Raymond Backreedy: The advantages of a predefined investment strategy

Common sense tells us that keeping all options open is better than committing to a rigid, predefined path. But in the investment space, that is only partly true, writes Raymond Backreedy

Humans are naturally cautious about making long term commitments. We value flexibility in the face of an unknown future.

Common sense tells us that keeping all options open is better than committing to a rigid, predefined path. But in the investment space, that is only partly true.

An evidence-based approach requires investors to make key decisions before they start investing, and then to adhere to these decisions in good and bad times. The fundamental decision is the allocation of risk across asset classes: the strategic asset allocation (SAA). Once set, the portfolio will be systematically rebalanced to the SAA either periodically or on a threshold basis.

This approach is quite rigid. The investor pledges to follow predefined rules even during rapidly changing market conditions. But this discipline brings significant advantages.

As an example let’s take March 2020, one of the most volatile months in the history of the stock market. With the Covid-19 pandemic running wild, many economies were effectively halted and financial markets reacted aggressively. The chart below shows the daily price behaviour, in USD terms, of the SPY ETF (which tracks the S&P500 index) over the month:

Source: Bloomberg

In the three consecutive trading days March 12, March 13 and March 16, the SPY ETF price fell 9.57% on the first day, rebounded 8.55% on the second and fell again by 10.94% on the third. Talk about a roller coaster ride.

During the same month, the bond market reacted quite differently, as you would have expected. The chart below shows the daily price behaviour, again in USD terms, of the IEI ETF (which tracks the US Treasury 3-7 Year Bond Index) during March:

Source: Bloomberg

The largest price fall, on March 17, was 1.1%. The largest rise, on March 20, was 1.2%.

The short-term correlation between the equity index and the bond index was -0.6, underlining the value of bonds as a portfolio diversifier and defensive asset class, as the chart below illustrates:

Source: Bloomberg

An evidence-based investor with a portfolio of $100, evenly split between the two above-mentioned ETFs with a predefined rebalancing threshold of 5%, would have experienced quite dramatic changes in allocation throughout the month in question. The rebalancing threshold would have been reached on March 16 (as the equity weight fell to 44.1%), triggering a purchase of the equity ETF and a sale of the bond ETF.

The decision to rebalance and the setting of thresholds would have been made objectively before the market volatility rose. This allows for a quick and agile execution. There are no complicated investment processes to follow and there is no catalyst for emotional intervention.

Compare this with the alternative of trying to adjust one’s portfolio in response to the crisis. Investors or their fund managers can, of course, move in and out of stocks or funds as they see fit, and the best possible outcome would have been to sell before March 12, buy before March 13 and quickly capitalise profits after March 16 gains.

But there is precious little evidence that investors or fund managers, no matter how skilful and experienced, can time markets with such precision.

The problem for fund managers is made worse by internal processes which get in the way of such nimble behaviour.

Since the Global Financial Crisis of 2008/09, every investment decision that a fund manager wishes to implement is subject to scrutiny by investment and risk committees, requiring a clear business case and risk assessment. By the time decisions have been ratified, it is often the case that the horses have bolted.

Does that mean we need to allow investment managers more freedom and relax the control systems? Perhaps investors in Neil Woodford’s funds can answer that question.

The star investment manager left Invesco to set up his own investment house seeking, among other things, fewer controls compared to the constrained environment under which he had been working. History teaches us that it did not end well for his clients.

Dr Raymond Backreedy is CIO at Sparrows Capital