Current market environment performance of dynamic, risk-managed investment solutions.
By Jerry Wagner
Markets rarely give investors a clear path forward. Economic signals can conflict, rate expectations can shift, and investor sentiment can change quickly. Some trends last longer than expected. Others reverse with little warning. And sometimes markets get stuck in a frustrating pattern that rewards neither full offense nor full defense.
Since I began investing in the late 1960s, I have believed investment management should be active, responsive, and risk-aware. When I started Flexible Plan Investments (FPI) in 1981, the only investment services we offered were actively managed—and that is still true today. I believed then, as I do now, that an investment manager should be “flexible” rather than locked into a rigid buy-and-hold approach.
Active management, or “dynamic risk management” as I now view it, is necessarily tactical. It seeks to participate in favorable market environments while recognizing that market conditions can change quickly. Dynamic risk management, as we apply it, is responsive to market forces. We don’t try to predict where the market is going. Rather, we respond to the directional clues the market itself provides.
Why active management?
In 1988, I met with a small group of colleagues to create the industry trade association now known as the National Association of Active Investment Managers (NAAIM). Formed in 1989, NAAIM brought together managers who had chosen active management over passive, buy-and-hold approaches. But the reason was often different from the common perception.
At the time, many members of the press and the financial industry viewed active managers, or “market timers,” as investors simply trying to “beat the market.” By that, they meant outperforming market indexes, such as the Dow Jones Industrial Average and the S&P 500, every quarter or every year, purely on returns.
But as I listened to my colleagues, I heard the same point I had long been making: Active management was about seeking to manage downside risk. It was not part of the go-go investment philosophy of the 1970s or the tech bubble of the 1990s. It was a way to help investors reduce the impact of major market declines that could do serious damage to portfolios.
We did not believe asset allocation or simple asset-class diversification was the only defense against these downturns. We had been in the business too long to believe that this approach alone could sufficiently address client risk. In every firm’s case, active management was viewed as an essential tool. NAAIM’s first president, John Sosnowy, would often say, “If you see a train bearing down on you, the best defense is to get off the tracks.”
One of NAAIM’s first projects was completed by three of us. We wrote a paper published by the Journal of Portfolio Management demonstrating that active management firms outperformed indexes on a risk-adjusted return basis. In other words, they earned more than would be statistically expected for the risk they were taking. The research was later replicated and validated in a different time period by a group of academic researchers.
So, we were active managers for defensive purposes. Why? Because when you reduce your losses in a market correction, you can have more money working for you when the market recovers. Over a full market cycle, you may end up with more money while taking less risk.
Simple math shows why reducing downside losses can matter more than trying to capture every bit of upside potential.
Let’s examine two hypothetical accounts. One account uses an active, tactical approach. The other uses a traditional, passive, buy-and-hold allocation model.
In the traditional account, the market and the investor lose 30% in one of the bear markets that we have experienced every four to five years over the last century. Then, over the next few years, as often happens, the market gains 30% back.
The investor is back to breakeven, right? No. The investment is still 9% lower because the 30% gain was earned on the smaller portfolio balance that remained after the loss.
By comparison, the active, tactical investor avoids half the market loss but captures only two-thirds of the market rally. Who has done better? The active investor has a 2% overall gain, while the passive investor has a 9% loss.
The active investor has more at the end of the market’s ups and downs compared to the passive investor. Year after year, cycle after cycle, losses can really add up.
The pros and cons of active management
Since many active managers are trend followers in some form, they face a couple of common challenges.
First, they have to wait for a trend to change. And that takes time. As a result, active managers may leave some money on the table when markets are topping out and may be late to participate when markets begin to recover. Their goal is to seek to avoid much of the downside while participating in a meaningful portion of the upside.
Second, markets are not always in a clear uptrend or downtrend. Sometimes they move sideways while investor forces are marshaling for a new bullish charge or a bearish retreat.
These periods are like encountering a curvy stretch of highway. For that kind of driving, automakers gave us two pedals: a brake and an accelerator. A buy-and-hold investor keeps a foot on the gas through every twist and turn. An active manager can use both pedals, seeking to stay on course while managing risk along the way.
Active management can perform well when markets are not trending clearly and investors are trying to get their bearings. But it can also underperform when market movements are just noisy rather than trend-driven.
That is why expectations matter. Defensive, active management generally does not seek to keep a portfolio fully invested through every period of turmoil. Short periods of underperformance can happen, especially when markets are choppy and trends are unclear. The key question is whether the strategy is still performing as expected based on its process, research, and long-term purpose.
A better way to evaluate performance
You cannot evaluate a risk-managed portfolio by comparing it only with a market benchmark such as the S&P 500. The S&P 500 is an unmanaged stock index, and it may carry more risk than some investors can tolerate during market corrections. A benchmark can be useful context, but it does not always reflect an investor’s goals, risk tolerance, or time horizon.
To help address that challenge, we developed a methodology for monitoring strategy performance in terms of probabilities. It gives us a way to evaluate whether a strategy is performing in line with our research or showing signs that something may have changed.
Our OnTarget Investing process brings that methodology to our clients. The OnTarget Monitor uses hundreds of Monte Carlo simulations of the client’s portfolio against the strategy’s benchmark. The portfolio value (the black line) is plotted against a color-coded projection of possible investment outcomes over the client’s stated investment time horizon.
Source: Flexible Plan Investments. See disclosures.
As long as the client’s portfolio is tracking through the green or blue areas, it is performing as expected or better. If it moves into the yellow area, the client may want to talk with their financial adviser about whether any changes are needed or complete a new suitability questionnaire. If it moves into the red area, a change may be appropriate.
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Dynamic risk management may not be perfect, but we believe it is a practical way to manage investment risk. It is responsive and gives managers more defensive tools to address the unexpected risks that can emerge in the financial landscape. At FPI, we combine dynamic risk management with multi-strategy diversification and our OnTarget Investing process to help keep client portfolios aligned with their financial goals.