Last month a grandson of one of our clients called me with the sad news that his grandfather had passed away. I knew his health had been fading over the past year, so while I was sorry to hear it, I wasn’t entirely surprised. It was a difficult conversation, as those things are, and the only comfort to come out of it was the fact that the elderly man had prepared for this day through proper planning. By keeping all of his documents current and in good order, he was able to ensure that his assets would pass to his loved-ones according to his wishes.
Pinnacle has various defenses built into to how we manage our portfolios. We live by the two unbreakable rules of keeping diversified and avoiding overvalued assets. In addition, we also look to keep various hedges in our portfolio to defend against adverse conditions that have the potential to rattle financial markets. Over the last few quarters we’ve owned treasury bonds to hedge against deflation taking hold, gold to defend against money printing and currency debasement, and the dollar to hedge against continuing risks seeping out of Europe. Today we’ll be buying a few points in oil to defend against the possibility that geo-politics creates a price spike in oil.
Consumers of investment management might consider three different methods to analyze investment returns. The first method is to look at absolute returns in the context of your financial plan. If the portfolio return was 7% annualized for ten years, was that return high enough for you to achieve your financial goals? What about 3% annualized returns, or 12% annualized returns? Of course, looking through the lens of absolute returns would disqualify negative returns as helping anyone to achieve their goals, so investors often look to other methods to evaluate portfolio returns. Today it is rare to find a manager in any asset class, including hedge funds, who claims to be able to consistently generate absolute returns.
The duration of a bond portfolio tells you how much the price of your bonds will change for each percentage change in interest rates. A high duration means more sensitivity or price volatility as interest rates change. Duration tells you virtually everything you want to know about the price sensitivity of U.S. government bonds, which are presumed to be risk-free from the standpoint of default risk. Prices of government bonds move with a mathematical certainty depending on the coupon and the maturity of the bonds, both of which go into the duration calculation. Investors increase the duration of their portfolio by increasing the maturity of the bonds they own, and shorten the duration by shortening bond maturities. As you move up the risk-of-default scale from government bonds, you can invest in what is known as “spread products,” or bonds that are priced based on the difference, or spread, in their yield to U.S. Treasury securities. Spread products include mortgage bonds, high quality corporate bonds, junk bonds, and emerging market bonds, all of which typically offer investors higher yields in exchange for a higher risk of default. The price of spread products is not only impacted by their duration, but is also greatly affected by investor’s perceptions of the default risk of the underlying bonds. These bonds are priced on their creditworthiness, and are often simply referred to as credit.
Early this week I appeared on a panel discussing gold at the world’s largest exchange traded fund (ETF) conference, which took place in Hollywood, Florida. Given that the conference was being held in a picturesque setting on the beach, there were plenty of opportunities to be distracted by sun, surf, and sand. (Full Disclosure: My two favorites were the Lotta Coladas, and other tropical smoothies, and an early morning kayak in the Atlantic.) But the real action was inside the conference, where 1,200 attendees piled in to hear the latest on the economy, bonds, commodities, gold, and all things new in the world of ETFs.
In my book, Buy and Hold is Dead (Again), I discuss in some detail Woody Brock’s views on the logical justification for active portfolio management. Brock lays out three ways active managers can outperform. First, they can better forecast structural changes in the economy. Second, they can better forecast how investors will react to changes in the news. And third, they can exploit logical errors of inference (accepted notions about how the markets work that later turn out to be wrong).
Recently I had the opportunity to review the investment results of two different money managers who had correctly called the market top in 2007 and by January of 2008 had safely invested 100% of their investment capital in cash. The resulting investment results are, as you can imagine, spectacular. Both firms are quantitative in nature, meaning that they use proprietary technical-analysis-based methods to determine market trends in order to make their investment calls. In one case, the manager has a trade-marked trend identification system that protects their clients from downturns. While I tip my hat to these managers, I continue to view any portfolio construction that is either all-in in terms of stocks and risk assets, or all-out in terms of cash, as a somewhat high risk proposition.