In this year’s Inside the Investment Committee presentation, I explained how consumers of investment management can view the performance of their money manager relative to a performance benchmark. If the benchmark is located on a graph where the vertical axis is return and the horizontal axis measures risk, then the portfolio return can fall into four quadrants relative to the benchmark. If the portfolio is either in the Southwest Quadrant or the Northeast Quadrant relative to the benchmark risk and return, meaning that the manager took less risk to earn lower returns (Southwest Quadrant) or the manager took more risk to earn higher returns (Northeast Quadrant), I label those returns “Intuitive.” This is so because it doesn’t take great skill to simply add cash to a managed account that owns benchmark securities to earn lower returns with less than benchmark risk, and it also takes little skill to borrow money and buy more of the benchmark securities to earn higher returns with greater than benchmark risk.
I label the Northwest Quadrant of relative performance the “Pleasant Fantasy” quadrant because it is completely unintuitive that a money manager should be able to consistently earn higher than benchmark returns while taking less risk than the benchmark portfolio. Clearly higher returns should be associated with higher risk.
[I can’t help but mention here that Pinnacle Moderate, Appreciation, and Ultra Appreciation strategies have each achieved Northwest Quadrant performance since inception.]
The quadrant I’m interested in today is the Southeast Quadrant of returns, which I’ve labeled the “Career Risk” quadrant of relative performance. I believe that money managers who consistently deliver less than benchmark returns and at the same time take more risk than the benchmark are themselves at risk that their clients might terminate their employment. This is not to say that there aren’t periods of time when a properly-managed portfolio might land squarely in the “more risk, lower return” relative return quadrant.
There are two circumstances I can think of to get there: First, when a manager has been correctly bullish about whatever market he or she invests in and has earned excess returns with more risk than the benchmark, thus landing in the entirely intuitive Northeast relative-return quadrant of taking more risk and earning higher returns. By the end of the bull market, the manager is overweight risk in his or her portfolio. However, if the manager does not recognize that the bull market is over and is late in removing his or her overweight to risk, then the portfolio will fall into the Southeast Quadrant. As long as risk assets are falling in value and the portfolio is overweight risk, then the short-term portfolio performance will trail the benchmark. In this situation the consumer is comforted by the fact that the manager was correctly bullish during the prior bull market, so the relative underperformance will be weighed against the amount of outperformance in the previous cycle.
This case isn’t relevant to Pinnacle clients since we have generally been either defensively or neutrally positioned relative to our benchmarks since the market bot
tomed in March of 2009. (We have written at length about how our view of systemic risk has made it difficult to be bullish over the past three years.) In fact, we have been willing to give up relative returns in exchange for taking significantly less risk than our benchmarks as we have struggled to decipher the meaning of unprecedented government and central bank intervention in financial markets.
The second circumstance that will land one in the Southeast Quadrant of relative performance is when a money manager has been neutral or bearish during a bull market, and decides to add risk to the portfolio during a market correction in anticipation of a continuing bull market. Even though this exercise in dollar-cost-averaging into declining markets will be applauded by value investors as additional risk assets are acquired at cheaper prices, in fact the portfolio performance may very well underperform the benchmark if the buying is taking place before the risk-markets make an absolute bottom in price. From the point in time when the manager begins to overweight risk in anticipation of rising prices until the market actually finds its lowest price, the portfolio will exhibit higher risk and lower returns than the benchmark on a relative basis.
Pinnacle’s investment team views the current market correction as… well… a correction, and not a bear market. If current market turbulence indeed is a correction, then we’ll employ a strategy of gradually adding risk assets to our managed accounts as they fall in value. At the moment, our strategy is working out very nicely. Every day risk markets close at lower prices, Pinnacle analysts are competing with each other to determine who has the best investment ideas. One of the most important considerations is which risk assets are performing the worst! As I write the list is starting to look pretty full, with gold and commodities leading the charge lower, and a number of U.S. equity sectors starting to sell-off in a way that only a value investor could love. If good value investing requires buying when prices are low, then it looks like we’re being presented with a wonderful opportunity.
However, we can’t know in advance just how low the risk markets will fall. As we continue to be buyers on declining prices, at some point, our relative performance will begin to trail our benchmarks on down days. This is a circumstance that Pinnacle clients haven’t experienced in close to ten years. If we’re correct in our assessment of the global economy, the market cycle, the valuation of risk assets, and the behavior of market participants, then our overweight position in risk assets shouldn’t be too early, meaning that we shouldn’t be living in the Southeast relative performance quadrant for more than a quarter or two (and hopefully not at all.) Unless we change our view, then the more prices fall the higher our exposure to risk assets is likely to be and the more volatile our portfolios will become. Of course, we’re constrained by portfolio policy in terms of how volatile each portfolio strategy is allowed to become.
This state of affairs will present an interesting challenge to Pinnacle clients. We know from long experience that market timing is an imprecise state of affairs. It’s highly unlikely that we will go overweight risk at precisely the right moment to catch a market bottom. (Full Disclosure: The last time Pinnacle purposely took a bullish position in risk assets was in October of 2002, very close to the beginning of a five-year bull market. The good news is that particular forecast was extremely accurate. The bad news is that we may have raised the bar on client expectations on our ability to perfectly time market bottoms.) If we are early in adding risk, and the markets continue to fall, Pinnacle client’s will have to evaluate whether we are appropriately managing risk as we try to earn excess returns when and if the bull market continues. Having labeled the Southeast Quadrant the “Career Risk” quadrant of relative performance, let me express my sincere hope that our clients have a longer time horizon than the few quarters it may take for our economic and market view to pan out.
In terms of the tactics we will use to add risk in such volatile markets, Sean Dillon recently penned an interesting post called “Our ‘Ratchet Strategy.’” We are trying to be patient and give the market every opportunity to fall further before we continue to add risk. At the moment we are just a hair shy of being at our neutral or benchmark risk allocations. The bulls on the investment team are beginning to snort. As prices continue to move lower, the opportunities for us to profit on higher prices in the near future are looking more appealing.
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