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What Is Countercyclical Indexing™?

Simple. Systematic. Low Fee.  Tax Efficient.  

We are full blown believers in low cost indexing. There is vast empirical evidence showing that low cost indexing beats stock picking and more active high fee asset management. At the same time, we feel that there are legitimate problems with many standard indexing strategies. The key problems we encounter are:

1) Stocks expose investors to an outsized risk of loss at times and most stock heavy indexing strategies fail to properly insulate this risk in a portfolio.

 

2) A static indexing strategy is inherently procyclical because stocks are typically riskier late in a market cycle and less risky early in a market cycle. A traditional static indexing approach leaves an investor overweight the riskiest assets at the riskiest times and underweight those low risk higher yielding assets when their returns are likely to be highest.

 

3) A static indexing approach creates outsized behavioral risk because the investor will typically become less comfortable with the stock market as it increases in value and rebalancing back to a nominal weighting (such as 60/40) is actually rebalancing back to a riskier portfolio on average because the 60% stock slice is typically riskier than the original 60% slice they allocated to.

 

4) Many indexing portfolios (such as bond aggregates) do not fully reflect the markets they are designed to mimic and result in incomplete and inappropriate index funds.

To better protect against and correct for these risks while maintaining a low fee and inactive investment strategy we created the Countercyclical Indexing™ strategy. This takes a standard index fund approach, but quantifies the relative risks in the assets and rebalances passively across time so that the portfolio manages the outsized equity risk that inherently exists in a portfolio. So, for instance, a 60/40 stock/bond portfolio will always rebalance back to 60/40, however, we know that 60/40 in a year like 2007 is much riskier than a 60/40 in 2009 after stocks have declined. This is because the stock component dominates the portfolio’s exposure to downside risk and is actually much more like a 90/10 portfolio in terms of where its downside risk comes from. To correct for this we quantify the relative risks in each component.

For instance, if the stock piece doubles in price your standard index will rebalance back to 60/40 even though that portfolio could be significantly riskier than your original 60/40. To correct for this the systematic Countercyclical portfolio will rebalance back to something like 50/50 or 40/60. In doing so we help create smoother returns across time that are more consistent with the way investors actually perceive risk. This helps us remain invested in the markets in a relatively passive and low fee manner while better controlling for the risks in the portfolio.

Countercyclical Indexing™ is a low fee, tax efficient and globally diversified indexing strategy that systematically rebalances a portfolio so that it reduces exposure to volatility in the financial markets across the market cycle.  In doing so we are reducing the portfolio’s exposure to downside when high risk assets become riskier late in the cycle and adding to high risk assets during downturns when they become less risky.  This better controls for the portfolio’s exposure to permanent loss risk and reduces drawdowns thereby better balancing an asset allocator’s portfolio between generating returns and hedging against downside loss.  This helps create better alignment between an investor’s risk profile and their exposure to the financial markets as opposed to most indexing strategies which involve a very high correlation to the stock market and its inevitable large drawdowns.  Most importantly, this is done in a passive, low fee and tax efficient manner.  That’s the short(ish) version.

Countercyclical Indexing™ is a smarter way to implement a low cost indexing strategy.

Now for the nerdy version.  Most indexing strategies are procyclical which leaves them inherently imbalanced and flawed at times. This means they are market cap weighted strategies that move with the broader financial markets. In general these strategies are overweight stocks which means that their exposure to the risk of permanent loss is assumed to be static. We know, however, that the stock market’s exposure to permanent loss risk is not static. It tends to increase as the market cycle matures and it tends to decline as the market cycle contracts. In essence, stocks often become more risky when they rise in value and less risky when they decline in value. This leaves investors overweight stocks when they are riskiest (late in the cycle) and underweight stocks early in the cycle when they are less risky.  This results in an imbalance in the investor’s risk profile and the way they perceive their exposure to permanent loss risk.

Rebalancing a portfolio over the course of the business cycle is part of any good portfolio plan.  But traditional portfolio theory says that we should rebalance a portfolio back to our initial nominal asset weightings.  For instance, a 60/40 stock/bond portfolio is cyclically adjusted at times to rebalance back to a 60/40 weighting as stocks tend to become overweighted relative to bonds due to outperformance.  But this procyclical or static portfolio allocation will expose investors to high levels of risk at the riskiest points in the business cycle because a 60/40 stock/bond portfolio is actually less risky early in the cycle and more risky late in the business cycle. In other words, traditional portfolio theory does not account for the dynamism of the business cycle which results in portfolios that do not properly account for changing risks during the course of the cycle. This leaves your risk profile misaligned with asset class exposure at various points in the business cycle.  We can quantify this empirically, for instance, because stocks have historically performed better in the first half of the business cycle than they have in the second half of the business cycle when accounting for relative risks and returns.¹

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Many investors also don’t understand that most portfolios are far more weighted for returns than downside loss protection.  For instance, a 60/40 portfolio is more like a 90/10 portfolio in terms of its balance between permanent loss protection and purchasing power protection.  This is due to the fact that the equity portion of the 60/40 is generating the vast majority of the volatility and downside loss potential.  As a result most “balanced” investors really aren’t very balanced at all.  They are always overweight risk in exchange for the higher potential of downside loss.  This means that even a “balanced” portfolio like a 60/40 can experience 30%+ losses as it did in the 70’s and 2000’s.

We start the portfolio construction process with the simple understanding that investors are allocating their savings.  And within their savings portfolio they are trying to protect their assets against the risk of permanent loss and the risk of inflation.  Modern Portfolio Theory doesn’t account for the fact that a stock heavy portfolio is always underweight permanent loss risk protection and becomes even more risky as the market cycle matures.  By using a Countercyclical Indexing approach we can create a portfolio that is more in-line with our savings by establishing an asset allocation that generates purchasing power protection, but does not do so in such an unbalanced manner as a traditional indexing portfolio. This results in an asset allocation that is more in-line with the way most investors actually perceive risk.

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Although our approach is passive we do tilt portfolios on a cyclical basis as relative risks evolve.  We rebalance to adjust for risk because we know that our clients have perceptions of risk that are just as dynamic as the financial markets.  Most investors tend to chase performance as assets increase in value.  But what they’re really chasing is not performance, but risk.  This is why so many investors tend to buy high and sell low.  Our approach is designed to counterbalance this response.  We adjust for risk as the cycle evolves thereby helping to keep our client’s risk tolerance in-line with that of the various asset classes we hold in underlying portfolios.  This can be done systematically because we can quantify where are are in the market cycle based on the relative values of net financial assets.

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This approach is grounded in global macro understandings, but is also derived from two time tested approaches – Ray Dalio’s Risk Parity approach² and William Sharpe’s Adaptive Asset Allocation approach³.  However, unlike Dalio’s Risk Parity approach we don’t seek to create parity across risks in the portfolio.  Instead, we utilize an adaptive methodology similar to William Sharpe’s adaptive Asset Allocation style based on the understanding that market values and risks are dynamic.  Therefore, it is logical to rebalance portfolios over the course of the business cycle to account for these changing risks.  Although the investor’s risk profile is generally static over the course of the business cycle, the investor’s portfolio will actually change over the course of the business cycle and expose them to varying degrees of risk. Our Countercyclical Indexing approach establishes a portfolio management approach that is more consistent with the way investors actually perceive risk over the course of the business cycle and increases the probability of improving risk adjusted returns.

¹ – Roche, Cullen.  2014.   Countercyclical Indexing & Roche, 2016. Understanding Modern Portfolio Construction

² –  Dalio, Ray, 2010.  Engineering Targeted Returns & Risks.

³ – Sharpe, William, 2009.  Adaptive Asset Allocation Policies.