Every Pinnacle client signs an Investment Policy Statement that spells out the long-term targets for risk and reward for each Pinnacle strategy. Risk is presented in absolute terms as a fixed range of returns based on back-testing a five asset-class portfolio from 1972 to the present. The range of expected annual returns (risk or volatility) in the IPS is based on the standard deviation, or the dispersion of returns, from the very long-term average return presented to clients in our now famous (or infamous) Red and Gray charts.
The IPS clearly states that the range shown in the agreement is an estimate and that actual portfolio volatility can deviate for short periods of time. That has certainly been the case: While Pinnacle strategies were managed to less than 40% of benchmark volatility on a relative basis during the 2007 – 2009 bear market, there were several periods where volatility exceeded the risks in our IPS statement on an absolute basis, because the volatility of the benchmark itself was unprecedented.
Clients should also consider the return side of the IPS agreement. The return targets in the IPS are also based on the red and gray chart five asset-class portfolios. The charts present the hypothetical returns for a portfolio assuming that an investor bought and held the portfolio and rebalanced to the strategy’s fixed asset allocation each month. Returns are shown both before and after inflation for the entire period. The return targets in our IPS are stated in a similar fashion — as a “premium” over inflation. So for example, if the DMG strategy targets inflation +5%, clients should anticipate that their long-term portfolio return should be the compounded total return of inflation plus the 5% return premium over their financial planning time horizon.
The target IPS returns for Pinnacle strategies are as follows:
Notably, the IPS states that this return target is to be achieved over a complete market cycle, but as we shall see, clients are probably best served by considering this target return goal over a much longer period… perhaps several market cycles or several inflation regimes.
The Problem with Return Targets
Before we look at actual DMG returns versus the IPS target, we should mention the flaws inherent in any approach that targets returns in excess of inflation. Note that the moving piece in the puzzle is the actual inflation data for any period being examined. For many years now Pinnacle financial planners have generally been using 3% inflation as a long-term base case assumption, so our financial plans that assume that investors are in the DMG model use 8% (3% inflation + 5% return premium) as the forecast for investment returns. In many cases the 8% figure is used for the return target for the aggregate of the total client investment assets, including investment assets not managed by Pinnacle. The problem is that when inflation moves higher, the return target does as well. For example, if inflation was 7% for the next ten years the target for portfolio returns would be 12% annualized (7% inflation + 5% return premium.) Unfortunately, there’s a high probability that such an inflation rate would actually produce lower, not higher, stock market returns. So in a high inflation world, the return target is “running away” from us faster than the equity markets would allow us to catch it.
Interestingly, the problem is reversed in a negative inflation environment. If inflation were to actually turn negative, a condition associated with a severe recession, it’s a near certainty that the stock market would experience severe losses.
(Note: In a negative inflation world, investors could typically count on very high bond market returns. However, in today’s extremely low interest rate environment, it isn’t clear that a prolonged period of negative inflation would drive significantly higher bond market returns over a long period of time.)
So in a negative inflation scenario what happens to our return target? If inflation is -4%, (a true economic catastrophe associated with a gigantic bear market in stocks), the return target would be a positive +1% (-4% deflation + 5% return premium.) It’s highly unlikely that actual Pinnacle portfolio returns would be positive in a catastrophic bear market. Similar to a high inflation scenario, in a negative inflation scenario the return target in the IPS would also be unattainable for the period. The only way to practically evaluate the return target in the IPS is to do so over long periods that incorporate the entire inflation cycle, which as stated earlier, could be periods as long as several decades.
It is useful to study the different inflation regimes we’ve experienced since the inception of Pinnacle’s tactical portfolio model performance. The annual inflation data that drive our IPS return targets are presented below. Not surprisingly the low annual inflation data for the past five years corresponds to low annual growth rates in the U.S. economy for the period. However, investors will be interested that inflation has only been 0.58% lower than our 3% inflation assumption since inception.
|TIME PERIOD||ANNUALIZED INFLATION|
All of which brings us to our actual Pinnacle portfolio returns versus the IPS return target. In this case we use our most popular model — our Dynamic Moderate Growth (DMG) strategy — as an example. The chart below shows the inflation target broken down by the inflation target, the return premium, and the compounded return on both as an area chart. The return of the Pinnacle DMG portfolio is shown as a solid line. We present the return versus the IPS target from inception, and then show five-year, three-year, one-year, and year-to-date results of the comparison*. It is interesting to note that even though Pinnacle clients correctly perceive 2002 to present as a very difficult period to generate absolute returns, in fact, the comparison to our IPS return target is remarkably close. For the period, the actual annual inflation rate was 2.42% so the IPS annual return target was 7.42% (2.42% inflation + the 5% return premium.) The DMG portfolio performance net of fees and expenses for the period was 7.03%, an annual shortfall of only 0.39%.
Looking at shorter time frames reveals different but highly intuitive results. Comparing actual portfolio returns to the IPS target over the past five years, which includes the 2007 – 2009 bear market, shows the portfolio to be trailing the target. For the past three years, which does not include the bear market, the portfolio handily beats the IPS target. The trailing twelve-month comparison shows us trailing the IPS target for the period, but for the year-to-date period Pinnacle portfolios are ahead of the IPS target.
(Click to enlarge)
Pinnacle Investment Policy Statements include assumptions about long-term returns that are expressed in terms of inflation premiums. When evaluated over the longest available time period, from portfolio inception, Pinnacle managed accounts have performed surprisingly well relative to the IPS return target. The IPS target return will be impacted by the inflation rate in the future, where either very high or very low inflation will make the IPS return target difficult to achieve for specific time periods. Clients should evaluate returns versus their IPS over long time-periods that include both high and low inflation regimes, and more than one market cycle. For this reason, virtually all Pinnacle performance benchmarks are market-based, and not IPS based, and allow our clients to properly assess portfolio performance relative to how financial markets are performing during the period.
Copyright: kml / 123RF Stock Photo