If you find yourself reacting to the news… you might not be doing it right. It is much more useful (and profitable) to anticipate trends in advance than it is to respond to the morning’s headlines.

When people talk about investments at cocktails parties or social gatherings, the conversation almost always veers towards “How do you believe that X will influence Y?”
The “X” in this case is always the hottest news item, and “Y” is typically the investment that is receiving the most press coverage.

Watching CNBC or Bloomberg News, you’ll get a good sense of the market’s mood for that moment . Market commentators will scramble to explain why today’s big story is moving the markets. When a story occurs for several days (or weeks) in a row, it becomes a source of public obsession. Eventually, that story becomes the most important thing moving the markets. Everyone becomes an expert in understanding the topic at hand, until the issue is resolved and the markets move to a new narrative.

It is worth mentioning that portfolio managers have relatively little control over client returns. If it was easy to control returns, we would always choose to generate spectacular profits. Right? Investing would become tedious, because everyone would have equally amazing performance.

What can be controlled is exposure to opportunity and risk. And the traditional way of doing this is through something called "asset allocation", which is part of a much bigger framework known as Modern Portfolio Theory (MPT).

The principle is fairly straightforward. By putting together a portfolio of non-correlated assets, you can hypothetically create smoother returns for investors.

In the example above, we compare the performance of the S&P 500 index (dark blue) with the 20-year U.S. Treasury Bond (light blue). The middle line represents a balanced portfolio which is equally invested in both. The time period illustrated is 1956-1962, shortly after Modern Portfolio Theory was developed by Harry Markowitz in The Journal of Finance.

It was a beautiful and elegant idea. Asset allocation created a new standard for the industry and is still in use today.

One of the useful things about asset allocation was that it enabled financial advisors to be agnostic about the financial markets. It was no longer considered necessary to anticipate (or respond) to the news. All the advisor needed to do was "stay the course" and periodically rebalance portfolios to a target allocation.

Meanwhile, investors had less portfolio volatility. Mutual funds had lower asset turnover, because investors stayed invested for longer periods of time.

This was the real genius behind asset allocation. It kept everyone happy (for a while).

The Limits of Asset Allocation

As a portfolio manager, I started to see the limitations of asset allocation during the Financial Crisis of 2008-2009. During that period not only did the S&P 500 lose half its value, but bonds were down, real estate was down, and commodities were down. "Winning" simply meant "losing less." The only major asset class that didn't lose value was... cash.

Now that the S&P 500 is over 10% off from its peak levels earlier this year, we are seeing similar parallels. Many traditional asset classes are becoming correlated - right when we want the benefits of diversification.

In the chart above, all major financial asset classes show some correlation to the S&P 500. There is a slightly negative correlation between the Barclays Aggregate Bond index and the MSCI Emerging Market index. Beyond that, everything else "sinks or swims" together.

Furthermore, the S&P 500 consistently outperformed most other asset classes over the past five years (and for the first half of this year). Attempts to diversify against U.S. market risk have generally produced performance lag, especially for those portfolios holding exposure to international and emerging market stocks. Bonds have lagged more recently, as a result of higher interest rates.

Source: www.novelinvestor.com

This isn't saying that asset allocation is dead. If the current market correction evolves into a typical bear market, investors using some form of asset allocation may see less downside.

My sense is that asset allocation may be inadequate on a stand-alone basis. People are starting to figure this out. There are other useful tools of risk management, and these include style/sector rotation, investment selection, hedged strategies, and market timing. This is a benefit of having an independent investment advisor for your portfolio, as traditional index funds don't do any of these things.

Jim Lee, CFA, CMT, CFP ®

 Disclosure: Information contained herein is for educational purposes only and is not to be considered a recommendation to buy or sell any security or investment advice. Securities listed herein are for illustrative purposes only and are not to be considered a recommendation.

Investing used to be simple. You would go out and buy and index fund, and then forget about it for the next ten years. It’s easy and inexpensive. This is called a “passive” strategy because you really didn’t need to do anything, beyond making the initial decision.

But not all index funds are created equal. While the Vanguard S&P 500 Index is still the largest mutual fund in the known multi-verse, there has been an explosion in what can be described as “enhanced” index funds. These are based on a few simple principles that have been shown to generate out-performance over time.

Enhanced index funds exist in something of a gray zone between “passive” and “active” strategies known as “factor” investing. It is an approach that fits well with the rising trend of robo-advisors coming into the marketplace today.

Based on Morningstar research, there are now 1,500 single-factor ETFs on the market. These can be categorized into five basic varieties….

Once a factor is identified, a custom index can be built by screening for stocks that satisfy the selected definition.

I’m beginning to see your eyes glaze over… but wait, this is really interesting stuff!

Looking back at almost 40 years of data, these five factors do appear to generate some outperformance over time, mostly in the 0.3% to 1.5% per year range.

The Size factor generally seems to provide the best returns, in exchange for the greatest risk. Meanwhile, the Low Volatility factor doesn’t seem to outperform over time, but does offer great protection during down periods. Both seem to be good, but each one is best under different circumstances. Furthermore, no single factor performs best every single year.

What ends up happening is a fairly highbrow game of “rock, paper, scissors.” You never know which one is going to win, so many portfolio managers choose a mixed strategy of factors. That means doing a little bit of each.

The key difference here is that unlike the original game, the investing version tends to play the same hand sequentially. Meaning, if Momentum has outperformed last year, the odds are good that Momentum will outperform this year, as well. This may occur until Momentum is so overpriced that it eventually fails. Sometimes, it fails badly.

While you might want to follow one-year trends in factor performance, following 5-year trends can be hazardous to your portfolio. In short, you can run the risk of becoming too predictable for your own good. Spend too much time playing with scissors, and you’ll eventually get crushed by a rock.

So, how do you know which factors to play?

The guys at Oppenheimer Funds put together an actively managed index strategy that allocates between the five basic factors, based on the business cycle. The timing for the business cycle is determined by watching key economic indicators and what they refer to as “global risk appetite.”

And the back-tested results are looking quite good, generating annualized out-performance in the +5% range. Please keep in mind the fact that most new strategies look pretty amazing in hindsight.

 At the end of 2017, a new ETF was released that follows this active allocation approach. The Oppenheimer Russell 1000 Dynamic Multifactor ETF (ticker: OMFL) is off to a great start. It may be one of the few new ETFs that you can buy, hold, and then forget about for ten years.

Can it be possible that index investing is simple again?

Jim Lee, CFA, CMT, CFP®

Disclosure: Information contained herein is for educational purposes only and is not to be considered a recommendation to buy or sell any security or investment advice. The advisor holds shares of the Oppenheimer Russell 1000 Dynamic Multifactor ETF in client accounts. Securities listed herein are for illustrative purposes only and are not to be considered a recommendation.

1. Where you focus is where you lean
2. You are less likely to have an accident if you are well-balanced
3. Everything is easier with momentum (except for making turns!)
4. Over-steering is like micro-managing. It only slows you down.
5. Keep your hands off the brakes, and let the hills do the work for you.
6. Everyone learns faster when leadership is shared.
7. Keep your eyes on the trail at least 20 feet ahead of you. More time to react.
8. Switch gears before absolutely necessary.
9. Everything is better with friends.
10. The best views usually follow the longest climbs.