Finding Appropriate Investment Strategies for Client Portfolios

Posted on: 08/21/2014

By Chuck Self – CIO/COO, iSectors® LLC

Finding Appropriate Investment Strategies for Your Client PortfoliosFinancial advisors (FAs) utilizing outsourced investment management processes face a significant number of choices.  Recently, there were 675 exchange-traded fund (ETF) investment strategists in Morningstar’s database.  How does one narrow the list of choices for further investigation effectively?

Unfortunately, many advisors choose only among the top performing advisors over the past year or quarter.  Even if three or five-year numbers are utilized, will the resultant list represent strategists likely to provide acceptable return patterns over the next five or ten years?  Remember, at this point in time, five-year numbers do not include the market crash that ended in March 2009.  You need to feel comfortable that the strategy chosen will weather any market storm.

Since there are plenty of high quality strategies from which to choose, we recommend going on the Morningstar’s comprehensive database and weed out options that are unproven or potentially hazardous to your clients’ portfolios.  By applying these three steps, a list of good candidates to investigate further can be compiled.

First, has the strategy accumulated a live track record through a complete market cycle?  Although we may focus on the down 23% 2008 fourth quarter, the actual month-end peak in the S&P 500 before the crash was on October 2007.  Therefore, unless the strategy has a live track record from at least October 2007, it is an unproven investment vehicle.  By clicking on the “More Data” button on Morningstar’s page you can see a strategy’s start date in the second to last column.

I emphasize live track records because those who do not have them always seem to have backtests that show methodology outperforming during 2007 to 2009 (and beyond).  Obviously, if the model or process did not work in that timeframe, it would not be published.  You can probably guess that there are firms out there run scores of backtests, identify the strategies with the most attractive results and build products around these strategies.  Don’t be one of the many advisors that have been fooled and suffer client losses by relying on backtested data.

If the methodology of a seasoned strategy is utilized for a new, more conservative investment option, it may be worthwhile considering.  But for our purposes, let’s only consider seasoned strategies.  Recently, this narrowed the list to 307 strategies.  To make the next steps easier, on the Morningstar site, change the “inception date” slide to “5 years” and sort by 3 year performance by clicking the column name twice.

Second, from the top performers (the ones that may show skill), you will want to click on the names of the top 10 to 15 strategies to look at the Morningstar Quicktake reports for the investments. Look for one or more of these three warning signs:

  • A “Composite Inception Date” (in the right column) later than 10/31/2007.
  • A “Rebalance/Allocation Frequency” (in the right column) of Daily or Weekly.  This is a sign of potential excess trading costs and, if the strategy earns gains, large amounts of taxable, short-term capital gains.
  • Small number (under five) of factors that are used as inputs in the investment process.  You can usually find this information in the “Investment Strategy” or “Investment Decision Making Process” section in the left column.  You do not want to expose your clients to strategies that have a limited number of inputs.  If the data for one or two of these inputs go awry, the strategy may veer off course and earn detrimental returns.

Third, you should contact the investment firms managing the remaining strategies on your list to receive their marketing material especially their fact sheets.  Information on these sheets on which you should focus include:

  • Manager Fees.  If the firm charges more than 0.50% to manage the strategy, the hurdle for continued outperformance is quite high.
  • Quarterly Upside vs. Quarterly Downside Capture Ratios.  The upside ratio should be significantly higher than the downside ratio.  Downside ratios under 20% lead to steady returns with small losses (if any) in down markets.
  • Performance in Low Return Years Other than 2008.  Almost all strategies investing during the full year of 2008 had negative returns.  But the performance records of 2007 and 2011, years with small equity market gains, can give you a sense of the strategy’s quality in low return eras.

Charles “Chuck” Self serves as the Chief Investment Officer (CIO) and the Chief Operating Officer (COO) at iSectors® LLC. He has over 30 years of experience in the investment management industry.



Leave a Reply

%d bloggers like this: