All That Fun For Nothing!

by: Columbia Threadneedle Investments

Summary

In sideways market environment marked by large price swings, investors need a way to navigate the round trip of drawdowns followed by recoveries.

Broad diversification is the best tool investors have to influence the efficiency of their portfolios.

The combination of milder downside capture and stronger upside capture holds the key to avoiding an investment result no better than "all that fun for nothing."

By Jeffrey Knight, CFA, Global Head of Investment Solutions and Asset Allocation

Early in my career, an investment mentor shared the personal trading habits of one of his former colleagues. The man traded frenetically, changing his views and holdings on an almost daily basis. At the conclusion of one calendar year, a year marked by hundreds of twists and turns in the positioning of his personal account, the man boasted of his success. "Success?" wondered my mentor. "Why do you consider the year to have been a success when your portfolio merely broke even?"

"Because," answered the colleague, "I had all that fun, and it didn't cost me anything!"

Since hearing the story, I must admit that the phrase, "all that fun for nothing" has become a personal favorite. With surprising regularity, financial markets provide the opportunity to drop that phrase as a deadpanned summary of recent events. Consider the first quarter of 2016 for the S&P 500 Index (Exhibit 1). The year started with an 11% plunge, but on February 12, the index began a recovery for the record books, reclaiming the most lost ground within a calendar quarter since 1933. The index ended the quarter with a positive return - exciting, to be sure, but the positive return was just 0.77%. All that fun for nothing.

Exhibit 1: S&P 500 Index cumulative returns (%)

Source: Bloomberg, March 31, 2016

Besides providing mild amusement through frustrating market environments, the phrase provides something more important - a concise expression of a baseline challenge of investment strategy. The challenge is simply this: When the months and quarters and years have come and gone, make sure you "have something to show for it." Successful investment strategy should never settle for all that fun for nothing.

Sometimes, having something to show for it happens with minimal effort. For example, in the five years following the financial crisis almost every asset class delivered high annual returns. At other times, however, cumulative profit can be more elusive (Exhibit 2). For the last 16 months, the U.S. stock market has behaved in a similar way to its first-quarter 2016 pattern - lots of price swings with no cumulative progress. Globally, the situation extends back even farther. In the case of the MSCI All Country World Index stock index, the closing level from Q1 2016 was first reached in October 2013, nearly two and a half years ago. The goal of having something to show for it has been elusive for buy-and-hold equity investors for some time.

Exhibit 2: Cumulative equity returns since the Great Financial Crisis (%)
Click to enlarge
Source: Bloomberg, March 31, 2016

We believe the key to overcoming a market environment defined by wide price swings but no cumulative progress lies in the arithmetic of compound returns. A drawdown of a given magnitude will require an even larger gain to reclaim the original portfolio value. If we think of a directionless market as a series of drawdowns followed by recoveries, we can then focus on devising a strategy that makes cumulative progress through the "round trip." Our strategy should seek an improvement in the balance of how our portfolio participates in each round trip. If we can identify strategies that flatter the comparison of our drawdowns to our recoveries, we are well on our way to succeeding across the round trips that occur in a trendless market environment. As Q2 begins, we have two recommendations to help with this challenge.

The first relates to portfolio efficiency. In general, the higher a portfolio's expected return relative to its volatility, the more effectively it can be expected to navigate a round trip. We believe the best tool investors have to influence the efficiency of their portfolios is diversification, and lately diversification has worked beautifully. The negative correlation we continue to see between stocks and bonds means that, on average, bonds will do well when equities languish, and vice versa. A portfolio that balances its risks across stocks and bonds should behave in a more stable fashion than a portfolio whose risks are concentrated in either asset class. Furthermore, broad diversification exposes portfolios to certain asset classes that have underperformed for some time and may offer high returns prospectively.

The second recommendation relates to our current outlook. Specifically, we are upgrading equities from an underweight position to a neutral position. Our previously conservative outlook was derived from numerous sources. First, our proprietary asset allocation indicators have regularly signaled a below-average outlook for equities over the past year. Second, we have noted several macro factors providing a headwind for equities, including the onset of a Fed tightening cycle, tightening conditions in credit markets, and a rising probability of recession. Each of these factors improved during Q1. While we continue to believe that equities are at least fully priced and late-cycle dynamics constrain their upside, we also think investors are generally well-served giving equities the benefit of the doubt, barring compelling evidence of elevated risks.

In a market environment marked by large price swings in a mostly sideways pattern, diversified investors have a big advantage. Well-diversified portfolios, especially those positioned with extra conservatism, should participate less forcefully in drawdowns affecting risky assets like those we observed in Q1. We believe portfolios like these may benefit from a selective and opportunistic increase in equity exposure, with the goal of participating a little more forcefully in what we expect to be, at least temporarily, an improved environment for taking risk. The combination of milder downside capture and stronger upside capture holds the key to avoiding an investment result no better than "all that fun for nothing."

Disclaimer: The views expressed in this material are the views of the author through the date of publication and are subject to change without notice at any time based upon market and other factors. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. This information may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable. Past performance does not guarantee future results. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Please see our social media guidelines.