How many times have well meaning but misguided investment advisors excused long-term underperformance with the comment, “well, we’re very conservative investors.” There is a misconception that successful track records must necessarily incorporate tremendous risk taking.
This myth says that if a strategy returns $2 for every $1 that the market goes up, it will necessarily fall $2 for each $1 lost in a market sell-off. Risk and return are thought to be inextricably linked over the market cycle. And with certain strategies (i.e. leveraging a portfolio), this is true. But it’s not true in all cases.
We use the term “flexible Beta” to convey the controversial notion that one of the things for which you pay an investment manager is to vary the portfolio’s risk profile depending on what is happening in the market. When markets are rising, Beta (volatility) is a good thing. In falling markets, Beta should be lowered.
The ETF Scout portfolio increased in value $2 for every $1 during the bull market lasting from May 31, 2003 to October 31, 2007. We enjoyed strong markets in small cap growth stocks (initially) and in later years in the natural resource and international sectors. Then the market finally peaked. As the stock market priced in a recession, financials, cyclicals, and eventually the broad market sold off. However, the subsequent portfolio shifts in the ETF Scout portfolio reduced portfolio Beta so that the portfolio protected profits better than the market during the sell-off.
In mid-January, for every $1 lost since October 31, the ETF Scout portfolio lost only $0.85. As a result of going up faster during the boom, and falling less during the decline, the overall outperformance improved so that over the entire cycle the ETF Scout Portfolio gained and held onto $2.45 for every $1 of market gain in the S&P 500.
We call this active management. Others say it can’t be done. We’ve been doing it nearly 5 years now.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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