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The initial emotional attachment to a new investment is the same for any new purchase, be it a new car, new sport equipment or expensive clothing. Behavioural economist Daniel Kahneman observed that humans typically experience the pain of loss with double the intensity than they experience the pleasure from an equivalent gain. This fear of loss is innate to all human beings and could lead to irrational investor behaviour.

Similar to taking great care when handling any new item until the initial concern of loss or damage wears off, investors sometimes opt for a phasing-in strategy of their investment to limit the chances of loss soon after investing. Phase-ins are attractive for emotional reasons. But do they, on average, do more harm than good?

What does the data show?

We asked one of South Africa’s largest LISPs about the most common frequency and duration of phase-in transactions. The feedback was that clients generally phase in monthly over six or 12 months. We then evaluated the phased returns (from July 2000 to July 2015) of the ASISA Low Equity and High Equity category averages (now the most popular categories) respectively over six and 12 months, versus directly investing into the fund.

How often did the phase-in strategy outperform? The result is shown in the table below.

 

The landscape has changed

Traditionally, phasing-in was one of very few tools available to limit capital losses during market downturns. There were not many established diversified portfolios to choose from to address perceived market risk. Investment product providers took it upon themselves to create a strategy to mitigate potential market risk, thus phasing-in was born. In essence, the investment product industry answered an investment management problem. But the industry has evolved with many new options for clients with different risk appetites.

And clients have welcomed these new offerings. The majority of new inflows are now going into well-diversified Multi Asset portfolios. With Multi Asset portfolios, the portfolio manager decides how much to allocate to each asset class. When equity markets are expensive, the manager will allocate less to equities, which decreases the investor’s chances of losing capital. For example, Multi Asset funds are currently highly exposed to cash, managing the risk of capital loss.

This Multi Asset approach to risk management is tried and tested, and the graph below shows how using Multi Asset funds (green and blue lines) have greatly reduced the magnitude of drawdowns that investors were exposed to relative to equity (red line) over the past 15 years (on a rolling 12-month basis). Naturally, the long-term returns of these funds will also be lower than equity funds. The point is: for risk-averse investors whose risk profile does not match a 100% equities portfolio, the asset managers are already managing the downside risk –phasing-in could potentially derail the strategy of the underlying investment manager.

 

Another tool to decrease an investor’s exposure to falling markets is the use of derivatives to hedge out at least some of the market risk. Funds that use this technique are normally a subset of the Multi Asset fund category. In addition to making asset allocation calls, they therefore also buy ‘insurance’ (through derivatives) against falling markets to protect investors’ money, while at the same time exposing it to growth opportunities.

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