Abstract

• Volatility has increased dramatically and is expected to continue.
• Volatility is an extraordinary drag on returns due to the disproportionate impact of losses versus gains.
• Volatility indicates downside protection be a critical component of portfolio construction.
• Traditional asset allocations are flawed 5 ways.
• Style-pure funds are inflexible with extreme exposure to systematic risk and no escape hatch.
•  Flexible funds, by design, can go defensive or opportunistic resulting in better odds for attractive capture ratios.
• 5 flexible funds, as a total core solution, is a practical, tactical replacement for traditional allocations.
• With flexible fund portfolios, advisors can potentially
• Improve investment returns.
• Enhance the positioning of their practice.

 

Traditional Asset Allocation

 

A portfolio like the pie chart below has been the standard for decades but the poor market performance during years 2000-2009 was exacerbated by flaws in traditional asset allocation.

 

 

 

Some advisors will strictly adhere to the allocations regardless of market conditions, while others will overlay their own tactical repositioning of the mutual funds. 

 

Only a special few advisors can “pull it off” (tactical repositioning). 

Most advisors should outsource this critical task.

 

 

Modernizing Modern Portfolio Theory

 

Q: Why modernize? 

A: 5 flaws in traditional asset allocation that can compromise performance, especially in volatile markets.

 

Flaw #1 “Winners will offset losers.” (a basic premise of MPT and traditional asset allocation.)

 

Traditional logic:  “Investing in several asset classes provides diversification and the mix of correlations will result in winners offsetting losers for better returns with lower risk.”

 

Practical logic:  “Investing in several asset classes provides diversification but since their correlation is inconsistent, tactical, flexible allocations, based on foreseeable market conditions, can result in attractive capture ratios, better returns, and lower risk.

 

The infamous downturn, October 2007-February 2009, was very damaging to traditionally allocated portfolios, because there was a correlation crisis-virtually no asset class weathered the storm.  A compelling argument for flexible, unconstrained funds.

 

According to the chart below, asset class returns varied on average, 42% (best vs. worst) for 10+ years. 

 

Huge differences in rates of return among asset classes spell “opportunity” for a flexible fund manager-another compelling argument for flexible investing.

 

                    Strict adherence to allocations turns a blind eye to foreseeable market conditions that could be screaming, “change!”  Flexible managers will:

• Reposition for opportunistic reasons.
• Reposition for defensive reasons.

Flaw #2 with traditional allocations, stocks dominate most recommended portfolios.

 

U.S. stocks represent a small percentage of global securities but normally dominate recommended portfolios.

Risk/return data in the chart below do NOT support that stocks dominate recommended allocations, as has been the standard.

 

FIVE YEAR RISK/RETURN DATA

 

 

 

Flaw #3 over weights bonds.

 

Including bonds in a portfolio has enhanced the safety and predictability of traditional portfolios. However, bond-interest is historically low and their market value is in jeopardy if interest rates rise.  Interest rates are currently near rock-bottom.

 

Most recommended allocations include a significant allocation to bonds and that should not be so automatic with rates so low.

 

Many flexible funds have no bias toward bonds.

 

Flaw #4. Under weights alternatives.

 

 

 

Classic Portfolio

These alternatives have performed as either growth investments or safe havens, depending on when.

Traditional portfolios are normally constructed with "style-pure" funds, which normally don't invest in alternative asset classes.

• Their prospectus may disallow it.
• Their main objective is to achieve a good risk/return record within their style/category.

Flexible fund managers will invest in any or all of these alternatives in the amounts they deem prudent.

 

Flaw #5 “Style pure” funds are inflexible.

 

Of the approximate 8,000 mutual funds, most are style pure.

By prospectus, their mandate is normally constrained.

 

Consider the dilemma of a manager of a foreign stock fund during the 2007-2009 downturn.  His prospectus prevented him from investing in other asset-classes or moving largely to cash.  He could only hope to lose less than peer funds and look good on a relative basis. Inflexibility can compromise performance.  As a category, Foreign Stock funds lost approximately 60% during the infamous downturn (Q4, 2007 – Q1, 2009).

 

 

In contrast, the Ivy Asset Strategy Fund, categorized Flexible, by Morningstar, invests in Foreign Stocks, too, along with many other asset classes. However, their allocations are very flexible.

 

 

Current and foreseeable market conditions can offer clues for practical, tactical portfolio management, especially for a proven flexible fund manager.

 

Flexible funds

 

They have recently been discovered, as total portfolio solutions.  

 

 

         Flexible Funds may be described as:

Go anywhere	Unconstrained	Dynamic
Tactical	Global	Hybrid

 

Flexible funds can invest in any or all of these and more:

U. S. Stocks	Foreign Stocks
Corporate Bonds	Gov’t Bonds
Foreign Bonds	Convertibles
Preferred Stocks	REIT’s
Junk Bonds	Gold
Currencies	Cash
Shorts	Natural Resources
Private Stock	Other Alternatives

 

 Risk/Return Data-- (the proof is in the pudding.)

 

• The 37% decline of the S&P 500 in 2008 resulted in a +58% breakeven requirement.
• Comparatively, a 29% decline* resulted in a +41% breakeven requirement.
• 800 bps of worse decline resulted in 1700 bps stiffer breakeven requirement.
• Downside capture ratios are critical in volatile markets.

 *Morningstar category-World Allocation funds

 

The following charts highlight the efficacy of flexible funds over 3, 5 and 10 years.

 

The capture ratios of flexible funds, (good upside/great downside) are fundamental to their overperformance in volatile markets.

 

Q:  How can advisors take full advantage of flexible funds?

A:  flex 5, a portfolio with a core that includes five flexible funds.

 

Why 5?

• Provides diversification of holdings and styles.
• Build conservative, moderate, growth or tax-efficient portfolios.
• All 5 need not be flexible if objective better served otherwise.
• Mitigate manager risk without over-diluting manager impact.
• Manageable number for advisors.
• Meaningful number for clients.
• Flex core can be 60-100%, allowing room for satellite investments.

 

Which 5?

Flex portfolios should include an appropriate mix of funds for a given client, after carefully profiling the client and considering:

• Performance and risk data.
• Overlap of classes, sectors, countries.
• Style/methodology/approach
• Quantitative versus Subjective
• Special risk controls
• Proven versus promising managers
• Other factors

An advisor, who offers timely, tactical portfolio management, is challenged to:

• Do extensive and frequent research.
• Follow a protocol for repositioning portfolios of multiple risk profiles (aggressive, moderate, conservative).
• Execute trades on a timely and multi-account basis.
• Monitor fund performance frequently.
• Reposition portfolios, as needed.
• Rebalance portfolios.
• Conduct portfolio reviews with clients.

With the challenges of extraordinary volatility, the role of the advisor is evolving.

When advisors outsource the tactical decisions, their role evolves to that of talent scout.

It’s a practice management solution.

 

 

Mr. Stattman manages the global, flexible fund, Blackrock Global Allocation, arguably, the icon fund of that category.

 

What does Mr. Stattman have that most advisors don’t?

To mention a few…

• Bona fide record of performance
• Experience as a full-time portfolio manager
• Global recognition, including prestigious awards for portfolio management
• Extensive staff of researchers
• Access to key people
• Systems for timely/efficient trading

 

By investing in Stattman’s fund, (or any proven flexible fund) advisors are essentially hiring top talent on behalf of their clients. It’s a practice management solution.

  

 The following illustration summarizes fund characteristics between classic (style-pure) funds and flexible funds. 

 

• The nineties conditioned investors to trust MPT.
• The “lost” decade put the spotlight on the inherent flaws of MPT and traditional portfolios…
• …as well as the efficacy of flexible mutual funds
• Today’s extraordinary volatility indicates extraordinary portfolio construction and management.
• Flex 5 takes full advantage of flexible funds as total portfolio solutions.

 

 

(c) PGA Financial

www.pgafw.com