A Simple Question Was Asked…and we answered.

A simple question was asked: Why not just buy and hold the index? And if not, how can a relatively small “part time” investment manager compete with all the available large institutional managers?

Sometimes simple questions can have long answers. The first part of the question is, “Does buy and hold work?”. The answer is, “It depends”. It depends on what time period you are asking about. For example, if the time period reviewed is 2000 to 2013, then it’s fair to say there are many other approaches, which would have outperformed. However, as you shorten the time periods, a single year for instance, under or over performance becomes much less predictable. While we can look at longer time periods, like the last 50 or 100 years, the indexes have performed admirably. However, individuals rarely have the patience that would have been required to let the experiment play out. Also, there is no assurance that the last 50 or 100 years might, in anyway, resemble the next long period of development or world economies. So, what should someone do?

The first step is to understand that reducing volatility or risk management is an important aspect of creating a sound portfolio. Reducing volatility reduces the risk of being either incredibly lucky or unlucky and increases the possibility of being right. Keep in mind, with our clients, we are usually trying to hit a goal or drive long term sustainable income. Increasing the chances of being right is important. One way to reduce volatility is diversification. This idea forms the basis for Modern Portfolio Theory. This theory suggests that a portfolio will have a better reward or risk trade-off if you mix stocks and bonds, rather than just one or the other. Similarly, when you mix in international or small companies, you get a similar reward or risk improvement. This works on indexes, and it works on managed portfolios like mutual funds.

Step One: Mix Asset Types So, how can we measure this improvement? I will momentarily get a little technical. Alpha is a statistical measure for the trade-off between risk and reward. Simply put, units of return per units of risk. We define reward/risk of the index as zero. If you are close to zero, your returns for a given amount of risk are similar to the index. In diversified portfolios, alpha improvements of 13 are common. Many mutual funds can outperform the index, but not significantly when you consider the additional cost. Since there is also risk that they might under perform, all else being equal, we generally prefer using indexes because of cost.

Once you understand the concepts of diversification and measuring improvements in reward to risk, then we can consider other ideas of how alpha can be improved. One asset class we like to use is alternatives, loosely investments that don’t track with stocks or bonds. As a group, their costs are generally much higher than most indexes, and their average returns are not particularly any better than owning a stock index. The reason for their appeal is the very low correlation with the stock and bond markets. This low correlation tends to significantly improve the alpha or reward/risk trade off of the entire portfolio. Alternatives can serve as a shock absorber to the portfolio, doing well at times when other things are not.

Step Two: Mix Asset Types, Alternatives So with all this in mind, we can reconsider the question, “Why not just buy the index?” Usually, what someone means is a diversified portfolio of indexes, i.e., participating in several indexes, not just one. We agree. It’s a great place to start. By doing that first step, you would achieve a low cost, diversified portfolio. A second step might be to consider adding various alternatives, such as private equity, REITs, commodities, hedge strategies, oil and gas. On average, we would expect an improvement to reward/risk and a smoother set of returns. However, with each step, 1) diversification, 2) alternatives, we create the opportunity for temporary underperformance. In other words, it is possible that a portfolio that is positioned with downside protection as a first priority might under perform an index, especially when the markets are hot. Investors can become discouraged, believing that we should eliminate the downside, but have no limit on the upside.

What would step three be? One problem with Modern Portfolio Theory, or simple diversification, is that assets that vary differently (low correlation) in good times, can move together (highly correlated) in bad markets. This means that diversification works great in good markets, but not as well in bad markets. So how can a portfolio be diversified against bad markets? The answer is active trading. Active trading has many approaches. For example, day trading, sector rotation, calendar effects, long/short and technical trading. It is fascinating how different portfolios act, often holding substantially the same assets, but trading them differently. Which active strategy is best? There is not a right or wrong answer. Each approach over time can achieve significant gains, but at different times and in different ways. However, in contrast to simple asset diversification, these “active trading styles” do not tend to move together in bad markets. Additionally, active trading also allows the portfolio to get out of the way or even take advantage of bad markets. The inclusion of active trading strategies to a portfolio is not specifically to outperform an index, but to more broadly diversify and increase the return/risk profile.

Step Three: Mix Asset Types, Alternatives, Active Trading
Generally, we will layer several active trading strategies, alternatives and a buy and hold index in one overall portfolio. The number of investment approaches and type of layering will depend on the number and size of accounts and the client’s wishes. Managers have minimums and trading costs needed to make sense relative to the size of that allocation.

How can a small, “part time” manager compete with a big institution or mutual fund? We run several active trading solutions for our clients. We created these solutions to fit a specific client request where we did not have full confidence in the market available options at a reduced cost. However, our main focus is always the larger picture. We build and monitor Steps One through Three. Even with just a diversified index, we can determine the right index model and rebalance it. Otherwise, the index portfolio slowly begins to take on additional risk, as it grows out of balance. When alternatives or active trading strategies are appropriate, we do a review of the offerings, consider tax implications and recommend an appropriate mix. Through these portfolio techniques, we attempt to better manage risk and have the portfolios better comply with our clients’ needs.

Large institutions or mutual funds cannot do this on a personal level. In addition, their fund prospectus and size limit their ability to move to cash or change asset classes. For example, a large value manager will always be just that, and if value is out of favor, their strategy is unchanged. Several years ago, a well known large growth fund was in the news because they held over 5% of Microsoft. The articles commented on how difficult it was for the fund to sell off even part of their position, because doing so with such a large number of shares can accelerate the stock’s price decline.

It is funny how quick theory can turn in to dogma. Investing is not a repeatable science, like we know that water boils at a specific temperature. Investing can use statistics, but it needs to be dynamic and has an aspect of art. The large institutions suffer partly from group think and are slow to change. Similar to how big media news suffered from bias, which then created room for cable, large retail investment firms can also become mired in yesterday’s methodology. Large retail institutions want the answer to be simple because it’s much easier to distribute a simple solution.

“The Flattening of the World,” wide access to information, has changed how we can compete. A smaller group, like Eagle West Group, can now outsource what used to be very expensive computer time. We can mix investment disciplines and approaches to create solutions that big institutions can’t package because we don’t have a static mental picture of what we do. We can deliver a reactive and customized investment portfolio that doesn’t rely on only the money that we directly manage.

A little about our “part time” managing: Again, we do run a few investment solutions for our clients. These solutions are reviewed on a weekly basis and use outsourced algorithms to do much of the heavy lifting. These algorithms calculate risk on each position in an attempt to avoid unlimited downside. Weekly reviews achieve the sensitivity we want, but without the requirement to watch the positions all day. Generally, we build these models primarily from indexes or where appropriate, large companies, who approximate an index. We do not attempt trading strategies which rely on original research or minute-to-minute trading. Thus far, our internal reward/risk statistics support that we have a good solution that is competitive with our outside managers, at a much lower cost. Our current investment solutions offered are: APM (Advance and Protect)-diversified constrained technical trading, APM growth -undiversified, unconstrained technical trading and Dividend -income generator from stock and/or bond.

Check the background of this investment professional on FINRA's BrokerCheck

Advisory services offered through EWG Elevate, Inc. dba Eagle West Group.

This represents a partial list of clients. They have not been compensated and were not selected based on duration, performance, account size.