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.
As Pinnacle clients know, the ‘secret sauce’ of Pinnacle’s investment process is that we target portfolio volatility, instead of portfolio asset allocation, when we want to get to home base. Regardless of the assets that we actually own in our managed accounts, when our quantitative analysis indicates that our managed accounts have roughly the same volatility as our client benchmark portfolios, then we say we are “at benchmark” or more typically, “at neutral” allocations. When Pinnacle analysts say we are neutral to the benchmark, we expect the volatility of the portfolio to meet our clients pre-agreed expectations for worst-case short-term market declines. I’ve been known to opine that being at neutral allocations is like kissing your sister, meaning that we don’t expect a whole lot of excitement in terms of relative returns to our benchmarks. From a neutral allocation, we no longer expect our asset allocation to drive excess returns and instead rely on sector rotation or security selection to outperform. In other words, we believe that the overall risk in the portfolio is similar to the overall risk in the benchmark. But we can still earn excess returns by owning the correct market sector, industry, country, duration, credit, currency, etc. And we can still earn excess returns by owning the correct Exchange Traded Fund (ETF) or mutual fund in order to get an exposure to any of the above in our portfolios.
At the moment we’re pretty close to neutral. On any given day we can win (meaning outperform the benchmark) on an up day or win on a down day, which from a practical standpoint makes a good case that we’re close to neutral allocations. Another signal that the portfolio is at, or close to, neutral is that the actual wins and losses are small. Over the past several weeks Pinnacle managed accounts have generally been beating our benchmarks by about 10 basis points, which can add up over time but is still a small absolute number over the course of an entire week. (10 basis points is 0.1% or one tenth of one percent.) The irony of our position is that because our benchmarks are comprised of two asset classes — U.S. stocks and U.S. bonds — we can win in terms of having less than benchmark volatility simply by owning a diversified portfolio that has a variety of asset classes in addition to U.S. stocks and bonds. The notion of winning through diversification is central to Modern Portfolio Theory, but it depends on the various asset classes we own having a low correlation to the S&P 500 Index. If correlations peak then our correlation benefit can easily disappear. However, if the definition of winning means to earn higher returns than the benchmark — which is an entirely different matter than having less volatility than the benchmark — then our insistence on diversified portfolios can be a concern. When the S&P 500 Index is leading international stocks, commodities, and other risk asset classes, we can win in terms of having less volatility than the benchmark but are likely to lose in terms of relative performance. In fact, this state of affairs has been going on for some time. For example, since September of 2009 the MSCI EAFE Index (Europe Australasia Far East) Index of developed countries earned a total return of +0.88% versus the S&P 500 return of +38.13%. For those who would rather own emerging countries, since October 4, 2010, the MSCI Emerging Market Index has lost 9.29% versus a gain of +22.88% for the S&P 500 Index. And for those who choose to diversify their portfolio by owning a diversified portfolio of commodities, the Dow Jones-AIG Commodity Index has gained +25.42% since February 27, 2009, which is very close to the bear market bottom, versus a gain of +96.7% for the S&P 500 Index. More recently, since August 23, 2011, the DJ-AIG index has lost a whopping 17.52% versus a gain of +18.29% for the S&P 500 Index. Clearly, for those who believe in diversified portfolios as a fundamental method of managing risk, being diversified — at least in terms of owning developed countries, emerging countries, and commodities — has not been overly helpful with portfolio return when comparing to a benchmark with only one risk proxy.
Nonetheless, Pinnacle portfolios currently exhibit neutral risk to their unmanaged benchmarks. Engaged investors will note that the past few weeks risk has been ‘off.’ As usual, Rick Vollaro, our Chief Investment Strategist, Carl Noble, our Senior Portfolio Analyst, and Sean Dillon, our Technical Analyst, do an excellent job recapping the pros and cons of the current market situation in this month’s Pinnacle Monthly. Pinnacle clients should check with their wealth managers if they’re uncertain what short-term volatility is implied by their benchmark policy. Other readers should double check their asset allocation and portfolio holdings to make certain they are comfortable with the worst case decline they might experience. There is too much systemic risk floating around to be overly casual about risk.
However, by virtue of being neutral Pinnacle is saying that the bulls and the bears both make a good case at the moment. Clearly the past several weeks have exhibited all of the traits of ‘risk-off’ and the past week has been full of bad news. The French election reminds us that democracies have a hard time voting for austerity, and the Greek election reminds us that the Euro experiment is still at risk of completely unraveling. At the same time, the news that JP Morgan has a rogue trader has everyone revisiting the question of “too big to fail” and everyone is scurrying around trying to understand the difference between hedging a bank’s risk portfolio versus hedging a proprietary trading account. Every down day of late is reminding investors that the past two years have been unkind to those who ignore the old saying, “sell in May and go away.” Yet, many also remember a different aphorism that goes, “Fool me once, shame on you. Fool me twice, shame on me.” Why? Because investors who were overly bearish during the market swoons over the summers of 2010 and 2011 missed strong rallies that subsequently took the S&P 500 Index to new highs. It seems the prevailing attitude among bullish investors is that this year they won’t get burned again by a shallow summer correction (2010 -14%) or bear market (2011 -19%). Pinnacle’s stance is that we are close to neutral now, and are likely to be buyers on further market weakness. What might change our view? If risk spreads begin to widen pointing to dramatic increases in systemic risk and/or if new data indicates that slow economic growth is morphing into a recession. At the moment, we don’t believe the latest news alters our view of either systemic risk or where we are in the business cycle, so we’re sitting at neutral while we analyze further developments and patiently await an opportunity to buy.
From the perspective of absolute returns, Pinnacle managed accounts will be more volatile than they were earlier in the year. From the perspective of relative returns, there shouldn’t be much news to report. In the words of my teenaged daughter, relative returns should be “chill.”
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