Here we provide a brief description of some of our thoughts, observations and guiding principles that shape our approach to investment management.
Absolute returns are key to the sustainable compounding of capital
The result of an absolute return approach through an active risk management process (when successful) is an asymmetric return profile exhibiting negative skew, that is, more and higher returns on the upside and fewer and lower returns on the downside. Controlling downside volatility and draw-downs is key if sustainable positive compounding of capital is the major objective. Achieving sustainable positive absolute returns is the result of taking and managing risk wisely.
The importance of asset allocation
Empirical studies demonstrate that about 90% of the variability in returns of a typical balanced (equities & bonds) mutual fund across time is explained by asset allocation policy (Ibbotson and Kaplan 2001). Other investment decisions such as security selection have a more modest impact and, on average, reduce portfolio return.
Modern Portfolio Theory is inherently flawed
The 2008 financial crisis has led many investors to re-examine some of the key assumptions that lie at the heart of modern portfolio theory.
MPT assumes investors are rational and risk averse when we know, through the study of behavioral economics, that they are not. We need only look at extreme overvaluations (i.e. market bubbles) and extreme market drawdowns to see evidence of this.
MPT assumes that the correlation of assets classes does not change over time. However, during periods of market stress traditional asset classes tend to become highly correlated with one another compared to their historical relationships. As a result, many asset allocation investors may think that they are suitably diversified when in reality they probably are not.
MPT assumes that there is a positive relationship between risk (as defined by volatility) and return. Empirical studies have shown that there actually isn't any permanent correlation between risk (volatility) and return. High volatility does not necessarily give better results, nor does lower volatility necessarily give lesser results.
MPT assumes that market returns are normally distributed, yet we now know that periods of volatile or extreme returns have occurred with greater frequency than a normal distribution would predict. Abnormal returns known as “fat tails” are not accounted for by MPT.
MPT assumes that all market participants are price takers and that investors have no influence over prices. The recent involvement (or “interference”) of big government in asset markets is enough to tell us that this should not be assumed.
Strategic Asset Allocation is, therefore, also flawed
The unfortunate side effect of the teaching of MPT as gospel is that it has led to a dangerous over reliance on strategic asset allocation; an approach that doesn’t make much sense unless markets are efficient and the assumptions made by MPT hold true. The beliefs that historical risk premiums, volatility and correlations across asset classes are reliable over time and that SAA controls systematic (or market) risk simply through diversification are particularly worrying. Diversification, as Warren Buffet has put it, “is protection against ignorance”. The notion that one must be completely diversified and have some exposure to all asset classes at all times (albeit in varying percentages) in an attempt to reduce systematic risk is a flawed one. There is a trade-off between diversification and knowledge. If you know something that gives you an edge, then holding an asset simply because diversification says you should hurts you by diluting that edge.
Momentum investing - the fewer assumptions the better
Momentum refers to the tendency for securities or markets, across all asset classes, to exhibit persistence in their relative performance over a period of time. Decades of academic research has confirmed the existence of momentum, a phenomenon thought to be for the most part a manifestation of various investor behaviours. One of the reasons we focus on momentum-driven strategies is that we can build strategies with models that make very few assumptions. This eliminates the need to estimate inherently difficult to estimate parameters and, as a result, we can produce more robust strategies.
Systematic investing - overcoming emotion
Systematic investing is a disciplined, rules-based, transparent and (most importantly) repeatable investment process. It removes the emotional aspects of investment management and is designed to take advantage of market inefficiencies & behavioural biases. Our belief is that, by removing the human decision making from long only asset allocation and by utilising a system that uses price inputs and technical indicators alone, we can avoid being caught up by the “noise” created by fundamental factors and those making irrational decisions in trying to interpret them.
Volatility is a measure of risk, but is not the measure of risk
Volatility (as defined by the standard deviation of returns) is a statistic most commonly rolled out when talking about risk. And while we agree that it is indeed a measure of risk, we don’t believe it’s the measure of risk. It’s a useful statistic when describing the price characteristics or nature of a particular investment over time but investors may view risks such as liquidity, inflation or default as more important. One alternative to volatility that we focus on is maximum draw-down. Minimising draw-downs is vitally important to the long-term compounding of capital because of the larger percentage returns required to make up losses (the math is cruel). Maximum draw-down is the largest peak to trough fall an investment has experienced over a particular period of time. It measures the maximum pain or the absolute worst return an investor would have experienced if they invested and withdrew at precisely to wrong times. It doesn’t show what the worst return period could be in the future but it does show how well draw-downs have been managed in the past during various market conditions.
Sequence of Returns Risk
It is not just long-term average returns that impact your capital accumulation, but the timing of those returns. Sequence risk is the risk that the order and timing of your investment returns is unfavourable; resulting in less capital precisely when you need to sell or withdraw from an investment. Imagine, for a moment, an investor approaching retirement or an investor who needed to redeem an investment to cover a capital expenditure in March of 2009; whom, due to the GFC, had just lost 30 or 40% (or more) of their portfolio value with little or no time to recover it. A focus on minimising deep and prolonged draw-downs reduces sequence risk.
Complex is better than complicated
A robust trading system is one that is built to perform well no matter what the future brings. A trading system that is built on the premise that the future is unknowable, can be assured that the future will bring conditions that the system anticipated; conditions that were not predicted.
A robust system should be diverse and complex in the sense that it may be composed of many moving parts but every part is there to serve a specific purpose. Diversity is important because it insulates a system from the effects of radical change within one of the constituent markets, just like an eco-system. However, it should not be difficult to analyse, understand or explain i.e. complicated.
Simple rules make systems more robust because those rules work in a greater variety of circumstances. Simple rules that are built on more durable concepts will hold up in actual trading better than will complicated rules that are tailored to more specific market behaviour. The hardiest species are those which are very simple, such as viruses and bacteria. They are less dependent on their specific surroundings and can easily adapt to a changing ecosystem.
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