The logic behind the fund that outperforms in falling markets

In the second of a two-part series, Andrew Craig, author, investment manager and founder of Plain English Finance, reveals three major reasons why his VT PEF Global Multi-asset fund is worth owning.

Here is part two of a transcript of a podcast recorded on Monday 10 December 2018 by interactive investor's Lee Wild and author of "How to own the world", investment manager and founder of Plain English Finance Andrew Craig.

For those accessing the podcast either via the audio file embedded below or link at the bottom of this page, this transcript begins at 19:10 minutes in.

Lee Wild, head of equity strategy at interactive investor:

Could you briefly explain what you mean by breakeven fallacy, sequencing and compounding?

Andrew Craig, author, investment manager and founder of Plain English Finance: 

People quite often ask, "What type of investor should buy the VT PEF Global Multi-asset fund?" And my slightly self-serving response is for the reasons of the subjects we’re about to discuss, is that it could be suitable for a very wide range of investors, and why is that?

Sequencing risk is basically if you're 60 and you've managed happily to get to the point where you've got half a million quid in your pension or a million quid in your pension, after a lifetime of working really hard. If you own things that are volatile like a FTSE tracker or an S&P tracker, or that small cap fund we talked about earlier, the Standard Life super, cunning and clever special small cap fund that’s done so well, in a year like 2008 your million quid is suddenly 500 grand. 

If you're 28 and you have ten grand in your pocket because you've been diligently saving since you first started your first job, and that same scenario happens, now you've got five grand. You've got two things. You've got a lifetime to build that back up, and obviously in absolute terms five grand is a lot less painful than half a million quid, so that's sequencing risk.

Sequencing risk is the fact that as ... and everybody knows this in terms of the, sort of, lifetime allocation that we all know. It's 100 minus your age is your equity explosion and all that good stuff that a lot of listeners probably will know about. 

So really when you're getting to 60 and you've got a significant amount of money, you probably need to be aware of sequencing risk and therefore it should be more appropriate to invest in a product like ours which explicitly tries to protect the downside, but still can offer you 20% years sometimes. And you don't really care if the tortoise is being very tortoise and is minus three, zero plus three if you’re never minus 30 and you're sometimes a plus 20. All other things being equal you’d like to think that’s a great product.

The other is the magic of compounding, being small numbers become big numbers. Einstein described it as the eighth wonder of the world, there's a great example which I like to quote which says:

"If you put five grand in a tax-free account the day a child is born and compound at 10% to keep the maths easy, on the child's 55th birthday they will have a million quid." 

It's actually 945 grand but compound earning with no further investment, just five grand once. 

"Quite often I say that to a cab driver on the way home, or somebody I meet in a bar and they look at me like I'm speaking nonsense, but the maths works like that". 

And so the point there is, if compounding is that powerful the other person that this strategy might be suitable for is actually somebody quite young. So rather than be the person who saw ten grand become five grand, why not be the person who sees their ten grand in a worst case scenario become nine grand, but benefit from slow compounding over time? 

And the reason that's super important is because most people psychologically, again to the pack animal point, we're really, really hard wired as human beings to be rubbish at, you know ... if we see something down a lot ... greed, fear, you know ... we’re very highly likely to quit that loss. 

So quite often, citing an example from two other professors actually ... [Al Rodentson] and Paul Marsh at the London Business School who have given evidence that going as far back as 1955 ... it's a great piece of work ... UK small caps ... again I like small caps, I used to work with small caps ... have done 15-ish % per annum since 1955.

So it's very simple. We should all just buy UK small caps, right? The problem is that along the way UK small caps have fallen by more than a half on something like four occasions, between 1955 and now. Most people when that happens panic and sell out at a loss. 

So, actually, psychologically if you have something that never falls more than 10%, hopefully 5% over the same time period, even though probably the 15% ish for small caps will get you a better result, it'll only get you about 5% of people a better result because 95% of people will have sold out. So you would be better off being a tortoise, like banging out six, seven, eight, nine, 10%, but never having a minus 50 or a minus 60% year. 

So that's sequencing risk, compounding and the breakeven fallacy.

To find out more about the VT PEF Global Multi-asset fund and why it's designed to excel in volatile market conditions, click here to read the article or here to listen to the podcast.