformed global equities. All up Montaka returned about 38 per cent which is materially superior to the market. But most importantly Montaka has created more wealth than the market by protecting the downside AND at the same time capturing the upside.

Contrast this with the experience illustrated by the grey bars. They represent returns of a portfolio with similar equity market exposure (on a beta basis for the finance junkies) to Montaka. Said another way, the grey bars are roughly the equivalent of the hypothetical “40/60” portfolio we discussed earlier. Of course in the down year this portfolio saved a lot of the loss the market experienced. But it also crimped returns in the next two years of strong market performance. All up this simple low-beta or low-exposure hypothetical portfolio returned just 14 per cent in the past 35 months. Sure, it felt good avoiding some of the losses in the first year, but it wasn’t so good missing the gains in the market that were to come.

The point is not just to run a low-volatility or low-exposure portfolio for the sake of smoothing returns. That won’t get you as far in the long run. The point is that the strategy required to avoid (most of) the downside should also be structured to capture (most of) the upside, much like Montaka has done for our clients over the past 3 years(well 3 years less a few days, but who’s counting?!).

To read part 1 where we first met Frank and Vanessa, please click here.

If you would like more information on how you can avoid the downside and capture the upside in our Montaka strategy, please click here.

*Montaka returns are based on the Montaka Global Fund 

Fund performance is calculated after fees and costs, including the investment management fee and performance fee. All returns are on a pre-tax basis. This post was prepared by Montgomery Investment Management Pty Ltd, AFSL No: 354 564 (Montgomery) the trustee of the Montaka Global Fund. Montgomery Global Investment Management Pty Ltd is the Investment Manager of the Montaka Global Fund and an Authorised Representative (AR No: 001007050) under the Montgomery Investment Management Pty Ltd AFSL. You should obtain and consider a copy of the Information Memorandum (IM) relating to the Fund before making a decision to invest. While the information in this document has been prepared with all reasonable care, Montgomery does not make any representation or warranty as to the accuracy or completeness of any statement in this document including any forecasts. Montgomery does not guarantee the performance of the Fund or the repayment of any investor’s capital. To the extent permitted by law, neither Montgomery nor its employees, consultants, advisers, of cers or authorised representatives are liable for any loss or damage arising as a result of reliance placed on the contents of this document. Past performance is not indicative of future performance. Applications to invest in the Montaka Global Fund are only considered from wholesale investors or investors willing to commit $1 million (or by invitation from Montgomery Investment Management). 


Christopher is a Portfolio Manager for the Montaka funds and the Montgomery Global funds. He joined MGIM at establishment in 2015.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. Mike Williams

    Is this really protecting the downside risk?.. which I thought was by hedging your longs with companies / sectors directly related to your longs. Just by adding any short position surely doesnt reduce your net exposure. Just being devils advocate….. always enjoy your posts. And given you post should I switch from MGL to Montaka? Cheers.

    • Mike, thanks for your question. Yes it is absolutely protecting the downside, both through a lower market exposure and the ability to profit from stock price falls in the short book. In Montaka, we run our short book independent of the long book and for the primary purpose of finding great money-making opportunities. The effect of holding the short is that there is a broad market offset against the longs, reducing our overall net market exposure. In a co-ordinated equity sell off we would therefore expect Montaka to fall less than the market, or even gain. We do not take out market index hedges nor pair trades. This sort of “hedging” you refer to may take place in certain other long/short funds and often has the effect of reducing near-term volatility of returns rather than adding value over time. Unfortunately, I cannot provide financial advice nor advise on the suitability of MGF vs Montaka for you. I can say that both are high quality global equity investment strategies, effected with extreme discipline. Thanks Chris

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