How to Meet Clients Expectations in a Low Return Environment – Part 2

Posted on: 06/22/2016

Charles (Chuck) Self, iSectors CIO, COO

by Chuck Self

Continued from Part I 

Once the portfolio has been properly managed, we should look to increase potential return. We will diversify from a static portfolio that aims to match or exceed benchmarks to a dynamic or tactical strategy that attempts to minimize downside risk. An equity program encompassing portfolios that achieve both goals is optimal.

It needs to be emphasized that the tactical strategy’s optimization goal should be different from that of the static strategy. If this is not the case, it likely that there will be significant overlaps between both portfolios. By choosing to minimize downside risk, the total equity portfolio has greater diversification.

In order to add return to the portfolio, the downside risk mitigation has to be significantly stronger than any upside reduced by implementing the strategy. The problem with many dynamic strategies is that total risk, over time, is less than that of the market. Even if downside risk is decreased, upside participation also declines. Over time, this leads to underperformance of the benchmarks.

The optimal tactical strategy will decrease risk in down markets and increase risk in positive markets. For instance, the iSectors® Post-MPT Growth Allocation attempts to own low equity market correlated assets such as bonds, real asset stocks and utility securities when the stock market is declining. When equities are doing well, the Allocation, hopefully, has no exposure to the low correlated sectors and 100% exposure to traditional equity sectors. The algorithm behind the allocation model will even call for a small amount of exposure to leveraged sector ETFs if market conditions allow.

iSectors Implementation: We recommend advisors consider moving one-half of clients’ equity allocations from their current holdings to the iSectors Post-MPT Growth Allocation. Post-MPT Growth is a tactical strategy invested in ETF market sectors in a manner that attempts to minimize downside risk. Although past performance may not be indicative of future returns, the following risk and return statistics describe the Post-MPT Growth Allocation and the Standard & Poor’s 500 index benchmark over the past 11 years (2/1/2005 to 3/31/2016):

Portfolio

Annual Return

Standard Deviation

Alpha 

Correlation to S&P 500

Upside Capture

Downside Capture

Post-MPT Growth

9.13%

14.20%

5.13%

60.04%

62.30%

50.71%

S&P 500

7.34%

14.62%

Post-MPT Growth hits the marks as an attractive diversifying asset since:

  • Clients have received over 175 basis points in added annualized return by investing in Post-MPT Growth in place of an index fund with slightly less risk.
  • Post-MPT Growth’s Alpha is significantly positive.
  • Post-MPT Growth has had only moderate correlation to the S&P 500.
  • The key to out-performance has been the attractive upside capture/downside capture relationship.

Turning to draw-down analysis, the table below reviews the 2007 to 2009 and 2011 drawdown events, the last two of greater than 10% for the S&P 500 on a monthly basis:

Portfolio

11/2007 to 2/2009

5/2011 to 9/2011

Post-MPT Growth

-33.81%

+8.31%

S&P 500

-50.95%

-16.26%

Again, Post-MPT Growth reduced downside risk in both events.

Individuals who wish to be referred to advisors utilizing iSectors Allocations should call Chuck Self at 920-257-5168 or email info@isectors.com.



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