How Do You Outperform?

I believe it is useful from time to time to review the basics and, this weekend, I offer a nice little two-part primer courtesy of our friends at Heritage Capital Research.  Part 1, which is below, discusses strategies for consistently outperforming benchmarks and it begins its thesis with a discussion of exactly how we should be defining a benchmark.  It's his contention that if you are claiming to outperform by simply choosing a benchmark that is way below what you expect to do, then you are cheating and misleading the investor.  It is his argument that a benchmark should be defined against other similar investment strategies, not just the easy ones, and if you do so will discover how very difficult it is to consistently outperform.

This is a very different discussion.  I'm not sure I agree with the basic thesis that the only valid benchmark is one graded against a similar strategy.  Thus if your strategy is 60/40 blue chip stocks vs AAA bonds, then your benchmark must be against other funds with the same mix.  No, I don't think that's what a real benchmark is at all.  In graduate business school, we were taught that a benchmark is very simply an opportunity cost which is to say where else can we be putting our money that requires no effort at all.  In B-school, the answer was the T-bill.  That is to say that the T-bill was the no-brainer strategy - no effort, guaranteed return.  Therefore any business decision that you make must do at least better than the T-bill or you don't do it.

In investments, we typically use the S&P index - that is your no-brainer benchmark is to simply take the effortless strategy of buying the index.  If you can't do better than the index, then you can't claim to be outperforming anything.  Every investment strategy must be measured against this pure vanilla benchmark and, for any benchmark to be at all meaningful, it must be the same for all strategies.  It is meaningless to merely state that you're beating some other 60/40 fund.  The only approach that does make sense is for Fund A to say it's beating the S&P by 2 points, Fund B by 3 points; then you evaluate other more subjective factors for your risk tolerance and ultimate decision.

That's always been the conventional wisdom anyway.  But I think this article presents an interesting different perspective.  How do we define performance?  How do you outperform?  Stay tuned tomorrow night for Part 2.  Hope everyone is enjoying our sunny weekend.

How Do You Outperform?

Updates from http://www.heritagecapitalresearch.com/ Daily State of the Markets

How Do You Outperform? By Dave Moenning on Apr 04, 2017 09:14 am A financial advisor recently asked me a question that, on the surface, sounded simple enough. In fact, I thought my answer was going to be a breeze and that since I had set aside an hour for the call, I'd probably wind up with an extra 30 minutes in my day! However, an hour and half later, we were still on the call, we were still actively discussing the topic, and we were still nowhere close to being done. So, although what follows is an abbreviated synopsis of this and ensuing conversations, I thought others might find the topic of interest. And since traders appear to be waiting on the earnings parade to begin, I figured this might be a good subject to address while we wait. Most will probably agree that the question initially posed to me was straightforward. So here goes: "As a portfolio manager, how do you outperform?" The easy answer is you buy stuff that provides a return which is higher than your benchmark. Bam. Done, right? Well... as commercial goes, not exactly. You see, the question wasn't, "How do you outperform once in a while?" No, the question was, "How do you outperform on a consistent basis?" I explained that one of the dirty little secrets in the investment management business is portfolio managers oftentimes select a benchmark with a lower risk profile than the portfolio they are actually managing. I.E. a manager will find a low bar that they hope to easily hurdle each quarter. For example, I know one active manager that runs a tactical asset allocation strategy yet somehow uses a conservative, income-oriented benchmark. And just like that, Morningstar awarded his fund 5 stars - despite what I see as middling performance given the approach being used. But after laughing over the idea of choosing a benchmark that is easy to beat, the advisor upped the ante on me. "Well, then let me rephrase," he said. "How do you beat a 60/40 stock/bond benchmark on a consistent basis by utilizing a similar mix in your portfolio?" Then it hit me, my advisor colleague was thinking that he could buy 50% SPY, 30% AGG, and then 20% "other stuff," and provide his clients with returns that exceeded the heralded 60/40 benchmark. I proceeded to explain that if you charge a management fee of 1.5% and pay transaction costs to rebalance, make macro calls, etc., you are almost guaranteed to underperform with such a plan. I suggested that unless the "other stuff" could radically outperform on a consistent basis, you were doomed to lag the benchmark. What About Using Relative Strength and Momentum? He then asked about the idea of flipping the allocation on its head and using 50% "other stuff" that included momentum and relative strength rotational strategies he had read about. I opined that when used judiciously, both the momentum factor and relative strength approach were certainly worth considering in a portfolio. However, I went on to generally say that, in my experience, while both can help a portfolio outperform when markets are running higher, such an approach (a) is subject to whipsaws that can create underperformance (usually at the most inopportune times) and (b) can create outsized underperformance on the downside if you don't get the moves "just right" - or get caught in a market that doesn't favor such an approach. I also suggested that such tactical strategies to investing were employed by lots of managers on many fronts but required a thorough understanding of the strategy. In other words, I wanted my colleague to note that you don't just start using a relative strength, rotation approach without a lot of research - and preferably a LOT of experience - because if employed improperly, the results can be painful. I concluded on the topic by saying that this approach didn't really fit with his objective of outperforming a 60/40 benchmark on a consistent basis. Choosing the Time Frame AND the Objective Next, we explored the idea of "outperformance" in more detail. I asked what time frame he was shooting for and what degree of outperformance he was seeking. Cutting to the chase, the overall objective was he wanted to be able to go into client review meetings on an annual basis confident that his investing approach would be viewed as satisfactory. So, I asked if "being around" the benchmark was an acceptable bogey during most calendar years. To which, he replied, "Yes, that's the idea - be close to or exceed the benchmark in most years." "What about during a year like 2008 or the 2000-02 period," I asked. "Are you going to be happy 'being around' the benchmark during those big, bad, bear markets? Are your clients able to accept a loss of 20% to 30% during a year like 2008?" (I noted that a 60/40 stock/bond mix employing the S&P 500 and the Barclays Aggregate Bond Index lost 19.83% in calendar year 2008 while the S&P itself was off 37%.) "Well, no," he replied. "I've got to do better than that when something really big happens - I've got to help them manage risk during that kind of debacle." "Ah," I said, "now we're getting somewhere!" The Goal: A Boring, Risk Managed Approach After a great deal of discussion (and multiple calls), I summarized that what he wanted for his clients (and in reality, what the vast majority of financial advisors and their clients really want) is for his portfolio performance to "be around" the benchmarks in most years and then to "lose less" when the big bears come to town. "Exactly!" he replied. To which, I responded, "So what we are after is a relatively boring asset allocation approach" - which I defined as a strategy that shouldn't create any 'big surprises' - "accompanied by a risk management strategy designed to try and protect capital during severely negative environments." I proceeded to cement the idea that such an approach can't/won't help when the markets "correct" and experience bouts of short-term volatility. "In other words," I said, "we can't expect a long-term strategy to function well during a short-term event - you get that, right?" So, what started as a discussion about performance and the idea of employing a mo-mo based, rotational approach had morphed into a plan that made sense. We wound up defining what he actually meant by the term "outperformance," we identified the risk parameters he was comfortable with, and we agreed on the time frame we were planning to work in. Perfect. Time to Get to Work With the objectives in hand, now it was my turn. In short, my team was being tasked with creating a series of risk-targeted, asset allocation strategies that would attempt to "be around" the benchmarks during most calendar years and then try to "lose less" when the bears went on the attack. Next time, we'll explore the approach we took to build such portfolios. Thought For The Day: Never underestimate the power of no. -Ray Charles Current Market Drivers We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).       1. The State of the U.S. Economy        2. The State of Trump Administration Policies        3. The State of Global Central Bank Policies Wishing you green screens and all the best for a great day, David D. Moenning  Chief Investment Officer  Sowell Management Services