Two of the most destructive forces for the economy are the words “let’s suppose” and the use of the = sign. When we put the two together, they form a combustible combination that gives seemingly well-intentioned and rational investors the power to disintegrate assets at will. This is because investors have a desperate need for quantitative models that will justify or ‘prove’ their investment theses, if for no other reason than it provides much better job security than having an investment thesis based on their good judgment and common sense. Unfortunately, this state of affairs gives rise to some of the most egregious misuses of the scientific method that one could imagine.
At a recent meeting with a long-time client, I found myself bemoaning the fact that it is extraordinarily difficult for consumers to ‘buy’ investment advice. Today’s financial markets are confusing, as are the many different strategies for managing money, and consumers are often left not knowing what to ask (or even, where to begin). For starters, if you don’t know, ask how your manager gets paid, how long he or she has been in the business, and how often the manager communicates with clients. After throwing those softballs and watching the manager hit them out of the park, here are six additional questions that are a little more subtle, and are sure to give you important insights into how a portfolio manager approaches portfolio construction and manages risk.
I am often surprised at how the investment industry media finds ‘news’ in investment methods that Pinnacle has been employing for years. This weekend’s Wall Street Journal offered a wonderful example. In a Saturday article entitled, “Same Returns, Less Risk,” Ben Levisohn and Joe Light describe a new investment strategy where portfolio managers handle risk by targeting portfolio volatility instead of a portfolio’s asset allocation. I found this of great interest because we’ve been utilizing this technique for close to a decade. The article identifies three different methods for targeting volatility. It’s worth reviewing them here and pointing out which of the three is closest to what we do at Pinnacle.
In this year’s Inside the Investment Committee presentation, I explained how consumers of investment management can view the performance of their money manager relative to a performance benchmark. If the benchmark is located on a graph where the vertical axis is return and the horizontal axis measures risk, then the portfolio return can fall into four quadrants relative to the benchmark. If the portfolio is either in the Southwest Quadrant or the Northeast Quadrant relative to the benchmark risk and return, meaning that the manager took less risk to earn lower returns (Southwest Quadrant) or the manager took more risk to earn higher returns (Northeast Quadrant), I label those returns “Intuitive.” This is so because it doesn’t take great skill to simply add cash to a managed account that owns benchmark securities to earn lower returns with less than benchmark risk, and it also takes little skill to borrow money and buy more of the benchmark securities to earn higher returns with greater than benchmark risk.
This weekend I had the opportunity to speak to the Baltimore Chapter of the American Association of Individual Investors (AAII). I was pleased to see so many members interested in learning about investment strategy on a Saturday morning. As I always do when discussing tactical asset allocation, I made it clear to the audience that allowing yourself to adjust your portfolio asset allocation based on your view of current risks and opportunities in the market makes perfect sense from a theoretical standpoint (unless you happen to be a Ph.D. in finance, in which case you don’t believe that markets ever deviate from their fair value). After all, if you believe that there are times when assets are undervalued or overvalued, then you should buy and sell appropriately in order to try to earn excess returns. However, while such activity makes sense theoretically, from a purely practical perspective things can get complicated in a hurry. In our experience there’s a surprising percentage of time when our ‘belief’ in market valuation lacks conviction. So, it’s important that your investment process allow you the luxury of claiming that you don’t have a high conviction view of the future direction of the market. At such times, investors need a place to go that constitutes home base. It’s the asset allocation for your portfolio where you have a clear understanding of the potential short-term downside risk of negative returns based on past performance. This “clear understanding” should be reviewed periodically and confirmed by all parties as being a safe allocation in terms of short-term and long-term return and risk expectations. This wonderful place, where everyone can take a deep breath and collect their wits, is called your benchmark allocation.
I just returned from the Financial Planning Association’s Retreat Conference where I was an invited speaker on the topic of “Investing Outside the Box: Modern Insights Into Portfolio Management.” Now that I’m back in the office, it’s time to catch up on my reading. Here is a review of today’s homework.
Ken Solow is the Chief Investment Officer of Pinnacle Advisory Group, and Sauro Locatelli is the Quantitative Analyst.
Pinnacle managed accounts are globally diversified. Most investors readily acknowledge that diversification is a benefit in its own right, since it tends to reduce portfolio volatility and helps investors avoid large investment mistakes. Global diversification offers more of the same: By owning stocks in different countries, you presumably get to invest in equities that have low correlations to the U.S. market, meaning they zig and zag at different times giving you a smoother ride as your portfolio grows in value. (This article discusses stock markets, but the same could be applied to almost any asset class.) Since the U.S. represents about 30% of the world’s stock market capitalization, you also get to invest in great companies that make up the other 70% of the global stock market. You will certainly recognize many of these international giants, including Nestle, HSBC Holdings, BP Plc, Vodaphone, Novartis, Royal Dutch Shell, and Toyota, just to name a few.
Registered Investment Advisors like Pinnacle Advisory Group are held by law to a fiduciary standard. That means that we’re bound to act at all times in our clients’ best interests, even if those interests should clash with our own. In doing so, we have a legal obligation to disclose to our clients exactly how we’re to be compensated, as well as any related conflicts of interest. At Pinnacle we have met this standard since we started the company in 1993.
A good 99% of Pinnacle’s assets under management come from our private wealth management business. However, we think this percentage is going to decline over time as a new kind of client is discovering Pinnacle Advisory Group. Institutional investors, including professional financial advisors who want to outsource their money management business, along with platform providers — those companies in the business of providing a variety of money managers to other institutional investors — are beginning to knock on our door. The interesting thing about this dynamic is that firms who are primarily in the business of providing investment services often have large and expensive sales forces whose job is to call on platform providers and “sell” the firm’s investment offerings. The Chief Investment Officers of platform providers spend their time trying to deflect the overwhelming amount of sales calls they get from investment companies. If you are in the business of making money by charging fees on assets under management, one of the best way to do it is to get your investment product offered on a platform where the provider essentially sells your services for you (and who often has a large number of investment advisors looking to them to do the due diligence on the investment managers). It’s a good system. Platform providers offer excellent money management firms to investment advisors and investment companies hire a sales force to get their product distributed on as many platforms as possible.