Swimming Against the Tide
What sort of yardstick are clients using to evaluate your investment management performance? Are they looking at the return assumptions embedded in their financial plan? Are they (God forbid) simply watching the S&P 500? Most of the time, the best benchmark will be a well-fitting composite index that approximates the long-term average or “strategic” asset allocation in the portfolio you run for them. Whatever the yardstick, proactively communicating and managing expectations around performance relative to that benchmark is one of the advisor’s most important jobs.
If you provide active management of any kind, you will experience performance differentials relative to your benchmark. In an ideal world, active management would lead to outperformance in all conditions. But this is almost never the case when the benchmark is an honest one. In reality, your choice of investment process and ‘style’ will strongly influence when and to what degree you diverge from your benchmark.
NextStep’s investment process is fundamental and value-centric in orientation. Our portfolios tend to add market risk (beta) when asset valuations are low, and take less market risk when they’re high. This has fairly predictable effects on relative performance. The portfolios will often lag their benchmarks towards the end of a bull market where euphoria and irrational behavior are primary market drivers. Coming out of the subsequent bottom, when panic gives way to more a benign outlook, our portfolios will tend to outperform, by that same yardstick. It is in effect, slightly counter-cyclical.
A counter-cyclical investment process is one which requires a degree of mental fortitude. It entails swimming against the tide of prevailing opinion; reducing risk when others are betting the farm and being brave when others are running for cover. In the words of the Oracle of Omaha, it’s about being greedy when others are fearful, and fearful when others are greedy.
This approach increases the demands on the advisor to proactively communicate and ultimately defend portfolio positioning, because it can lead to periods of major divergence versus the benchmark. And yet, it’s worth it.
It opens to the door to the possibility of out-performance in both absolute and risk-adjusted terms. The latter can be achieved by mitigating the depth of draw-downs at the end of the market cycle, something which can earn enduring client loyalty.
Outperformance in difficult market environments will tend to stabilize your revenues, because AUM will not drop pari-passu with the market. More stable revenue is desirable in its own right, but also tends to improve the value of your practice, should you ever choose to sell.
The conversations required to equip clients to handle significant short term under-performance of the benchmark tend to refocus them on more important things over which they have real control, such as savings rates and adopting the right risk profile in the first place.
Good advisors, like good mutual fund managers spend significant time and resources educating their clients about how they expect their investment strategies to behave in different scenarios in the future. This effort is almost always well rewarded. Forewarned is forearmed, and clients will give their advisors dramatically more leeway and extend dramatically more patience when they’ve been told what to expect in advance. NextStep’s role in that effort is to help you understand and think about how to discuss performance expectations with your clients. While often overlooked, we believe this is one of the most important roles of an advisor.
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The information and opinions expressed herein are for general information and educational purposes, and may change at any time. They do not constitute investment advice and are not a solicitation for the purchase or sale of any security or implementation of any specific investment strategy.