In our last edition of the CH Minute our Chief Investment Officer, Brian Trafford, covered what a benchmark is and how they are used to gauge a mutual fund’s performance. That CH Minute can be read here. During this edition of our bi-weekly newsletter, we turned our focus to downside protection and what methods we can use to help protect clients’ capital while also looking to grow their wealth.
What is downside protection?
In its simplest form, downside protection is a measurement of how much a given portfolio drops compared to the market overall. How this is done will depend on the investment management team and the tools they employ, together with the investment style that they employ. Another way to think of this is that it provides a safety net when an investment decreases in value.
What techniques can be deployed for downside protection?
In another CH Minute, we covered derivates and how our fund partners at Dynamic Funds use them in their Dynamic Alternative Yield fund (click here to read that CH Minute). Derivates provide downside risk protection as the fund manager is essentially paying a premium for “insurance” to protect an asset decreasing in value past an agreed-upon threshold.
One of the simplest ways to offer long-term downside protection is to make sure that the investments being purchased are different from the market as a whole and are less subject to the sorts of risks that can cause a security to underperform. Basic things like profitability, free cash flow, a lower-than-average level of debt within a given company, powerful brand recognition, and high barriers to entry to key market sectors that give those companies significant pricing power as well as cost controls. These form the “moat” that Warren Buffet talks about when he says he looks for companies with “large moats” around their businesses.
Other tools include more complex strategies that are managed by our investment partners such as stop-loss orders, trailing stops, shorting, and capping exposure to specific asset classes, sectors and geographies.
Finally, we look to build properly diversified portfolios that are not all subject to the same types of risk. This helps to balance out returns over time and make the investment ride much smoother.
How does CH Financial protect from the downside?
When creating or managing a portfolio, we use diversification to deploy cash into numerous asset classes. The asset classes that CH currently invests in include:
- Canadian Fixed Income
- International Fixed Income
- Real Estate
- Alternative Strategy
- Canadian Large Cap Equity
- International Large Cap Equity
- Small-Cap Equity
CH creates portfolios using two core mutual funds, then “layer” in other mutual funds as the portfolio grows and/or more money is invested. The mutual funds we “layer” in provide diversification through exposure to other asset classes.
So, why use more than one fund in each asset class? We do so to provide further diversification but also to pair mutual funds in the same asset class that are complementary to each other. We pair mutual funds that have a low correlation, meaning there is very little to no security overlap. Simply put, the comparable mutual funds won’t own the same basket of stocks.
Finally, within this diversified portfolio, we make sure that our managers remain focused on the quality of the businesses that they buy. Additionally, we ensure that each of those businesses has strong free cash flows that will help lessen the likelihood that their value will drop when the markets get choppy.
While other advisors may be looking for the next mutual fund idea with high returns, our focus at CH is to pick mutual funds while simultaneously looking for ways to reduce risk, without compromising the targeted return for our client’s portfolios. Whether it’s diversification, using low correlated investments, or deploying completely uncorrelated mutual funds in a client’s portfolio, we are constantly focused on downside protection for clients. Please feel free to contact your advisor with any questions or to further discuss how downside protection is protecting your capital while building your wealth.