AS a result of the sharp stock market crashes in September and October last year, a lot of traditional unit trust funds suffered huge losses last year and early this year.
Even though the performance of those funds has recovered greatly over the past few months, the bad experience has caused some investors, especially those with low risk tolerance, to sell a big portion of their holdings as they felt very uncomfortable with the risks involved.
There are three main approaches in managing a portfolio, namely relative return, absolute return and total return approaches.
Most of the unit trust funds in the market use the relative return approach. Their key objective is to beat the stock market index.
For example, if we are buying normal equity unit trust funds, the key objective is to beat the benchmark index, FTSE Bursa Malaysia KL Composite Index (FBM KLCI).
As long as they are able to beat the FBM KLCI, they will claim that they have already outperformed the market.
For example, if the FBM KLCI plunged by 40% and their fund returns dropped by 30%, as their fund returns dipped less than the KLCI by 10% (40% - 30%), they would claim that their funds outperformed the market by 10% even though their funds still incurred a big loss of 30%.
Investors with low-risk tolerance level would feel very uncomfortable as they have suffered a loss of 30%! As a result, investors with high aversion to losses and fear about market uncertainties may prefer the absolute and total return approaches.
One of the key advantages of using these approaches is that they use cash return as the benchmark.
For example, they can use fixed deposit (FD) returns as the benchmark return. Given that FD cannot provide negative returns, fund managers using these approaches will have to generate positive returns to outperform the FD returns.
Normally, fund managers will set a target return above the cash return.
For example, they may set a target return of 5% above the 12-month FD return. If the 12-month FD return is 2.5%, they need to generate a return of 7.5% (5%+2.5%) each year.
Given that absolute and total return approaches do not need to benchmark against the stock market index, fund managers using these approaches will hold all cash whenever the market experiences big crashes whereas the relative return approach requires the funds to stay invested i.e. may be at least more than 50%.
This explains why traditional unit trust funds, which mainly uses the relative return approach, suffer big losses whenever the stock market crashes as they are required to keep investment at big percentages even though the stock market is heading south.
To them, the biggest risk is to underperform the benchmark index whereas the biggest risk faced by the absolute and total return approaches is losing the capital.
Apart from constantly looking for positive returns, the absolute and total return approaches may use derivative instruments to enhance their returns. They may buy futures to generate higher returns if they feel that the stock market sentiment is bullish and the overall market is on the uptrend.
Besides, they can adopt any investment strategy and invest in any asset classes or any markets to generate positive returns.
Hence, investors may invest in various types of assets, including some alternative investments like exchange-traded funds, commodities and properties or different overseas markets, like the United States, Hong Kong or Singapore.
As a result, the funds’ performance will have low correlation to the overall market movements.
The main difference between the absolute return and total return approaches is that the former may borrow money to invest whereas the latter does not allow gearing.
Besides, for those countries that allow short-selling, the absolute return approach may sell short the market.
Nevertheless, the key risk faced by both approaches is that they may underperform the overall market during a bull market.
Given that they do not have to benchmark to the stock market index, they may be under-invested during a bull market.
As a result, their returns will be lower compared with those traditional unit trusts that adopt the relative return approach.
In short, investors need to understand that investing funds using either the absolute and total return approaches or relative return approach involve risks.
Investors need to understand their own risk tolerance levels before investing in funds using the absolute and total return approaches because they may be investing in some investment instruments that they are not familiar with.
● Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting.
Thestar
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