[Innovation happens when old ways of thinking and long held assumptions are challenged. An accelerating number of new tools and methodologies are rapidly coming into the world of traditional asset management and are spawning new approaches in managing portfolios and risk. To explore where this new environment is taking some money management firms, the Institute for Innovation Development recently talked with Tom Hardin, Managing Director and Chief Investment Officer of Canterbury Investment Management – an investment advisory firm specializing in providing financial advisers, institutional investors, and retirement professionals with an adaptive ETF portfolio management solution built on defined rules and evidence-based results. Focused on their proprietary Portfolio Thermostat Strategy and their The Portfolio Thermostat Fund (MUTF:CAPTX), Tom warns advisors and other money managers about the risks in not challenging “conventional wisdom” and positioning yourself to take advantage of a new era of investment innovation and opportunity for investors.]
Hortz: Why do you characterize today’s investment environment as an unprecedented time of innovation and a new age of enlightenment?
Hardin: Today, we have access to virtually unlimited computing power and equally robust software algorithms that are designed to process big data and uncover hidden, relevant information. The early adoption of new cutting-edge technologies and enhanced operating systems usually leads to massive disruption of the status quo and traditional ways of thinking. These technologies open a gateway to new horizons of possibility and prompt a re-examination of all our assumptions, theories, and methods being currently used.
We feel strongly that we have entered a new age of financial enlightenment that will lead to a seemingly endless stream of new information and innovative product creation like the development of highly unique exchange traded funds. When new technologies are combined with equally robust adaptive portfolio strategies, then innovation can thrive, making it possible to better manage a portfolio through any market environment - bull or bear.
Hortz: With the advancement of new investment tools and changing investing paradigms, why do you feel that most asset managers still depend upon outdated methodologies and resort to the same old approaches?
Hardin: Traditional portfolio management was built based on theories and beliefs that were formed 30 to 50 years ago. The primary challenge for portfolio managers has been to overcome the years of ingrained “conventional wisdoms” that have become unquestioned truths. Overcoming these conventions requires a whole new way of thinking that will, often times, fly in the face of existing beliefs. Those individuals who lack a compelling vision of what the future could be are more likely to be slow to adapt to change and risk becoming obsolete. Remember that conventional wisdom is the enemy of innovation.
It is also important to note that advancements in new technologies and tools only have the “potential” to create change. The full benefits of any new technology will not be fully realized until a learning curve of trial and error is complete, and the creation of new applications have had a chance to catch up.
Hortz: Can you walk us through an example of an incorrect assumption being widely used by investment professionals?
Hardin: Let’s begin with the universal assumption that drives the way portfolio managers and investors invest - the risk/return relationship. This is driven by a common belief, perpetuated by the old theories, that given enough time, the willingness to assume more risk is required in order produce higher returns. The relationship hinges upon the acceptance of a tradeoff - invested money generates higher profits only if subjected to higher risk. Low levels of risk only entitle you to low potential returns.
The risk/reward proposition is an assumption born from business. A business owner, or potential business owner, would first assess whether or not a business decision was worth making. He/she would evaluate the capital and the timeline required in order to determine the risk of the decision. A business decision that required more initial capital, or a longer timeline, would require a higher potential return to compensate the business owner for the higher level of risk.
The idea of the risk/reward relationship was then transferred to portfolio management and became a conventional wisdom. When applied to securities, the risk/reward relationship becomes a flawed assumption. In liquid securities, risk is defined as volatility (high volatility is a bear market characteristic and low volatility is a bull market characteristic) or as the willingness to accept larger drawdowns in value. Contrary to owning or managing a business, owning a portfolio of securities is not about risk/reward because taking higher risk does not lead to higher returns. Subjecting a portfolio to more risk (higher volatility) leads to higher probabilities of substantial declines that offset the benefits of previous gains. Declines of 15%, 20%, or more could take years to recoup. Portfolio growth is not merely about making money, but also the ability to keep it.
Portfolio management is about creating the most efficient portfolio; the one that produces the highest returns versus the amount of risk taken. Markets are dynamic and ever-changing, therefore, the most efficient portfolio is a constant moving target. The combination of securities that produces the most efficient portfolio in a volatile, bearish environment should look very different from an efficient portfolio in a bullish environment.
Fixed percentage asset allocation models, based on investor risk tolerance and the risk/reward relationship, will fail to achieve the target risk profile because of a simple fact: pie charts are fixed, but markets are dynamic. By failing to adapt to changing market environments, fixed allocation models will subject investors to increased risk in the form of higher volatility and larger declines. By creating a stable portfolio reflective of the dynamic nature of markets, lower levels of “risk” can allow for higher compounded returns.
Hortz: What has your research uncovered about ways to manage investment risk and creating models with predictive value?
Hardin: Our studies show that changes in market volatility can be an effective leading indicator of future market behavior. Low or decreasing volatility is typically associated with bull markets, while high and increasing volatility is characteristic of bear markets and bubbles. We use the Canterbury Volatility Index (NYSE:CVI) as the market’s “volatility” thermometer. The CVI flags an increase in volatility, which is a leading indication of a change in the market environment, most typically a negative change.
Our system for identifying market and security environments is not a prediction of return, but rather has predictive value in identifying risk. If normal bull market corrections fall within the 8% to 12% range, and if we can successfully identify those bull markets, then we know our downside is limited and the potential for upside is high. By selecting securities that hold key bullish characteristics, we can construct a portfolio with limited risk, and higher potential for compounded returns.
Hortz: Can you explain for us the thinking behind your portfolio thermostat strategy?
Hardin: The Portfolio Thermostat is an adaptive portfolio strategy that was created based on the same principles as a home thermostat. A home thermostat is an adaptive system that responds to dynamic changes in outdoor temperatures in order to maintain a comfortable and stable indoor temperature. The Portfolio Thermostat is designed to maintain an efficient/stable volatility by adapting the portfolio’s holdings to move in concert with ever-changing market environments.
Markets and weather have a lot in common. Just as the weather will experience various environments, markets will also go through variable environments, whether they are bullish; bearish; or somewhere in between. In order to make the necessary adjustments, the home thermostat requires a process for identifying the current weather conditions. Similarly, an essential capability of the Portfolio Thermostat is its ability to distinguish between the different market environments. The risk typical of each market environment can be substantial. A normal bull market correction falls within the 8% to 12% range, while bear market drawdowns can go upwards of 20% and beyond. The Portfolio Thermostat has provided empirical evidence that it can differentiate the market environments and make the proper adjustments to limit drawdowns to a normal bull market correction.
By having an adaptive, evidence-based system to navigate all market environments, we believe investors can experience a new paradigm in portfolio management. The home thermostat changed the way we experience comfortable indoor living. The thermostat employs a complex process to produce the solution to ever-changing weather conditions. The Portfolio Thermostat is a complex system that can revolutionize how we invest in dynamic market environments.
Hortz: What are the steps or methodology you use in applying your thermostat strategy to building client portfolios?
Hardin: Here are the steps we follow in our process of constructing portfolios:
Step 1: Identify the Current Market Environment - The Portfolio Thermostat identifies 5 Bullish (rational) Market States, 4 Bearish (irrational), and 3 Transitional. These Market States are based on Long-Term, Volatility, and Short-Term supply and demand indicators.
Step 2: Classify the Universe of ETFs into Diverse Investment Classes – Our Portfolio Thermostat typically invests in ETFs. The model categorizes each ETF into one of two major classes: the Global Stock Market Universe or Bonds and Alternatives to the Global Stock Market.
Step 3: Construct an Efficient Portfolio to Match the Current Market Environment - The Portfolio Thermostat’s objective is to select the combination of securities that best fit the unique characteristics of the current market state. This requires a continual monitoring process wherein portfolio holdings are rotated in or out as the environment shifts in order to maintain the most optimal combination of securities with efficient diversification to combat the current environment.
Hortz: Why is your long-term portfolio management strategy so focused on a short-term horizon?
Hardin: Adaptive portfolio management requires daily (short-term) monitoring. The importance of the short term in the Portfolio Thermostat process cannot be overemphasized. The key is knowing which short-term factors are important and which are not. There is nothing we can do about the past. Decisions are made on a real-time basis, so long-term growth and success depends heavily upon how the short term is managed. A viable strategy, therefore, needs to be dynamic enough to shift as the markets shift, but also use an objective, systematic, and testable process that can distinguish between significant changes and normal market noise.
Hortz: What is your best advice to advisors about meeting the challenges and taking advantage of evolving portfolio management methods?
Hardin: First of all, please be aware of the many “conventional wisdoms” that have become so ingrained into the portfolio management process that they are treated as undisputable truths. We have entered an unprecedented time of disruptive innovation with a slew of new cutting-edge investment tools and technologies.
Beware that conventional wisdoms can continue to survive in the face of overwhelming and irrefutable proof that they are worse than wrong. They are dangerous to your wealth. Overcoming the conventional wisdom requires a whole new way of thinking that will often times fly in the face of what was always assumed.
A successful investment strategy for the 21st century requires a clear focus and understanding of the investment environment. You must re-examine all of your preconceived notions, abandon the useless, and be willing to incorporate the many useful new advances into your strategy. As the financial enlightenment in portfolio management progresses, traditional asset managers will be forced to adapt, or get out of the way. Innovation will happen when we allow our imagination to re-examine everything we thought we knew for sure.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.