08 May 2018

The first principle of the ALPS Fund’s strategy is based on the fact that staying invested in equity markets over the long term produces very good returns – an average of 8.8% pa in the US since 1871, and slightly better in Australia over a shorter period. This is why, most of the time, the Fund owns shares in the Australian, US, and European markets. Share markets are typically volatile, with a string of positive months followed by a few negative months. As long as these monthly moves are less than 5% up or down, they tend to balance each other out in the long run, leading to the average return of 8.8% pa mentioned above.

We think in terms of “months” rather than weeks or days because it has been established since the 1960s that there is very little information in weekly or daily returns. You may have heard of the view that share prices are a “random walk”: this is true over short periods, and it is only over longer periods that genuine trends become visible. This is the reason why gatekeepers insist on judging fund performance on the basis of monthly returns. This is also the reason why the ALPS portfolio is re-balanced every month, not every week or every day.

The trouble with share markets is that, in addition to these monthly wobbles, they produce big negative returns in about two years in every decade – not just minus 10% or so, but minus 30% or 40%, like in the GFC. The second principle of the ALPS Fund’s strategy is to protect our investors against these serious capital losses of capital, either by holding cash or by buying protection against the downturns.

Buying protection (e.g. put options) is like taking out insurance. It costs money, and you never know in advance whether you will need it or not. Unlike insurance, however, buying protection is very expensive – an average of about 7% of capital each year. Obviously, no investor can afford to carry this sort of protection all the time, so Arminius tries to target the times when investors will really need protection. That is, we don’t try to insure against ordinary monthly moves of 5% or less. Instead, we only buy protection when we think that the market is in danger of falling by 10% or more in the near future.

In short, we try to protect the ALPS portfolio against extreme events, but not against minor monthly moves. This approach is like insuring your house, your car and your boat, but not bothering to insure against the loss of a TV or a computer, because the insurance cost and the excess makes small claims hardly worthwhile.

You will have seen from our commentaries in 2017 that we thought that the US and Australian markets were overpriced and would suffer a correction some time in 2018. Going into February and March 2018, we took the view that the financial conditions were not yet in place to trigger a serious downturn, and we were right. We regarded the February and March corrections as similar to the small tremors which precede a major earthquake. Almost all world markets fell in February and March, but not very far. The ALPS Fund lost 2.6% in February and 3.5% in March – uncomfortable, but not big enough losses to insure against.

At the end of April, the Fund was down -1.93% for the first four months of 2018. However, we think that global markets are likely to weaken in the second half of the year, perhaps as early as May, so we expect to take out protection in the near future.