"As a portfolio and risk manager, I decided that there had to be a better way to manage the risk of inevitable volatile bear markets, while providing advisors and investors peace of mind." - Tom Hardin, Canterbury Investment
[Research has been coming out that seriously challenges conventional investment wisdom and endeavors to systematically bash down many of the portfolio management pillars that investors have steadfastly been reliant on. One example is the latest Canterbury Market States Study that provides statistically relevant evidence that markets are not random nor do they behave in a normally distributed pattern. Implications are far reaching and putting into question many strategic portfolio management methodologies, risk/reward metrics and also whether portfolio management decisions should be based on subjective views of the investor’s risk tolerance and personal financial objectives.
It is important to keep up with these types of disruptive research efforts because it is only in these challenges of old ways of thinking and long held assumptions that true investment management innovation can happen.
To further explore this new ongoing research effort, the Institute for Innovation Development recently talked with Institute member Tom Hardin, Managing Director and Chief Investment Officer of Canterbury Investment Management – an investment advisory firm specializing in providing financial advisers, institutional investors, and retirement professionals with an adaptive ETF portfolio management solution built on defined rules and evidence - based results. Focused on their proprietary Portfolio Thermostat Strategy and the Portfolio Thermostat Fund (CAPTX), Hardin warns advisors and other money managers about the risks in not challenging “conventional wisdom” and recommends how they can position themselves to take advantage of a new era of investment thinking and opportunity for investors.]
Hortz: Please give us some background on your research efforts. What were your motivations and thinking behind how you decided on this research path that you have been taking?
Hardin: My motivation to rethink portfolio management strategy and to pursue an alternative path is two-fold. One motivator comes from decades of personal observations that made it crystal clear that traditional portfolio management, quite simply, does not work during volatile bear markets.
The second is a much higher motivator that stems from my deep discussions with affluent clients and financial advisors. Many surveys have confirmed that both, advisors and their clients, lack the confidence that their existing portfolio can handle the next market downturn. As a portfolio and risk manager, I decided that there had to be a better way to manage the risk of inevitable volatile bear markets, while providing advisors and investors peace of mind.
About 15 years ago, our team here at Canterbury began a quest to research and challenge the validity of all previous investment theories and the assumptions that were used to form traditional portfolio management practices. We took every known assumption that has been around prior to the turn of the century and questioned them all. Guess what? We found that the vast majority of the old assumptions that have become “conventional wisdom,” were flat wrong.
Hortz: As a researcher, how do you go about disproving old and developing new investment assumptions and portfolio management practices?
Hardin: As far as disproving old assumptions and practices, we begin by asking a logical question… Is doing what I am doing now getting me the result that I want? If I am not getting the result I want, then ask... is there something wrong with the process being used, or the assumptions that the process was built on? We found that more often than not, the failed management process was based on flawed assumptions.
One of the best ways to disprove old assumptions, or to develop new ones, is to think opposite… For example, take the keystone assumption that traditional portfolio management was based on, the risk/reward relationship. The assumption is that if one is willing to accept more risk and stay invested for a long enough time, then he or she should be rewarded with higher returns. What if I said the opposite? Taking more risk, over time, would be more likely to produce poor results, instead of higher returns.
The problem with the old assumption is that the longer the time invested, the more possibilities for negative outliers. It is true that taking higher risks may produce periods with substantial returns, but just one bad downturn can wipe out all previous gains. Risk is defined as volatility and substantial declines in value (called drawdowns). Accepting more volatility and larger drawdowns are exactly what we don’t want. It doesn’t pass the logic test. Hence, portfolio management is not about the risk/return relationship.
The successful management of liquid securities then becomes about “portfolio efficiency.” An efficient portfolio will be managed to have lower or decreasing volatility and smaller drawdowns. Low portfolio volatility and drawdowns means that the diversification is being adjusted to work in the current market environment. As a result, long-term geometric compounding of returns will be enhanced.
Hortz: Why does your current research paper focus on disproving that markets behave in a random and normally distributed pattern? What is the significance and implications of that challenge?
Hardin: These false assumptions are another example of conventional wisdom that goes unquestioned. Doing the research, you uncover that traditional “strategic” portfolio management was based on academic theory and, more specifically, established on the assumptions of a bell curve of normal distribution - that market movements were random, like flipping a coin. The probabilities of a coin flip were 50/50 heads or tails. There is no way to determine which way the next flip will go.
Remember, modern portfolio theory and most of the “risk/reward” metrics used in portfolio management today are based on the assumptions from the bell curves’ elegant equations. The academics have been teaching basically the same thing for the last 50 plus years. They are responsible for many of the market assumptions that most of today’s portfolio management methods were built on.
The problem is that the bell curve is lousy at predicting the size and frequency of the market’s “outliers.” What are “outliers? In this case, outliers are low probability – high impact events. Some daily outliers can be extreme. For example, the markets can experience 4th, 5th, 6th standard deviation events. These market trading events are so unlikely, that a single occurrence should only happen once in several hundred years.
The truth is, and what our research shows, is that large daily market outliers occur more frequently and can be much larger than what the bell curve would predict. In addition, outliers tend to occur in groups over short periods of time. The combination of all these factors provide statistically relevant evidence that markets are not random nor equally distributed. In other words, it is impractical to use the same mathematical method, based on the same assumptions used to predict the probabilities of a closed system, like flipping a coin, to try to predict and calculate the wide possibilities of the trading ranges in the markets.
The most significant conclusion drawn from our research shows that the markets’ movements are not random nor equally distributed, but instead will experience extended periods of high volatility with large drawdowns as well as periods of low volatility with small pullbacks or corrections. Our studies show that changes in the characteristics of volatility have predictive value. Therefore, the key to cracking the market’s code is the study of volatility.
Hortz: Tell us more about your concept of Market States.
Hardin: Through our research, we have been able to determine major patterns in the market environment over time. There are many similarities between the financial markets and weather, above the Mason-Dixon line, where there are four distinct seasons. Similarly, we have identified four unique market environments. We call them Market States. The first is a Bullish Market State. This environment has low risk and is highly efficient. It will typically limit the risk to a normal correction of about 8-12%. Then there is a Bearish Market State that has environments with unlimited risk for loss.
There are also two Transitional Market States. A Transitional environment is in the process of shifting from one extreme environment to another, similar to the transition between summer and winter. One transitional Market State environment begins as volatility is increasing from a low level. The increase in volatility may be signaling a potential high-risk market ahead, meaning a bearish Market State. The other transitional Market State begins when a clear decrease in volatility is established following a previously emotional highly volatile period.
Lastly, the seasons do not go from winter to summer overnight and markets do not shift from a bullish to a bearish environment based on a couple spikes in volatility. Both require some time, and both will go through a process to shift from one extreme to the other.
Hortz: What significance does a Market State have on a portfolio and the portfolio management process?
Hardin: Markets are liquid. The liquidity in markets is created by investors’ real time buying and selling. Securities prices will fluctuate based on the law (not the theory or hypothesis) of Supply and Demand. The shifts between supply and demand can be stable and orderly or highly emotional or anything in between. As a result, a fixed portfolio’s volatility will vary within a wide range. For example, when a portfolio experiences an increase in volatility, then we know that the correlations among the portfolio’s securities are increasing, and the portfolio is experiencing a decline in the benefit of diversification.
In other words, the combination of diversified securities that was producing an efficient portfolio in the past, is now becoming less efficient as the environment begins to change. Logically, how can a fixed, stagnant portfolio always be efficient when the markets are dynamic? The only way to maintain portfolio efficiency when markets begin to shift from one environment to another is to take advantage of the liquidity available and begin to adapt the holdings to match the new realities of the now existing market environment.
Hortz: How would one go about “adapting” a portfolio?
Hardin: We've developed an adaptive portfolio management methodology. We call it the Canterbury Portfolio Thermostat. Our adaptive portfolio management process acts like a thermostat, in that it can identify the current market environment and adapt the portfolio’s holdings to match and move in concert with the changing environment.
The efficient portfolio is a moving target. The holdings of an efficient portfolio, during a bull market, will be different from the holdings of an efficient portfolio during a bear market. Therefore, risk management should not be based on predictions of the future, but should be adaptive and performed on an ongoing basis. There's so much better risk control for the portfolio in having this real-time dimension added.
Hortz: What advice can you give advisors on what best to focus on in this evolving investment environment?
Hardin: Based on our experience, the most important role of an investment manager is to manage the client’s expectations and emotional risk. It is our job to make good decisions and provide acceptable results regardless of the variable market environments. You need to be able to demonstrate that your focus is to manage for volatility risk and market corrections. If you can do that, then the clients are going to do well over the long run and be less anxious.
As an ongoing tool to reinforce this to clients, we built a dashboard to help the advisor “change the conversation.” The dashboard is designed to teach and visualize for clients what key portfolio metrics to focus on, show that the portfolio is efficient, and provide confidence in the ongoing process of adaptive portfolio management.
I think that advisors and clients alike will readily admit that they spend too much time feeling stressed about the portfolio and worried about what's going to happen. What happens if it blows up? There is a lot of worry and that shouldn't be the case. Today, it is possible to produce the benefits of compounded returns through any market environment – bull or bear.
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