When volatility is the dominant trend in stock markets it is easy for investors to focus purely on the negatives and to forget any positive news. The old adage of a ‘falling tide drags down all boats’ strikes a chord with investors, many of whom are tempted to sit on their hands increasing holdings in fixed-term securities or, worse, running for cover in cash.

In the current climate the negatives about the credit markets and the US economy are weighing heavily on sentiment and rate cuts by the US Federal Reserve and the BoE have failed to bolster markets as much as might have been hoped. And, even if we are now looking at light at the end of the banking crisis and credit crunch tunnel, the concerns are morphing into worries about the economy and the effects of inflation. Commodity prices – energy, selected metals and agriculturals – are booming, despite the forecasts for economic growth. Cue the next headache.

There are plenty of defensible and rational explanations for institutions and professional traders to be wary of the current markets – or out of markets. Most investment professionals are, however, aware of the impact that being out of the market and missing the best days, weeks or months can have over time. One widely cited long cycle study of the US S&P 500 between 1976 and 2005 suggested the effect of missing the 10 and 20 best monthly returns would be truly disastrous. The ‘buy and hold’ returns were $36,000 for a $1,000 initial investment. The effect of missing the 10 best months, in this near-30 year period, was to slash returns to below $13,000. Missing the best 20 months reduced returns to $6,000. Dramatic stuff. In our opinion, such analysis misses the point for anyone other than traders. They focus on ‘random periods’ in markets, whether it’s days, weeks or months – but long term investors don’t operate on random days, weeks or months.

At Blue Sky Asset Management, we wanted to focus on the gains that could be made by investors who were in the markets. We therefore studied the effect of prolonged bear markets and the reactions of investors during and following these periods. The results are insightful.

Time in the markets, not timing the markets

The cue for our interest was this year’s anniversary of the market trough that followed the prolonged Technology, Media and Telecoms-inspired market collapse of 2000-2003. For those who do not remember – or perhaps prefer to forget – 12 March 2008 marked the fifth anniversary. Our analysis sought to demonstrate, for the first time, the impact of being out of the market and missing a hypothetical block of time, such as an entire 12 months, at each turning point of a bear market. We focused on the last three FTSE All-Share bear markets – 2000 to 2003; 1987; and 1972 to 1974. Table 1 details the numbers and shows the stark effects of missing the early stages of the recoveries, notably just the first twelve months.

During the TMT bear market the All-Share shed 51.5% in value. In the first year of the recovery it added 40.31% and by its fifth anniversary had gained 86.21%. Investors missing the first year of the recovery would only have seen gains of 32.72%. In the four-month 1987 bear market the All-Share dropped 36.64%. A year later it had gained 21.58% and after five years had posted gains of 53.89%. Missing the first year meant investors made just 26.57%. During the 1972-74 All-Share crash the market shed 70% of its value in a truly devastating slide. A year after the nadir the market had gained 128.49% and within five years it had added 244.95%. If you missed the first year the 244% was just 50%.But we also looked at the longer term implications of being out of the market, as opposed to simply studying the fifth anniversary numbers. Assessing ‘bear market troughs’ to subsequent ‘bull market peaks’, we identified 1987 to 2000 market gains of 317.85% – but investors missing the first 12 months would only have seen 243.67%. From the 1974 trough to the 1987 peak the gains were an astounding 1,756.93% – but missing the first 12 months would have cut the gains by an equally eye watering 1000%, to 712.95%.

History repeats itself

The importance of the pivotal points in markets and their effects on long-term performance is – and as all seasoned professional investors know many of these best investment times come in the latter stages of, or just following, crisis or uncertainty. Markets always look bearish on the way down and during periods of volatility, but long-term investors weather the downdrafts and benefit from the bull trends. It is a clear case of time in the market being more important than timing the markets.

Research is key to driving process and identifying and creating value approaches for institutional investors and clients. A research-driven approach to structured investments is actually relatively new but it is rapidly and increasingly facilitating new solutions for all types of investors, and is highlighting a growing polarisation between ‘intelligent structured investments’ and the more widely known ‘plain vanilla products’. It should be obvious where the value is to be found. Investors who want overlays for traditional investment options and/or alternatives to cash solutions are rapidly emerging from the structured investments arena that challenge the rationale of conventional or alternative funds. Market risk mitigation – if not total elimination – with enhanced upside performance is a mantra for many investment solution providers – but few deliver it with the simplicity and efficacy of structured investments, that do exactly what they say, subject only to counterparty risk.

Understanding the impact of the best investment periods upon long term portfolio performance is an essential point for investors. Being cognisant of timely solutions is the moral of the study.

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Biography

CHRIS TAYLOR

Chris Taylor is Chief Executive of Blue Sky Asset Management. He was previously Director of UK Structured Products Distribution at HSBC Asset Management, the global investment business of HSBC Group.