What Matters Most – The Case For Active Risk Management by Franklin Templeton Investments
Investors Know Their Priorities
The first priority is usually—
“I don’t want to lose my money.”
This would probably explain why risk management featured so prominently in a recent survey conducted by Franklin Templeton in partnership with The Wall Street Journal.
When respondents were asked what they considered important when choosing investments, risk management topped the list. A close second was the ability to beat the overall market’s performance, and thirdly to lose less than the market when it’s down.
Five Reasons Investors Need Active Risk Management
The impact of the global financial crisis reminded people of the importance of risk management.
Active management and risk management go hand in hand. In fact, without diligent active management
of investments, risk management is typically non-existent.
This brochure presents five reasons why active risk management is crucial for investor outcomes.
- Indexes Are Indifferent to Bubbles
Passive investments often follow a market capitalization weighting process that allocates more to potentially overvalued stocks—even when the valuations reach staggering heights.
- It’s Important to Reduce Your Downside Exposure
Small reductions in downside performance can make a big difference in long-term returns.
- Volatility Matters—Especially in Retirement
When combined with consistent withdrawals (aka “retirement income”), market losses can be significantly harder to overcome.
- You Need Real People to Be Able to Apply Real Experience
There really is no substitute for experience when it comes to investing.
- Effective Risk Management Requires a Truly Active Manager
Not all actively managed funds measure up the same when it comes to differentiating their portfolios from their benchmarks. Effective risk management requires a truly active approach.
Indexes Are Indifferent to Bubbles
Indexes, and the passive investments that track them, are dispassionate followers of market behavior. If a sector or region becomes the darling of the day, there is no oversight to counterbalance that sentiment. The charts below show historical stock “bubbles” and their aftermaths, which resulted from the rapid price appreciation of certain segments of the market. As the stock prices in those segments ran up, they became an even greater portion of the index.
Two Noteworthy Sector Bubbles
In periods of rising markets, a market capitalization weighting process that allocates more to potentially overvalued stocks can work to an index return’s benefit. However, when the story changes, as in 2000, when 24% of the S&P 500 Index was represented by tech stocks, or at the end of 2006, when 22% was represented by financials, this approach can be risky. See below how the S&P 500 Index weightings readjusted downward due to sector-specific declines.
One Famous Geographic Bubble
Similarly, Japan’s massive run-up in the late 1980s led to a subsequent spectacular collapse. At its height, Japanese stocks composed well over a third of the MSCI World Index.
It’s Important to Reduce Your Downside Exposure
There are good reasons why investors say risk management is so important. But while investors may be more focused on what risk does to their anxiety level, it’s probably more important to look at what volatility can do to their bottom line.
Downside capture is a statistic that indicates how correlated a fund is to a market when the market declines. The lower the downside capture, the better the fund has preserved wealth during market downturns. Over time, a lower downside capture can make a significant difference to an investor’s portfolio.
What if the S&P 500 Index Was Managed for Risk?
With 500 stocks included in the index, it would be easy to think that performance wouldn’t improve that much just by excluding the five worst or even the 25 worst performing stocks in any given year. However, the long-term numbers tell a different story.
Volatility Matters – Especially in Retirement
The math behind loss recovery is part of the reason that lowering downside capture is so important. Equal percentage returns on the downside and the upside won’t get an investor back to square one. See the recovery gains needed to offset declines in the table below.
Investment Losses Are Experienced Exponentially when Taking Retirement Distributions
The importance of managing risk is heightened by the wave of investors currently nearing or entering retirement. Many will be looking for more than just market accumulation from their investments; they will also be looking for income. When combined with consistent withdrawals (aka “retirement income”), market losses are significantly harder to recover from.
You Need Real People to Be Able to Apply Real Experience
Even the most efficiently run passively-managed index portfolio has no memory of the last bear market, or the last bull market for that matter. There is no learning from mistakes or successes, as these portfolios are primarily designed to mimic a benchmark.
By contrast, Franklin Templeton mutual funds are guided by some of the most experienced managers in the industry, with average tenure of 10 years at the firm and over 16 years of industry experience.
“The Global Bond Team’s unconstrained approach gives us maximum flexibility to not only manage risk, but also to take advantage of global opportunities for investors.”
Dr. Michael Hasenstab • CIO Global Macro • Industry Experience: 20 Years
“We put as much emphasis on understanding an investment’s potential downside as we do on evaluating its upside.”
Peter Langerman • CEO Franklin Mutual Series • Industry Experience: 29 Years
“ In today’s interest rate environment, it’s especially important for fixed income investors to have portfolios that are managed with an eye on risk.”
Christopher Molumphy • CIO Franklin Templeton Fixed Income Group® • Industry Experience: 28 Years
“Risk management has always been an integral part of our investment process at Templeton. We view risk primarily as the permanent impairment of capital, not as short-term volatility. Volatility can actually provide opportunities for investors with a fundamental focus and long-term investment horizon.”
Cindy Sweeting • Director of Portfolio Management, Templeton Global Equity Group • Industry Experience: 31 Years
“One of our most popular strategies focuses on companies with a history of consistent and substantial dividend increases. In many ways, the backbone of this strategy is that it not only helps to screen for growth potential, but also downside risk.”
Don Taylor • CIO Franklin Value Group • Industry Experience: 33 Years
Effective Risk Management Requires a Truly Active Manager
Benchmark indexes and funds that are modeled after them do not discriminate when it comes to risk potential. This is one reason it is important to know how much an actively managed fund is distinctly different from its benchmark index.
Some funds may actually be “closet indexers,” which means they are invested very similarly to their benchmark indexes, while other funds have a composition that is very different from their benchmark indexes. A measurement called “Active Share” can help investors identify truly active managers. Active share can be a particularly informative metric when looking at funds with broad and diversified benchmark indexes, such as the S&P 500 or the Russell 2000.
The portion of stock holdings in an actively managed equity fund that differs from its benchmark index. Active share:
- Helps to identify “closet indexers”
- Helps prove an investment manager is truly active
- Identifies potential for relative outperformance
“It makes sense that portfolios that are less like indexes lead to performance that is less like an index. So, it seems a safe bet that active share can help investors build better portfolios and have realistic expectations about performance.” –MORNINGSTAR
Investors Have Spoken
As mentioned earlier, the majority of investors participating in the recent Franklin Templeton/The Wall Street Journal survey stated that these three things were important to them:
- Losing less than the market when it’s down
- Investing in products that can outperform the market
- Risk management
Franklin Templeton Investments understands why these are priorities for investors. That’s why for over 65 years, our firm has used an active management approach.
Franklin Templeton’s Active Share Scorecard
Sir John Templeton once said “If you want to have a better performance than the crowd, you must do things differently from the crowd.” These days, indexes are a barometer of the investment crowd. Active share scores reveal which active managers are actually investing differently from their benchmark indexes. Franklin Templeton’s high average active share scores across our U.S. registered non-sector specific equity fund lineup show that we are truly active managers.
Franklin Templeton Investments – Gain from Our Perspective®
At Franklin Templeton Investments, we’re dedicated to one goal: delivering exceptional asset management for our shareholders. By bringing together multiple, world-class investment teams in a single firm, we’re able to offer specialized expertise across styles and asset classes, all supported by the strength and resources of one of the world’s largest asset managers.
Focus on Investment Excellence
At the core of our firm you’ll find multiple independent investment teams—each with a focused area of expertise-from traditional to alternative strategies and multi-asset solutions. Across the firm, our portfolio teams share a commitment to excellence grounded in rigorous, fundamental research and robust, disciplined risk management.
Global Perspective Shaped by Local Expertise
In today’s complex and interconnected world, smart investing demands a global perspective. Having pioneered global investing more than 60 years ago, our perspective is built on decades of experience and shaped by the local expertise of our investment professionals who are on the ground across the globe, working to spot smart investment ideas and potential risks firsthand.
Strength and Experience
Today, Franklin Templeton is a global leader in asset management serving individuals and institutions in over 150 countries. Since our founding in 1947, we’ve stayed focused on putting clients first and delivering relevant investment solutions, strong long-term results and reliable, personal service that have helped us to become a trusted partner to millions of investors around the globe.