Lately I have participated in several discussions about how to make money at “neutral vol,” or when Pinnacle portfolios are positioned to have roughly the same volatility as our benchmark portfolios. A good starting point for the conversation is to analyze the total equity positions we own in the portfolio versus the neutral allocation to equity in our benchmark portfolios. In Investment-Speak, changing the overall portfolio risk posture by underweighting risk assets is called a “beta trade.” We are reducing the portfolio allocation to market risk.
(Note: There are many ways to increase or decrease portfolio volatility using equity selection. I freely acknowledge that these changes can and do influence portfolio beta. If you are math geek, or a Pinnacle analyst, please take a deep breath and just let it go…)
(And if you were thinking that this also applies to the fixed income positions in Pinnacle portfolios… you are correct.)
The chart to the right shows Pinnacle’s Moderate Portfolio total month-end equity allocations, including U.S. equity, International equity, commodities, and equity alternatives, for the trailing four years (beginning in August 2009). We also show a horizontal line that highlights the 60% equity allocation in our Moderate portfolio benchmark. You can see that we have made relatively mild beta changes to the portfolio over the past four years with the biggest deviation from the neutral allocation occurring in late 2011. For the most part we have been reluctant to make large beta bets with portfolio asset allocation over the past four years as Pinnacle analysts wrestle with the question of whether the bull market is built on improving economic fundamentals or, in the opinion of bearish investors, financial engineering by our Central Bank that will end badly.
Having reviewed our overall willingness to take market risk during this bull market and seeing that most of the time we have been within a narrow range of neutral risk (plus or minus 5% of benchmark equity weightings,) the questions remains: What else can be done to earn excess returns and manage risk while at neutral volatility compared to our benchmark? The answer has a pleasant sounding cadence: Countries, Currencies, Commodities, Sectors, and Industries.
By wisely managing our allocations to these investment categories we can add value in our managed accounts, even though the total equity is close to neutral, or in the case of the Moderate Portfolio, 60% equity. “Countries” refers to our ability to rotate our asset allocation to any country or region in the world that is represented by either exchange traded funds or actively managed mutual funds. Today Pinnacle portfolios are underweight international equities relative to our benchmarks. To the extent that the funds that would have been invested in international stocks remain invested in equities, and to the extent that those equities have the approximate risk characteristics of our blended equity benchmark, then we could be making money versus our benchmark with this decision even though the portfolio is projected to have similar volatility to what it would have had at neutral allocations.
“Currencies” are another way to influence returns at neutral volatility. Today Pinnacle analysts are suggesting that the Fed will soon begin tapering their quantitative easing policy because the economy seems to be strengthening. This would result in a stronger dollar versus most other currencies. By hedging the dollar versus our international equity positions, and by owning the dollar outright in an exchange traded fund, we can (if we are right) earn excess returns at neutral volatility. Notably we consider our dollar investment to be an alternative investment in the fixed income allocation of our portfolio. However, our currency hedges in the equity space can make a big difference in equity returns.
The commodity story is similar to the U.S. and international stock story. Assuming that commodities generally offer equity-like volatility, then we can add value by under weighting or over weighting commodities versus other equity allocations. Today Pinnacle is dramatically underweight commodities versus our neutral allocations in the Moderate Portfolio (and in all of our managed accounts.) At our current neutral equity allocations we can deduce that the proceeds from the commodity underweight are invested elsewhere in our equity portfolio. This, once again, gives us the opportunity to add value at neutral volatility.
Finally “Sectors” and “Industries” refers to our ability to sector rotate within the U.S. equity sector using exchange-traded funds. It is true that defensive sectors of the U.S. market can have significantly lower volatility than more cyclical sectors and industries, but generally speaking, sector rotation allows us to stay invested in equities while adding value to the portfolio if our sector and industry picks are correct.
So there you go. If you were wondering how we make money for clients at neutral volatility, just remember CCCS&I, or Countries, Currencies, Commodities, Sectors, and Industries. They are on the agenda of every investment team meeting and are the basic tools we use to add value to Pinnacle portfolios.
Copyright: gunnar3000 / 123RF Stock Photo