In the parade of Greek letters that are used to describe modern portfolio theory statistics, the most well known is beta. When William Sharp published his Nobel Prize winning Capital Asset Pricing Model (CAPM) in the 1960’s, he posited that there are two kinds of risk. One is systematic risk, or market risk which can’t be diversified away by investors. The measure of systematic risk, or non-diversifiable risk, is beta. Beta is used to measure the volatility of a managed portfolio versus the volatility of the stock market. The second well know MPT stat is alpha. Alpha measures whether risk-adjusted portfolio returns are better than you would have predicted using the CAPM model. To earn positive portfolio alpha has been the holy grail of investment managers for 40 years.
The poor sister of this collection of Greek letters and MPT science is the notion of R-Squared. R-Squared measures the strength of the relationship between the movement of the stock market and the movement of the portfolio. The higher the R-squared the more the market tells us about the likely direction of portfolio performance. Pinnacle portfolios have a high R-Squared meaning that a high percentage of the direction of our portfolio returns can be explained by the direction of the broad market returns. Having a low R-Squared is a prized commodity in bear markets where investors want portfolio performance to have a low relationship to the stock market (i.e. they don’t want their portfolio going down when the market is going down). Usually these low R-Squared investments are hedge funds, real estate funds, private equity, and market timing portfolios and they are invested in the “alternative investment” allocation of a managed portfolio. These positions are meant to “hedge” the core holdings of stocks that have a high R-Squared. At Pinnacle we call these low R-Squared strategies either hedge fund strategies or “eclectic managers.”
Pinnacle managed accounts are meant to be “core” portfolios. Our tactical strategy is meant to be implemented for the majority of our client’s invested capital. We are not offering the possibility that our portfolios will achieve investment gains in bear markets. Our version of risk management is simply to minimize losses in bear markets so that we can legitimately earn back those losses in bull markets. We do not consider our management style to be “an interesting diversification” for someone’s managed account. We provide active management as an alternative to buy and hold investing for our client’s core portfolio holdings. Our philosophy is to manage wealth somewhere between buy and hold and low R-Squared strategies. As I often say, Pinnacle clients are likely to be frustrated in bull markets when returns are compared to stocks, and bear markets when they are compared to cash. This means that clients are always likely to be frustrated with our relative returns. But over time, we will generate enough excess returns over buying and holding that our client’s are comfortable allowing us to manage the majority of their investable assets.
