A Journey of Discovery

Developing a robust investment proposition

In this short article Richard Ross outlines the thought processes that have led to the Chadwicks approach to managing risk in clients’ investment portfolios

The collapse of first Bear Stearns swiftly followed by Lehman Brothers in 2008 triggered a series of events that highlighted real shortcomings in widely held investment theories. Until then the perceived wisdom, based on modern portfolio theory, was that providing you had an appropriately balanced portfolio you should just sit out any volatility and it would all come right in the end. Of course it did come right, thankfully fairly quickly, but nonetheless it was a very uncomfortable experience for all of us.

I started to question what my clients were really looking for and the extent to which our proposition had met those expectations. While having a balanced portfolio meant losses were lower than the equity markets generally suffered they were still significantly higher than it would be reasonable to expect – and to say it was out of my hands and happened to everyone seemed a pretty poor response.

My conclusion was that most of my clients were loss-adverse rather than risk-adverse. This is an important distinction. An institutional investor looks at risk – or volatility – as a measure where either side of the mean is equally valid. If an investment manager targets a volatility of ± 10% the institutional investor is satisfied as long as he meets that target. An individual client on the other hand is far more sensitive to a return of -10% than he is to a return of +10%.

The classic way of reducing risk is to reduce exposure to equities (shares) and increase exposure to bonds (e.g. Gilts). However, in the light of Quantitative Easing increasing bond holdings did not look an especially attractive alternative.

What was needed was a process that allowed clients to have the upside benefits of investing in equities but reduced the potential for the very large losses seen both in 2008 and in the wake of the Dotcom bust in 2004.

I first looked at trend investing around  18 months ago but I did not immediately appreciate its potential. However, it remained a subject that interested me and I left it on the back-burner while I looked at alternatives. My interest was rekindled at a lecture by Professor Stephen Thomas from City University’s Cass Business School. His team has researched this technique in some depth and during subsequent conversations I have gained a clearer insight into both the theory and how it can be practically applied.

The approach relies on behavioural finance – the psychology behind investment decisions. The Efficient Markets Hypothesis assumes rational investors will act on new information – empirical evidence counters this. Investors tend to delay decisions, they sell at the wrong time and their tendency to loss-avoidance means they hold into underperforming stocks for too long. This applies equally to both professional and individual investors. This mismatch between efficient market theory and reality and the resulting delay in investor action means it is possible to use back- analysis to establish a market’s trend and momentum. This in turn means you can create strong signals for when it is better to both leave and rejoin a market, moving in and out of cash, resulting in lower falls in value and, in some instances, increased overall performance.

The availability of price data means the approach can be back-tested over very long periods. Since 2000 the approach has been very successful, both reducing volatility and increasing returns (see graph 1)

but over the longer term, especially in the 1990s, there were extended periods during which a trend-following portfolio would have underperformed (see graph 2).

However, even during this period the risk- adjusted return was better for the momentum portfolio. Taking the period from 1971 – 2008 and using the MSCI World equity index the average monthly return for the momentum approach was 0.8% higher but more importantly the maximum drawdown (high to low) was 22.55% compared with 46.31%.

My conclusion was that momentum investment is an effective way of using technical analysis to reduce volatility but, more importantly, the size of drawdowns – arguably the most unsettling aspect of equity investing. While there will be periods when the approach will yield lower overall returns many would see this as a price worth paying for stability. It is important to appreciate that the process has a tendency to reduce but not eliminate losses. It also is worth noting that it produced poor results in October 1987 (Black Monday) when the markets fell over a very short period. The alternative of using a derivative-based approach was rejected on grounds of clarity and opportunity cost.

A new option

Markets over the last couple of years have seemingly ignored the underlying economics to recover very strongly from the 2008 falls. In Mid- 2011 the world, however, still felt a very uncertain place with pundits from Vince Cable and Gordon Brown to people who actually know what they were talking about warning that the next financial disaster is just around the corner. I believed we could offer a response to these concerns.

In May 2011 we introduced the option of a trend-following underpin to our Capital Management clients. Their portfolios were based on Modern Portfolio Theory which says that holding a mix of assets in appropriate proportions will reduce risk without unduly hampering performance. This had been shown to work most of the time and remained our starting point. We wanted something that would reduce losses on the occasions when the protection offered by Modern Portfolio Theory failed – which tended to be when markets were under great stress and assets moved to correlate closely. We saw trend analysis as offering this additional layer of risk management.

At the same time we decided to implement changes following our research into the relative merits of actively managed funds and passive, index tracking funds. The Efficient Market Hypotheses suggests it will be difficult for a fund manager to consistently out-perform the market average and this has been demonstrated empirically.

At this initial stage we decided to concentrate on the four main areas where our clients held equities – UK, US, Europe and Japan. The Efficient Markets Hypothesis suggested that it would be more likely that active managers would outperform in less efficient markets so we decided to leave these unchanged, as was also the case with Fixed Interest and Property holdings.

The test of the approach came far sooner than we had expected. At the end of July the indicators were that we should move out of all four market sectors. We did and the avoided most of the falls associated with the worst quarter since 2002

Following the early success we have continued to refine our proposition based on solid academic research. The anticipated outcome of our approach would be that you would see a small reduction in performance but in return see a significant reduction in both risk and maximum drawdown, which fits well with the desires of the majority of our clients.

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This newsletter is intended for information only and does not represent personalised financial advice. If you require advice in respect of your financial planning, you should contact us. Past performance is not a guide to future performance. The information in this newsletter was correct as at Oct 18, 2011 but may not apply at the time of reading.