3 strategies to plug in to market changes

Investors must manage their portfolios knowing the risks, Martin Pelletier writes.

Markets do not go up forever, but some investors seem to have forgotten that simple fact after an eight-year bull run.

U.S. stocks in particular have done very well, outperforming other global equity markets by a wide margin thanks to a couple of rounds of quantitative easing, ultra-low interest rates and the potential for an unprecedented fiscal spending plan. But other markets have also had healthy runs of late. This isn’t to say that employing a simple “own the market” strategy is wrong, but investors must be aware of the risks of doing so.

Remember that the duration of a correction, even the one caused by the 2008 fiscal crisis, is rather short, steep and unexpected, while market recoveries occur over multiple years, causing managers to put on and take off risk at the wrong time.

It’s not all the managers’ fault, because in today’s environment they face what is known as career risk if they lose clients who are dissatisfied that they are not keeping up with the market.

With all that in mind, investors have three basic approaches to managing their equity portfolios, each varying in their level of risk.

The first is what is called alpha, or outperforming the market and thereby selecting managers who are able to do so. Achieving alpha is a lot harder than it sounds and trying to get it can prove quite dangerous if the wrong managers are chosen. Be sure to look for managers with a record of maximizing return per unit of risk, which is reflected in superior Sharpe ratios. Also, have a look at how well they performed during a market correction to see if any downside protection was offered.

It is also easier for managers to outperform by stock picking in smaller and less efficient markets such as Canada. Many have a tougher time in very large and more efficient markets like the U.S., where passive strategies such as exchange-traded funds make more sense.

As a result, investors may want to deploy both active and passive strategies. However, the weighting should be more toward active at market highs and passive at market lows.

There are also investment managers who take an entirely different approach than passive and active by targeting absolute returns, creating a lower-risk and more stable return profile independent of what everyone else is doing. These managers work with their investors to set a target return to meet a particular goal in the context of the current market environment. This may mean trying to earn a healthy spread to bonds, such as a target return of five to six per cent for a more conservative investor or something in the high single digits for a more aggressive investor.

Finally, investors should always consider fees: we recommend paying no more than 1.5 per cent for alpha and absolute return managers, and 0.5 per cent for passive managers.

For investors with larger portfolios, it is worth considering taking a diversified approach by deploying a combination of all three strategies, but be cognizant of their differing return profiles when reviewing performance.

Financial Post Martin Pelletier, CFA is a portfolio manager and OCIO at TriVest Wealth Counsel Ltd, a Calgarybased private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.