In my previous post, “Providing the Correct Pattern of Returns for Your Clients,” we discussed how the financial turmoil and opportunities during the past seven years resulted in advisors’ clients abandoning their prescribed investment program due to fear and/or greed. Experience and studies show us that equities is the best asset class for clients over the long run. But very few clients can tolerate the volatility of a portfolio with a large equity allocation.
Thus, the major question is how do we keep clients invested in the equity markets at all times to take advantage of the long-term upward trend in stocks? We suggested that advisors should be providing clients strategies that participate to a significant extent in bull markets while providing strong protection during negative equity markets. Although past performance is not indicative of future returns, we found that the iSectors® Post-MPT Growth Allocation has had the following twelve-month return patterns over the past ten years:
- When the equity market declined, Post-MPT Growth always dropped less than the market and averaged a loss capture of 40%.
- When the market rose at a rate of under 10%, Post-MPT Growth outperformed the market 86% of the time an averaged a 15% return.
- When the market rose at a rate greater than 10%, Post MPT Growth’s return averaged 15% and captured 70% of the market’s gain.
As attractive as this return pattern may be, there is another question that needs to be answered: Is this return pattern repeatable in the future? We all have seen strategies with wonderful performance over many years, fade in subsequent periods. Although there are no guarantees, here are some factors that should be analyzed to increase your conviction that the positive performance pattern can be repeated:
- Live Track Record Length – Especially in the ETF strategy world, there is a proliferation of products that are being sold on the basis of backtests. Obviously, no one is going to market a strategy with an unattractive simulated performance record. Although some information on expected risk/return patterns can be ascertained from backtests, the live track record, with real money on the line, should be scrutinized thoroughly. At a minimum, the strategy should have live 2011 numbers for comparison to benchmarks during the May to September market correction. Better yet, strategies that were available beginning in October 2007 can be analyzed for their downside protection in the worst bear market we are likely to see for a while.
- Post-MPT Growth: The strategy’s inception was in February 2005 and therefore has live performance numbers for both the 2007-2009 bear market and the 2011 correction.
- Number of Input Factors – Many strategies are “technical” in nature relying on market data of one to four series to determine how money should be invested. You do not want to expose your clients to strategies with a limited number of inputs. Recently, we have seen a strategy that had great historical numbers present negative 2014 returns because their primary input factor to their model went awry.
- Post-MPT Growth: The strategy utilizes 15 economic and market input variables to create objective risk/return expectations for the nine market sectors available for investment.
- Investment Universe – Most allocation strategies claim diversification by owning some combination of capitalization (large, mid, small) and style (growth, value) holdings. Unfortunately, these asset classes have become too similar as the following correlation chart indicates. The product’s asset class universe must contain low to moderately correlated asset classes to achieve the diversification necessary to provide downside protection.
- Post-MPT Growth: The strategy utilizes nine asset class sectors that generally have low to modest correlation to each other. Therefore, the portfolio is truly diversified and has the ability to deliver stronger downside protection in market corrections:
If you have any questions about this process, please contact Chuck Self at 1-920-257-5168 or leave a comment below.