Jul 2017 by Joe Burns
Forward-thinking investors understand the benefits of rebalancing portfolios ahead of changing market conditions. It is intuitively obvious, and yet incredibly difficult. Just looking over the past 20 years, many investors were significantly overweight equities in 1999, and again in 2007, only to endure two massive drawdowns.
Forward-thinking investors understand the benefits of rebalancing portfolios ahead of changing market conditions. It is intuitively obvious, and yet incredibly difficult. Just looking over the past 20 years, many investors were significantly overweight equities in 1999, and again in 2007, only to endure two massive drawdowns. Few investors want to question why a certain strategy is so successful, much less question when a successful strategy will stop working. But there is a critically important distinction between trying to time the markets, and proactively rebalancing portfolios.
Modern history is peppered with funds and strategies that enjoyed immense popularity before ultimately letting investors down. With such focus on quantitative methods in today’s markets, investors may recall the story of Long-Term Capital Management. LTCM was a quantitatively managed fund that delivered phenomenal performance with apparently minimal risk, leading investors to allocate billions of dollars to the firm.
Then one day, the strategy stopped working. Looking back, investors should have known that any vehicle, be it quantitative or fundamental, active or passive that generates such robust performance year-after-year likely contains certain risks, with a potential for significant drawdown. Fast-forward to today, and it’s the passive, long-only, daily-liquid products luring investors into a sense of eternal success. Other strategies, including hedge funds, have taken a backseat due to their hedged nature and the performance difficulties of certain “high profile” funds. So why, then, might now be a smart time to add hedge funds?
The key for investors, as always, is to look forward. And while the recent past has been a great environment for long-only risk assets, certain investment strategies may provide several unique advantages for investors, including the potential for:
• Capital Preservation
• Return Enhancement
• Portfolio Diversification
Since the end of World War II, the S&P 500 Index has experienced ten distinct bear markets (defined as a peak-to-trough loss of at least -20%), with an average timeframe between periods of just over five years. Our current market rally has persisted now for 8+ years, making it the 2nd longest period without a -20% decline since the Great Depression, surpassed only by the bull market of the ‘90’s.1 The duration of this market rally combined with historically elevated equity valuations, record-level margin debt and increasing investor complacency strongly suggest that now is a good time to seek out strategies designed to protect capital in difficult markets. Investors should consider diversified, multi-strategy funds with a proven ability to protect capital in tough markets (e.g. ‘94, ‘98, ‘00-02, Sep/Oct. ‘08, Summer ‘11, Spring ‘14, Aug. ‘15, Q1’16), and evaluate how a firm’s risk management has evolved over the long-term.
As with capital protection, investors have not faced the need to seek out return enhancement strategies recently, with the S&P generating an annualized return of over 17% since March 2009 compared to its historical rate of return of approximately 9.5%.2 At the same time, the risk-free rate (as measured by the 3-month U.S. T-Bill rate) has hovered around 1.5% since the onset of the Central Bank interventionist policies, compared with a long-term average closer to 3.5%.3 This has resulted in an expansion of the equity risk premium from roughly 6% to 16%, providing significant tailwind to long-only equity exposure.
However, few would argue that these benign market conditions will persist indefinitely. Looking forward, investors should consider not only how to protect their downside but also how to enhance their returns. A focus on strategies designed to capitalize on idiosyncratic situations and rapidly changing opportunities should prove useful in falling markets. The dynamic nature of many hedge funds provides investors with a potential enhancement in returns, given their ability to deploy capital in different markets at different points of an economic cycle. This is especially true of smaller managers that can be more nimble in their investment approach, and specialist funds with the skill set needed to navigate less efficient markets.
A third portfolio management axiom that has diminished in importance over the past few years has been diversification. Diversification only works when the correlation of securities within and across markets is not structurally elevated.
Encouragingly, we have started to see a decrease in cross-asset correlation over the past few months, coinciding with capital flows and monetary policies finally starting to diverge across the globe.4 We fully expect that increased exposure to strategies designed to balance the risk/return profile of multi-asset class portfolios will only increase in value going forward. At this point in the market cycle, investors should seek out non-traditional trading strategies that are structurally uncorrelated to equity and fixed income markets.
As investors, we are often on the lookout for things that will one day "look obvious in hindsight." Though it would be nice if the markets continue to appreciate 10-15-20% every year, at some point the music will stop, as it always does. Preparing for that market shift is key, and this is an opportune time for investors and their advisors to consider strategies that will help protect client wealth, can enhance client returns and diversify client portfolios. And while that is itself a challenge, investors who allow themselves to think differently may very well find themselves ahead of the pack.
(2) http://dqydj.com/sp-500-return-calculator/ , as of April 2017. Historical return from January 1929.
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