Tuesday, August 24, 2010

Isbitts, The Flexible Investing Playbook

In The Flexible Investing Playbook: Asset Allocation Strategies for Long-Term Success (Wiley, 2010) Robert A. Isbitts sets out to reeducate investors. The “next many years,” he claims, “will be about two things.” First, buy and hold is dead; investors should rent the market instead of owning it. Second, risk management is critical. (p. 6)

Isbitts reworks the classic 60/40 approach to investing. The old mantra was to put 60 percent of your money in stocks and 40 percent in bonds. Isbitts’ take is tactical—try to make at least 6 percent for every 10 percent move up in the market and try to limit losses to 4 percent for every 10 percent move down in the market. Easier said than done, as everyone who manages money would undoubtedly attest. It’s one thing to write about cycles: up, down, and transition. It’s another thing entirely to offer effective guidelines to identify these market phases in real time. Although Isbitts and his team engage in cycle analysis, he circumvents the problem of timing, in part at least, by appealing to asset allocation.

He discusses three model portfolio strategies. First, the hybrid strategy “pursues long-term preservation and growth of capital over a one- to three-year period by investing in a combination of investment styles expected to exhibit low correlation to the broad stock and bond markets.” Second, the concentrated equity strategy pursues the same goals “over a three- to five-year period by investing in a group of equity money managers (through their mutual funds) who run concentrated portfolios.” Third, the global cycle strategy extends the time horizon to five to ten years. It invests “in a mix of funds that target global, secular business themes.” (pp. 131-32)

These strategies can be pursued individually. But, taken concurrently, they offer the investor the ability to hedge his position during “countertrend” declines in stock prices while holding onto his core long-term positions. As should be apparent, this three-pronged approach to asset allocation is not designed for the investor with a small account. Isbitts’ background is in wealth management.

The final part of the book deals with evaluating performance. Benchmark envy, he writes, “is one of the most destructive forces to investors.” (p. 177) Benchmarks should be used for comparison over “long stretches of time—5 to 10 years,” not as a short-term measure of whether an investment is working out.

Isbitts describes some useful ways to keep score: capture ratios, standard deviation, rolling returns, and R-squared. Here I’ll confine myself to only two: capture ratios and rolling returns.

The capture ratio “is a statistic that tells you how much of the market’s move you have experienced.” (p. 180) If your portfolio grows by 8% during a 10% up move in the market, you would have a 0.80 up capture ratio. If the market goes down 10% and your portfolio falls by 6%, you would have a down capture ratio of 0.60. If in the same bear market scenario your portfolio has a 2% gain, your down capture ratio is -0.20. The capture ratio is a useful statistic because it shows how various portfolios have performed historically and how they might react to future market conditions.

Isbitts argues in favor of using rolling returns in place of trailing or annual returns to evaluate a manager’s past effectiveness. He illustrates the problem with the standard metrics with this table of the “annual returns of three different hypothetical portfolios.”

As you might suspect, these are not three different portfolios. A is the return of the S&P 500 from February 2002 to January 2007; B is the index’s return from October 2002 to September 2007; C is its return from July 2002 to June 2007.

If the investor looks at rolling returns graphs (and they can be for whatever length his analytics tool permits—3-, 6-, 12-month, or for those with a very long time horizon 5- or 10-year) he can glean important information. The author suggests studying how often a fund’s “rolling 12-month return has crossed into negative territory and for how long” and doing peak-to-trough analysis “whereby we analyze returns from different market tops to market bottoms, and vice versa.” (p. 186)

This is a thoughtful book on portfolio construction, one which financial advisors would do well to read. The individual investor might not be able to implement all of Isbitts’ suggestions, but the principles set forth in this book should enable him to both reassess the potential robustness of his portfolio and make some improvements to his mix.

No comments:

Post a Comment