The Pinnacle investment team has been working diligently for the past eight weeks to gradually move our managed portfolios to a neutral asset allocation. This leads to the question, what the heck is a “neutral” asset allocation and why should I care? Interestingly, a large percentage of the traditional investment world (by traditional, I mean non-hedge funds) doesn’t use the term, “neutral”. In order to manage risk, they own a target mix of asset classes that when taken together is assumed to deliver a combination of returns and volatility that the investor agrees is acceptable. This mix of asset classes is the asset allocation known as the investor’s Investment Policy. As long as the investment advisor never strays from this special target asset allocation, then the client agrees to be patient while the assumed returns presumably arrive over a long-term time horizon.
Traditional investors believe that because their target asset allocation has delivered returns and volatility within certain well-defined parameters in the past, then it should do so in the future. Importantly, this special target mix of asset classes is presumed to exhibit the important characteristic of “efficiency,” where efficient means gathering the most returns for each unit of risk or volatility. The only way to mess up this scientifically constructed portfolio is to change the asset allocation, which throws both parties into an uproar. This is because when you subscribe to this philosophy of money management, the further you stray from the target portfolio, the more you risk not getting expected portfolio performance. So in this case, “safe” means owning the securities in the target or benchmark, and risk means owning something other than the benchmark securities.
Pinnacle’s observation of this strategy of investing—known variously as “strategic asset allocation,” “fix-mix allocation,” or “buy, sell, and rebalance”—is that gathering 100% of the underlying market risk and return can be risky in itself. What if asset classes are overvalued? What if market conditions are dangerous? Dealing with the what-ifs is frustrating when the philosophy of money management depends on the notion that asset classes are theoretically always efficiently priced. Why rebalance to a fixed mix of underlying assets based on average historical performance if current conditions are decidedly not average, and in fact represent opportunities for extra returns or defending above average risk?
To answer that question, Pinnacle creates a condition we call “neutral” portfolio volatility. In a neutral portfolio condition, our analysts target the volatility of the benchmark portfolio instead of targeting the holdings of the target portfolio. Traditional investors will correctly point out that owning the volatility of the benchmark portfolio does not mean we will earn the returns of the benchmark portfolio. This observation is undeniably correct. A second important point is that “neutral” is a relative term. Benchmark portfolio volatility moves up and down depending on market conditions, even though the underlying securities in the target portfolio remain the same. So when we say portfolios are at “neutral” volatility, it does not mean a fixed level of portfolio volatility. It just means that we own a portfolio of securities we believe will exhibit volatility similar to the benchmark at that point in time.
As expressed in Pinnacle’s Prime or Quantitative portfolios, our secret sauce is that while our portfolio construction is constrained by targeting relative portfolio volatility, we retain the freedom to own different asset classes in our search for good value. We have the freedom to own different securities from the benchmark, and we have the freedom to intentionally change our portfolio volatility relative to the benchmark in either bear markets (to reduce volatility) or bull markets (to add to volatility.) As mentioned above, this “freedom” means we intentionally take the risk of underperforming our benchmark in exchange for the opportunity to outperform, especially in bear markets. This is extremely important to risk-averse investors who can’t afford a steep decline in portfolio value implied by traditional buy and hold portfolio strategy. It is also important to clients needing to defend against sequence risk, or the risk of an untimely portfolio decline early in their retirement.