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Chalk Talk: June 2016

 “I’ve never met a backtest I didn’t like.”

– William Sharpe

Most people approaching or already in retirement have a desire for their investment portfolio to do three things, almost without exception:

1. Generate income to supplement other sources of cash flow such as pensions and social security

2. Grow over time to outpace inflation

3. Don’t lose value

We continuously remind our clients that these are really three conflicting objectives that are at odds with one another. Capital appreciation comes at the cost of volatility which means we must endure temporary declines in value. Substantive income generation and capital growth are not typically derived from the same investments. And minimizing or eliminating volatility will necessarily reduce opportunities for growth. 

Yet, the investment industry routinely trots out investment solutions that offer the promise of delivering on those three objectives all at once. I recently attended a presentation from a large financial institution that was pitching their investment fund that is designed for “outcomes”, namely, the three identified above. The idea is that we can own less volatile or uncorrelated securities to limit the downside during market drops, generate income through dividends and interest payments, and participate in the upside potential returns. Imagine that – a single fund designed to answer the challenge!

And just like in politics, the investment business generally spends far more time on fundraising than on practicing its craft.

Well, there’s never really much new under the sun in investing. And just like in politics, the investment business generally spends far more time on fundraising that on practicing its craft. The notion of a solution that will “protect the downside while capturing the upside” has always been one of the most popular stories to sell in the industry – particularly in the retirement market. This seemingly Holy Grail of a pitch has been packaged and sold in forms as annuities, hedge funds, structured products, and now increasingly by way of mutual funds and exchange traded funds. Unfortunately, there’s an inconvenient glitch in this story: Stocks only appreciate in value because they can also go down in value. 

The challenge of meeting these three objectives should not be misunderstood. It is not solved by buying into a marketing spin that claims a single investment fund or solution can magically remove risk while preserving the return opportunity. The solution is to craft and stick to a deliberate strategy that structures the investment and financial plan in a way that provides for balance, contingencies, and options. More specifically:

– Proper diversification helps to deal with the inevitable volatility in a specific asset class or segment of the market.

– A sensible income plan prepares for scenarios in which it would be detrimental to permanently impair an investment portfolio by selling assets that have declined in value. 

– Achieving all three objectives can be accomplished in the context of an ongoing financial planning process, not through a single investment vehicle.

So my advice is to beware of funds that are touted as “smart beta”, “absolute return”, or “delivers stock-like returns with bond-like volatility”. Too many investment vehicles are created by marketing departments, not by research labs. As Josh Brown says, “If you are marketing these things, you can always find a time frame where they did deliver, and that’s the time frame you market”.

It’s common misconception among investors that downside volatility is something that can be deftly avoided by using the right investment strategy. It can be difficult to come to grips with the notion that price declines must be accepted in order to realize the future returns. So we’re firm believers that one of our most valuable activities here is to continuously coach clients on ways to balance those conflicting goals in real world scenarios. 

As always, thank you for your trust and confidence in us. Your feedback is always welcome.

Michael Traynor CFA®

Chief Investment Officer