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Absolute Investing Overview

Investing with an absolute approach is different from buying and holding. Typically, it involves buying and selling investable instruments with a goal of positive returns every year, regardless of how a relative benchmark is performing. Our absolute investing philosophy centers around this concept and our mission is to bring viable strategies and options that seek absolute returns to the individual investor.

At the center of our absolute investment approach is risk management. As market participants, we can not influence the returns any given investment will provide, that would require a crystal ball, but we can actively manage the risk our portfolios are subjected to.

Our risk management begins at the strategy level and then rolls up to the entire portfolio. Our first objective is to use various strategies, whether created by Provident or other money managers, that tend to offer low correlation to one another. Typically, risk managed at the strategy level may incorporate various options, such as using stop-loss orders, purchasing puts, diversification through the holdings within a strategy and the ability to move to cash.

Managing risk and having an absolute return approach don't guarantee portfolios will be positive every year, but it offers a little more peace of mind when you commit hard-earned capital towards achieving an investment goal.  See related articles on drawdown and the mathematics of winning and losing for additional information on the benefits of risk management.

Diversification goes beyond the traditional asset allocation models proposed by many financial professionals.  In reality, traditional asset allocation models that focus on dividing a portfolio among growth, value, international, small-cap and large-cap stocks may be subject to more risk than one realizes.  The following represents the correlation of stock categories for a traditional diversification approach found in table 1.0 versus the correlation of various Provident Capital Management strategies in table 1.1.

Ideally, one seeking diversification would want to find investment options that are not correlated to one another, meaning the strategies' respective performance moves independently of one another.  Typically, the closer the correlation is to zero, the lower the volatility of the portfolio will be, leading to potentially a lower drawdown and a higher risk/reward scenario.

Investment options that are closely correlated (i.e. close to +1) will be found to move in the same direction, minimizing any attempt to achieve diversification.  The inverse is also true, investment options that are negatively correlated demonstrate a connection by typically moving in opposite directions.

Adapt Strategies for the Current Cycle

In a nutshell:

Adapting Tactical and Absolute Return Strategies, which us risk management can, under the right circumstances, out perform and potential reduce losses more than traditional buy and hold / benchmark strategies during weak cycles.

The past 200 years of stock market history show that weak performance periods follow strong periods
    The last strong cycle finished in late 1999

Strong Cycles

Time PeriodAnnual Average ReturnDuration

1815-183510.0 %20 Years

1843-185313.7%10 Years

1861-188112.0 %20 Years

1987-190215.2 %  5 Years

1921-192925.2 %  8 Years

1949-196614.0 %17 Years

1982-199914.9 %17 Years

Average14.9%17 Years


Weak periods have lasted up to 20 years

Weak Cycles

Time PeriodAnnual Average ReturnDuration

1802-1815+ 2.7 %13 Years

1835-1843-  0.6 %  8 Years

1853-1861-  3.0 %  8 Years

1981-1897+ 3.9 %16 Years

1902-1921   0.0 %19 Years

1929-1949+ 0.8 %20 Years

1966-1982-  1.4 %16 Years

1999-????   ??? %?? Years

Average 0.0 %16 Years

Two simple questions every investor should be asking themselves:

 Can I take another 3-5 years of negative to flat performance and still reach my financial goals?
    Do I have the same confidence as I did before 2000 or 2008 in my current investment approach?

If you answered NO to either of these questions consider using an absolute return and or tactical approach in your investment strategy.  


Past performance does not guarantee future returns.  The success or failure of a tactical and absolute return strategy depends up many factor including but not limited to the managers's ability to avoid large market losses.  There can be no guarantee that PCM will be able to avoid such losses or that PCM will be able to identify periods of week performance in the stock market in the future.  

Weak and Strong Market Cycles is research by Robert Powers and Sy Harding Market Cycles Study.  The Table above summarized Powers' interpretations of strong and weak cycles, along with average annual returns adjusted for inflation and duration of the cycle

Modern Asset Allocation: Riskier Than You Think
  • Written by R.Todd Wood, MBA
  • How one defines "conservative" is an important question. Conservative investing has different meanings to different constituencies, and perhaps has even been over simplified due to the pigeon-holing effect of investor risk categories.For many investors, being conservative means they can't afford to take risks that would potentially reduce or eat into principal; however, standard asset allocation models are static and typically heavily weight bonds for conservative investors. While this methodology has worked well in low inflationary markets, risk of a decade of bull markets in bonds means caution should be the primary message to investors. The future may be different from the recent past, and static allocations of heavily weighted portfolios in fixed income creates a poor risk reward senario.
  • Standard Conservative Investing
  • Conservative investors, and by default large bond holders, tend to hold on to their bond investments for long periods. Just a few years ago it would have been difficult for many fixed-income holders, including pension funds and individuals, to consider they would be facing the sovereign debt issues across Europe.
  • It seems to be an investment norm that conservative investors should hold between 50%-80% bonds of varying maturities, issuers and quality, depending upon the client's income needs and risk tolerance. But this does not mean bonds are without risk for investors who have purchased bonds over the past few years at, or above, par. Rising interest rates causes bond prices to fall.
  • The bond market crash of 1979-1980 had bond investors on their heels when then-Federal Reserve Chairman Paul Volcker announced he was going to raise the discount rate by two full percentage points. "By some estimates, investors have losses totaling 25% of the market value of their bond holdings, or more the $400 billion."
  • Conservative investing is relative to the individual. Prevalent static-allocation models with a lack of active risk management, coupled with the attitude that markets will come back, could do a disservice to investors. Retiring baby boomers are at an increased risk of facing losses to the fixed-income portion of their portfolios, which may comprise more than 50% of investable assets based on current conventional wisdom.
  • Modern Portfolio Theory and Risk
  • The creation of modern portfolio theory (MPT) and subsequent methods of allocating one's portfolio into various asset and sub-asset classes has turned into an analytical function of form over substance. The most powerful tenant of MPT is finding and allocating a portfolio based on the correlation of the various investment options one has. What many professional advisors have failed to realize is that correlations are not static. As an example when equity markets fall sharply, correlations of various equity classes rise. The fairly static division of asset classes and sub-asset classes into portfolios of aggressive, growth, moderate or conservative risk profiles, considered the hallmark of the professional advisor using MPT as a crutch, has put investors at more directional market risk.
  • Table 1.0 is a correlation heat map of the most common equity allocations, but also includes real estate as represented by the NAREIT Index. As one can see, these are highly correlated and offer very little diversification.
  •  
  • From a directional risk perspective, an investor may as well just pick one of these sub-asset classes instead of allocating a portion of their 40% equities across seven different equity investments and leave a remainder of 60% in bonds.
  • What the Numbers Really Say
  • Perhaps a more detailed example will help illustrate the effects of a converging correlation among various asset and sub-asset classes. Let's look at a hypothetical allocation for a conservative investor with 60% of the assets spread between bonds, 35% in equities and 5% in real assets consisting of real estate and commodities. Overall this looks to be a very diversified and conservative portfolio; however, if one digs a little deeper to examine the correlation of the components and the R-squared values of the asset class to the overall portfolio, an interesting picture develops beyond the correlation of various equity alternatives and brings to light the directional risk of the overall portfolio.
  • Graph 1.1 represents the allocation in % terms of the individual asset classes and sub-asset classes recommend by the mainstream financial community.
  • Graph 1.1 Conservative Portfolio Allocation in Terms of Percent of One’s Portfolio
  • We took the returns of each sub-asset class from January 1995 to December 2010 in a hypothetical conservative portfolio, calculated the relationship of performance of each piece of the portfolio and how closely it moves with the overall portfolio (R-squared), and took the sum of the allocation percent times the R-squared times the standard deviation to give us an idea of the directional portfolio risk.
  • Graph 1.2 Directional Risk Exposure of Conservative Portfolio Consisting of an Allocation 60% Bonds, 35% Equities, 5% Real Assets
  • Graph 1.2 indicates the directional risk exposure, based on the pieces that comprise the "Conservative" portfolio and how they move in relationship to equities, bonds or real assets. What this research and analysis demonstrates is investors have much more directional risk than what is alluded to or explained by mainstream investment methodology, and what is considered a conservative portfolio by most professionals actually has nearly two times the directional risk exposure in equities. When equities are going higher, this doesn't present a problem to our conservative investor. However, when stocks are not doing well and going down, sometimes significantly as in 2000 and 2008 with over 50% losses to stocks each time, the conservative investor finds themselves with losses greater than ever expected.
  • Differentiation for Better Results
  • At Provident Capital Management, this analysis started what was to be a paradigm shift in portfolio risk analysis and how we determine the appropriateness of a particular investment approach for our clients. The findings have enlightened us about how we look at risk and have helped redirect our research and client portfolio allocation away from standardized asset allocation theme of stocks, bonds and alternatives. Our focus is more on the correlation effects, how the sub-components move in relation to each other and the overall portfolio in up and down market conditions. Developing portfolios containing truly non-correlated pieces helps to reduce volatility and drawdown.
  • In summary, traditional wall street analysis produces what appears at first glance to be a well-diversified portfolio, but is in fact fraught with the risk of substantial loss. Mainstream allocation models may lead investors to a false sense of security. In my view, a low volatility, low drawdown approach which may, over short periods of time move sideways, is much more acceptable then taking the rollercoaster ride of conventional benchmark strategies.
  • There are no guaranties the past correlations will remain consistent. Risk analysis requires more than reviewing drawdown and volatility. The past may not be indicative of the future.
  • Table 1.0

Philosophy

Provident Capital Management's belief is that superior full-market cycle returns are directly correlated to a reduction or elimination of large drawdowns in any given portfolio or investment strategy. To accomplish this, an investment strategy must employ some form of risk management and should have the ability to capture positive returns in both rising and falling markets. Furthermore, it is important to have the ability to participate in all asset classes, all asset sizes and all asset styles across all markets to insure diversification that is truly non-correlated.

Our firm uses ETF's and stocks to bring to market model driven, quantitative, multi-directional strategies, formerly only available to institutions and accredited investors. These strategies are available in liquid and transparent separate managed accounts offering investors an attractive alternative to the traditional mutual and hedge funds. 

Provident Capital Management is committed to providing the investment community with high-quality absolute return and tactical solutions that are liquid and transparent. We offer an attractive alternative to hedge funds, mutual funds and traditional buy and hold strategies.

Tools and research are available to develop strategies that will deliver respectable performance in today's low return environment. Wall Street's preference for "benchmarking" equity managers to traditional equity indexes exposes institutional investors to excessive risk as measured by draw-downs (up to 30% to 50% over the past 5 and 10 years). Furthermore, recent high correlation across all asset classes, especially in times of financial distress, is minimizing benefits of traditional asset allocation.

Provident offers a solution to the dilemma of portfolio shocks and high volatility, large and prolonged draw-downs and cyclical low returns. Provident's strategies can be used in conjunction with traditional asset allocation approaches or used as a distinctive investment methodology. Through its multi-factor quantitative approach Provident's strategies have been built for the present and future. Portfolios and strategies are designed to produce positive returns in up, down and sideways markets.

Through risk mitigation, without sacrificing upside capture, PCM's quantitative strategies reduce portfolio draw-down and enhance returns. Our service is delivered via liquid and transparent separate accounts or LP structure through major custodians such as TD Ameritrade and Schwab. We measure our success by how effective we are at producing positive returns with as little volatility as possible versus comparing our performance to an arbitrary index.

What are Absolute Return Strategies?

"Absolute return funds look to make positive returns whether the overall market is up or down, while index-tracking funds try to beat the index they are tracking." - Forbes, Investopedia

PCM's Absolute Return Strategies use low-volatility investments such as cash and money market funds, and then at times selected by the manager, will take directional positions in index Exchange Traded Funds. The strategies historically offer low correlation to financial market performance such as the Standard and Poors 500 Stock Index (S&P 500 Index).

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What in the world is going on?

A brief review of 2014 financial markets and what it may mean for 2015:

With the exception of the US, India and China, the world''s equity markets were down in 2014. Japan was down 7.4% and officially entered into a recession. The three largest European markets; the U.K., Germany, and France were down 13 plus percent and their economies are very close to following Japan into a recession.


The Goldman Sachs Commodity Index, led by Oil and Precious Metals fell 33%. This in turn led to significant losses in commodity export economies/stock markets such as Russia, down 49%, Brazil, down 18.2% and Australia, down 9%.

**Source of above Map and Performance Statistics: Investors'' Business Daily


Interest rates around the globe fell sharply. As an example, the US 10 Year Government Bond Yield has fallen from 2.95% to under 1.80% a drop of 115 basis points or 39%. The 10 year German Bond rate is below .50% and Swedish Banks are now CHARGING 75 basis points (paying a rate of -.75%) on funds held in their accounts.


Since the great financial collapse of 2008 the world has been in an inflation - deflation tug of war. Falling world equity prices, falling commodity prices, and falling interest rates in the face of massive central bank intervention clearly suggest that deflation won the battle in 2014. So you may find yourself asking; what is so bad about deflation? It doesn''t seem so bad when we save at the pump.


Deflation is a problem for several reasons. First, the decline that we have seen in oil prices is already leading to layoffs of very good paying jobs in the only real area of job growth that the U.S. has seen since the 2008-2009 financial collapse (Oil exploration, Fracking). In addition, many of these shale companies and even the big oil companies have already reported that there will be major cuts in capital expenditures. These cuts in spending for new projects, equipment and technology upgrades will have a further ripple effect that will cause layoffs in related fields such as engineering, law, accounting and for suppliers such as drilling equipment, pipes, and steel manufacturers. Many of the smaller shale businesses won''t make it and there will be a setback to the huge strides that the U.S. has made towards oil independence.


A second problem is that lower oil means a stronger dollar. A stronger dollar can hurt the U.S. economy, as our products become too expensive and non-competitive on the global market, once again costing jobs and reducing incomes. In addition, as our dollar continues to strengthen and the economy worsens from job losses, consumers and businesses begin to delay expenditures in hopes that they can save by waiting. This can lead to a very vicious and destructive cycle for the growth of any economy.


Lastly, the selloff in oil has been so severe and happened over such a short period of time, it is likely that we don''t yet know the ripple effect of that in the financial markets. Much like we were told that the housing crisis was "contained", financial markets can experience a domino effect when any asset class falls this much and this quickly. With margin debt at historical highs, the need to cover a margin call generated by the drop in oil and derivative financial products can quickly cause fear and panic in other asset classes. It is estimated that the energy sector represents as much as 15-20% of high yield bonds. This is one area that we could begin to see many defaults and also result in a ripple effect to other asset classes.


There are several headwinds as we go into 2015 including the Fed potentially raising rates, extreme high bullish sentiment, volatility increasing, high yield bonds indicating that risk aversion is increasing, recent pullback in the historically high margin debt levels, market levels significantly higher than the long term mean, and deflation as discussed. It will be a very interesting year to watch the markets, as quantitative easing has ended and markets appear to be returning to more normal levels of volatility.

Created on Friday, 16 January 2015 14:37

Written by: Michael J. Chapman, CFP®, Chief Investment Officer
Melissa Wieder, CFP®, Director Institutional Services

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