Experienced investors know they can’t control what the market is going to offer. While it’s not unusual to find an asset manager targeting a specific return, actually achieving that goal is sometimes as much a matter of luck as skill. The simple fact is that no one, not the best stock picker or bond buyer in the world, can accurately predict returns in one year, let alone consistently year-over-year – no one knows the future. There has to be a better way for individuals and advisors to select the managers with whom they entrust their financial well-being.
There is a small but growing community of advisors who are leaving behind the old ways of picking managers in an effort to give their clients something they can’t get on their own or from a robo-advisor. These advisors pay as much, if not more, attention to potential risks as they do to potential returns. After all, fund managers invest in risks, not returns, when they select the securities in a fund, even if they are just rebalancing an index. Returns are nothing more than the result of a portfolio’s risk selection, whether deliberately chosen or passively accepted.
When the market is greedy, indiscriminate buying means that the return-focused manager will have to take on more risk than was necessary before the market greed kicked in. When the market is fearful, indiscriminate selling means that the return-focused manager can take on less risk than was necessary before the market sold off. But an emerging group of risk-minded advisors recognize that if a manager is always focused on returns, he is unlikely to be consistent in how he selects risk. Meanwhile, an index offers no control over the risks in the portfolio. In both cases, a lack of focus on risk makes their job of achieving client goals much harder.
A fund manager may reduce the dependence on luck by deliberately focusing on selecting risk in an effort to have a consistent investment process regardless of what the market is doing. Managers who adopt this approach make it easier for advisors to draw a straight line between their investment strategies and suitability for a client’s goal of steady performance. This is especially true when it comes to investing in fixed income, where capital preservation is usually the highest priority.
Recent bond market swings have put many advisors in the tough position of trying to explain how their fixed income portfolios are expected to preserve capital when interest rates go up. But the answer to today’s fixed income market isn’t to give up on capital preservation entirely because it’s “too hard”. Some call capital preservation an absolute return goal, which means the portfolio aims to always be positive over some timeframe, but there is more to it. To preserve capital, an advisor must also seek lower volatility because she never knows when her clients need to access their money. Having confidence that a portfolio will always be positive in a three year timeframe means little to the client who has a medical emergency in year two. Having confidence in absolute returns within one year with low volatility is much more meaningful.
There are three key characteristics specific to fixed income for advisors to look for when evaluating whether managers are selecting risks to preserve capital. First, volatility is most effectively managed by keeping a low sensitivity to interest rate moves, also referred to as having a short duration. Second, a portfolio should have a high enough yield that any income earned will be able to compensate for price movements. Third, to earn higher yields without losing sight of the capital preservation goal, security selection can often matter more than any other factor when building a portfolio.
The interdependence of the three key characteristics of fixed income capital preservation shows why cutting corners and addressing just one or two of them might have failed in previous market disruptions. Bonds with short durations may naturally be less sensitive to interest rate movements, but declines in bond prices will still cause unrealized losses if the bonds don’t earn enough income to overcome the price moves or if bonds aren’t carefully selected to reduce the impact of indiscriminate selling. And even though a higher yielding portfolio is necessary, not just any portfolio of higher yielding bonds will do if an advisor is concerned with preserving capital.
