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A financial advisor recently asked me a question that, on the surface, sounded simple enough. In fact, I thought my answer was going to be a breeze and that since I had set aside an hour for the call, I'd probably wind up with an extra 30 minutes in my day! However, an hour and half later, we were still on the call, we were still actively discussing the topic, and we were still nowhere close to being done.

So, although what follows is an abbreviated synopsis of this and ensuing conversations, I thought others might find the topic of interest. And since traders appear to be waiting on the earnings parade to begin, I figured this might be a good subject to address while we wait.

Most will probably agree that the question initially posed to me was straightforward. So here goes: "As a portfolio manager, how do you outperform?"

The easy answer is you buy stuff that provides a return which is higher than your benchmark. Bam. Done, right?

Well... as commercial goes, not exactly.

You see, the question wasn't, "How do you outperform once in a while?" No, the question was, "How do you outperform on a consistent basis?"

I explained that one of the dirty little secrets in the investment management business is portfolio managers oftentimes select a benchmark with a lower risk profile than the portfolio they are actually managing. I.E. a manager will find a low bar that they hope to easily hurdle each quarter.

For example, I know one active manager that runs a tactical asset allocation strategy yet somehow uses a conservative, income-oriented benchmark. And just like that, Morningstar awarded his fund 5 stars - despite what I see as middling performance given the approach being used.

But after laughing over the idea of choosing a benchmark that is easy to beat, the advisor upped the ante on me. "Well, then let me rephrase," he said. "How do you beat a 60/40 stock/bond benchmark on a consistent basis by utilizing a similar mix in your portfolio?"

Then it hit me, my advisor colleague was thinking that he could buy 50% SPY, 30% AGG, and then 20% "other stuff," and provide his clients with returns that exceeded the heralded 60/40 benchmark.

I proceeded to explain that if you charge a management fee of 1.5% and pay transaction costs to rebalance, make macro calls, etc., you are almost guaranteed to underperform with such a plan. I suggested that unless the "other stuff" could radically outperform on a consistent basis, you were doomed to lag the benchmark.

What About Using Relative Strength and Momentum?

He then asked about the idea of flipping the allocation on its head and using 50% "other stuff" that included momentum and relative strength rotational strategies he had read about.

I opined that when used judiciously, both the momentum factor and relative strength approach were certainly worth considering in a portfolio. However, I went on to generally say that, in my experience, while both can help a portfolio outperform when markets are running higher, such an approach (a) is subject to whipsaws that can create underperformance (usually at the most inopportune times) and (b) can create outsized underperformance on the downside if you don't get the moves "just right" - or get caught in a market that doesn't favor such an approach.

I also suggested that such tactical strategies to investing were employed by lots of managers on many fronts but required a thorough understanding of the strategy. In other words, I wanted my colleague to note that you don't just start using a relative strength, rotation approach without a lot of research - and preferably a LOT of experience - because if employed improperly, the results can be painful.

I concluded on the topic by saying that this approach didn't really fit with his objective of outperforming a 60/40 benchmark on a consistent basis.

Choosing the Time Frame AND the Objective

Next, we explored the idea of "outperformance" in more detail. I asked what time frame he was shooting for and what degree of outperformance he was seeking.

Cutting to the chase, the overall objective was he wanted to be able to go into client review meetings on an annual basis confident that his investing approach would be viewed as satisfactory.

So, I asked if "being around" the benchmark was an acceptable bogey during most calendar years. To which, he replied, "Yes, that's the idea - be close to or exceed the benchmark in most years."

"What about during a year like 2008 or the 2000-02 period," I asked. "Are you going to be happy 'being around' the benchmark during those big, bad, bear markets? Are your clients able to accept a loss of 20% to 30% during a year like 2008?" (I noted that a 60/40 stock/bond mix employing the S&P 500 and the Barclays Aggregate Bond Index lost 19.83% in calendar year 2008 while the S&P itself was off 37%.)

"Well, no," he replied. "I've got to do better than that when something really big happens - I've got to help them manage risk during that kind of debacle."

"Ah," I said, "now we're getting somewhere!"

The Goal: A Boring, Risk Managed Approach

After a great deal of discussion (and multiple calls), I summarized that what he wanted for his clients (and in reality, what the vast majority of financial advisors and their clients really want) is for his portfolio performance to "be around" the benchmarks in most years and then to "lose less" when the big bears come to town.

"Exactly!" he replied.

To which, I responded, "So what we are after is a relatively boring asset allocation approach" - which I defined as a strategy that shouldn't create any 'big surprises' - "accompanied by a risk management strategy designed to try and protect capital during severely negative environments."

I proceeded to cement the idea that such an approach can't/won't help when the markets "correct" and experience bouts of short-term volatility. "In other words," I said, "we can't expect a long-term strategy to function well during a short-term event - you get that, right?"

So, what started as a discussion about performance and the idea of employing a mo-mo based, rotational approach had morphed into a plan that made sense. We wound up defining what he actually meant by the term "outperformance," we identified the risk parameters he was comfortable with, and we agreed on the time frame we were planning to work in. Perfect.

Time to Get to Work

With the objectives in hand, now it was my turn. In short, my team was being tasked with creating a series of risk-targeted, asset allocation strategies that would attempt to "be around" the benchmarks during most calendar years and then try to "lose less" when the bears went on the attack.

Next time, we'll explore the approach we took to build such portfolios.

Thought For The Day:

Never underestimate the power of no. -Ray Charles

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of the U.S. Economy
      2. The State of Trump Administration Policies
      3. The State of Global Central Bank Policies


Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Sowell Management Services

Disclosure: At the time of publication, Mr. Moenning and/or Sowell Management Services held long positions in the following securities mentioned: none. Note that positions may change at any time.

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The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

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David D. Moenning is an investment adviser representative of Sowell Management Services, a registered investment advisor. For a complete description of investment risks, fees and services, review the firm brochure (ADV Part 2) which is available by contacting Sowell. Sowell is not registered as a broker-dealer.

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