Hidden Volatility Costs and Active Portfolio Management

2 / Apr AUTHOR NAME: Art Galvan 0 COMMENTS

I have been in the Institutional Trading business for 28 years and recently made the move into the Financial Advisory world. I landed at a reputable BD/Insurance shop to learn about the retail world and its’s ins and outs. My experience led me to the investment side of things so that is what I focused on.

What I learned is that most of the large shops on the street focus on buying and holding a mix of mutual funds or Exchange Traded Funds (ETFs) based on a client’s age and risk appetite. The premise is that the portfolio will have a predetermined mix of different asset classes that will ebb and flow. The asset class mix is built to be uncorrelated, yet most portfolios are built and compared to the index products that are quoted by the minute on CNBC like the S&P 500.

The crash of 2008-2009 taught us that in times of extreme stress, everything becomes correlated. When investors receive margin calls and there is an urgent need for cash, everything goes on sale. This is the definition of a fire sale.

What can we learn from that period?

The market has recovered quite nicely since 2009 and it seems that good times are here again. The buy and hold crowd say that crashes like 2008 are temporary and markets always recover.

I agree that markets do recover. However, when there is market duress, most retail shops will tell you to stay the course and don’t panic.

Most of them are not in a position to tactically manage your portfolio, so what else can they tell you?

Most Advisors are not in the business of watching market indicators daily and their respective firms don’t advise them when to change holdings in the portfolios. The firm will only let them know, on an annual basis, when to rebalance the portfolio when it gets out of the original percentage holdings. There can be a cost in the “buy and hold” strategy as you will see.

2018 is off to a rocky start. Volatility is back in the markets. In a recent article,*

Mark Spitznagel talks about the tax on volatility. The main point in this great article is:

The volatility tax is the hidden tax on an investment portfolio caused by the negative compounding of large investment losses.  Here’s how this “tax” is levied: Steep portfolio losses (or “crashes”) crush the long-run compound annual growth rate (CAGR) of that portfolio. It just takes too long to recover from a much lower starting point.”

The main point to drive home is that most advisors are not equipped to talk about mitigating your risk while active portfolio management will try to recognize when the market is about to take a turn for the worse.

What will your current advisor do?

Think of this simple exercise:

  • If your portfolio loses 50% one year, it would take a 100% return to make up that loss!
  • This is where an active portfolio manager makes sense.

If an active manager can help you avoid the entire 50% downturn by paring down your risk, then you won’t have to make 100% to return to breakeven.

  • When the market begins to recover, your starting point will be higher than the buy and hold portfolio that stayed the course.
  • While most shops are not built to actively manage your money, Formula Folios is built specifically for this.
  • Smart, Simple, Safe… our firms core belief!

I subsequently left the aforementioned BD shop and partnered with Formula Folios.

We are monitoring the markets daily and have our hand on the light switch. When our indicators signal that the market is healthy, we are invested so that your portfolio grows.

When our indicators tell us that the market is NOT healthy, we have the ability to pare down risk, or dim the light switch, and avoid the hidden taxes on volatility mentioned in Mr. Spitznagel’s article.

Though our risk mitigation may lead to caution and miss out on some of the upside, we believe that it is far better to miss the large market corrections and have a better starting point when the market recovers.

Please feel free to contact me if you have any questions.

Art Galvan

* https://www.universa.net/UniversaResearch_SafeHavenPart4_VolatilityTax.pdf

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