Over the past couple of weeks, we have executed several portfolio transactions in line with our belief that the second half of the year may be a good one for stock investors. Most of the trades have been relative in nature; for example, we’ve swapped defensive U.S. sector holdings for late cyclical sectors. We also traded “up” within our international holdings, by swapping a fairly conservative actively managed fund for an ETF targeting mainland Europe (the iShares MSCI EMU Index Fund; symbol EZU). In our two most aggressive policies, we purchased the iShares MSCI Italy Index Fund (symbol EWI).
We continue to position portfolios at neutral levels of risk, believing that the substantial downside risks (Europe, the looming fiscal cliff, an economic slowdown, etc.) are balanced by the growing possibility that global central banks may soon inject more stimulus that could propel risk markets higher again — similar to what’s happened the past two years (see our June Market Review for more details on our outlook).
A few weeks ago, I introduced you to the concept of pro-forma portfolios, and explained how we use them to estimate our current portfolios’ position in terms of volatility and beta. There is an Italian saying that could be translated as “to trust is good, not to trust is better.” While the pro-forma portfolios give us the best possible ex-ante estimates of the amount of risk in the portfolios, these are by definition estimates and not reality, and we can only trust them so much. For this reason we have developed two very short-term measures of volatility and beta based on the actual daily portfolio returns, which we routinely compare to the pro-forma estimates to make sure the portfolios are in fact behaving as we expected. The first measure is called one-month time-weighted trailing volatility and starts with the calculation of the equal-weighted average of the portfolio’s daily volatility over trailing 5 days (1 week), 10 days (2 weeks) and 20 days (4 weeks). This number is then divided by the same average volatility calculated for the portfolio’s benchmark. The ratio gives us a measure of how volatile the portfolio is being relative to its benchmark:
Over the past few weeks the Investment Team has been reviewing our tactics for getting our portfolio back to a neutral stance and explaining them to our clients and other interested parties. However, the way we measure the positioning of our portfolios and define a neutral stance is itself worthy of discussion.
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.
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.
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.
Recently the Pinnacle investment team met to discuss the state of the world, the views of the independent analysts we follow, our market expectations, and what it all means to the asset allocation of Pinnacle portfolios. As always, it was a lively discussion that swung between business cycle dynamics, technical condition of markets, valuation, and bigger picture themes.
“Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep by him in reserve.”