When was the last time a client asked, “What was my portfolio’s alpha?” You may encounter that question with institutions and sophisticated clients, but more often than not, clients are more likely to ask, “Are my investments going to be ok?”
The answer to the question could vary depending on a client’s stage of life, goals, objectives, and risk tolerance. But it will likely have little to do with Alpha or any other Greek letter you may have learned about in college.
As a financial advisor, it is important to ensure your clients are comfortable and confident with the financial plan you helped them design. At Horizon, we believe a client’s investment journey has three distinct stages – Gain, Protect, and Spend. Objectives and risk tolerances typically change in each stage, and as their needs change, we believe there should be a difference in how portfolios are constructed.
If a client is in the Gain, or accumulation, stage, an appropriate answer to “Are my investments going to be ok?” might be, “Yes, as long as you continue earning, saving, and investing with an allocation to asset classes seeking to provide you growth over the long term.” However, for a client in the Protect, or preservation, stage, an appropriate answer might be, “Yes, if the portfolio you are invested in continues to seek to protect against catastrophic loss.” As such, the metrics used to evaluate an individual strategy’s relevant goals, objectives, and risks will probably change based on the client’s stage of life. Likewise, when selecting strategies for inclusion in portfolios, it may be a good idea to evaluate the most relevant metrics for the client’s objectives.
With the plethora of data at an advisor’s fingertips today, making investment decisions can be overwhelming as you consider which metrics are the most important for the client’s specific situation. In this piece, we hope to provide helpful context on evaluating strategies in a goals-based framework and provide a variety of metrics we consider most relevant for investment selection and monitoring in the stages of a client’s investment journey. Some metrics are standalone measures, while others are relative to benchmarks. Keep in mind that there are plenty of qualitative aspects to the investment decision-making process, but that will not be covered fully in this analysis.
STANDALONE MEASURES
The following are measures advisors may consider using to evaluate portfolios. Some are standalone measures that can be viewed in an absolute context while others are relative measures that provide an evaluation relative to a given benchmark or index.1
Total Return: how much the investment has increased or decreased in value based on price appreciation and income.
Standard Deviation: a measure of the investment’s dispersion of returns about an average, which depicts how widely the returns varied over a certain period.
Sharpe Ratio: a risk-adjusted measure using standard deviation and excess return of the investment over a risk-free rate.
Max Drawdown: a measure of the investment’s largest price drop from peak to trough.
Calmar Ratio: a ratio of an investment’s total return divided by the maximum drawdown.
RELATIVE MEASURES
Beta: a measure of an investment’s systematic risk relative to a benchmark. Systematic risk is the tendency of the value of a security and the benchmark to move together. The beta of the market is 1.00. A beta higher than 1.00 indicates that a security is more volatile than the market but may provide the potential for more return; lower than 1.00, less volatile and therefore may provide less potential return.
Alpha: a measure of the difference between a portfolio’s actual returns and its expected performance given its beta to a benchmark. An alpha greater than zero indicates that the security outperformed the benchmark.
1Definitions by Horizon Investments
Gain Stage Portfolios
Clients in the Gain stage are generally younger or have a longer time horizon before they need to fund a goal. The main objective in this stage is long-term growth, and the main risk is volatility. Meeting clients’ goals typically involves:
- Selecting the most suitable portfolio focusing on equities for long-term growth.
- Continually contributing to the portfolio to maximize wealth potential.
Given the main objective of this stage is growth while mitigating volatility, prioritizing total return and risk-adjusted return measures may make sense. We believe the approach of traditional investment management that seeks to maximize return per unit of risk applies most appropriately to investment selection in this stage since time isn’t a constraint like it is for pre-retirees.
The following table compares strategies relative to equity market performance over a full market cycle. We will use the metrics to determine a recommendation for an accumulation investor based off the goal and risk identified for this stage.
Based on the information provided in the table, we believe the best fit for an accumulation mandate in the Gain stage is Strategy B. Here’s why:
- Given the objective for these portfolios is long-term growth, Beta relative to the stock market is a relevant consideration. Strategy A and B have similar Betas to the Market. Strategy C has a low Beta relative to the market, which may present challenges for achieving long-term growth.
- Since traditional investment management aims to maximize return for expected risk, prioritizing higher risk-adjusted metrics may make sense in the Gain Stage. Strategy B leads Strategy A in Sharpe Ratio and Alpha. While Strategy C leads both A and B in Alpha, its long-term return expectations may not be high enough for clients in this stage.
- Even though Strategy B may suffer a sharper maximum drawdown than Strategy A and C, Gain stage clients generally have long time horizons to allow for recoveries.
Protect Stage Portfolios
Clients in the Protect, or preservation, stage are generally pre-retirees or within 5-7 years of funding a goal. This stage’s main objective is preserving wealth; the main risk is absolute drawdown or loss. Achieving success for clients in this stage is about smoothly transitioning them from the accumulation stage to the distribution stage by focusing on two main principles:
- Maintaining a portfolio tilted toward equities for some growth potential.
- Having a process for mitigating catastrophic loss.
Given the main objective of this stage is risk mitigation, we think it makes sense to prioritize downside-related metrics like Max Drawdown and Calmar ratio. The traditional investment management framework that has historically been relied upon becomes less helpful in this stage as clients tend to be more focused on protecting against catastrophic loss rather than risk-adjusted statistics. Clients are typically seeking risk mitigation when they move to cash during periods of market stress. They’re more focused on limiting losses than optimizing risk-adjusted returns.
The following table compares strategies relative to equity market performance over a full market cycle. We will use the metrics to determine a recommendation for a preservation investor.
Based on the information provided in the table, we believe the best fit for a preservation mandate in the Protect stage is Strategy A. Here’s why:
- Given that clients in this stage still may need moderate exposure to stocks for growth potential, total return and Beta relative to equity markets are both relevant considerations.
- Given the objective of this stage is preserving wealth while mitigating against absolute drawdown, prioritizing downside-related metrics may make sense. While Strategy C has the lowest Max Drawdown, Strategy A has the highest Calmar Ratio, which suggests that Strategy A’s return per unit of max drawdown is the highest.
- Even though Strategy A has lower risk-adjusted returns, as measured by Sharpe and Alpha, than Strategy B, the maximum drawdown experienced by Strategy B may be significant enough to threaten the objective of wealth preservation. Further, a 40% drawdown experienced by a client in the Preservation stage may result in them abandoning their financial plan.
Spend Stage Portfolios
Clients in the Spend, or distribution, stage are often retired or at a point where they are using their investment portfolio to fund their goals. The main objective in this stage is maximizing longevity, and the main risk is running out of money. Achieving success for clients in this stage incorporates the following:
- Understanding the client’s current withdrawal need and selecting the portfolio with the appropriate allocation to provide sustainable growth for future withdrawals.
- Having a process for mitigating catastrophic loss.
Given the objectives and risks of this stage, reviewing risk-adjusted returns and drawdowns are considerations, but may be a lower priority. As such, traditional risk tolerance typically becomes less meaningful in this stage, as the goal is to provide sustainable withdrawals, regardless of their traditional appetite for risk.
The following table compares strategies associated with equity market performance over a full market cycle. We will use the metrics to determine a recommendation for a distribution investor.
Based on the information provided in the table, we believe the best fit for a distribution mandate in the Spend stage is Strategy A. Here’s why:
- Given that clients in this stage need stock exposure for growth potential to support future withdrawals, total return and Beta relative to equity markets are relevant considerations. Strategy C’s total return of 3.5% per year is likely not an appropriate solution for clients who need to withdraw 4% or more per year over an extended period.
- Given the need for downside protection during this stage, reviewing downside metrics is appropriate. Strategy A has the highest Calmar Ratio, which suggests that the return per unit of max drawdown is the highest.
- While Clients invested in Strategy B may have the highest return over long time horizons, a sharp maximum drawdown experienced in this stage can significantly impact how long retirement savings may last.
Conclusion
Successful investing for clients is often more complex than building a portfolio with the highest historical risk-adjusted return. The job of a prudent goals-based financial advisor entails knowing what stage of the investment journey their client is in, which portfolios may be appropriate for each stage, and their client’s risk tolerance, and then selecting suitable investments for the portfolio. We believe comprehensive investment selection and monitoring entails reviewing all relevant metrics and recognizing that some may be more important than others depending on the client’s stage of the investment journey. Employing a goals-based approach to investment selection may help identify the most appropriate strategies to meet your client’s goals while potentially mitigating their risks.
Disclosure
This information is for educational use only. It should not be considered investment advice or a recommendation to buy or sell any security or to adopt a particular investment strategy. The information presented in the above scenarios is for illustrative purposes only. It should not be implied that any account will achieve returns, volatility, or other results similar to the strategies in the illustrations. This material has been prepared for informational purposes only without regard to any particular user’s investment objectives or financial situation. Investors must make their own decisions based on their specific financial circumstances and obligations.
Horizon is not proposing any of these combinations as suitable for a client and is not undertaking to make these allocations otherwise available or to update them as market conditions may warrant. This material does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. The opinions expressed herein are not investment recommendations, but rather opinions that reflect the judgment of Horizon as of the date of the report and are subject to change without notice.
We do not intend and will not endeavor to provide notice of if and when our opinions or actions change. This document does not constitute an offer to sell or a solicitation of an offer to buy any security or product and may not be relied upon in connection with the purchase or sale of any security or device.
The investments recommended by Horizon Investments are not guaranteed. There can be economic times where all investments are unfavorable and depreciate in value. Clients may lose money. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Any risk management processes described herein include an effort to monitor and manage risk, but should not be confused with and do not imply low risk or the ability to control risk.
Horizon Investments, the Horizon H, and Gain Protect Spend are all registered trademarks of Horizon Investments, LLC.
© 2023 Horizon Investments, LLC.
