Long-term investors who attempt to reduce the risks inherent in stock market investing are losing out, writes Proinsias O'Mahony.
It has been a brutal year for the Irish stock market. International indices have fared better but growing fears of a US recession in 2008 have exacerbated concerns that global markets may be in for a torrid time next year.
It begs the question: is it worth insuring against market falls? Should people be putting their money into tracker bonds that offer money-back guarantees? Should long-term investors employ stop-loss orders that take them out of a position if markets head south or does risk reduction invariably bring an all-too-substantial reduction in reward?
Alas, recent research from two authoritative sources confirms that the latter is true. In the 2007 edition of ABN Amro's Global Investment Returns Yearbook, the authors found that long-term investors seeking to insulate themselves against short-term losses suffered a disproportionate degradation in performance.
Looking at data for US markets from 1900, they found that the average annual return for equities was 9.8 per cent. Had investors utilised stop-loss orders that would result in them selling their shares whenever they fell 10 per cent, the annual returns drop to 8.8 per cent. Investors who chose to lock in profits by selling once returns hit 10 per cent suffered a worse fate again, with annual returns for the whole period dropping to just 5.9 per cent.
Use of more complex products that used derivatives for protection fared little better. Indeed, the authors found that an old-fashioned division of money between stocks and bonds made more sense.
Similar conclusions were reached by Barclays in its 2007 Equity Gilt Study.
Using data from 1899-2005, it found that products that used derivatives to reduce portfolio volatility were "likely to eliminate excess equity returns over time" and that risk-averse investors were "better off investing in other less volatile assets" rather than opting for structured instruments that tried to marry the objectives of stock market growth with absolute security.
In Ireland, more cautious investors have traditionally opted for tracker bonds. Tracker bonds are fixed-term investments that tend to span a three to six-year period and many offer a guarantee that investors will be able to recoup their initial investment at the end of term.
Irish Life's website says that tracker bonds "give investors access to the potentially higher returns that stock markets provide but without the risks normally associated with similar investments", a line also taken by Ulster Bank, which says that they are ideal for investors who want "exciting growth potential but need security of capital too".
Critics caution, however, that it is very unlikely that tracker bonds will come anywhere close to providing the returns typically on offer from equity investments.
Firstly, there is usually a cap on the stock market growth accorded to the investor. For example, an investor might receive, say, 60 per cent of the growth of the stock index being tracked over the lifetime of the bond.
Secondly, the product provider rather than the investor receives the dividend on the shares. This is a more significant price to pay for a capital guarantee than one might think.
In the 2004 edition of the aforementioned ABN AMRO yearbook, the authors found that dividends have contributed over half of total equity returns since 1900. Other studies confirm just how crucial dividends are in securing investment returns.
James Montier, investment author and global equity strategist at Dresdner Kleinwort, has written that US data shows that "some 72 per cent of the total return an investor achieved was delivered via the dividend yield" between 1950 and 2000.
Nor is this an American phenomenon. "Across nine major global markets, we find that an average 65 per cent of total return has been generated by the dividend yield since 1950".
Thirdly, many critics object that trackers' relationship to stock market growth is a tenuous one at best. With trackers, the majority of one's money is put into a deposit account and the remainder is invested in shares via derivatives.
Television personality Eddie Hobbs once dismissed tracker bonds as "merely sexed-up deposit accounts". Brendan Burgess, founder of personal finance website Askaboutmoney.com, agrees.
"Avoid these products - they make a lot of money for the banks and brokers who sell them and very little for the unfortunate consumers who buy them," he writes in the Askaboutmoney Guide to Savings and Investments.
Nevertheless, trackers have a superficial allure that will doubtless tempt many spooked by the volatility of markets over the last few months.
The global bear market of 2000-2002 certainly had that effect, with a net inflow of €500 million into tracker products offered by members of the Irish Association of Investment Managers in 2003 - a "virtual stampede", as one fund manager put it at the time. By 2004, tracker bonds accounted for 40 per cent of Irish Life's sales.
In Britain, too, the market for increasingly sophisticated derivatives attempting to curtail portfolio volatility continues to grow, with a Financial Times report saying that the derivatives protection market in the UK was worth more than £29 billion (€40 billion) this year.
A popular investment is not necessarily a good one, however.
Rolf Elgeti, head of equity strategy at ABN Amro, is unequivocal in his conclusions. "Downside protection erodes returns, and by more than the risk is reduced. The best way to control risk is to diversify across securities, across assets, and across markets."
Nor does Elgeti believe in exiting the market after large falls. "It may have seemed difficult to stay in stocks after the tech bubble burst, but four years of exceptional equity returns have largely eliminated losses from the savage, start-of-century bear market" (note that Elgeti's words were uttered in the early months of 2007, so his advice is general rather than specific to the current situation).
The moral? "Things that seem difficult to do are often precisely the ones that are worth doing."
