Forgetting to Avoid the Next Train Wreck

There was a recent article in Financial Advisor Magazine titled: Avoiding the Next Train Wreck.

 

The question posed was, “Do the systems that some managers used to avoid the 2008 market collapse make sense now?”

 

While I won’t go into many details — the idea is that those firms that performed well in the last market downturn (2007-2009) aren’t all they are made out to be. The article focuses mostly on those funds that benefited from trend following and how that the negative trends in 2007 saved them from the significant downturn that started later in 2008. Now trend systems aren’t the only risk mitigation tool available. An email I received today soliciting a fund that has “most of the upside” while avoiding “most of the downside” prompted me to write this commentary.

 

This manager uses put options on major ETFs to provide downside protection. This system therefore uses a hedging tool. Back to trend systems, we use a 10-month trend system based on long-term studies that show that volatility can be greatly reduced while maintaining exposure to the various global markets. The trend system did work very well in 2007 as most trends turned negative prompting a much larger allocation to cash. On a 10-month trend, the S&P 500 ETF (SPY) was below trend in November of 2007. The Russell 2000 also was lower in November of 2007 although it was questionable early in the year beginning in July. Looking across the pond — the popular international large cap MSCI EAFE Index fund from iShares (EFA) was also in a downtrend in November of 2007.

 

So it is clear that in this case the trend following systems were beneficial. Looking at the past 3 years and the same can’t be said. The markets have been “trendless” and therefore trend systems experience swings that whipsaw the various investments above & below their longer-term trends.  The challenge that I have is that while one might question the validity of a system — in this case trend-following systems, the reality is that no investment system works all the time. The above hedged/option portfolio underperformed the S&P 500 over the past 4 years and made up the majority of its outperformance by not losing money in years like 2000, 2001, 2002, and 2008. The problem is that the system lost 0.65% in 2003 when the S&P 500 was up 28.7%. Therefore the key attractiveness to any risk-mitigating portfolios has to be over a full business cycle which is often 5-7 years.

 

So the bottom line is that investors should find an investment strategy that works and stick with it. And when reviewing strategies the best place to start is with a diversified portfolio that is global in nature. However, deciding mid-stream to change strategies as the last market downturn fades in to memory seems to be questionable advice at best. Rather — common sense might tell you that rather this is the best time to begin reviewing strategies as both the business cycle and bull market show their age.

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