An Active, Defensive Portfolio

The Keller Partners 10×10 Portfolio [fact sheet] takes an unconventional approach toward a very conventional objective — a portfolio that delivers both “participation and protection.”  It begins with the premise that retirement portfolios need to participate fully in rising markets (such as the ones we’ve enjoyed for the last eight years), yet be able to survive the less frequent, but devastating financial tsunamis such as 2002, 2008, or even 2011. Obviously, two very different kinds of investment “climates.” A portfolio that can adapt successfully to both must be able to shift gears — it must, by design, be active — free to adapt.

In its participation mode, the 10×10 Portfolio holds ten mega-cap stocks, selecting from the shares of the largest corporations.  The portfolio is fully invested and unconstrained during the extended “fair-weather”/”risk-on” periods, which prevail most of the time.  Less frequently, when our Trend Model shifts its analytical conclusion, the portfolio can reduce exposure to equities, sometimes significantly.

This “top-down” investment management process begins with a sophisticated trend analysis model developed by our firm over several decades. While all mathematical analyses of the stock market are imprecise, the KP Model does manage to get the underlying direction right about two thirds of the time. The Model is trend-agnostic — green periods are just as critical as red periods. We seek not only to detect and manage systematic risk, but are also keenly interested in capturing systematic reward.

The ten portfolio investments are currently chosen from the 100 blue chips that comprise the Standard & Poor’s 100 Index, but the selection process can be applied to any large universe of stocks. The only other permitted investment for the portfolio is cash, which, in times of market stress — for example the first quarter of 2016 — can become a significant defensive allocation.

The selection of the individual portfolio issues presents a second opportunity for adding value (alpha). They are chosen with a rules-based scoring system that attempts to identify issues with superior internal momentum scores.  When fully invested, the portfolio has ten positions and is thus deliberately under-diversified.  This allows for the possibility that the selection process will add value through occasional sector over-weighting or under-weighting.

In order to allow the portfolio to fully participate in rising markets, yet still make shifts in equity exposure when the Model has determined that risk has increased, the management process is necessarily active. These days of universal celebration of passive investing, active management  is widely viewed as a negative.  However, that criticism will survive hold if the investment in the cost of active management is not offset by higher Sharpe Ratios over a full cycle.  We believe that it isn’t possible to meet the typical client’s risk/return expectations without a certain degree of activity (and the analytical tools to direct that activity).

At times such as these, when markets have been rising for a very long time, we need to recall that whenever the next one of those financial tsunamis appears, it is likely to completely devastate the currently popular passive, “set it and forget it” portfolio strategies.  Large percentage losses are mathematically devastating to long-term return patterns.  But, much more important, individual investors cannot emotionally survive the portfolio drawdowns that have typically accompanied Black Swan events.  In the real world, when their portfolio losses become unbearable, they tend to call their advisers and sell everything. Unfortunately, this desire to liquidate typically occurs much closer to the bottom than the top.  And, the emotional injury is often equal to the financial loss.

Investment reality mandates that retirement portfolios need to be able to adjust for stormy weather. Beyond the promise of a smoother trajectory, a more comfortable ride for the client, an intelligently-managed active portfolio can significantly outperform a passive buy-and-hold strategy over a full cycle.  The mechanical costs of active management become a necessary investment in client success and client retention.