Pinnacle’s investment team has been working diligently to reallocate our active portfolios to a neutral position. Here are ten things you need to know about neutral allocation.
1) There is no such thing as “neutral volatility” for the vast majority of investors. Mirroring the benchmark portfolio and rebalancing it to it is considered the best way to manage volatility. By owning a diversified portfolio and rebalancing to a fixed asset allocation, investors hope/expect to experience the historical average volatility of the benchmark over long periods of time. One downside to this method is that there are times when economic and market conditions are not average, and portfolio risk/volatility and return should be expected to vary greatly from historical averages when those conditions occur.
2) At Pinnacle, neutral volatility means that we target the benchmark’s volatility, but not necessarily the benchmark’s holdings. This allows Pinnacle to be constrained by our client’s portfolio policy based on acceptable levels of volatility while giving our analysts the freedom to change our holdings in search of good investment values.
3) Having neutral volatility does not mean we will earn the same returns as the benchmark portfolio. The obvious observation is “the more we vary from owning the five asset classes in the same percentages as our benchmark portfolio, the more likely we are to earn different returns from the benchmark portfolio.” It is less obvious that we can be at neutral volatility relative to the benchmark (have the same volatility as the benchmark) and still have a wide variation of holdings from the target, which could lead to a wide variation of returns, both positive and negative.
4) Pinnacle’s “default” allocation for volatility to is to have close to the same volatility as the portfolio benchmark. We target neutral volatility when our conviction in our market forecast is low (which happens most of the time.) It is only when the investment team has high conviction in the forecast that we move significantly off of neutral volatility. The last time this happened was when we forecast the S&P 500 market decline in the fourth quarter of 2018, reducing portfolio volatility to approx. 80% of benchmark volatility.
5) Pinnacle client portfolio policy is structured around the traditional method of matching risk and reward expectations to a benchmark asset allocation. A more conservative client who owns our 60%/40% DMG (Dynamic Moderate Growth portfolio) has a level of confidence in the average return his or her portfolio (factoring in inflation) over time, as well as worst case, and average, hypothetical portfolio declines going back to 1970. It is important to note that actual portfolio performance should typically fall within these extremes when portfolios are positioned at neutral.
6) Positioning the portfolio for neutral volatility does not mean that Pinnacle can’t outperform in both bull and bear markets. Changing the asset allocation of the portfolio to have measurably more or less volatility than the benchmark is called a “Beta trade.” Once the portfolio is positioned at neutral, analysts use sector, industry, region, and country rotation designed to help improve on the average. These trades are called “alpha trades.”
7) Pinnacle’s conviction in it’s market forecast flows directly from the five building blocks we use to form our investment outlook. The building blocks are economic cycle, monetary policy, technical analysis, quantitative analysis, and investment research. While we utilize several quantitative tools to measure analyst conviction, ultimately it is up to the Chief Investment Officer to decide whether portfolios will be positioned at neutral volatility, or if conditions warrant over- or under-weighting volatility, based on the forecast.
8) Pinnacle does not target fixed levels of volatility for each portfolio policy. Instead, the process targets portfolio volatility relative to our benchmarks. Pinnacle portfolio volatility can be higher or lower over time and still be neutral relative to the portfolio benchmark. Of course, the Pinnacle investment team can position the portfolio to have higher or lower volatility than the benchmark at any point in time based on our forecast as long as they stay close to the investment philosophy laid out in the IPS.
9) Pinnacle tracks our portfolio volatility in two ways. One method models portfolio asset allocation and security selection based on past performance. The second method uses two techniques of measuring portfolio volatility, portfolio beta and standard deviation, to track portfolio volatility on a monthly, annualized basis. Used in combination, analysts have a very good idea of current portfolio volatility and projected volatility based on changes they are considering to our managed accounts.
10) When implementing our process of investing based on volatility relative to our benchmarks, adding portfolio risk assets to the portfolio increases volatility on an absolute basis. However, if we are positioned defensively, adding to risk assets in order to get to neutral volatility actually reduces the risk of relatively underperforming our benchmark.
Pinnacle Prime accounts are currently invested to match approximately 93% of benchmark volatility. See the latest Market Review to get a detailed view of Pinnacle’s market outlook.
