August 2019 – Risk Management and Asset Allocation drives out-performance

Risk management is a key source of value add for the Best Ideas investment strategies. Both Best Ideas strategies use a combination of stop losses, trailing stops and profit stops to dynamically manage risk.

During August, our risk management strategies resulted in out-performance of 2.08% for Best Ideas Competitive Edge and 2.05% for Best Ideas Market Timing.

At the end of July, our Asset Allocation Framework was showing that sentiment was over-optimistic. Volatility was low (i.e. VIX was at 12). One of the charts that we watch to monitor short-term risk is a S&P 500 chart with Keltner bands (using the average true range or ATR; another way of measuring volatility). The chart shows the bands compressing in July (see below).

We reduced risk by tightening the stops across most of the stocks in July. The portfolio’s risk budget (i.e. the theoretical loss if all of the stops were triggered simultaneously) was halved from approximately 20% to 10%.

All other things being equal, stops should be tighter during periods of low volatility. The stops won’t be triggered if the market sticks to its current trend. But they will be triggered sooner if the behaviour of the market suddenly changes.

The chart above show the S&P 500 index, its moving average (dotted line) and two Keltner bands (red and blue lines). Keltner bands adjust dynamically to changing market direction (i.e. the slope of the moving average) and volatility (i.e. the size of the bands). As you can see, the bands became very narrow in late-July when volatility was low.

Volatility is serially auto-correlated. In other words, low volatility is usually followed by more low volatility and vice versa. That is of course until the volatility regime changes, at which point extremes in the opposite direction occur. This is exactly what happened in August.

The late-July/early-August sell-off moved the S&P 500 into a short-term (20-day or one month) downtrend. You can see this on the chart above where the price bars break through the lower Keltner bands.

This resulted in the strategies dynamically de-risking over the first few days of August as many of our risk limits were triggered.

The stocks that were sold included some of strategies’ value and growth names. This meant that the allocations to quality/defensive stocks, gold mining stocks, cash and long-term bonds (in Market Timing) increased as a percentage of the overall portfolio. In other words, the portfolio became progressively more defensive as volatility increased.

By mid-August, the strategies were well positioned to weather and take advantage of a further downturn. Both strategies would have held up very well had the S&P 500 fallen further.

But this also meant that we now had to manager the risk of a “whipsaw”, that is missing a recovery in the market because we were too defensively positioned.

This is where our Asset Allocation Framework helped to increase our equity allocation in a timely manner. The over-optimism was gone and shorter-term measures of sentiment were showing signs of extreme pessimism (see our mid-August Sentiment update). These positive signs meant that there was a chance the market might rally in the short-term.

We purchased stocks progressively over the second-half of August, bringing the equity allocation of both strategies back up to their target allocations.

August is great example of the value that Guiscard Capital brings to the Best Ideas investment strategies. Both strategies are made up of the highest conviction positions or “best ideas” of a group of exceptional fund managers. It requires skill and experience to identify these managers and their highest conviction ideas (which aren’t necessarily their largest positions).

It takes more than just a collection of good ideas to create a successful investment strategy. Portfolio construction and risk management are essential. As is an asset allocation framework that dynamically adjusts the portfolios exposure to stocks as the weight-of-evidence across multiple indicators changes.