Orcam Financial Group specializes in constructing diversified, low fee, tax efficient portfolios that match an investor’s risk profile with the cyclical changes in the markets as the business cycle evolves.
We call this approach “Countercyclical Indexing™” because it is a low fee, tax efficient and diversified strategy designed to match an investor’s profile to the changes in the business cycle as stocks tend to become riskier late in market cycles and less risky early in market cycles.
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 linear 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.
This is due to the fact that, as assets rise relative to other assets, they become increasingly risky. Likewise, as certain assets decline in value they become less risky relative to other assets. This means most investors are overweight risk late in the business cycle and underweight risk early in the 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 Despite this reality most investors chase returns late in the business cycle and sell early in the business cycle. Not accounting for the dynamism of relative risks in asset classes means most investors underperform on a risk adjusted basis over the course of the cycle.
Although our approach is relatively inactive (meaning we don’t make frequent changes to the portfolios on a quarterly or annual basis) 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 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™ strategy 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.
But we go even one step further than this. While the equity piece is the dominant volatility exposure in our portfolios we know that current bond markets leave much to be desired. Your standard 60/40 just doesn’t cut it these days because the 40% bond piece cannot possibly generate the high risk adjusted returns that the past 30 years have gifted to investors. As a result of this, investors are confronted with two big problems these days – stocks are highly valued and bonds yield almost nothing. Our solution to this is a multi-strategy approach where we are not only rebalancing the equity piece to account for permanent loss risk, but we also manage the bond piece to account for interest rate risk. This dual countercyclical approach helps to mitigate the two biggest risks that investors confront these days and helps the investor feel confident in the strategy they are implementing unlike so many of the indexing strategies these days that leave the investor hoping for the best and unprepared for the worse.
Our global macro strategies reflect the personalized risk profiles of our clients. Depending on your specific profile you will own a version of three countercyclical indexing strategies. All of these strategies are low fee, tax efficient, broadly diversified index based approaches that are based on a systematic portfolio management approach.
If you would like to discuss a customized portfolio review and our portfolio management services please reach out to us.
¹ – Roche, Cullen. 2014. Countercyclical Indexing.
² – Roche, Cullen. 2016. Understanding Modern Portfolio Construction.
[/box]* Past performance is never indicative of future returns. Importantly, Orcam Financial Group does not sell the concept of “alpha” or market beating returns. In fact, the arithmetic of the market teaches us that we should expect to underperform a broad benchmark after taxes and fees are properly accounted for. We are not in the business of selling outperformance and “market beating” returns. We believe most investors should spend more time trying to build appropriate portfolios rather than trying to build outperforming portfolios.