The seemingly endless nearly-13-year bull market has engendered for many financial advisors a growing, uneasy feeling that has been known to develop into a downright anxiety over where to invest clients’ money. This concern can lead some to employ defensive strategies that may drag on performance as equity markets continue their climb. This sets up performance-related questions from clients, and a vicious cycle of investment anxiety continues.
An intriguing series of blog posts I recently read posed interesting perspectives on this important issue of advisor investment anxiety. That is why we reached out to Institute member Jon Robinson, CEO and co-founder of Blueprint Investment Partners – an asset manager with strong opinions and experience in handling this investment dilemma. Given the nature of modern-day investment anxiety, we wanted to explore their insights more fully, which may be helpful in addressing some of the challenges for advisors in the current investment environment.
Hortz: Given the state of the market over the last few months, what are you hearing from financial advisors?
Robinson: We are hearing a lot of apprehension. Many advisors are experiencing that cliché dilemma where there’s an angel on one shoulder and a devil on the other, each offering conflicting messages.
On one hand, they want to de-risk their portfolios now because their gut says the bull market has lasted too long and a large drawdown or crash is imminent. On the other hand, they recognize that in de-risking, murmurs about “irrational exuberance” become clamors, usually having a disastrous impact on upside capture.
Advisors are in a tough spot. How do they participate in the upside but keep an eye on the downside? After nearly 13 years of substantial gains, how do they move into more defensive strategies without triggering taxable events? Those are some of the questions constantly coming up in our conversations.
The first question is particularly salient for advisors who have money they need to put to work. We’ve heard from advisors who are sitting on as much as 50% cash, uncertain about where to allocate it right now because they sense the stock market party may be winding down.
Hortz: What has your research shown as a solution to some of these concerns?
Robinson: Human emotion is the common thread among everything I just spoke about – anxiety, apprehension, “gut” feelings, exuberance, uncertainty. We think human emotion is the biggest obstacle to successful investing.
So, I think the best question to ask is this: How do you remove human emotion from investment decision making?
Blueprint is resolute in our answer: Advisors need a rules-based process that will dictate their response to various market environments. They need a system that does the decision making for them by pre-determining when and where to enter the market and when and where to exit.
If you agree with that philosophy, then it means how advisors have historically constructed portfolios is all wrong. Too many have focused on what goes into the portfolio rather than scrutinizing the systems that will direct portfolio decisions.
Here’s a specific example: Buy and hold is technically a system. But a lousy one! If you’re a client about to retire, you simply cannot take a 50% drawdown. In our view, a system like trend following is more suitable because it can capture upside when an asset class is climbing, but it also quickly pivots when conditions change to protect against potentially catastrophic downside losses.
Hortz: What are the specific benefits of a trend following approach?
Robinson: Oh wow, where do I start? I could probably write a book on this subject alone.
First, the benefit that usually resonates best with an advisor’s clients is that trend following is a reliable way to protect against large market declines. This preserves capital and allows for compounding to continue at a higher base.
But it’s also an inherently tax-friendly approach to investing because it sells losses quickly and holds winning positions indefinitely if the trend doesn’t change. In our trend-followed portfolios, for example, during most environments our process will allow us to produce a tax-aware outcome. This is due to our systems being designed to produce tax alpha by harvesting short-term losses and maintaining exposure to winning positions.
Circling back to the anxiety many advisors are feeling about the current market environment, another reason trend following can be so impactful is because it allows you to objectively stay invested longer than your emotions alone would have allowed.
Lastly, trend following works broadly across asset classes, which allows for robust diversification. Trend following isn’t limited in the way a factor-based approach or other constrained methodology would be. Rather, trend-following systems can be applied to all asset classes, to passive investment vehicles, and even to individual stocks. Our approach, for example, is applied to the full world allocation, as well as single stocks.
Hortz: How does trend following compare to other defensive strategies?
Robinson: I’d caution against labeling trend following as a defensive strategy, given its ability to adapt in both rising and falling market environments. The persistent upside capture is an often-overlooked feature to trend following.
With that said, many defensive strategies prioritize risk management to such an extreme level that advisors end up “overpaying” for the downside protection, either in terms of fees or opportunity cost. These strategies are akin to driving your car with the emergency brake engaged. They may do a great job of slowing down losses, but the cost or drag on performance is a serious limitation. Trend following is different because it is does not promote a permanently defensive position; it applies the brakes when conditions warrant but doesn’t start slowing down just because the light has been green for a while.
Here’s another way to think about it: While many traditional defensive strategies talk in terms of “defined outcomes,” trend followers talk in terms of “defined entries” and “defined exits.” In the end, that usually means trend-followed portfolios have more flexibility and freedom to be opportunistic and defensive.
Hortz: The way you describe trend following sounds rather simple – increase exposure when the trend is moving up, decrease exposure when the trend is moving down. Yet, esoteric and complex investment strategies have surged in popularity over the last nearly 13 years – and not just among defensively postured vehicles. How do you reconcile those two realities?
Robinson: Humans are drawn to complexity. I think it’s a gut versus head thing. The gut is instinctual – fight or flight – and is more likely to pursue simplicity. But the head is analytical and more likely to choose complexity. When presented with a few options, the head is wired to think the more complex one is probably the best choice, even if it’s just perceived complexity. Some of Dan Ariely’s research, for example, shows that the head might conclude that 34.0001% is better than 34% – that’s what I mean by perceived complexity.
Investing is an arena where the battle between gut and head is particularly brutal. Just like it’s hard to take emotions out of the investing process, it’s difficult to turn off that nagging voice from the analytical head (System 2 as Daniel Kahneman has called it) that investing can’t be simple to be effective.
Humans just don’t naturally trust simplicity, and sometimes that’s for good reason in the investing world. Again, a buy-and-hold strategy is technically simple. Really most passive approaches are. But, remember that example I mentioned earlier of a near-retiree who can’t handle a catastrophic loss in her portfolio? For that client, she needs simple and effective, and across dynamic market environments. That’s trend following.
Hortz: How do think these cognitive roadblocks for advisors can be addressed?
Robinson: I don’t mean to sound like a robot, but the more you can remove human emotion from decision making, the better. So, the answer to your question is data, research, and information.
Blueprint is truly data centric, not just in how we manage our portfolios – buying and selling based on price data – but in all facets of our business. We’ve conducted extensive research to help advisors objectively weigh the merits of trend following. And, we have published several research papers to share our findings. Our latest is an analysis of whether liquid alts achieve the goal of diversification.
We seek to be a resource to advisors who want to learn more about trend following and how to best utilize these strategies in their portfolios, depending on the financial needs and risk tolerances of their clients. We talk with advisors about case studies that illustrate when trend following works well as a core strategy versus a tactical sleeve and/or hedged equity/risk mitigation strategy.
If you show advisors the actual data about how a trend-following system can protect capital, it can be eye opening.
Hortz: Besides a large market drop, what else are advisors worried about?
Robinson: I’m sure this won’t surprise you, but inflation is the other big topic we’re hearing about lately. Advisors are wondering how their portfolios – and their clients’ behavior – will weather an inflationary environment, considering we have had 30 years without one.
There is also some nervous energy around how a persistent inflationary environment will impact interest rates and subsequently bond yields. This is a serious concern and a topic we’ve been sounding an alarm about for years. If we find ourselves in a persistent inflationary environment, rates are likely to adjust upward, and that’s problematic for a traditional 60/40 portfolio. Simply, a 60/40 allocation contains much more risk than the typical balanced investor desires.
Earlier this year a research report evaluated the best strategies for inflationary times and found that trend-based approaches ranked as three of the top five and four of the top nine strategies for hedging inflation. Furthermore, while the trend-based strategies performed positively in non-inflationary times, the non-trend-based approaches that appeared in the top 10 only performed mediocrely.
We were not surprised by those findings because trend following is a reliable strategy for dealing with new and unforeseen events. Even the inflation we are seeing right now has plenty of new and unforeseen about it. While we are seeing it in real assets such as used car prices, real estate, energy, and agriculture, financial assets like inflation-protected securities and the dollar have been fairly steady. That’s unusual. But trend following doesn’t care if that’s unusual because the strategy is built to protect the blind side by adapting to whatever is taking place.