Twelve. Fast and Furious
Are you headed for the wall?
A racecar driver’s success depends on the performance and safety standards of the chosen vehicle, but there’s only so much a seat belt and other safety features can do. For obvious reasons, it’s critical to find a balance between the thrill of a high-speed race and careful driving. David Pintaric knows this first hand.
The president of WRP Investments in Youngstown, Ohio, also happens to race high-end sports cars in his spare time, and is currently racing on the same circuit that once counted the late actor and car enthusiast Paul Newman as a driver.
On May 12, 2012, the Dodge Viper he was driving left the track, hit a cement barrier, went end over end multiple times, and skidded to a halt, only to then be struck by another car.
“It was the scariest moment of my life,” Pintaric said.137
137 John Sullivan’s interview with David Pintaric, June 2013.
Although knocked unconscious and taken to the hospital, he walked away without a scratch. It’s a moment he now shares with thousands of others, as the video of the horrific crash and seemingly miraculous aftermath has gone viral on YouTube. He credits the right equipment and a top-notch crew with saving his life, and the crash is something experts now examine to improve car safety and design.
“In retrospect, there’s a lot to be said for the engineers,” he says. “They saved my life. I’m sure they went through some computer modeling, and although they probably didn’t want real world experience, I was able to provide it for them.”
The optimization of car and engine is what kept him safe and ready to race another day, Pintaric adds. And he now has a metaphor at the ready when discussing the value of alternative investments with his clients.
“The engine and the portfolio have to be finely tuned in order to run smoothly,” he relates. “Both have to be firing on all cylinders in order to get to the desired goal. And, importantly, both should be modified to meet whatever conditions, market or weather-related, that might suddenly appear. [Caution], in both cases, is obviously paramount.”
We will now turn to balancing risk and return potential within the alternative portfolio.
Post-Modern Portfolios: Revving the Engine
I’ve talked about how traditional tenets of investing, such as the efficient frontier and modern portfolio theory developed by Dr. Markowitz, aren’t necessarily wrong, it’s just that too many financial professionals and investors may fail to consider the latest variables and solutions available. In other words, your current car might drive just fine, but could a new model offer more fuel efficiency or stereo features that better fit your needs? However, at the same time, could the speeds the new car is able to reach endanger the driver and passengers?
Like a car, an optimal portfolio is created by combining assets that complement one another and help address a number of variables, including volatility. As seen in earlier chapters, adding alternative investments to the portfolio has historically been shown to improve risk-adjusted returns. While there is no guarantee they will do so in the future, depending on the combination of investments, the mix can impact risk, return, or some combination of both.
The right mix of risk and reward for a given market environment would result in optimal portfolio performance, just as the right combination of safety measures could increase Pintaric’s chances for a safe and winning ride. Unfortunately, a perfectly safe car, just like the “optimal” portfolio, does not exist. Similarly, investors always face the risk of poor returns despite the precautions they take. Does this mean everyone should avoid investing entirely? Not at all. It simply means that as new developments and strategies are introduced, it’s worth it to take a look.
Getting Tactical: Rotate the Tires
As I mentioned briefly in the book’s introduction, the general concept of buy-and-hold, as a singular strategy, is not as effective as it once was, quite simply because of an increase in the number and volatility of the variables that potentially affect a portfolio. That doesn’t mean, however, that constantly reacting to threats and opportunities in an effort to time the market is any better. A fine line exists between selling too soon and holding too long. What are some signs that an investment is underperforming? What are the metrics used to identify said underperformance, and how long is too long to stick with it?
Money managers and financial professionals spend an inordinate amount of money and resources in an effort to answer these very questions and involve what are known as tactical asset allocation strategies.
Tactical asset allocation involves the shifting of the percentages of various asset classes within a portfolio depending on the attractiveness of various markets. Alternative investment managers can be evaluated through two lenses on how well they execute a tactical rotation strategy—their investment reasoning and corporate governance.138
138 Interview with Brian Hargreaves, Vice President of Alternative Investments, Curian Capital, 2013.
Investment reasoning involves a close examination of the manager’s performance through various market cycles, whether it’s volatile equity markets, a disruptive event involving the credit quality of fixed income markets, or confusion over interest rates and the direction they may take in the near future.139 What does the manager’s performance look like throughout each, and what active changes do they make to the exposure in the portfolio? Investment managers are rarely evaluated on a one-month, six-month, or even one-year basis, as time is needed for the investment reasoning to play out. For example, gold can be a volatile investment. A manager of a gold commodities fund might therefore lose 20% within a given time frame, but if that timeframe is short enough, he might still be operating within the mandate for which he was hired, and a 30% gain from the pre-drop price might be close behind.
139 Interview with Brian Hargreaves, Vice President of Alternative Investments, Curian Capital, 2013.
Corporate governance involves an evaluation of items such as portfolio management turnover, operations and compliance errors, and changes to ownership structures and the management companies. Any and all could be distractions that have an impact on performance.140
140 Ibid.
How nimble or steadfast the manager or advisor is in replacing investments is key to a successful tactical rotation strategy. Like tires on a car during a race, replace too soon and it’s wasted time and money; replace too late (or not at all) and disaster could strike.
Alternative Investments: Riding an Annuity Chassis
I’ve mentioned mutual funds, managed futures, and exchange traded funds, among others, as examples of products that provide access to the alternative investment space. There’s another product that isn’t associated with terms like “cutting edge” and “innovative” in the public lexicon, so it doesn’t immediately come to mind when thinking about alternative investments, yet it offers access nonetheless. More and more variable annuities are adding alternative investment products to their subaccount options because of the benefits of combining the two. Variable annuities are insurance contracts in which the value of the investment portion fluctuates based on underlying subaccounts. Investments made in the subaccounts accumulate tax free and can be withdrawn without penalty beginning at age 59½. Taxes are then paid on the capital gains of the investments, but not the amount of the original investment, known as the investment basis.
In recent years, variable annuities have focused on addressing the need for guaranteed sources of income in retirement through what are known as living benefit riders that are attached to the annuity contract. These guarantees are backed by the insurance company issuing the contract. Annuity owners accumulate wealth with the power of tax deferral, meaning that they do not have to pay taxes until they take the money out of the annuity. They can then partially choose how best to distribute their accumulated, tax-deferred gains, subject to their individual situation and certain provisions that can vary based on the annuity provider. These living benefit riders, combined with an increasing number of subaccount options (or the underlying investments in which the annuity assets can be invested) led to an explosion of industry growth in the 1990s and 2000s.
Before investing, investors should carefully consider the investment objectives, risks, charges, and expenses of a variable annuity and its underlying investments options. The current contract prospectus and underlying fund prospectus which are contained in the same document provide this and other important information. Please contact your representative or the company to obtain the prospectuses. Please read the prospectuses carefully before investing or sending money. Optional benefits are available for an extra charge in addition to the ongoing fees and expenses of the variable annuity. The long-term advantage of the benefit will vary with the terms of the benefit option, the investment performance of the variable investment options selected, and the length of time the annuity is owned. As a result, in some circumstances the cost of the option may exceed the actual benefit paid under the option.
Annuities focus on tax deferral and providing steady streams of income. Recently for many investors, diversification increasingly became a concern, and demand grew for products that could help address the concern.
Because alternative investment strategies can potentially generate high trading activity and in turn generate tax ramifications for investors, investing in a tax-deferred vehicle like an annuity may benefit the investor (it is important to also recognize that losses can still occur including loss of principal).
For this reason, insurance companies are partnering with asset managers and alternative investment specialists to package products that can potentially meet a variety of investor risk tolerances in a tax-deferred environment.
Portfolio Optimization: Balancing Risk and Return
Alternative investments work well as a diversifier, but I don’t believe they should be used to the exclusion of other investment vehicles; they are a tool that could help reduce volatility over time. See Chapter Five for how allocations to alternative investments and strategies have historically improved returns and managed risks. Of course, past performance is no guarantee of future results.
Ultimately, the goal of an investor in constructing a portfolio is to gather assets together in a risk-appropriate combination, balancing the desire for return with their fear of loss. Each component of the portfolio plays a distinct role in that objective. At times it can be a delicate balance and, when viewed in isolation, the role of the individual asset is not always obvious. Therefore, it is best to view the contribution of any asset not in regard to its individual performance, but in terms of how it has enabled the portfolio in aggregate to accomplish a suitable risk/reward profile for the investor.
Portfolio Overlay: Understanding the Diagnostics
One critical point I emphasize about this chapter (and indeed the book) is the importance of overlay management. Just as engine components must harmonize to function efficiently, so too do the various components of a portfolio. Any adjustments to the portfolio are evaluated through the overlay system, meaning in total, and their effects on each individual position are then analyzed. In other words, balance and coordination among multiple separate account managers is the key. Disconnected pieces of a portfolio are integrated into a single account so a single investment solution is ultimately implemented. If one were to overload a number of alternative investments without some type of overlay system, it could potentially destroy value.
It is no different than with traditional investments, where investors want to ensure their mutual fund investments don’t overlap with one another and/or with their individual stock and bond investments. It also involves an understanding of how the components of the portfolio are correlated, whereby it has the lowest standard deviation possible while seeking the greatest return possible on an ongoing basis with the end investor’s interest in mind. I believe the importance and value of overlay management cannot be overemphasized, and as we discuss various alternative strategies and structures in the following chapters, it will become apparent why.
From the Alt Vault: Valuable Takeaways from Chapter Twelve
Designing a suitable portfolio can be challenging because of the sheer number of investment choices. On top of that, even if done correctly, inefficiencies can be introduced that drag on performance. Financial professionals can help.
The portfolio, like a highly-tuned engine, must regularly be tuned up to ensure suitability.
Variable annuity products may offer access to alts in a tax-deferred framework.
Financial professionals can help achieve a suitable portfolio.
What’s next: While not without risk, leverage can be added to alternative investment strategies. Once reserved only for qualified investors, financial services companies are packaging similar such investment strategies into product structures and vehicles that individual investors can use. But what are those investment strategies, how are they used, and what are the specific strategies employed?