Blow Up Risk – How Tony Stark Would Build A Portfolio by Maz Jadallah – AlphaClone

Blow up risk is one of the most important and difficult investor risks to manage.  It comes in two flavors – manager blow up risk and market blow up risk.  Diversification is the best way to mitigate over concentration in a manager or investment product but diversification presents its own set of challenges.  What products do I choose to meet my investment objectives?  How many?  How do I know the products I selected are the right ones more me today and in the future?  Diversification also doesn’t provide much help during broad market blow ups.

There’s no easy way to insulate a portfolio from broad market blow ups and still be invested.  Even if you had a 100% allocation to a diversified portfolio of hedge funds, your portfolio would have still lost about a 1/3 of its value at one point over the past 10 years (see Exhibit 1).

Blow Up Risk

Think losing a third of your nest egg is bad?  Most investors did much worse.  That’s because a vast majority of all investment portfolios have little to no exposure to actively hedged strategies, instead opting for a mix of long only mutual funds, long only index funds or a combination.  How much worse did long only investors do?

Exhibit 2 summarizes drawdowns for a selection of popular mutual funds and the four primary index funds used as building blocks to construct passive portfolios.  For a look at how we selected our mutual funds please see “How We Picked Mutual Funds” at the end of this article.

Blow Up Risk

With average maximum drawdowns of 52% for active strategies and and 61% for passive vehicles, there’s not a lot diversification can do to protect investor capital during those extreme drawdown events.  That’s why investors continue to pour money into alternatives and  hedge funds despite the ton of bad press (some deserved) and consistently poor performance they’ve shown over the past decade – they just can’t afford a 50%+ drawdown in their equity exposure, neither can most individual investors.

But accessing and consistently selecting good hedge funds is very difficult even for the most advanced institutional investors – individual investors don’t stand a chance.  Performance data is rarely transparent, blow up risk abounds and lock ups and high fees make the cost of exiting an underperforming manager painfully high.

Blow Up Risk – Active Indexing Can Help Solve the Investor Riddle

Blow ups matter because investors have a hard time holding their investments through severe drawdowns – so limiting the severity of your portfolios drawdown increases the likelihood that you’ll stay invested.  Making good investment choices today and continuously in the future also matters a great deal because those choices will determine how effectively you can meet your investment objectives.  This is true irrespective of whether you are allocating to active managers (picking horses) or passive ETFs (picking horse races).  Why then do investors always chase performance as their method of product selection and insist on mostly long only portfolios?

There’s an alternative.  What if you could combine:

  • A built-in dynamic market hedge designed to protect against deep drawdowns while still fully participating in strong bull markets, with …
  • All the benefits of passive investing – systematic, rules-based, efficient, liquid, low fee, tax friendly, and…
  • A process that continuously scores and selects skilled investment managers in a way that dramatically reduces manager blow up risk while avoiding their high fees and lock ups.

We call the process above “Active Indexing” and it is at the heart of our investment products.

Blow Up Risk

We don’t pretend to offer investors a panacea, only a thoughtful approach to solving for some of the most difficult investor challenges – a) making consistently good investment choices and b) insulating your portfolio from blow ups.  Like any high active share investment approach, our approach is not immune to periods of underperformance – but over the long term our actual net investment results speak for themselves.

How We Picked Mutual Funds

While the list of managers we include is certainly not exhaustive, we based our selection on factors we feel influence an investor’s selection process.  These include, performance, length of track record, manager brand equity, analyst recommendations and fund size.  We further categorize the active funds into four categories.

Incumbents

These funds include names like American Funds Growth Fund (AGTHX) and Dodge & Cox Stock (DODGX). They’ve been around since the beginning of time and in many ways created the mutual fund industry.

Old School Select

Nothing succeeds like success and these funds have demonstrated as much consistently. Funds like Oakmark I (OAKMX) have consistently outperformed the S&P 500 over the long term and like other funds in this category, is adored by the capable analysts are Morningstar.

New Kids on the Block

These funds are relative new arrivals with inception dates post-2000. Dimensional Fund Advisors US Core Equity (DFEOX) for example was started on 9/16/2005.  Despite their new comer status, these funds have carved out solid market positions with investors and have earned industry accolades for their investment approach.

Fallen Angels

These teams that run these funds have attained legendary status. By legendary, we mean, at their peak they were widely regarded as the best in the business.  But in the brutal business of investing, even the mighty can and do fall as we’ve seen all too clearly with Sequoia Fund (SEQUX) recently.