Reaching the cross road

We've been on a roller coaster lately, albeit a mild one. Just after Turkey's woes triggered a setback, the market quickly recovered its losses and touched a new high. Officially, the correction is now over and the bull market has set a new record. As of August 22, the bull turned 3453 days old, earning the distinction of being the longest ever in history. Yet, as impressive as that sounds, it's another one of those statistics that don't mean much. In fact, the higher the market goes, the more over-valued it becomes. And the older the bull grows, the more severe will be the downturn.

If that sounds too pessimistic, it is. Consider this: as of this week, the S&P 500 is up about 6% so far this year. However, excluding the technology high fliers (so called the FAANG), which have had the lion's share of the market rally, the S&P 500 would be just about flat. So if you're not feeling the positive impact on your portfolio to that extent, you're in good company. Major sectors, such as industrials (automotive), consumer and energy are still in correction mode, notwithstanding the bull market is on. The same goes for banks and energy stocks in Canada, which are either flat or in negative territory for the year.

The fact that technology stocks remain the major driver of this bull market is not very comforting. And the fact that we are starting to see cracks within the FAANG does not bode well for the short-term. Yes, the bullish trend for Apple, Amazon and Alphabet remains intact, but the other two members (Facebook and Netflix) are starting to face issues. According to Reuters, net outflows from US large cap and growth stocks (estimated at $3 billion in the week ending August 3), indicates that investors are concerned that the lead of technology companies is being challenged.

In our last update, we opined that strong corpprate earnings have so far helped the US market defy gravity. However, purchasing managers's indices, which are a proxy of global economic growth, are signalling a possible slowdown. When economic growth slows down, earnings follow. Moreover, central bank asset purchases, which were the source of major demand for stocks and bonds in the past years, have slowed down considerably. It is now estimated that such purchases would have peaked at US Dollars 2.3 trillion in 2017 and will have dropped to almost nothing by the end of the current year. Now that the market is deprived of a major source of liquidity, the impact is bound to show sooner rather than later. For the time being, the release of corporate cash held overseas has extended a temporary liquidity lifeline to everybody, but that also is a finite resource.

All things considered, and listening to various money managers, one gets a clear view of where things are heading in the intermediate term, despite the near term uncertainty (or bullishness, if you're on that side of the fence). The current debate is now about how long this aging bull market can still go. Everybody seems to agree that it's on borrowed time, and not for long. The debate is whether we have really reached the top or whether we will see one final melt up (i.e. a final upward spat) before it's over. In other words, even if we are convinced that the intermediate-term prospects are not bright, the market is moody and there is nothing to prevent it from staging another major rally before the bull rolls over and dies.

There is a silver lining behind such pessimism though. The fact that several sectors have already corrected means that, when the market slumps, losses will not be similar across the board. Sectors that are already in negative territory, such as consumer and interest sensitive sectors, will likely suffer less. Parking some money in those sectors will help contain your losses.

Another defensive tactic that you can apply would be to reduce your reliance on index funds and increase your reliance on actively managed funds. That works better during periods of market setbacks, simply because actively managed funds are less volatile, i.e. less risky, than index funds. This is a statistically proven fact. Now, some might argue that volatility does not matter if you're in for the long term. We beg to disagree. Markets do recover always, but the question is how long will it take, and will you have enough time and patience to wait for the market to recover. If you don't, paper losses become permanent. We have covered this topic at length in several writings, namely our recent note on Maximum Equity Allocation. The bottom line is: volatility does matter.

To prepare for the uncertaintly, last month we suggested a so-called all-weather portfolio. This time, we suggest populating this portfolio with a number of actively managed funds, with positive Manager Value Added results. Moreover, we compare the risk/return profile of such portfolio to a hypothetical one composed of index funds, or exchange traded funds, from the same categories (with similar allocations). This allows us to highlight the strengths of our proposed approach and to illustrate how you can use the powerful tools available on this website to handily beat index funds. Read on.

The Value-Added Portfolio Risk and Return

From the table below, you can see that the Manager Value-Added Portfolio (MVA Porftfolio) depicts a 5-year return of 6.88% (as of July 31), which is almost similar to the return of an index fund portfolio (in fact the MVA portfolio is slightly better, particularly if you include ETF costs, but nevermind that, because we can afford to be generous here). At the same time, the MVA portfolio is 16% less volatile (or less risky). By the same token, and looking at the same side of the coin, we can also say that the index fund portfolio is roughly 19% more volatile than the MVA portfolio. This is a simple difference which we explained in our previous note entitled "The free lunch that many investors fail to see". To keep things simple, let's just say that, had we increased the risk of the MVA Portfolio by 19%, we would have obtained the superior result of 8.1%. By doing that, we would have achieved two important things:

1. One, we would have handily beaten the index fund portfolio by a decent margin;

and, 2. Two, we would have achieved such superior result by assuming no more risk than that of a portfolio made of index funds.

This is what we call the value-added from active portfolio management. So how do you how do you get such value added?

How you do it

The simple answer is: by choosing funds with a positive MVA. In this update, we have done that by proposing a portfolio with funds that depict a positve MVA. You can view such portfolio by clicking here (out of respect for our paid subscribers, we have made such page strictly available to them). Note that there are many other funds that can meet our positive MVA criteria. So if you have other views on the chosen funds, or if you have other preferences, you can dig into our database and filter each category for funds with positive MVA (this is also a paid subscriber feature).

The next question that comes to mind is: how do you increase the risk of the MVA portfolio by 19% so that you can match the risk of the ETF portrolio? The simple way to do it is to increase the amount invested in the equity and high yield funds by a similar percentage. It might take one or two interations to get there, but our Portfolio Dignostics tool is fast and powerful, so you can get it done in a heartbeat.

MVA Portfolio Risk and Retun Profile (as of July 31, 2018)
5-Year Return
MVA Portfolio6.9%
Index Fund Portfolio6.7%
5-Year Risk
MVA Portfolio84.3%
Index Fund Portfolio100%
Risk-Adjusted Return(RAR)
MVA Portfolio RAR8.1%
Value of $10,000 invested in MVA Portfolio (6.9% compounded return over 5 years)$13,947
Value of $12,000 invested in MVA Portfolio (6.9% compounded return over 5 years)$16,597
Risk Adjustment Factor19%

One small point before we wrap this. When we re-introduced MVA in our Free Lunch note of August 9, 2018, we cautioned that several factors might derail our expectations, such as a change in market dynamics, or a change in the fund manager's investment strategy, market outlook, risk profile or fund mandate. While totally beyond anybody's control, such things can happen sometimes, hence the inability to guarantee any future outcome. Having said that, the proposed MVA strategy is based on robust empirical evidence and a well recognized portfolio management theory introduced by William Sharpe back in the sixties. In other words, we are not re-inventing the wheel here. We have simply elaborated a practical tool that helps you, or your advisor, put this powerful theory into practice. By doing that, we help you find actively managwed funds with positive MVA so that you can beat the index.

August 23, 2018