Removing Risk like the Layers of an Onion

Managing risk is one of the fundamentals of investing. At Cabana, we have a systems-based approach to managing risk within our portfolios. We believe that the risk of a particular asset class is inherently correlated with where we are in the economic cycle. In other words, there are certain periods within the repeating cycle when all major asset classes become risky. This, of course, is due to the omnipresent desire of all investors to seek the greatest return on their money relative to the perceived risk of the investment. As a rule, the more risk assumed by an investor, the more opportunity for gain. When perceived risk increases, the relative attractiveness of the investment changes, and at a point, the increased risk no longer justifies the increased opportunity for gain.

The economic cycle in stages

Perceived risk is inherently tied to economic indicators like interest rates, corporate earnings and valuation (price) of assets. When interest rates are low, earnings are robust and price is generally reflective of these conditions, the perceived risk of assets like stocks is low, and the opportunity for positive returns is high. During such a period, equities outperform other asset classes, like treasuries, corporate bonds, commodities and cash. This is reflective of the initial stages of a bull market and can last for many years. Throughout this time, we frequently see more subdued growth in other assets given that their opportunity for return is less.

Eventually, such favorable conditions lead to the prospect of inflation as a result of years of demand-side growth. When this occurs, interest rates begin to rise, which causes the risk associated with assets that are sensitive to interest rates to rise. These assets include treasuries, corporate bonds, real estate and dividend-paying stocks. This period represents a maturing bull market and growth assets (like stocks) may continue to outperform.

What happens next? The continuing rise in interest rates begins to negatively impact money supply within the economy and importantly, corporate earnings. When this happens, investors begin to perceive greater risk in stocks and eventually become unable to justify the opportunity for return in these assets. Investors move money from stocks to other assets like commodities, which have less perceived risk in the face of rising interest rates. In fact, it is often the rise in commodity prices that causes the rising rates in the first place. This period reflects the end of the bull market.

As market participants perceive greater and greater risk to the economy, they become less concerned with growth opportunities and more concerned with receiving a safe return on their investment. Money flows into things like corporate bonds and preferred stocks. As corporate earnings deteriorate, investors continue to move money from equities into “safer” assets. This results in further price declines in stocks and a pullback in interest rates. This period reflects the beginning of the bear market. In time, investors perceive risk in even safe assets, like investment grade bonds, and become less concerned with a return on their money, but rather simply want their money returned.

Money then flows into treasuries, gold and the U.S. dollar. Interest rates drop precipitously, and the price of “risk free” assets rises. This period represents the depths of the bear market and leads to the beginnings of the new bull market.

At a certain point, interest rates drop, along with inflationary pressures (i.e. input costs like commodities and labor). A company’s prospects for borrowing at fair rates and investing in their own products begins to improve. The risk associated with owning equity assets diminishes, and investors begin to once again justify the opportunity for reward in owning stocks. The economic cycle begins again as a new bull market is born.

A systems-based approach to managing risk

The above outline of the economic cycle is neither seamless nor completely linear. There are fits and starts at each step along the way as millions and millions of investors digest the constant flow of relevant information. It is this ongoing process that results in the pricing and re-pricing of assets, all with the idea of potential reward relative to perceived risk. Often there is one step back for every two steps forward. We believe that it is important to focus on the forest, rather than on the trees. We don’t try to outsmart or time the natural process described above. We simply strive to identify, in a general sense, where we are in the macroeconomic cycle and invest our money in those assets that are relatively attractive within that period of the cycle. All Cabana portfolios follow this same process and run off a proprietary algorithm, which attempts to do just this. In short, we establish when things are changing and remove “risky” assets from our portfolios. As we move through the economic cycle, we reallocate to match the conditions with the most attractive assets. The most attractive assets are also the least risky. Think about that for a second. We are constantly removing risk from our portfolios in response to the economy – just like peeling off layers of an onion.

Staying within identified drawdown parameters

This same principle applies to improving economic conditions. For example, treasury bonds, corporate bonds and fixed-income assets may be perceived as “risky” in a bull market with rising interest rates. In response, we peel off those risk assets (just like an onion) and replace them with more attractive assets like stocks. The speed at which risk is peeled off is dependent upon the identified target drawdown percentage of each portfolio. For example, our Core Tactical 7 Portfolio peels off risk during a deteriorating market quicker than our Core Tactical 13 Portfolio. The amount of risk within each portfolio at a given time reflects the target drawdown percentage of the portfolio. The lower the target drawdown, the less risk (and opportunity for gain) found in the portfolio at any given point. With this said, by the time we reach the depths of a bear market, all portfolios have had their risk peeled away. The higher target drawdown portfolios just peel it away more slowly. The process I describe is how we seek to stay within the drawdown parameters of each portfolio. This process also allows us to participate in the upside as markets recover. Because we remove risk in layers, rather than all at once, we keep the possibility for gains on the table as long as possible.

Peeling the onion in the real world 

Below you will find the down-market capture ratio relative to the S&P 500 in the fourth quarter of 2018, as well as the up-market capture ratio relative to the S&P 500 in January 2019. These statistics highlight our ability to protect against losses in down markets while still participating in up markets.

Removing risk in deteriorating conditions

Downside v. the S&P 500 (Oct. 1 – Dec. 31)

Core Tactical 7: 37%

Core Tactical 10: 58%

Core Tactical 13: 74%

Core Tactical 16: 95%

Core Tactical 20: 92%

Removing risk gradually, and participating as markets recover

Upside v. the S&P 500 (Jan. 1 – Jan. 31)

Core Tactical 7: 68%

Core Tactical 10: 73%

Core Tactical 13: 89%

Core Tactical 16: 112%

Core Tactical 20: 147%

*To determine the above calculations, Cabana’s return for the time period noted is divided by that of the S&P 500. Cabana’s income and tax-efficient portfolios do not apply here, as they run on a variation of Cabana’s algorithm which manages drawdown differently and trade less frequently.

For more information about Cabana’s Target Drawdown Series and risk management approach contact us at info@cabanaportfolio.com or 479-442-6464.

 

Disclaimers:
 

Cabana LLC (dba “Cabana Asset Management), is an SEC registered investment adviser with offices in Fayetteville, AR and Plano, TX. The firm only transacts business in states where it is properly registered or is exempted from registration requirements. Registration as an investment adviser is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability. Additional information regarding Cabana, including its fees, can be found in Cabana’s Form ADV, Part 2. A copy of which is available upon request or online at https://www.adviserinfo.sec.gov/.

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Past performance may not be indicative of future returns. No current or prospective client should assume that the future performance of any specific investment or strategy will be profitable or equal to past performance levels.

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Cabana, LLC manages assets on multiple custodial platforms. Performance results may vary based upon differences in associated costs and asset availability within the Cabana Model.

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