Sequencing

Lately I’ve been reading a lot about sequencing. The term is used in reference to how the Federal Reserve might go about communicating and then changing current monetary policy. The sequencing might go something like this: 1) The Fed ends quantitative easing as scheduled by the end of June but announces that it will continue to reinvest maturing bonds in U.S. Treasury securities, thereby keeping its balance sheet from shrinking, 2) Two months later the Fed announces that it will no longer reinvest bond proceeds and allow its balance sheet to gradually shrink, 3) Two months later the Fed changes the language in its monthly statement so that it no longer implies short-term interest rates won’t change in the foreseeable future, and 4) Sometime in the first quarter of 2012 the Fed raises short-term interest rates for the first of many increases to occur during the year. Of course, no one really knows if this sequence is correct and we suspect that the Fed, like everyone else, will react to economic data as it develops.

We have been having our own discussions about sequencing in the investment team over the past few weeks. Recent events have us pondering the possibility that the economy will slow to the point that it will impact risk markets. The signs are there if you care to see them. They include the commodities market imploding last week, bonds rallying, QE2 inexorably ending in June and market participants wondering if the risk markets are beginning to price this into current prices, the Arab “spring” beginning to look a little “chilly,” the dollar showing signs of rallying, unemployment claims spiking up again recently, and leading economic indicators showing signs of slowing. All of the above may be nothing more than the “wall of worry” that bull markets always climb. After all, earnings continue to come roaring in and this quarter looks like another slam dunk for corporate America. But still…we’ve been thinking about how we might take risk off if necessary.

The sequencing might go something like this. First we are selling our Germany ETF in DA and DUA portfolios and preparing to sell our commodity futures position in all portfolios as soon as this week. Next we rotate to more defensive industries within our cyclical sectors like Energy, Tech, Consumer Discretionary, etc. Next we rotate from cyclicals to defensive sectors like Health Care, Staples, and Utilities. Finally we rotate from defensive equity sectors to cash. A similar sequencing will occur in the fixed income allocations of our portfolios but we haven’t really focused on those discussions just yet. Sequencing seems to be the name of the game of late.

Guest Lecturing at Hofstra University

I have been invited to speak to the finance students at the Zarb School of Business at Hofstra University. The engagement is sponsored by GARP, the Global Association of Risk Managers. I’m very grateful to the Pinnacle client who asked me if I would be interested in speaking as well as Ahmet Karagozoglu, Ph.D., and Associate Professor at the School of Finance, who actually extended the formal invitation to speak to his class. This isn’t the first time I’ve been asked to guest lecture to finance students at the MBA level. Professors Russ Wermers and Sarah Kroncke were kind enough to have me speak to their finance students last year at the Smith School of Business at the University of Maryland. Then as now, I am eager to discuss portfolio construction with such fine young students whose knowledge of the financial markets is for the most part shaped by the text books they have read, whatever “color” their excellent professors have added to the story, and I presume whatever experience they have trading their personal on-line accounts. For the record, Professor Kroncke’s students at Maryland actually get to manage real money in the Mayer and Senbet Funds set up by the University Endowment.

While my topic for the lecture is “Managing Portfolio Risk in Natural Disasters, A Playbook for Black Swan Events,” it seems to me that the additional message that I want to share with these students includes an overview of the basic structure of institutional portfolios and how that is likely to impact their future employment. While we manage close to $1 billion in assets nowadays at Pinnacle, the fact is that the assets belong to our individual clients in accounts that are custodied by third parties. The accounts are transparent and liquid. This structure defines what strategies we utilize to maximize returns and minimize risk for our clients. Many of the Hofstra students that I will meet are likely to be employed by bank proprietary trading desks, hedge funds, mutual funds and private equity firms that don’t have similar constraints for portfolio construction. Risk management in these investment communities is based on a different set of rules about how to manage volatility. They will be working at firms that manage huge amounts of capital in pooled accounts that have long-term lockups that don’t allow investors to withdraw their capital for years, and that are completely opaque in the sense that clients can’t see the securities in the fund until the quarterly or annual report. Thus they will be afforded the opportunity to implement all kinds of strategies without the harsh spotlight of clients seeing every trade.

I think I might share the basic rules that we have learned about risk management at Pinnacle, including the potential pitfalls of quantitative investing. I am convinced that the tactical strategies we employ for our clients are so fundamentally sound that they are worth sharing, even if by Wall Street standards they might seem overly simplistic. Evaluating the business cycle, investor psychology, and intrinsic value to find value opportunities is critical to earning excess returns. Avoiding excess leverage, excess derivative usage, and large concentrated stock positions also is critical to avoiding true “Black Swan” events. It might not be sexy, but I’m looking forward to engaging the finance students at Hofstra in a discussion about how to invest in strategies that don’t blow up and have a high probability of creating long-term value for their clients. I can’t wait.

A Good Reminder

One of my favorite analysts is Dennis Gartman, the highly regarded Editor and Publisher of the daily Gartman Letter. Here is what he had to say in his Thursday, February 24th, letter regarding oil futures:

“At this point, all we can rationally say is that one can pick-a-number when it comes to prices. We shall believe almost anything at this point, and we say that with a sense of both urgency and calm; with a sense of confusion and rationality; with a sense of awe and respect. There is really little else that one can or should say. These are those interesting times we hear so much about.”

Last week we also heard from Chen Zhao, Managing Editor of BCA Research, who when discussing China and food prices felt obligated to remind us of the following:

“…what are these market moves telling us about underlying economic conditions? Those who have been around long enough know there is no “scientific way” to distill useful messages from market noise. Interpretation is all about perception, hunches and gut feeling.”

I must admit to being a little puzzled by all of this angst considering that the S&P 500 Index still hasn’t been able to muster a 5% top to bottom decline, even with the revolutionary change in Egypt and the near civil war in Libya. Nevertheless, when the experts are throwing up their hands in awe about current market conditions and reminding us that that there is no “scientific” way to discount the risks of current news, it is a good reminder that Pinnacle portfolios have several built in safe-guards to ensure that we don’t make a big investment mistake in volatile markets.

First, we run diversified portfolios that own several asset classes that often act as performance hedges to our base-case view of market events. Second, we don’t use leverage in our portfolios which significantly reduces portfolio volatility. Third, we trade incrementally based on our “weight of the evidence” approach to changes in the news…no big bets here. Fourth, we celebrate our use of perception, hunches and gut feelings, but we also honor rules-based quantitative approaches to decision making just in case our hunch is wrong. Finally, our investment time horizon is at least long enough to allow us to try and find more durable and long-term themes to invest when the daily news gets crazy and daily market volatility is frightening.

These safe-guards are all designed to help us add value to portfolios while defending against making win-lose portfolio decisions. It may not be sexy, but when events become unpredictable (think Libya here) it’s a good reminder that sound portfolio construction techniques can be very valuable.

Comments on the Md. State Retirement Pension Plan

I recently took a quick look at the Md. State Pension Plan year-end numbers. As a student of portfolio construction, here are a few comments. First, the numbers are presented in a way to suggest that the Plan utilizes a “tactical overlay” from its “target” or fixed asset allocation. Note that the targets for U.S. and international equity are equal and that the plan considers “global equity” a separate target in the plan. The total U.S. equity target is only 12.3% which is surprisingly low. But the current allocation to total equity is 51.2% of the plan which is a big bet on equities versus the target. My guess is that “credit/debt strategies” represent some kind of hedge-fund-like fixed income strategies, and combined with the fixed income allocation of 17.3% means 22.8% of the fund is fixed income oriented. Considering the fund only has 2% in cash and the total fixed income target is 25%, I would characterize this portfolio as a growth-oriented portfolio comparable to Pinnacle’s Dynamic Appreciation portfolio.

Of particular interest is the 37% target of the portfolio for alternative investments. The current 23.7% actual allocation sounds about right all things considered. Still, I can’t help but wonder if the 37% alternative target is expressing too much faith in Wall Street engineered financial products like hedge funds and private equity that promise better than market returns based on 1) a return premium due to their lack of liquidity, or 2) better management due to high fees. While the risk in the real estate allocation can be attributed to the asset class, the risk of the remaining alternatives can probably be attributed to the ability of the hedge fund managers to execute their strategies. Let’s hope the plan administrators don’t buy too much Wall Street BS about these strategies.

Pinnacle’s DA portfolio outperformed this portfolio for the trailing 3-yr and 5-yr period. To be fair, this looks like a typical institutional portfolio construction to me. Pinnacle assets under management: $870 million. State of Md. Pension assets: $35.9 billion.

Investing in the Neutral Zone

I remember the old Star Trek episodes that began with distress calls from some poor spaceship stuck in the Neutral Zone, a vast negotiated area of neutral space designed to separate the Federation of Planets (the good guys) from the Klingons or the Romulans (the bad guys). For the most part, things never went well for the good guys stuck in the Neutral Zone. Captain Kirk, Mr. Spock, and the rest of the Star Trek crew had to fight their way out of many cunningly devised traps set for them by the Klingons and the Romulans in order to get back to safety.

It seems to me that for the past 18 months Pinnacle has also been stuck in the Neutral Zone. For us, the neutral zone is investing diversified portfolios so that they have the same volatility as our investment benchmarks. On a practical level, “neutral” means we haven’t taken a long or short position in risk assets relative to the benchmark. When we are in the neutral zone our incremental approach to changing portfolio asset allocation becomes even more…well….incremental. Small changes in asset class weightings take up a disproportionate amount of time relative to the size of the trades. The timing of even the smallest transactions becomes of paramount concern in the Neutral Zone because the smallest amount of gain or loss due to timing concerns can make huge differences in relative, if not absolute, returns. The importance of investment selection is also magnified when we are neutral to our benchmarks for similar reasons. When our analysts do not make a large relative bet regarding portfolio risk, then all of the nuances of portfolio construction and management become magnified. When you are stuck in the Neutral Zone, owning cash at 0% interest is a major concern. Eclectic managers who underperform for relatively short time periods also become a major concern.

The two worst enemies in the Pinnacle neutral zone are 1) a loss of perspective as analysts become overly focused on incremental decisions, and 2) problems with correlations. Yes, once again I’m carrying on about how asset class correlation can play havoc with short-term portfolio risk and reward assumptions. In the neutral zone any and all of the alternative investments in the portfolio can betray you because by definition their performance can zig and zag differently from the benchmark asset classes at any time. If you are trying to beat a relative benchmark, I suggest you hope for an encounter with Klingons or Romulans, because if you are unfortunate enough to run into peak correlations in the Neutral Zone, your chances of survival are limited.

Buckets of Risk

A substantial part of my job is to try to explain Pinnacle’s investment process to folks who are interested in active and tactical management. Although I spend my days in the trenches with Pinnacle analysts trying to implement our strategy, it is no small challenge to try and simplify our process into an explanation that investors can understand. My latest attempt at explaining what we do around here is to ask investors to visualize several different “buckets of risk.” Let me explain.

In prior posts I’ve discussed Pinnacle’s investment process as a different kind of core holding where our portfolios meet the requirement of attempting to systematically deliver returns within a well defined range of risk or volatility. Traditionally, core holdings are strategic buy and hold portfolios because both advisors and clients can point to historical back-tested performance of asset classes in order to agree on rational parameters for risk and reward. Instead of buying and holding where we are constrained to own asset classes in fixed percentages, we instead are constrained by the historical risk and volatility of the buy and hold portfolio, but with no constraints in terms of what we actually own. Think of it this way…each Pinnacle investment strategy has its own separate “bucket” of risk that is a different sized bucket from the other Pinnacle strategies. We offer clients five different risk buckets to choose from: Dynamic Conservative, Dynamic Conservative Growth, Dynamic Moderate Growth, Dynamic Appreciation, and Dynamic Ultra Appreciation. As you might imagine, as you move from conservative to ultra appreciation each bucket is allowed to own more risk and volatility. This in turn implies higher future returns. How our clients actually choose which bucket is right for them is (hopefully) the result of working with our wealth managers in the financial planning process.

The cool part of this, the part that differentiates us from most other advisors, is that we are free to fill each risk bucket with whatever asset classes we want to own as long as we don’t overfill the bucket. To reiterate, we are not constrained to buy and hold a fixed mix of pre-defined asset classes for each bucket. Instead, our analysts are free to find value opportunities wherever changing market circumstances cause them to appear, and we are free to change them as our experience, judgment, informed intuition, and quantitative assessments may dictate. The risk bucket is defined by historical market returns, but the assets we own at any point in time are only limited by our best evaluation of what constitutes good value. We pledge to honor what we consider to be the two unbreakable rules of investing: 1) We will fill the risk buckets with a diversified portfolio of asset classes, and 2) We will try not to fill the bucket with overvalued assets. At the end of the day Pinnacle clients have different levels of interest in the details of how we fill their risk bucket, but in my experience they all are vested in the idea that we systematically manage risk…and that’s exactly what we do. To offer clients an actively managed core holding is an oxymoron in the investment business. Those that understand this will find great value in our investment process.

Don't "Over Think" It

During one of our investment team meetings last week, we made the point that it is often important to look for the “easy” trade. It reminds me a lot of watching youth soccer teams where the athletes try to thread a pass through several defenders in order to set up the Striker with a breathtaking play, when a simple pass towards the sidelines would advance the ball and create a situation that is ultimately harder to defend. In our case, I believe we were discussing dividend paying stocks in the context of market valuation, where the earnings yield of high quality S&P companies is more than twice the yield of US Treasury bonds. The “easy" trade would be to buy a high dividend ETF and hold it as long as the dividend growth is supported by the economic and earnings cycle.

Our discussion prompted some emails among team members trying to explain our current investment stance into a few short declarative sentences. And here is what Yours Truly had to say:

“The economy is very slow but the evidence is murky as to whether it is still slowing. The stock market is secularly expensive but on many measures it is now cyclically cheap. With the Fed and the President (but maybe not Congress) standing by to apply fiscal and monetary stimulus, there is real risk in getting too far out of the market. Considering that the portfolios are running very cool already with a beta for DMG at about .35, it would appear that no more selling is warranted, and that we should wait until we break the bottom of the range for any further changes.”

Like many other things in life, trying to simplify can be a good thing. We don’t want to “over think” this market. If we can find an easy trade to fit our theme it is definitely worth our strong consideration for inclusion in our managed accounts.