Ken Solow, at a recent recent Advisors4Advisors webinar entitled, “Why Active Management is the Answer for Today’s RIA’s,” was asked great questions about “go anywhere” tactical portfolio management and recent studies that “prove” active management does not work. He explains his firm's tactical approach in detail and talks about his RIA's new institutional division, providing turnkey asset management to independent advisors.
Q: The latest research shows that tactical asset allocation hasn’t proven its worth. How does your approach produce different results? Where can we find the numbers to confirm and verify your results for ourselves?
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The industry misuses benchmark tracking error studies to reach conclusions about tactical asset allocation, and I've written extensively
about this. To my knowledge, there are no studies that prove or disprove the benefits of “go anywhere” investment strategies because there is no universe of managers to track with public track records, and there can be no agreement on the proper benchmark to determine if alpha was created. The best way to confirm numbers is to carefully analyze tactical manager track records. Here again, advisors should be careful to determine if the track records include back-tested and hypothetical returns and if they meet the standards for GIPS compliance. We are happy to share our performance information. If interested, please
Q: When reporting performance to clients, what do you benchmark against?
We provide in-depth performance reporting to Pinnacle clients monthly, and use two asset class benchmarks. I’ve written about challenges associated with benchmarking “go anywhere” portfolios
Q. Why do you use volatility as your measure of risk? Isn’t downside deviation or something that measures maximum drawdown a better measure?
Downside deviation and maximum drawdown are both useful measures of risk. Lately, we’ve described our approach as “risk budgeting.”
Our process recognizes that traditional MPT portfolio construction uses asset class targets to manage risk based on past asset-class performance. Because valuation is not considered in the MPT equation, and because the MPT model makes assumptions that we do not believe are robust to reality, we wanted to find a better way to constrain our portfolios so that we could own any asset class that offered good value while still meeting our client’s requirements for having a structured approach to portfolio volatility. By back-testing buy and hold portfolio constructions to the early 1970s, we are able to show clients the baseline volatility of various buy-and-hold portfolio policies. This provides the range of volatility that is specified in client policy statements. The range of volatility, or volatility budget, is stated in terms of standard deviation — or more specifically, a range of likely returns around the average expected portfolio return based on back-tested strategic models. Pinnacle wealth managers discuss historical maximum drawdowns and recovery times with clients when helping them choose portfolio policy.
In our day-to-day work, we constrain volatility relative
to our strategic two asset class benchmarks for volatility. This acts as a practical constraint on portfolio construction. Historically, Pinnacle has been as low as 40% of benchmark volatility and as high as 120% of portfolio volatility. The Wall Street Journal
on June 14, 2012 discussed several approaches to risk budgeting different from Pinnacle’s
method of allowing a range of volatility relative to a volatility benchmark portfolio. For example, you could simply target a fixed amount
of volatility as stated by projections of standard deviation, or maximum portfolio drawdowns. For us, using a relative approach allows us the most flexibility in dangerous market environments, and also allows our client’s to have a longer-term time horizon when viewing market cycles and portfolio volatility.
Finally, I always encourage advisors to beware of focusing too much on portfolio drawdowns as a measure of risk control because it tends to draw a client’s focus away from viewing returns in the context of a complete market cycle. Many managers who did a good job of managing the portfolio decline in 2007-2009 have completely missed the rally from 2009 to present. A relative approach helps balance between the nonsensical approach of “buy and hold and hope” and focusing on very short-term portfolio moves.
Q: What do you do when you have conflicting tactical signals?
Excellent question! There are always conflicting tactical signals. We examine the weight of the evidence and then select a view of the market cycle that has the highest probability of being correct. On many occasions, we have a low level of conviction in our forecast. When this occurs, we maintain neutral levels of volatility in our portfolios relative to our benchmarks. Our clients have already signed off on the likely levels of volatility when we own benchmark levels of risk. When we have high levels of conviction, we tend to move towards bullish or bearish allocations of risk. While we are technically allowed to make extreme asset allocation bets by policy, as a practical fact we simply won’t go to 100% cash because that implies 100% conviction in our forecast. Because we still view risk relatively, instead of absolutely, investing the portfolio to extremes becomes a high risk proposition for the client and the firm.
Today’s investment markets make it very difficult to arrive at a high conviction forecast. Policy intervention has so distorted financial markets that making asset allocation decisions always seems to have an element of speculation about what policy makers might do next. On the other hand, systemic risks have been off the charts since the Lehman Brothers collapse. Finding a balance between safely investing client capital and not “fighting the fed” has been quite a challenge. We continue to look to our three areas of focus, the market cycle, technical analysis, and traditional valuation, to create sensible portfolios for our clients.
Q: Do you license the dynamic models to other advisors?
We’ve created a separate division of Pinnacle Advisory Group, called Pinnacle Advisor Solutions, to work directly with financial advisors. Please
for more information.