We’re three weeks into the football season so it’s time to break out the tired sports metaphors. Today’s column is titled, “Blocking and Tackling,” which I’m using as a new and interesting way to announce that this is a good time to review the fundamentals of Pinnacle’s investment philosophy. With luck, we’ll soon have an opportunity to write about how to invest without being “blind-sided,” how avoiding a bear market allows us to not have to “drop back ten yards and punt,” and how looking at trailing returns is an exercise in “Monday morning quarterbacking.” But for now, let’s concentrate on blocking and tackling.
Last week Pinnacle analysts unanimously concluded that Pinnacle portfolios should be tilted slightly bullish. For our long-suffering Chief Investment Strategist, Rick Vollaro, whose job is (in part) to get an idea of what the consensus opinion of Pinnacle analysts might be, last week’s unanimity was something of a relief. Over the past year there has been plenty of disagreement on the team regarding the current bull market as some analysts remain skeptical (count me in), while others have been more willing to take risk. The unanimous conclusion to tilt slightly bullish is actually another way of saying that we are unwilling to be outright bullish, a state of affairs that would require the team to have high conviction about our market forecast. In other words, we have high conviction that we have fairly low conviction. If you understand this somewhat confusing state of affairs, then you truly understand the nuances of how we actively manage portfolios.
When we say we’re willing to be slightly bullish, this technically means that we’re willing to position the portfolio to have slightly more volatility than our blended benchmark portfolio for each Pinnacle strategy. Interestingly, in real time it’s difficult to know just how bullish we are. Sauro Locatelli, Pinnacle’s quantitative analyst, has constructed several quantitative models to measure portfolio volatility in real time. Last week, as we pondered how to best reposition the portfolio, we were working with a pro-forma model that uses current data to forecast how the portfolio might perform if we made certain changes. According to the pro-forma model, we are currently somewhere between 5% and 10% more volatile than the benchmark. However, according to models that measure the actual trailing volatility of our portfolios, as opposed to forward-looking models of pro-forma volatility, we are still close to benchmark. In fact, the models are very sensitive to daily performance and the data dances all over the place. Fortunately, the team has worked with our models for a long time and we have a good idea of the impact of proposed trades with or without the quantitative modeling. If we get this right, then we should see portfolios outperform to the upside in “risk on” days, and presumably underperform on “risk-off” days. This has certainly been the case over the past few weeks.
It is also interesting to note that when we have low conviction, we position the portfolios to have benchmark levels of risk, while other investors who have low conviction position their portfolio to have no risk at all. The difference in philosophy regarding risk taking is the difference between investors who are trying to earn absolute positive returns versus investors who are trying to earn relative positive returns. As relative value managers, we steal some of the fundamental precepts of Buy and Hold investors, which is somewhat ironic for an investment team under the supervision of a CIO who has authored a book called, Buy and Hold is Dead (AGAIN). We still subscribe to the notion that a diversified portfolio is a necessary requirement for proper risk management. We also believe that the historical risk and reward parameters for a blended and unleveraged benchmark portfolio are relevant for investors trying to evaluate worst case drawdowns in portfolio values. And finally, we believe that investment strategy must be evaluated over a reasonable period of time, which (for better or worse) we define as a complete market cycle. Hence, by owning the blended benchmark when conviction is low, we are putting investors in the best possible position in terms of having a realistic perspective of worst case historical portfolio drawdowns and still offer the opportunity to not miss longer-term opportunities for portfolio return.
Absolute return investors believe this definition of risk completely misses the mark. For them, risk is either the risk of losing all of their capital, or the risk of short-term downside volatility of their capital. We find both of these definitions of risk to be problematic if you choose to view investing as a process of allocating capital to have the highest probability of earning a risk premium over time. If you own a portfolio that is diversified by asset class, within asset classes, and without leverage, the possibility of losing all of your capital in even the most violent bear market is extraordinarily unlikely. The notion of defining risk as peak to trough declines creates a situation where diversification is abandoned in favor of cash. While owning cash in bear markets is wonderful, getting the timing exactly right is very hard to do. We would rather give ourselves the flexibility to reduce risk versus our benchmark, which allows us the very important freedom to be wrong in our assessment of markets, while still giving us the flexibility to manage risk over and above simply buying and holding a diversified portfolio of asset classes. The result of our relative approach to risk management is that when we have low conviction in our forecast, we own the benchmark portfolio.
It is also interesting to note that all of this relative risk posturing results in comparing our very diversified portfolios to a blended benchmark constructed of only two asset classes, U.S. stocks and U.S. bonds. As I have lamented on many occasions, the notion that we must beat the performance of a two asset class benchmark while sticking to a strategy that requires us to own a globally diversified portfolio is somewhat absurd. However, since this is an absurdity of our own making, it’s worth explaining our position about benchmarks once again. The fact is, any benchmarks that we conjure up to use for portfolio comparison will be completely arbitrary. Choosing two well-known proxies for risk and reward for bonds and equities keeps things simple, and keeps the benchmark performance easily understandable for Pinnacle clients. However, when the S&P 500 Index, our proxy for stocks, is beating all other risk proxies including developed country international stocks, commodities, and emerging market stocks, we tend to suffer in terms of our relative return comparisons.
Finally, I should note that the current theme we are investing is ‘reflation,’ meaning that we believe the global Central Bank efforts to push asset values higher will be successful. This does not mean we believe that buying billions in mortgages will necessarily stimulate the U.S. economy through supporting the housing market or actually reduce the rate of unemployment. Nor does it mean that the structural problems in the Eurozone will be fixed because Mr. Draghi has declared that buying European government bonds is part of the European Central Bank’s mandate to promote stability in the price of the euro. However, it does mean that we believe there’s a likelihood that the liquidity from these programs will find its way into global risk markets such as Europe, U.S. late cyclical stocks, gold, oil, and corporate bonds and mortgages. It also means that the hedges we own that are designed to work well if we’re wrong in our assessment of global reflation are likely to trail (so if we’re correct in our view, the same geniuses who made you money in the above mentioned investment ideas will lose you money by owning the dollar, high quality bonds, volatility hedges, and defensive stocks). Hopefully our discerning clients will focus on the overall portfolio performance and allow us the luxury of defending against big investment mistakes. This means that clients won’t focus on the “losers” in their portfolio, which we own for the purpose of safely owning the “winners.” This is the conundrum faced by anyone who understands the nature of a diversified portfolio. While we all claim to want portfolio diversification for the purpose of risk management, the only diversification we really want is to own cash in bear markets. In bull markets we want to own as much of the winning asset classes as possible since everything else — either relatively or absolutely — loses money. Unfortunately, only in hindsight do we get to see which asset classes turned out to be the winners and the losers… an inconvenient truth if ever there was one.
Pinnacle clients who understand high conviction/low conviction forecasts, relative versus absolute returns, comparing performance to two asset class benchmarks, and the many frustrations of maintaining a diversified portfolio have earned our special Pinnacle advanced degree in active and tactical portfolio management (as well as our short-course in sports metaphors). They can now move past blocking and tackling and pass on to more sophisticated plays in our Pinnacle playbook.
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