As Silicon Valley has waded into financial services recently, a wave of venture-backed “Robo-Advisor” firms has started to attract client assets.  Marketed as simple, easy-to-use and inexpensive, the robo-advisor model has two critical shortcomings, which will wreak havoc on their clients’ portfolios going forward.

To be clear, systematic investing, low-cost products that provide exposures to markets of interest and easy-to-use tools are all strong value propositions.  Many investors who can’t spend the time doing research or whose portfolios aren’t big enough to gain the interest of professional advisors are likely to benefit from these features offered by the robo-advisor space.  However, investors who entrust their long-term investments to such formats are likely to be blindsided by financial market volatility. 

Many of these services have beautiful graphics, depicting the “likely” long-term outcome of an investment made today (of course, “likely” is far different from “guaranteed”).  Many providers also educate clients by illustrating what long-term portfolios may be worth in the case of “below average” performance in markets, and they draw smooth curves which lead from today’s balance to the future’s sizeable nest egg.  Problem one is that there will never be a smooth path to that nest egg. 

We’ve witnessed two drawdowns in equities of greater than 50% in the last 15 years, and as these services cater to a more tech-savvy clientele (read: younger), the portfolios they construct are likely to have relatively higher allocations to equities than other investors might consider.  One group even refuses to offer any allocation to bonds, due to currently low yields - apparently the benefits of negative correlation weren’t coded into their algorithms.  These investors are going to face equity market volatility over their lifetimes, and when they do, the smooth curve that illustrates their hypothetical path to retirement will be proven to be demonstrably misleading.

Problem two, particularly for the clients of robo-advisors on the low-end of the cost spectrum, is that once market volatility has reduced their portfolio’s value significantly and swiftly, they have no one to speak with about it.  Online risk-tolerance questionnaires that are administered in the middle of a raging bull market are likely to elicit different responses than those given by a client who just watched Enron go from the seventh biggest company in the US to $0, or another client whose financials ETF got massacred when Congress’s first vote on TARP didn’t have the votes. 

This is a problem because fear and greed are going to overtake many clients who have no trusted advisor to speak with.  As that happens, terrible decisions will be made (buy the all-time highs, sell the 50% drawdown).  The greatest investors in the world have colleagues and advisors to bounce ideas off of and talk through news and scenarios impacting their book.  The idea that non-professional investors are going to do better in the long run because they are completely alone when markets get turbulent, but they saved 50bps in advisory fees, is unlikely to be true.

The good news is, when their new balances are locked in by unadvised, unadvisable actions like capitulating at the bottom of a market drawdown, the robo-advisors’ software will still be able to draw them a smooth curve to their future retirement.  The bad news is that the curve ends on the investor’s 211th birthday.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

There are three sources from which skill- (or luck-) based returns can be captured: security selection, tactical allocation, and strategic allocation.  While upwards of 90% of the industry is focused on either generating security selection alpha or arguing it doesn’t exist in great enough quantities to be worth seeking, the other sources of alpha are waiting to be exploited.

Benjamin Graham, Warren Buffett, and anyone who has sat for the CFA exam are likely to point out that buying quality companies while they are out of favor is an excellent way to earn above-market returns with comparable, or perhaps less, risk.  This is certainly true, but unfortunately the competition is fierce - as of July 2014, there were approximately 120,000 CFA members in 35 countries, all looking for inefficiencies in corporate valuations. 

Tactical asset allocation, or opportunistically allocating to out of favor sectors, capitalization tranches or other factor-based groups of stocks, is another way that alpha can be generated.  This alpha is a hybrid of security selection and opportunistic, in the sense that there is a “timing” element to larger clusters of securities with similar characteristics.  There are several professional services doing a great job of helping make recommendations between international and domestic equities, high-yield and emerging market government debt, etc., although this source is largely underutilized relative to traditional security selection.

Finally, strategic allocation is the most underrepresented alpha source of the three.  Purely opportunistic alpha, precious few services even exist to advise on mining additional alpha from the strategic allocation level of portfolios.  Bald-faced market timing, often pitched and historically a failed approach, is one way to try to access this alpha source.  However, a more sensible, risk-management based approach is through rebalancing. 

By employing a scientific approach to portfolio rebalancing (note: “once a year” and “when things are out of whack” are not scientific), investors are able to capitalize on outsized moves in market factors, ultimately retaining more of their profits from periodic up-markets, and growing the portfolio more rapidly with additional strategic allocations during periodic down-markets. This overlay can be easily implemented to add risk-adjusted returns, simply replacing existing rebalancing “strategies” that leave alpha on the table.

The good news is that these alpha sources are independent variables – that is, investors can derive alpha from each of the three sources within their portfolio simultaneously.  This could be done by hiring consistent active managers to manage individual sub-asset classes, researching or hiring a research firm to make recommendations on when to tactically shift assets within equity or fixed-income allocations, and finally, hiring a strategic allocation service to provide recommendations on allocating between equity and fixed-income allocations.

Most of the asset management world is busy chasing down the next great stock story and spending all of their 12b-1’s to convince you they have added 100 basis points of alpha each year (gross of fees, of course).  Tactical, and to an even greater extent strategic allocation services are being underutilized, and can generate far more alpha from the untapped sources while most of the asset management industry trips over themselves selling you their “unique approach” to large-cap value.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

An active manager launches a new fund and builds a tremendous three-year track record, outperforming benchmarks with less volatility.  The manager then hits everyone’s radar, and assets begin to pile into the fund.   Soon, the internal discussion at the fund management company is a debate between closing the fund in order to preserve the manager’s ability to generate alpha, or leaving it open and gathering all of the assets possible.

No one collecting a management fee is incentivized to close a fund.

Mapping the expected alpha generation of different investment formats against the accepted capacities of these strategies illustrates this point:

Beginning with highest alpha, lowest capacity strategies, proprietary trading often benchmarks against being able to create 75-100% returns on the margin a trader is provided over the course of a year.  While relative to traditional asset management these returns sound impossibly high, the facts remain that many prop-trading strategies can produce these levels of return, with far less volatility than equities – but only up to a certain capacity.  In fact, many trading groups think more about how many dollars can be pulled out of the market than what rate of return can be generated.  Interestingly, these traders are often compensated on incentive fees (a percentage of profits) only.

Moving down the alpha curve, or out the capacity curve, emerging manager hedge funds which implement limited-capacity strategies often have the capability to produce 25-50% returns per annum, with drawdowns limited to 10-20%.  The primary source of income for these firms is derived again from their incentive fees, with nominal management fees barely covering the costs of operation.

Further out you see established hedge funds, running billions of dollars.  At this stage, big institutional investors who pay their annual 2% management fees provide the core, consistent revenues to the firm, and so these groups often (not always) reduce risk, target alpha generation in the high single digits per annum, and avoid taking the positions that helped get them into the billions of dollars in AUM.

Sharing the same independent variable value, long-only managers in small caps, emerging markets and other capacity constrained asset classes are often able to generate vastly more alpha relative to their large cap and government bond counterparts, although their limited ability to hedge risks precludes them from generating the same alpha as hedge funds of similar size.  These managers are entirely compensated by management fees, and fall into the conundrum presented in the introduction – do we maintain our superior risk adjusted performance, or grab for assets and make hay while the sun is shining?

Frequently, these managers slide further down the alpha curve, taking on upwards of $50 and $100bn in “actively managed” portfolios.  Unsurprisingly, assets and fees grow while alpha-per-AUM declines rapidly.  Investors rarely fire a manager for middling performance, so more and more active funds tend towards the lowest point on the graph, an index strategy that can handle vastly more assets, but by definition generates no alpha.

Fund managers with smaller, more nimble portfolios have long argued that they are able to generate more alpha than the behemoths in their space, and there is no shortage of statistical evidence supporting their claims.  Alpha generation is clearly negatively correlated with assets under management.  Alpha is not infinite, and the more assets a manager has, the lower the alpha-per-dollar managed.  Be advised that if you are seeking alpha, the capacity and compensation structures of your managers are critical.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

A popular trend in the fixed-income world is the creation of products which provide exposure to fixed-income generally, without exposing investors to the risk they consider the most concerning: interest rate risk.  The story goes that “yields can’t go much lower” and bonds have been in a 30 year bull market that has to end at some point.  So, products have been created which generate income but hedge off interest rate exposure with short positions in treasuries or similarly high quality securities.

This is a disaster waiting to happen. 

First, let’s address what the net position created actually is.  If you are long credit, you do have an income generating asset, but you also have a proxy for equity exposure.  High yield bonds are much more highly correlated with equities than they are with their IG fixed-income counterparts, and so an “equity junior” position of sorts has been established. 

Next, layer on a position that is short the only traditional asset that provides negative correlation to equities in retail portfolios.  By trying to create a pure interest rate risk hedge via treasuries, these products are adding the equivalent of more net long equity exposure (if there is a marked equity decline, treasuries historically rally due to their safe haven reputation).  So this “hedged” product has two components: one that is long an equity proxy, and another that is short the only asset negatively correlated to equities. 

1 Equity – (-1) Equity = 2 Equities, right?

So how can these products masquerade as fixed-income (read: low-risk) investments?  Financial engineering at its worst, these new funds are preparing the most conservative part of client portfolios for the most volatile experience.

The case for these products is often that, with low rates and easy credit, the higher yields in these HY Corporates are safe bets from a credit-risk standpoint.  The one “real” concern is that the Fed is going to hike rates, and of course that will decimate treasury notes or anything without a sufficient credit cushion.  So, according to the sellers of these funds, invest with a long-equity footing in fixed-income, complemented by shorting an anti-equity position.  Or simply, double down on equities for the diversifying, lower-risk part of a client’s portfolio.

So what happens if credit spreads widen, equities pull back and investors globally rush into the safe-haven of last resort, US Government Bonds?  Well, first, as credit spreads blow out, the risk taking portion of these funds will get hammered.  Then, to complement, treasuries will rally as a result of massive global inflows, and the “interest rate hedge” will work against the portfolio doubly. 

A reason to short quality, it is claimed, is that treasury rates have a zero bound.  I suggest a counterpoint: Swiss debt has negative yields out to ten years, and Dutch mortgage rates are negative!  It is clear that the Fed has deprived investors and their trusted advisors of accessible yield, but chasing it this far does not seem prudent.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

The proliferation of alternative strategy mutual funds has generally been a positive for retail investors, who are otherwise consigned to portfolios consisting of long positions in stocks and bonds.  Differentiated, or non-correlated, cash flows are the key to diversification from an asset allocation standpoint.  However, the investment options that pool together many of these strategies under one umbrella (oftentimes with a fee for that umbrella) are an easy but ultimately unwise selection.

The term multi-strategy, in reference to hedge funds, has a wide array of meanings.  In their best form, multi-strategy funds combine several positive alpha, non-correlated strategies and leverage them against each other, allowing for higher returns per unit of risk and per dollar invested.  Leverage is often bemoaned as purely additional risk, but in the context of a multi-strategy fund it represents the opportunity to de-risk the portfolio by adding more non-correlated cash flows. 

Take a look at some of the most well-known hedge funds in the world, with extremely successful track records, and you will see multi-strategy as their category.  You will also find these funds at the top of the “regulatory capital” tables, despite having less AUM than many firms.  That seeming disparity is achieved with the successful implementation of leverage.

So if positive alpha, non-correlated cash flows are good things in multi-strategy hedge funds, shouldn’t those benefits translate to the new liquid-alts models in mutual fund formats?  Sadly, they do not.

Mutual Funds that are employing several hedged strategies under one umbrella are not allowed access to the kind of leverage that make their less liquid Hedge Fund brethren superior investments.  Rather, multi-strategy mutual funds are often restricted on their exposures to little more than 100% of the assets in the portfolio.  With such limitations, it is nearly impossible to generate meaningful alpha using hedged strategies.  While the result may very well be a much smoother ride than equities, the watered down returns and additional fee drag make them much less appealing than individual hedged strategies in a 1940 Act format.

Further, the benefits that can be gained by allocating to multiple non-correlated return streams are eliminated in the mutual fund format, because investors aren’t able to decide when to add to out-of-favor strategies, or take profits from well-performing strategies.  Investors would be much better off allocating to the individual strategies on their own, and rebalancing them actively to benefit from the non-correlation.  Leaving them under one umbrella eliminates those significant marginal returns, and usually does so for an extra cost. 

Alternative strategy mutual funds may be the best thing to happen to retail investors since the reduction of the cap gains rate.  However, running portfolios of individual strategies allows advisors to extract the benefits of their non-correlation, where multi-strategy mutual funds do not.  We believe the best portfolios have a high number of positive alpha, non-correlated investments in a setting where advisors are able to capitalize on that non-correlation, rather than letting it go to waste under a shell with another layer of fees.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

Valuation is only a worthwhile metric in determining the price of a security when markets are functioning properly.  Well functioning markets have a combination of many buyers and many sellers, whose individually self-motivated actions lead to price discovery and liquidity.  One problem with markets is that liquidity can rapidly disappear, leaving investors holding a bag full of assets which are not worth anything near their “valuation”. 

The proliferation of ETFs has certainly increased access and liquidity in many markets, including stocks, bonds and precious metals.  This proliferation has also created a liquidity trap.  Investors have become accustomed to well functioning markets for high yield bond ETFs, wherein they are able to buy and sell diversified baskets of bonds with a single ticker on an exchange.  But can a derivative or a basket honestly offer better liquidity than the underlying assets?

In practice, we’ve seen many liquidity crises in the recent past.  The auction rate securities market, for example, seemed to provide an outsized benefit of money market like liquidity with enhanced triple-tax free yields.  Ostensibly, this was a free lunch for institutional and high net worth investors.  In terms of liquidity, there had only been 44 failed auctions between 1984 and 2007, but in the spring of 2008, the market froze.  Billions of dollars of “value” in ARS was marked down to zero on investors’ statements.  The issue was that the banks, historical buyers of last resort, had changed their behavior, and there was no one left to keep the market functioning.

So today, while the high yield bond ETF markets are functioning just fine, a major risk has developed under the surface.  Just as with ARS in 2007, confidence around liquidity has never been higher, because it has yet to be tested.  As the liquidity in the high yield bond market has rapidly declined, the liquidity mismatch between high yield bond ETFs and their underlying bonds has grown significantly.  When this ETF market’s liquidity has a hiccup, there is a chance for massive dislocation between the ETF’s NAV and the price at which it trades.

The implicit safety net would be to count on arbitrageurs to profit from the dislocation between the NAVs and market prices.  Unfortunately, this will be a difficult inefficiency to exploit, given the continued (and increasing) lack of liquidity in the underlying bonds.  Case and point, despite there being a great opportunity to exploit dislocations for convertible bond arbitrageurs in 2008, many of them instead went out of business while the securities they traded reached levels that implied worse than 100% default rates.

The point to remember is that when liquidity dries up, prices have little to do with valuation and much more to do with the price someone who is liquid is willing to pay.  Liquidity provides a much stronger hand in investing, and right now, the illusion of liquidity in high yield bond ETFs is creating a lot of weak hands who believe they are strong hands.   By the time many of them realize what they have, there is likely to be significant and permanent price impairment in their portfolios.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

Debated over whether it is fact, fiction, marketing or all of the above, “Smart Beta” had been a growing point of contention in the asset management industry recently.  Our view, based more on the math than the marketing, is that these strategies are deserving of the attention and assets they are garnering, and advisers would be well served to consider them.

The term “Smart Beta” refers to the gray area that strategies which aren’t quite active management, but aren’t quite indexing, occupy.  Smart beta strategies could just as easily be called quantitative strategies, if the word Quant hadn’t already scared everyone to death in August of 2007.  The majority of these strategies use the following approach:  1. Start with a widely-held index.  2.  Determine via multiple-regression and factor analysis which aspects of the securities in the index tend to identify outperformance.  3.  Systematically allocate to the securities with the highest concentration of the good factors and the lowest concentration of the bad factors. 

Where it exists, the outperformance comes from the homework of the quantitative analysts before the trades are implemented.  Once the securities are selected, they are often bought and held until the next quarter/year, when the same algorithms are run again to select the securities which now rank highest in the factor analysis.

Passive strategists have argued that smart beta strategies can’t work, because if everyone is doing it, there won’t be any outperformance available.  While this statement is absolutely true, it is also irrelevant, because everyone isn’t going to implement these strategies.  The same rule applies for why an increase in the number of indexing investors causes an increase in the amount of available alpha for the active management world.  Market inefficiencies are finite and the more people sharing in them, the less there is for each individual participant.

ABOUT THE NAME

Was it Smart Beta when the Fama-French Three-Factor-Model described a stock’s returns being comprised of its beta, but also of its market capitalization (bias toward small caps) and price-to-book ratio (bias toward value)?  Was it Smart Beta when Cliff Asness showed consistent outperformance by stocks that had demonstrated price momentum? 

These well documented (University of Chicago) investment analyses, along with many other Smart Beta strategies, are producing higher returns than their given index, without a proportionate increase in volatility.  Statistically, those excess returns are referred to as alpha, not smart beta.  Jack Bogle is probably right that the term is more marketing than definitional, but for an industry that has been inundated with conflicting messages about the efficacy of active management, new nomenclature that provides a fresh start to outperforming a “buy everything” approach is welcomed in our view.

NOT PASSIVE

While these strategies can come with a lower price tag than many traditional actively managed funds, the potential alpha they can generate, and the processes they use, are comparable.  Many asset managers pride themselves on a repeatable process in their fundamental analysis – Smart Beta simply takes the repeatable aspect to the next level.  Signals and factors that aided bottom-up portfolio managers decades ago can now easily be codified and tested against the universe of investable assets, with an incredible savings in time and manpower, which is largely being passed on to the investor.

As Smart Beta products proliferate, the opportunities to implement strategies that harness quantitative descriptions of well documented market inefficiencies become cheaper and more prevalent – all of which constitute a huge positive for investors.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

The free lunch that is Diversification is often overused in the asset management industry, as we discussed in Part 1.  Here, we discuss why wealth managers are too frequently underutilizing this well known portfolio tool.

Diversification from the wealth manager’s perspective is all about non- and negatively-correlated assets.  Let’s start with the basics, stock and bond allocations.  Stock allocations are often anti-diversifying from an asset allocation standpoint.  It is true that owning a dozen stock funds will reduce the idiosyncratic risk of any underlying company to a negligible level.  The non-diversifying aspect arises because a portfolio has to overallocate cash to lower-beta funds in order to increase the portfolio’s beta to the desired level.  For example, all of the extra cash used to increase the weighting to Fund A, with a beta of 0.8, to a targeted market risk level (beta of 1), comes at the expense of additional portfolio level diversification that won’t be accomplished. 

One solution is to eliminate lower-beta funds that require additional allocation and replace them with higher beta funds that can achieve a targeted risk level with a smaller allocation in the portfolio, leaving additional cash to further diversify.

Bonds are also an asset class in retail portfolios that aren’t well utilized for diversification.  What is the market beta of a portfolio with 60% S&P 500 and 40% bond exposures?  It is all determined by what bonds are being held, and too frequently equities are being complemented with high yields – which are very highly correlated.  Just because the securities are different doesn’t mean they are diversifying from an asset allocation standpoint, e.g. adding high yield corporates to a portfolio of equities.  Trading both makes sense in a capital structure arbitrage fund, but owning both is redundant and cash inefficient in constrained retail portfolios.

A solution would be to increase equity exposure further (assuming the equity risk implicit in high yields was being factored in initially), and replace credit exposure with negatively correlated bonds, such as treasuries or agency paper. 

The big problem facing retail portfolios is that they are bogged down by capital-intensive, lower-risk funds that drain additional capacity which could be allocated to investments that diversify at an asset allocation level.  A litmus test for diversifying asset allocation is the simple question, “did this asset class make or lose money in 2008?”  Large caps, small caps, credit and convertibles all lost money, while treasuries, managed futures and trading strategies all made money.

Ultimately, the optimal portfolio is comprised of as many positive alpha, non-correlated investments as possible, which are strategically rebalanced.  Moving traditional portfolios in this direction can be achieved through the following process:

                Step 1: Replace lower-beta stock funds with higher-beta funds at a lower allocation weighting, and retain excess cash.

                Step 2: Sell redundant corporate credit exposure and replace it with enough additional equity exposure to position        the portfolio at its target risk level, and retain excess cash.

                Step 3: Without reducing market exposures, use the excess cash generated by steps 1 and 2 to increase exposure to truly diversifying investments (in the asset allocation sense of the word, non- or negatively correlated).  Again, this can include treasuries, managed futures, and trading strategies.

                Step 4: Use a strategic approach to rebalancing this new portfolio, which will capture outsized returns from each of the asset classes represented, and lower the average cost in the portfolio.  Rebalancing is the only way a fully invested portfolio can earn more than the sum of its parts.  

The higher the quantity of non- and negatively-correlated assets in a portfolio, the higher the available excess return for portfolios that are strategically rebalanced.  Reducing the inefficient use of capital that stems from lower-beta stock funds and high yield bonds can free up enough cash to diversify into non-correlated assets in a meaningful way, without giving up targeted market exposures.  Staying overweighted in lower-beta stock funds and adding high yield corporates isn't Diversification.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

One of the few free lunches ever to exist in investing is the concept of Diversification.  There are two applications of diversification that relate to the retail investor, one of which is the responsibility of the asset manager, and the other, the responsibility of the wealth manager.  Here we will cover the diversification expected (and unexpected) from asset managers.

Academically, diversification is discussed in the context of the asset manager.  Adding additional securities to a portfolio reduces the idiosyncratic risk (upside or downside) that any individual security poses to the portfolio.  Obviously, the fact that diversifying reduces both upside and downside risk makes it a double-edged sword.

Mutual funds often have upwards of 80 different securities in equity portfolios, and hundreds or even thousands within fixed-income portfolios.  For fixed-income investments with a primary focus on yield, this very high number of securities makes sense – why not limit idiosyncratic downside risk across as many similarly-yielding bonds as possible?  Since performing bonds go out at par, it isn’t like there is much upside risk to capture.

Equities are a different story.  Given the fact that the return distribution of equities is negatively skewed, some diversification is a no-brainer (i.e. reducing more-likely downside risk at the cost of less-likely upside risk is a good trade).  However, asset managers who exceed the 30-stock count, the point at which the vast majority of diversification’s benefit has been implemented, begin to trend more and more toward being closet indexers.  There is nothing worse than what is tantamount to a passive strategy charging active management fees.  Perhaps surprisingly, investors are to blame for this.

Active equity mangers know they won’t get fired (indirectly, by investors) unless they end up in the bottom decile of performance, and so they choose to add many more names to their portfolios than their skill or conviction would suggest, in order to hug their index and end up “right in that meaty part of the curve”. “Not showing off, not falling behind,” to quote George Costanza, is the approach that provides the most job security.

But these are precisely the managers who should be fired.  Going back to our discussion on active vs. passive, if an active manager is charging standard active management fees, but is not generating any alpha, then investors are much better off indexing or finding a worthwhile manager.  By only firing managers who end up in the bottom decile, a result that may come from taking risks that eventually pay off, investors have conditioned much of the asset management industry to hug their indices, keep collecting fees, and hope no one notices.

The asymptotic curve that maps additional securities on the x-axis and decreasing idiosyncratic risk on the y-axis was explained to me years ago by a highly successful equity portfolio manager with billions of client dollars under management.  This PM explained that the small reduction in risk that is associated with increasing a portfolio from 30 to 80 securities has a name – a career.  Investors should consider alpha generation and the number of securities in a portfolio at least as much as raw performance before deciding which managers to fire. 

The free lunch that Diversification brings to a portfolio has diminishing, and eventually negative, returns to scale when you factor in the active management fees associated with implementing it.  The number of securities in an equity portfolio should be negatively correlated with fees and expenses, and if it isn’t, should serve as a serious red flag.  Closet indexing is not Diversification.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

Investment product performance is composed of two very important elements, beta (what the market delivers) and alpha (what the manager delivers).  There is a layer of complication to this analysis, however, and it comes from the fact that “what a manager delivers” may be superior security selection, superior beta positioning, or both (or neither).

Investment selection alpha is what the value investing world means when they claim alpha generation.  In its simplest form, a portfolio manager selects some subset of securities from the larger set of securities in an index, and if the portfolio manager generates a higher gross return, he has generated alpha relative to that index.

But what if, for example, the manager selects all of the securities in the index, weights them by capitalization (like the index), and balances that against either a significant cash allocation, or a negative cash allocation (leverage)?  If the market’s return is positive, the leveraged manager outperforms, and if the market’s return is negative the cash-allocated manager outperforms.  If a manager generates a higher gross return, is this not positive alpha?  Or, is the portfolio manager better described by the pejorative “beta jockey”?

Investment selection alpha and opportunistic alpha both add significantly to investors’ portfolios, yet superior stock and sector selection grab all the headlines.  In fact, generating opportunistic alpha is condemned as “market timing” by those who would not profit from it.  I’ve even heard it called “witchcraft” by a Ph.D who thought opportunistic alpha was about perfectly predicting the market.

No one can perfectly predict the market, as evidenced by the world’s lack of a single trillionaire.  Rather, statistical analysis of critical market factors can produce confidence in higher likelihoods of some outcomes.  Managers employing an opportunistic approach use such research to position accordingly, and those deviations from their index or benchmark result in alpha (positive or negative).

The challenge with opportunistic alpha, and the primary reason it is underrepresented in investment discussion, is that it is more difficult to measure.  The cleanest form of opportunistic alpha is delivered by the managed futures industry.  Here, long or short futures positions are taken over a range of timeframes, across a wide array of underlying assets.  Since these managers rarely hold core long positions, their benchmark – and beta – is the risk free rate.  Anything generated above (below) this rate is positive (negative) alpha.  Not only does this alpha spend the same way investment selection alpha does, it further diversifies by being uncorrelated.

The lack of correlation is driven by the fact that investment selection alpha is sought consistently throughout all periods of the market.  Whether the market is down 20%, flat or up 20%, investment selection alpha is generated if returns are -19%, 1% or 21%, respectively (assuming the same volatility). Visually, investment selection alpha shifts the return distribution to the right.  

Significant opportunistic alpha tends to be generated during outsized market moves, resulting in a positive skewing of the return distribution.  Truncating the left tail and extending the right tail is how opportunistic alpha reshapes the return distribution, rather than shifting it.

Another technique that can generate opportunistic alpha is rebalancing.  Relative to what would normally occur in a client’s portfolio, such as an annual rebalance, an approach based on studied market factors that seeks to exploit market moves that have already happened can generate as much alpha as the work done on investment selection.  All investors benefit from increased alpha, and reallocating some of the focus from investment selection alpha to opportunistic alpha could have a significant, positive impact on portfolios. 

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

Nassim Taleb’s Antifragile: Things That Gain From Disorder, aside from enlightening readers on one of the most insightful and applicable concepts in finance and beyond, has a critical lesson for every investor.

Briefly, one of Taleb’s key points is that things which are fragile are defined as being harmed by disorder (or volatility).  Common wisdom is that the opposite of being fragile is being robust, or being unharmed by disorder.  Taleb’s key insight is that the opposite of being fragile is instead being antifragile, or benefitting from disorder (or volatility).  He goes on to describe a continuum, or triad, of conditions which range from Fragile to Robust to Antifragile.  So where do different investors fit in this continuum? 

Glaringly, those in the de-accumulation phase of their investment lifecycle are the most fragile.  As clients sell assets to generate income, fluctuations in asset prices have a detrimental effect on their portfolio values.  Specifically, the more volatility their portfolio is subjected to, the quicker they will run out of money.  We all know that protecting retirees from portfolio volatility is critical to their success, and this is because they are in a Fragile position.

Those who are invested in the market and have reasonably long liquidity horizons would best be described as Robust to volatility.  These investors aren’t going to end up worse off in the long run if they can refrain from taking withdrawals during a period of portfolio decline, but it also wouldn’t be accurate to characterize them as benefitting from it.  Many investors think being Robust to volatility is the best they can do, and position accordingly.  Introducing them to the concept of Antifragility could help improve their outcomes.

Those investors who are accumulating assets are in the best position to have an Antifragile portfolio.  Contributing regularly to retirement accounts allows for the dollar cost averaging effect we’ve discussed previously, and it is precisely this effect that benefits from volatility.  Specifically, the more volatility their portfolio is subjected to, the higher their long-term returns will be.

So how can we help move the Fragile and the Robust toward a more Antifragile portfolio on the continuum?  One way is through intelligent rebalancing.  By applying a rigorous methodology to buying relative losers with proceeds from relative winners, rebalancing can capitalize on both the upside and downside volatility of individual portfolio elements.  Over time, rebalancing in this way will lead to increased returns specifically due to that volatility.  Antifragility, or benefitting from volatility, will be a brand new concept to most investors - one that can provide them a lot of intellectual and financial value.

Having a fully invested portfolio and a longer liquidity horizon no longer has to mean settling for Robust in Taleb’s continuum.  Adding a rebalancing methodology that considers upside and downside volatility distinctly can make all of your portfolios less Fragile, and more Antifragile.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

Adding to our previous discussion around the benefits that volatility generates for dollar cost averaging strategies, we now consider whether those benefits can be exploited by the fully invested.  Again, the excess returns come from the fact that DCA exploits the “buy more low” and “buy less high” aspect of fixed-dollar investments, and are enhanced by additional volatility.

So, are the benefits derived from DCA exclusively available to those making bi-weekly allocations?  Good news, the answer is no.  In fact, every investor who is already fully invested can structure their portfolio approach so as to gain additional benefits from volatility over time – just like DCA.  This is achieved by executing a strategy of “intra-portfolio dollar cost averaging”.

Traditional DCA takes new cash flows and buys more of relatively cheap assets and less of relatively expensive assets.  For investors who are not adding meaningful additional cash flows to their portfolio (those with the most significant account sizes), a comparable strategy can add additional returns in excess of what the underlying investments in their portfolios will generate.

By systematically buying relatively cheap assets with proceeds derived from selling relatively expensive assets, a fully invested portfolio can generate additional gains over time.   The same concept as DCA applies, as investors will improve the average price of their investments over time, and ultimately earn more than the sum of the portfolio’s parts.  It is also true that increased volatility can enhance those excess returns.  This argument applies even a step further, in that intra-portfolio dollar cost averaging is the only way a fully invested portfolio can earn more than the sum of its parts.

Another less technical term for intra-portfolio dollar cost averaging is ‘rebalancing’.  Unfortunately, rather than being exploited, rebalancing is typically an afterthought, and is rarely considered a domain to which you can apply a systematic process and generate additional returns.  When executed with a system that exploits volatility like its DCA brethren, rebalancing can be an extremely powerful portfolio tool – we at Strategic Alpha have measured excess gains at the portfolio level of 80 basis points per year.

Considering all of the effort that goes into generating investment selection alpha (or ‘fee reduction alpha’ for the passive strategists among us), it seems worthwhile to consider other areas of potential gain that have gone unexploited for so long.  We invite you to consider our studied approach at www.Strategic-Alpha.com.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

We all know that Dollar Cost Averaging is an excellent way to improve returns, earning even more than the long-term return of the assets in which you’re investing.  This is accomplished as DCA forces investors to buy more at relative lows and less at relative highs over the life of an investment.  This is difficult to do on a discretionary basis because of a number of our cognitive biases, but the systematic nature of DCA eliminates our emotional overrides and simply takes advantage of changing asset prices.

So given that DCA is a great strategy, we ask if it is strengthened or weakened by additional volatility?  Common industry knowledge tells us that volatility is bad, something that needs to be justified by returns.  When you are implementing a DCA strategy, however, volatility is objectively a good thing – and the more the merrier.

Example:  Assume two investments, X and Y, have the same long-term rate of return.  Also assume that investment X has a higher level of volatility then investment Y – it reaches higher relative highs and lower relative lows over the invested period.  (At this point, all investment textbooks tell you it is a no-brainer to invest in Y.)  As we proceed with our DCA strategy, a market decline impacts the price of X by -50% and Y by -25%.  Our fixed-dollar investment (the cornerstone of DCA and retirement saving) buys much more of X at the deflated price than Y.  Then the price of X rises much more than the price of Y during the subsequent recovery, and we buy less of X than Y at the inflated price.  Continuing our DCA strategy, rinsing and repeating the above, we end up with a much lower cost basis for investment X, thus generating a much higher IRR in X, even though X and Y had the same long-term performance.

Without exception, it is better to select the higher volatility asset when executing a DCA strategy and deciding between two investments with the same long-term return.  In this way, volatility is the friend of the DCA investor.  There are many corollaries that stem from this realization, which will be covered in future posts.  For now, let’s just establish that the group of people using DCA is enormous, comprised of every American with a 401(k), and as of yet no one has told them about the benefits of volatility.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes. www.Strategic-Alpha.com

The passive management industry has done an incredible job of projecting their mantra into the investing zeitgeist, and each year we are subjected to claims like “74% of active managers underperformed their index.”  Like all good cons, this is not an untrue statement.  It is however, an excellent use of misdirection - making implications about passive strategies that are untrue. 

“If that many active managers underperform, I guess I’ll just go passive.”  This is the inference that the passive industry seeks from the world, and sadly one that the uncritical investor has fallen prey to.  The following is not a rejection of passive strategies, but a few thoughts on how to more accurately consider the active vs. passive debate.

Let’s start with an obvious point.  It may be the case that 74% of active managers underperform their index in a given year, but what is left unsaid is that if all passive managers are doing their best to follow their investment policy, 100% of them will underperform!  Why?  Investment strategy returns can be reduced to a reasonably simple equation:

                Strategy Return = Market Exposure + Alpha – Fees

So if your alpha is 0% (all passive strategies), and your fees are > $0 (all businesses), then your returns are lower than what pure market exposure would produce.  100% of passive strategies should underperform their indices.  74% isn’t great, but it’s better than 100%. 

OVERSIMPLIFIED

All passive managers are aware that active managers’ returns are a product of their market exposure (Beta), and their skill (Alpha).  The fact that they continue with the ruse of comparing all active managers to a non-risk-adjusted performance figure is deplorable, because it confuses most investors.

Most active managers run less risky portfolios than their index or benchmark.  Asset management is risk management, and prudent risk reduction should not be penalized.  When sophisticated investors compare managers, they compare risk-adjusted returns.  The only way we should be determining an active manager’s value is by measuring alpha generation.

ZERO SUM GAME

Alpha does not exist in nature.  If alpha is created in one manager’s portfolio, it necessarily means that another manager has generated negative alpha.  Picking the manager that can generate long-term alpha isn’t a trivial exercise, but it is certainly worth the effort considering the impact that the power of compounding over decades has.  Even if there is no alpha on average, there are many managers who generate it. 

You wouldn’t stop watching the NFL and say, “Another terrible year, on average the league was just .500, again.”

So when is an active manager worthy?  Don’t compare returns to an index, compare alpha to expenses.  If an active manager generates more alpha than they charge in fees, they are worthwhile.  In fact, it is a little easier than that, because the next best alternative to a good manager, indexing, has some costs.  So a manager is worthwhile in practice as long as their alpha, less their expenses, has an absolute value lower than the comparable index fund's expenses.

It is more work to analyze managers under this far more accurate framework, but it is absolutely worth the effort.  Passive strategies are certainly better than active managers’ whose fees exceed their alpha – I just wish they would say that instead of perpetuating their con. 

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com

Not that the article in Fortune committed the original sin on this topic - I’ve heard similar representations in the past – but this piece crystalized an inaccurate impression that has been used to impugn lots of strategies, from long/short equity to managed futures.  As a final preface, I’d like to note that this is a defense which, clearly, Paul Tudor Jones doesn’t need my help on.  From the article:

"My notion of a hedge fund is that it is a series of sophisticated, targeted bets on stocks or bonds or some portion of the market….

But if you listen to Jones, that’s not what you get when you invest in a hedge fund at all. What you are really getting, if Jones is right, is a one-way bet on volatility…

And it turns out, Jones, a three-decade veteran of the hedge fund business, is right. Hedge funds tend to do well in years in which volatility is rising. And they suck wind in years when it is not…

The bigger problem for hedge funds is this: There are now much cheaper ways to bet on volatility…

If you are looking to lose money, and considering investing in a hedge fund, the VIX funds are a much cheaper way to do it."

Quickly, we need to define our terms.  Being long of anything, be it a security, derivative, or variable exposure, means quite specifically that a benefit is derived from an increase in the element.  In one example, if the S&P 500 moves from 2000 to 2200, an unlevered long position gains 10% (plus reinvested dividends).  If a long position is taken on some proxy for volatility, say the VIX, a benefit will be derived if and only if the position is initiated at lower VIX level than when the position is closed (and even then there are some technical issues which are detrimental to investors).

Being long volatility, as opposed to stocks, has never been a successful longer-term strategy.  This is because volatility is a second-order representation of the behavior of values of actual companies.  While volatility does gyrate up and down, it does so without the underlying growth of the economy that has provided a very long-term trend upward in equities.  Owning a basic long position in volatility is at best a short-term, tactical trade. 

More to the point, hedge funds don’t necessarily do well in periods of rising volatility.  Hedge funds, often engaged in relative value or arbitrage trades, are much more likely to do well during periods of high volatility.  The period during which volatility increases may or not be a profitable time for a hedge fund.  Rising volatility tends to imply declining equity prices, so it would follow that a hedged fund (one whose market beta is < 1) would outperform during a period of declining equity prices.  But more broadly, the value created by hedge funds isn’t primarily concentrated during those periods of equity decline, but rather during extended periods of higher volatility, wherein greater discrepancies between like-securities occur, and the arbitrageur can generate more alpha.

The difference between what hedge funds are actually capitalizing on and the claim in the Fortune piece is that being long volatility can only benefit an investor during the short bursts of increasing volatility.  It is different than an increase in prices in the following way:  A period of increasing stock prices benefits shareholders – plain and simple.  A period of high stock prices, say a year in which the S&P begins at 2300 and ends at 2300, will not benefit (aside from dividends) investors who are long the S&P.  Likewise, being long volatility during a year of high volatility, say a year wherein the VIX clocks in at 35 at some point each month, will not benefit investors who are long volatility, but it is likely to benefit strategies which profit in times of high volatility.

In conclusion, alternative investment strategies are more likely to prosper, relative to the market, in periods of high volatility, as opposed to periods of increasing volatility.  A nuance to be sure, but a critical one, and one that should illustrate why it is unlikely that return streams from hedge funds can be replicated by an inexpensive ETF.

Unfortunately, volatility is regularly defined as the standard deviation of the return distribution of an investment.  This is unfortunate because the well-known implications of the statistic (e.g. 95% of occurrences fall within 2 standard deviations) are only relevant to data that are normally distributed, while the vast majority of investment products are decidedly not.  Moreover, practically, standard deviation is only relevant to investors who are equally concerned with upside and downside volatility – one of these people, I have never met.

On the technical side, equities have historically offered a negatively skewed return distribution, meaning there are more profound moves to the downside, though more rare, and smaller, more consistent moves to the upside.  The Implication that the typical difference between an investment’s mean return and observed return is the same during periods of outperformance and underperformance is misleading, and complicates the responsibilities of managing client expectations. 

More importantly, from a practical standpoint, investors in aggregate are risk-averse.  This means that the utility they derive from a gain is lower than the utility they lose from a loss of equal magnitude.  More simply, losing a dollar hurts more than winning a dollar feels good.  So how can it be, then, that the vast majority of analysis of investment products focuses on standard deviation, rather than breaking out upside volatility and downside volatility.  Investors obviously seek to maximize returns, but they do so with an eye on intermittent losses, not deviations from the average.

One way that the alternative investment universe has led the way is by addressing upside and downside volatility separately, as well as looking at ‘maximum drawdown’, or the biggest percentage loss an investor would have suffered from peak-to-trough (e.g. in the period from 2007-2009, an investor in the S&P 500 would have had to endure a drawdown of 55.3%).  Furthermore, identifying investments with positively skewed return distributions (bigger right-tails than left-tails) is a great way to diversify and capitalize on upside volatility.

Risk-weighting investments by downside deviation will go a long way in narrowing the gap between client expectations and outcomes.  The implications of a standard deviation in normal distributions are not applicable to the investments we own, and they are not important to that subset of investors who worry more about losses than gains – everyone.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.  www.Strategic-Alpha.com