This article is Part Four of our ‘Investing – An Alternative Approach’ miniseries. The series aims to inform readers about how the Frame Long Short Australian Equity Fund generates returns for its investors.
What is discretionary investing?
Any form of investment management where investing decisions are made at the sole discretion of an individual is classified as discretionary investing. Trading, individual stock selection and portfolio construction can all be done on a discretionary basis. Most retail investors manage their portfolios in a discretionary way.
We deconstruct discretionary investing into two categories: hedging and alpha generation. Hedging activity is designed to protect and preserve performance from aggressive downwards moves in the market, ultimately acting to smooth a portfolio’s return profile. Alpha focused activity is designed to add extra performance to the portfolio.
Hedging is an important part of managing a portfolio, and when done properly, it can significantly reduce drawdowns. In its simplest form, hedging involves allocating part of your portfolio to an asset that has returns negatively correlated to those of your portfolio. This is not to be confused with diversification, which involves investing in uncorrelated assets. Hedging can be achieved through a variety of strategies, including trading short and the utilisation of derivatives. Short selling involves borrowing an asset, selling it on market and buying it back in the future. You will obviously profit if the price falls and lose money if the price rises*. Derivatives are financial instruments whose value is derived from the value of another asset. Taking a short position in index futures or buying put options on an asset may both generate positive returns if the value of the underlying declines**. More complex strategies are available that involve combining the above techniques.
These strategies can be very useful in preserving capital, especially in times of financial stress. Trading short and hedging using derivatives is especially important when investing systematically – you cannot override the system so hedging the portfolio is essential to protect portfolio returns. For example, if your systematic strategy is in a stock that has released a bad earnings report, you can cover some or all your exposure by shorting the stock until the systematic stops are hit. Similarly, if the market is looking weak due to macroeconomic factors and the systematic part of your strategy is fully invested, you can short the index through futures or buy downside protection with a put option.
Alpha generation is any investment that is undertaken with the sole purpose of delivering excess returns. This is opposed to hedging activity where you are prepared to accept losses in exchange for downside protection. Investments designed to generate alpha can be long or short term. A longer-term approach may involve building positions that will outperform over time, independently of the rest of the portfolio. Short-term strategies involve intraday trading and swing trading. Intraday strategies involve trading in and out of an asset in the space of one trading day, while swing trading has a longer holding period (a couple of days to weeks). Both types of trading can be based around company announcements, macro announcements, price/volume action or a combination of all three.
Why use discretionary investing strategies?
In our view, combining discretionary investing strategies with a systematic portfolio can allow investors to generate returns that are uncorrelated to systematic only strategies in the long term.
In addition, they allow the investor to capitalise on sudden or unexpected company specific or macroeconomic announcements. Long term systematic strategies generally take more time to process and analyse data. This is because it can sometimes take days for new information to become fully reflected in the market, a disadvantage when considering the dynamic nature of macroeconomic developments and company announcements. For example, if a company announces it has won a new contract mid-session, you could buy the stock immediately after the announcement and sell it on the close, profiting from the rise in price as the market adjusts to the new information.
The types of discretionary strategies discussed in this piece are by no means exhaustive, rather they demonstrate how they can add value to a portfolio, especially when they are integrated with a systematic component.
Part Five is the final instalment of the miniseries. It will look at the Frame Long Short Australian Equity Fund and how it fits into the current investment landscape.
*Short selling is a high-risk practice and losses can theoretically be unlimited. Not all retail brokers allow customers to trade short. It is a strategy usually reserved for experienced investors and funds management professionals.
**Derivative instruments can be very complicated and high risk due to the use of leverage. Separate broking accounts are usually required for retail investors to trade derivatives. Investing in derivatives should be left to experienced investors and investment management professionals.