Do the terms “upward sloping equity glide paths” and “bond tents” seem unfamiliar to you? They are terms that financial planning researchers are using to describe investment strategies designed to mitigate “sequence risk,” the risk that your portfolio returns will occur in the wrong order, thereby negatively impacting the amount of income your retirement account will generate. Pinnacle’s Director of Wealth Management, Michael Kitces, writes an interesting article on the subject in this month’s OnWallStreet, titled, “Avoid the Retirement Danger Zone.” (You can read the article by clicking here.) Since most Pinnacle clients fall in the age range of 50 to 70, where pre-retirement and early post-retirement risk is the highest, and since the recent election has clients questioning recent portfolio volatility (in this case, to the upside), it seems a good time to revisit the question of whether active portfolio management still makes sense.
Pinnacle’s Dynamic Prime series of portfolios are tactically and actively managed. As active managers, our investment team is tasked with reducing portfolio risk in bear markets over and above the risk reduction you achieve by simply buying and holding a diversified portfolio. Since more than 90% of our clients are invested in Pinnacle’s actively managed Dynamic Prime strategies, it’s worth asking, “why invest in a risk-managed strategy in the first place?” Another question to be considered might be, “how have Pinnacle’s risk-managed strategies performed versus the universe of active managers during this bull market?”
Tasked with managing downside portfolio volatility using a variety of different investment tactics, the data shows that the universe of active managers has been puzzled by the unprecedented conditions underlying the current seven-year bull market. The chart to the right (click to enlarge) compares passive portfolios to active managers by comparing the S&P 500 Index and the MSCI World Index as proxies for either U.S. or Global passive (unmanaged) portfolios, and the HFR Global Hedge Fund Universe and the Morningstar Tactical Mutual Fund Universe as proxies for active managers. As the chart demonstrates, the past seven years have been a difficult period for active managers to add value versus passive equity benchmarks.
Industry research about retirement planning clearly shows that downside portfolio volatility, more popularly (and perhaps improperly) called, “risk,” becomes much more important as investors near retirement or are in their early retirement years. (See Kitces: “Avoid the Retirement Danger Zone.”) Portfolio declines in these years can be devastating because clients are withdrawing income from their portfolio during a bear market, but are no longer earning current income to cushion the blow to their investable net worth. As a result, declines that occur early in retirement reduce the amount of capital available to grow and compound when the inevitable bull market follows the bear. Because compounding returns have a particularly important impact on long-term portfolio values needed to fund retirement, early-retirement declines can destroy a retirement plan.
From a psychological point of view, early-retirement bear markets are even more devastating. Investors who are not used to relying solely on portfolio income and Social Security to fund their retirement spending tend to be more fearful of portfolio declines. The additional anxiety is warranted. When they were still employed they could potentially “make up” temporarily lost portfolio values by extending their retirement date. The extra savings could help to cushion the impact of a bear market as earned income continued to pay for household expenses pre-retirement. Post-retirement the prospect of making an unplanned life-style change by having to return to the workforce—or having to reduce a planned retirement standard of living—is frightening.
The combination of financial planning research’s unequivocal message regarding the dangers of portfolio volatility in the early years of retirement, combined with the psychological issues of taking portfolio withdrawals in bear markets and the fear that retirement plans are being destroyed, make a strong case that active and tactical management can be an important element of a retirement plan.
Alternatives for Risk-Averse Investors
Risk-managed investment strategies offer a terrific solution for early-retirement portfolio risk because they can significantly reduce portfolio volatility beyond the benefits of simple portfolio diversification. However, the evidence is clear that these strategies are under-performing passive strategies in this bull market.
What are some other alternatives for risk-averse investors?
The alternative that makes the least sense is to chase returns by investing in growth strategies that only perform well in bull markets. Investing in equity indexes, or mutual funds that require managers to stay fully invested in stocks, will only feel good until investors experience the vicious downside volatility of a typical bear market. Once the bear begins to growl, investors will, by definition, experience most or all of the volatility of declining markets. Having watched investors make the decision to chase returns in the later stages of a bull market with predictable negative consequences for more than three decades, I can only hope they will resist the ‘easy’ solution of buying ‘winning’ strategies at just the wrong moment.
Another alternative is to invest in properly diversified portfolios using a passive, buy and hold approach. The tactics for maximizing returns when investing in properly diversified passive portfolios include:
· Diversification, or owning a variety of different asset classes
· Reducing transaction costs
· Reducing tax costs
· Rebalancing the portfolio when needed
· Reducing asset management fees
With the advent of “robo-portfolios,” offered by a variety of firms, investors can cheaply acquire passively managed diversified portfolios. These portfolios offer all of the benefits listed above. The problem is that diversification is the only strategy on the list that cushions the impact of a bear market over short-term time periods, whereas tactical investing seeks to significantly soften the impact over and above simple diversification strategies. Additionally, in today’s expensive markets there is risk that diversification may not work to manage downside risk in the next bear market, as it didn’t in the most recent 2007-2009 bear market.
Investors can certainly choose to limit themselves to diversification as the sole tactic they will rely on to manage risk in an early-retirement bear market, but let the buyer beware. Active and tactical strategies, such as Pinnacle’s Dynamic Market series of portfolio strategies, can offer much more in the way of risk reduction once a bear market takes hold.
Pinnacle’s Relative Performance to other Active Managers
If investors still believe that active and tactical risk-managed investing makes sense for their particular risk tolerance and financial planning situation, they might ask how Pinnacle’s risk-managed strategies are performing versus the universe of active managers. The chart to the right (click to enlarge) shows historical total returns for the current bull market beginning Feb 2009 of Pinnacle’s three growth-oriented strategies in the Prime portfolio series, Dynamic Ultra Appreciation (DUA), Dynamic Appreciation (DA), and Dynamic Moderate Growth (DMG), versus the HFR Global Hedge Fund Index and the Morningstar Tactical Universe. Net of fees, Pinnacle’s actively-managed strategies have outperformed during the current bull market.
We are now seven years into a bull market and the Pinnacle Investment Team (at this writing) has an officially “neutral” stance, meaning we don’t have a high conviction forecast about either a bull or bear market on the immediate horizon. We don’t know when the bull market will end, but we do believe it will. If you have any questions about expected investment performance over complete market cycles, now is a good time to revisit Pinnacle’s Dynamic Prime investment strategies with your advisor. If the bull market continues, our actively managed investment performance could continue to trail passive benchmarks if our investment team believes that underlying market, business, interest rate, political, and geopolitical risks, are not worth staying fully invested. On the other hand, it is quite possible that sector rotation and other tactics will begin to create positive relative performance in the portfolios even if the bull market continues.
Assuming we continue to provide competitive returns versus the universe of active managers, a question for Pinnacle clients invested in our Dynamic strategies might be, “does it still make sense to invest in active management given the important role that active management plays in a retirement plan and the psychological lift it can provide in a bear market?” For many of our clients, we believe it does.
We recognize that some clients want an actively managed portfolio for all the reasons we have cited above, but they also want the benefits of a traditional, passively managed, broadly diversified portfolio across multiple asset classes. For these clients, we offer our Dynamic Market portfolio strategies that are designed using a 70% passive, buy and hold portfolio as a core holding within the portfolio. Dynamic Market seeks to capture 100% of the core market risk and return, while still offering some active management in a satellite allocation that is 30% of the total portfolio. For more information about this strategy, please contact your Wealth Manager.