The degree of economic damage triggered by COVID-19 is not knowable at this time, which is a reason to think honestly about how any investment framework can identify appropriate trigger points to adjust portfolio risk levels amidst this massive volatility. The unknowns boil down to the timing and the pace of the economic reopening, which is largely a function of the spread of the virus; the effectiveness of the monetary and fiscal policy response; and the after-effects of all these factors and how they influence the strength of the recovery. That is a lot of uncertainty and it is reflected in the very wide range of economic forecasts—forecasts that normally have a much narrower level of dispersion.
This lack of clarity means that the financial market response is also an evolving story. The free fall in financial assets in February and March has flipped into a powerful rebound driven by massive central bank and fiscal intervention with the possibility of more to come.
The unanswered question is whether the markets’ manic behavior is accurately pricing in the unknowns. Will the virus play out in a less extreme way than feared? Or is the financial asset rebound an overreaction to fiscal and monetary interventions that will ultimately reverse, taking markets to new lows. Will the economy be back on track in 2021 or will the recovery sputter as it seeks to overcome lasting consequences of the economic damage and policy responses?
We’ve been around long enough to know that there is no justification for any confident forecast over the next year or two at least. Stress-testing and focusing on a range of possible outcomes is a necessary approach.
The Uncomfortable Challenge of Pulling the Trigger
This level of uncertainty can be a problem for financial advisors, which is our core business.
How do we know when to dial overall portfolio risk up or down? How do we safeguard against whipsaw driven by extreme daily shifts in market sentiment? How do we protect against paralysis that could lead us to miss a historic buying opportunity? These are real concerns for advisors.
At Litman Gregory, our approach has always been valuation-driven, incorporating scenario analysis and a shorter-term portfolio-level risk overlay. We make tactical moves when we believe valuations offer a high probability of being well rewarded over a market cycle.
But valuation analysis is an inexact exercise. And that means that it can be tricky to know when to pull the trigger, especially in this type of environment where macro fundamentals could be impacted for some time. Market timing isn’t a reliable alternative strategy. Are there other things advisors can do to supplement our own analysis?
The Value of Being in the Trenches
Over 30-plus years of market cycles, we’ve had thousands of real-time conversations with fund managers and we’ve learned there is value that comes from being in the financial market trenches.
What does this mean? The ability to look at specific investments from the bottom-up, stress-test them for a worst case, and understand the downside/upside relationship is, we believe, a big advantage. It is much easier to find the courage to invest with that specific knowledge than it is when one is relying on broad market valuation measures and metrics that are less exact. For advisors, we believe deferring some portion of the trigger-pulling responsibility to skilled investors who are in the trenches is helpful in extremely stressed markets. It diversifies some level of responsibility for when to adjust risk in a sensible way.
Why This is So
In this environment, stock pickers should be analyzing balance sheets to assess the ability of a business to survive and analyzing whether a stock is pricing in future profitability that is too negative even in a severe and protracted downturn. Assessing the ability of borrowers to service debt and the recovery prospects for those entities that can’t is a key source of confident decision making in the credit world. This can lead to the identification of buying opportunities (and shorting opportunities) disproportionately skewed toward success, even if there is deep economic damage. This process is grounding and invaluable to decision making in a period where clarity and courage are in short supply.
Those investors who can examine a wide universe of opportunities add to their frame of reference and overall context and can seek out the risk/reward opportunities that are most compelling.
Importantly, markets that become dysfunctional due to forced selling and panic are ones that tend to offer up particularly compelling opportunities. Chris Davis, the stock picker, often shares the story of his grandfather telling him that you potentially make the most money in bear markets, you just don’t know it at the time. This is particularly true in extreme, panic-driven bears.
Active management can add the most value in the aftermath of periods driven by extreme emotion as markets calm down and normalize back to fundamentals. We saw that after the dot-com bubble burst and after the 2008 financial crisis. We believe this pattern is likely to repeat in the aftermath of the COVID-19-driven market crisis. But to benefit from that requires pulling the trigger at an appropriate level—moving more from defense to offense—and a willingness to take on short-term risk to capture exceptional long-term returns.
The Masters Alternative Strategies Fund: Three Reasons We Believe the Fund May Be Well-Suited for the Next Few Years
First, Litman Gregory chose risk-sensitive managers who have the patience and discipline to resist the temptation to buy into frothy markets. They are willing to miss out on some return over the short term while waiting for better opportunities. This held back the fund’s return in recent years, but we believe these managers are set up to take advantage of the better opportunities they held out for.
Second, the fund’s investors are experienced, having been battle-tested over several market cycles.
Finally, and importantly, in creating this fund, while we sought risk-sensitive managers, we also wanted managers who would not be afraid to dial up risk levels when they believe probabilities are skewed in favor of high returns (note: higher risk is relative—this fund’s portfolio is not expected to reach risk levels associated with equity funds). We also wanted managers who had the flexibility of a broad opportunity set. The current period is the most profound opportunity for our managers to take advantage of their flexible mandates to add to risk since the fund was launched in 2011.
Important Perspective Regarding Returns in This Environment
Going into 2020, the fund was relatively conservatively postured, and it held up as we would have expected through the first part of the downturn. (From the S&P 500 peak on February 19 through March 12, stocks were down 26% while the fund was down 5.6%). But as markets became panicked and pockets of indiscriminate forced selling surfaced, the fund suffered as even defensive asset classes were hit. This period was similar to parts of the 2008 financial crisis. Fundamentally based analysis and investment are never rewarded during periods of market dysfunction.
Performance quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the funds may be lower or higher than the performance quoted. To obtain standardized performance of the funds, and performance as of the most recently completed calendar month, please visit www.mastersfunds.com.
However, panicked markets are temporary and the very same market dysfunction that can lead to disappointing returns during these short periods sets up risk-taking opportunities associated with higher return potential and less intermediate-term risk. We are already seeing the fund’s sub-advisors doing some buying and taking on more risk, though most still hold plenty of dry powder. For background on what the fund’s managers are doing read this and/or watch the recent webinar.
The fund was created in the aftermath of the financial crisis of 2008–2009. We wanted managers and strategies wired to minimize risk and provide diversification—something we believed was important given the significant macro risks—but also to be able to generate better returns when opportunities were compelling. This is precisely that time.
We are large investors in the fund and look forward to the decisions the managers will make as they navigate this undoubtedly challenging period of market disruption in order to set up the fund for the recovery that follows. We are confident this may happen over time as short-term dislocations give way to rational pricing—something that has happened with every market cycle.
Ken Gregory
April 15, 2020