Investment Portfolio Design for an Unpredictable World
Investors are always faced with choices. My experience tells me that these choices are often driven by simple quirks of human behavior. Two of these that seem to be big drivers seem to be recency bias and a desire for simplification. Both of these naturally make us poor investors.
For example, in March of 2020 in the throes of the COVID-19 pandemic we spoke with a number of investors who were thinking of just taking their whole equity portfolio flat. Today as we approach another all-time high that clearly would have been a bad time to sell. That same period, forced many people to ask a question they hadn’t asked for a long time, “Where do I go for safety when the market is dropping?” It should perhaps not be a surprise that many of those investments made in that time period have not performed as admirably since.
As alternative asset specialists, we look to periods of volatility to generate returns. Larger moves are simply easier to trade for directional traders and declining markets tend to offer more predictable behavior than rising markets. The S&P on the other hand tends to be mean reverting, the further down it goes the more we expect the recovery to be. This is especially true according to almost every financial advisor who tells you that buy and hold is the best strategy.
|Manager A||Manager B||Manager C|
Past performance is not indicative of future results
What if we compared three return streams over a longer period? The set of strategies shown above starts in 2003. Which one of the above would you choose? I can say from experience that none of my customers would choose Manager B. It had a 50% drawdown which would require a 100% gain to recover. Manager A has the lowest drawdown but Manager C wins in all the remaining categories. Which one would you choose?
You might be surprised to learn that everyone chooses Manager B. Not in this example of course, but in real life. Manager B is the S&P 500. We hear a lot of focus on the cost related to index funds and many ask, “Why you might pay someone a “high fee” to manage your money if the returns are similar?” Manager A is one such managed futures fund with a 30% incentive fee. Both programs end up in a similar place but take different paths to get there.
Let’s be honest though, most of us would choose Manager C. It is the highest return for the least amount of volatility. A “free lunch” so to speak. It is also a 50/50 split between Manager A and Manager B. But most investors don’t have managed futures in their portfolio because when compared to the S&P over the current bull run it does look less attractive. It also tends to make less money during good times which always stands out against the other assets in a portfolio making money as the market rises. We want things to be simple so we do a one to one comparison and choose accordingly. The 52% equity drawdown took over 5 years to recover.
If 2020 has taught us anything, it is that things rarely stay simple. When things get difficult again, which portfolio will you have? My suggestion would be to plan your all weather portfolio now. You never know when it will start raining again.
Manager C assumes an investment with the assets being divided equally between the S&P 500 Index and a single commodity trading advisor. The performance capsule is net of CTA and brokerage fees charged to the accounts under their respective management. It assumes that all profits, net of fees, were reinvested and that the returns were compounded monthly.
THIS COMPOSITE PERFORMANCE RECORD IS HYPOTHETICAL AND THESE TRADING ADVISORS HAVE NOT TRADED TOGETHER IN THE MANNER SHOWN IN THE COMPOSITE. HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY MULTI-ADVISOR MANAGED ACCOUNT OR POOL WILL OR IS LIKELY TO ACHIEVE A COMPOSITE PERFORMANCE RECORD SIMILAR TO THAT SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN A HYPOTHETICAL COMPOSITE PERFORMANCE RECORD AND THE ACTUAL RECORD SUBSEQUENTLY ACHIEVED.
ONE OF THE LIMITATIONS OF A HYPOTHETICAL COMPOSITE PERFORMANCE RECORD IS THAT DECISIONS RELATING TO THE SELECTION OF TRADING ADVISORS AND THE ALLOCATION OF ASSETS AMONG THOSE TRADING ADVISORS WERE MADE WITH THE BENEFIT OF HINDSIGHT BASED UPON THE HISTORICAL RATES OF RETURN OF THE SELECTED TRADING ADVISORS. THEREFORE, COMPOSITE PERFORMANCE RECORDS INVARIABLY SHOW POSITIVE RATES OF RETURN. ANOTHER INHERENT LIMITATION ON THESE RESULTS IS THAT THE ALLOCATION DECISIONS REFLECTED IN THE PERFORMANCE RECORD WERE NOT MADE UNDER ACTUAL MARKET CONDITIONS AND, THEREFORE, CANNOT COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FURTHERMORE, THE COMPOSITE PERFORMANCE RECORD MAY BE DISTORTED BECAUSE THE ALLOCATION OF ASSETS CHANGES FROM TIME TO TIME AND THESE ADJUSTMENTS ARE NOT REFLECTED IN THE COMPOSITE.