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Playing Defense With A Chance To Score

Recent historic declines in global markets begs the age old question of how to effectively manage risk/return exposure. Playing defense while still having upside exposure is key. Defined outcome strategies can provide the comfort and relative safety that financial professionals and their clients increasingly seek. The investing world got a rude awakening over the last several trading days. In response to the historic decline, investors will be subjected to a wide range of advice ranging from the banal to the brilliant, but most of it will overlook the simplest solution – choosing the right investment instruments at this juncture can enable investors to pass through difficult times with minimal damage to their wallet or their mind. Most investors have pressure to generate returns while simultaneously avoiding disasters. The problem is that without a crystal ball, the only way to generate returns is by taking on risk. There is simply no way around this. “High return, low risk” products brings out the skeptic in me – trust me, there is risk somewhere within the package that is applicable to the return. If the risk is not well understood or seems too good to be true it may be best to simply stay away. This begs the question: what is the best way to play defense while staying in the mix for gains? In a State Street survey of 420 institutional decision makers , a primary conclusion is that many participants are not protecting their portfolios enough against potential market downturns. Furthermore, when participants do seek out protection strategies, the study finds that they are not exploring the full range of downside protection strategies available to them. One interesting statistic from the study is that a majority of respondents are using dynamic asset allocation, which essentially relies on the strategy getting out of the way at the right moment (perhaps a crystal ball would be helpful here). Another interesting statistic is that approximately 25% of those polled had used hedge funds at some point but no longer do so, which sends a message that the CALPERS decision not to invest in hedge funds going forward may be a trend rather than an anomaly. In recent discussions on these topics, I have heard several advisors propose the use of alternatives to generate returns while protecting portfolios from a crash. A strategy a couple of advisors focused on is Managed Futures due to their low correlation with the market. However, at the same time, there was concern over historically inconsistent performance – so while the odds are high an investor would see increased diversification from them, there is less confidence in generating consistent returns. The quandary for investors becomes how to balance many competing factors. For instance, how should one balance the beneficial low correlation of Managed Futures with inconsistent and ultimately unpredictable performance? Additionally, identifying the right active Managed Future fund – i.e. a manager and approach you trust, is crucial. It seems like a lot of decisions need to be made just right (e.g. right manager, right strategy, right time) to have a shot at an effective solution. Along the same lines, State Street also expresses concerns over too much reliance on investing forecasting skills, particularly when it comes to tactical asset allocation. Defined outcome investing offers a simplified method to participate in equity markets while effectively playing defense. Perhaps I am jaded from 20 years in the industry but one simply cannot get reward without commensurate risk. Defined outcomes clearly define this balance upfront. For instance, our index based strategy looks to limit downside exposure on the S&P 500 to 12.5% on an annual basis. This comes at a cost. We cap the upside at around 15% annually, a healthy return, to pay for the limited exposure down. Thus, the risk/reward equation is clearly spelled out. If the market drops materially like in 2008, you are spared the heartache, taking a minimal relative loss and nicely outperforming. If the market moves up strongly like in 2013, you will underperform but still generate a respectable mid-teen return. It is clear, consistent and provides investors the clarity they deserve. With an increasing abundance of market uncertainty, we believe that defined outcome strategies can provide the comfort and relative safety that financial professionals and their clients increasingly seek. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

When To Deploy Capital

One of my clients asked me what I think is a hard question: When should I deploy capital? I’ll try to answer that here. There are three main things to consider in using cash to buy or sell assets: What is your time horizon? When will you likely need the money for spending purposes? How promising is the asset in question? What do you think it might return versus alternatives, including holding cash? How safe is the asset in question? Will it survive to the end of your time horizon under almost all circumstances, and at least preserve value while you wait? Other questions like “Should I dollar cost average, or invest the lump?” are lesser questions, because what will make the most difference in ultimate returns comes from the above three questions. Putting it another way, the results of dollar cost averaging depend on returns after you put in the last dollar of the lump, as does investing the lump sum all at once. Thinking about price momentum and mean reversion are also lesser matters, because if your time horizon is a long one, the initial results will have a modest effect on the ultimate results. Now, if you care about price momentum, you may as well ignore the rest of the piece and start trading in and out with the waves of the market – assuming you can do it. If you care about mean reversion, you can wait in cash until we get “the mother of all sell-offs” and then invest. That has its problems as well: What’s a big enough sell-off? There are a lot of bears waiting for rock-bottom valuations, but the promised bargain valuations don’t materialize, because others invest at higher prices than you would, and the prices never get as low as you would like. Ask John Hussman . Investing has to be done on a “good enough” basis. The optimal return in hindsight is never achieved. Thus, at least for value investors like me, we focus on what we can figure out: How long can I set aside this capital? Is this a promising investment at a relatively attractive price? Do I have a margin of safety buying this? Those are the same questions as the first three, just phrased differently. Now, I’m not saying that there is never a time to sit on cash, but decisions like that are typically limited to times where valuations are utterly nuts, like 1964-65, 1968, 1972, 1999-2000 – basically, parts of the go-go years and the dot-com bubble. Those situations don’t last more than a decade, and are typically much shorter. Beyond that, if you have the capital to spare, and the opportunity is safe and cheap, then deploy the capital. You’ll never get it perfect. The price may fall after you buy. Those are the breaks. If that really bothers you, then maybe do half of what you would ultimately do, but set a time limit for investment of the other half. Remember, the opposite can happen, and the price could run away from you. A better idea might show up later. If there is enough liquidity, trade into the new idea. Since perfection is not achievable, if you have something good enough, I recommend that you execute and deploy the capital. Over the long haul, given relative peace, the advantage belongs to the one who is invested. If you still wonder about this question you can read the following two articles: In the end, there is no perfect answer, so if the situation is good enough, give it your best shot. Disclosure: None.

Smart Beta, Dumb Money And EMH

Someone asked me about Smart Beta in the forum the other day and I got to thinking about this. Indexers are all basically chasing some form of beta. But some indexers chase beta in stupid ways and some indexers chase beta in smart ways. An increasingly common example of this is the many forms of factor investing that have become popular in recent years (in case you haven’t noticed, I don’t like factor investing – see here and here ). I am generalizing, but I tend to believe that factor investing is just a new clever way to get people to pay higher fees for owning index funds. Now, this particular reader asked about the profit factor so I went exploring. It turns out that there are more than a few ETFs that track this profit factor. The largest one is the WisdomTree MidCap Earnings ETF ( EZM), which has 770 million in assets and “seeks to track the investment results of earnings-generating mid-cap companies in the U.S. equity market.” So, I go and compare this fund to the Russell Mid-Cap Index. It actually appears to be beating the index since inception, but it has a 99% correlation. Something doesn’t smell right about that. So, I look under the hood and find that it actually deviates from the Mid-Cap Index quite a bit. While the Mid-Cap Index has an average market cap of 10.5B this fund has a market cap of just 4.2B. Ah, so there’s the outperformance. It’s not profits, it’s just higher risk smaller cap stocks. And if you layer on the Russell 2,000 Small Cap Index, whose market cap is 1.5B, you get a near perfect replica of EZM. This is precisely what I expected given that I’ve run some version of this experiment almost every day for the last few years when assessing people’s portfolios. The kicker is, this fund isn’t “smart” at all. The only thing that’s smart about it is that it deviates from the Russell Mid-Cap Index giving it the appearance of better performance. And so what we have here is a sort of sad case of dumb money chasing market inefficiency and proving that the only thing inefficient here is their factor chasing charade. And in doing so they’re paying 0.38% per year for a fund that costs as low as 0.07% elsewhere. That’s almost $2.5 million in annual fees being flushed down the drain there. And that’s just one fund out of a growing list of hundreds and maybe thousands. I’d laugh if it didn’t make me sad. Share this article with a colleague