Protected Equity

Safer option during volatile times

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With interest rates at records lows both in South Africa and abroad, equities are perhaps the only class of investment assets that remain fairly priced. This makes them an obvious choice for investors seeking to earn inflation-beating long-term returns. 

However equities are exposed to global economic risks, and could well demonstrate greater volatility in future According to Adriaan van Niekerk, head of equities at Prescient Investment Management, it is in this environment that protected equity investments come into their own because they remove much of the risk associated with pure equity, while still providing exposure to the upside.

“Protected equity investments offer returns similar to equities over time, but with much lower risk. As a result, they are appealing during times of market volatility as we’re likely to experience in future.”

Prescient has managed protected equity mandates since 1998. Its flagship product, the Positive Return Fund, has not delivered negative returns over any 12 month rolling period since inception.

The principle of protected equity is that the fund acquires derivatives to protect the equity exposure from falls in the stock market. The cost of the derivatives can be viewed as an “insurance premium” against a downside event. The size of the premium varies according to the level of protection that the investor needs. 

When the market falls, the return on the derivatives offsets the fall in value of the equities, leaving investors better off than they would be if they hold a conventional equity portfolio. However, the cost of the derivatives does reduce the overall portfolio return in a rising market, when compared to a conventional equity portfolio. The net result of a protected equity strategy is smoother overall returns over time. 
Over the past five years Prescient has gained experience by applying protective overlay strategies to its active quants portfolio. It recently launched a unit trust, the Prescient Equity Defender Fund, to give investors access to these strategies.

The objectives of the Equity Defender Fund are to participate in the upside of the equity market using Prescient’s Equity Active Quant process, while also delivering much lower drawdowns than the market by using protective derivatives.

Van Niekerk, who developed Prescient’s equity selection strategy, explained: “The process uses quantitative techniques to target shares that offer the best economic value and delivery of outperformance over time, while maintaining positive investment characteristics. 

“This approach has generated consistent alpha and top quartile performance over one, three and five years in South Africa. The market’s understanding of Prescient’s quantitative approach to investing has grown, with performance underlining its efficacy.”

Quantitative investment managers deploy mathematical models to price and select securities and reduce risk. By assigning a numerical value to variables, they use maths to understand real world events like changes in share prices. 

The big difference between quantitative investing and more traditional approaches is that quantitative analysis relies on objective facts rather than subjective forecasts.

“In quantitative investment, risks are identified and quantified. Scenarios are run to understand the likelihood of underperformance and portfolios are structured to minimise these possibilities. 

“This compares with the stock selection process of fundamental or qualitative managers who research and analyse companies in detail. For these traditional managers, forecasting plays a major role. Revenue and economic predictions, and various other assumptions, form part of the valuation process,” explained van Niekerk.

Another difference between quantitative managers and fundamental managers is that the former strive for consistent outperformance, while qualitative managers often underperform during certain periods as they focus on the long term.

Said van Niekerk: “We undertake continuous research into improving our model and recently added refinements to Equity Active Quant. Our objective is to generate consistent outperformance of the benchmark and the introduction of a new metric that combines value and share price performance enhances our ability in this regard.”

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Issue 72