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This article was originally published on RealMoney.com on November 20th at 10:30am EDT

I think the topic of risk has been so misunderstood among investors, large and small, that I want to explore it a bit here.

After the cataclysmic disaster that was 2008-09 we saw a plethora of funds emerge with built-in risk management controls. Those were strategies focused so hard on avoiding big, bad drawdowns that there was virtually no chance of making money.

A good example is the Cambria Global Tactical ETF (GTAA) — it has since been renamed as fund management changed about six months ago. This go-anywhere actively-managed ETF employed a trend-following technique in which it promised to protect investors’ capital by avoiding significant drawdowns. Anytime one of GTAA’s target holdings traded below its long-term moving average, the fund would sit on the sidelines in cash rather than own it.

Not only was there no real opportunity for alpha, the fund’s thesis effectively promised there would be none.

‘Alpha’ can be defined as “the excess return of a fund relative to the return of its benchmark index.”

flatlineThe fund debuted in October 2010 at $25 and today, more than four years later, trades at $25.65 (Wednesday’s close). I can’t think of an asset class besides gold that performed as poorly and that includes 1%-yielding money markets. But there were no significant drawdowns.

Go Anywhere or Go Anywhere But Up?

GTAA is not the only such fund. In fact there were many created in the wake of the Great Recession and there are more still being formed today. But the trend-following fund is, itself, following a trend. It is a bet by those putting together the fund that investors’ fear will remain at the forefront and they will be willing to pay fees (in some cases exorbitant ones) to ensure potential downside is limited or eliminated.

I believe the focus on drawdown-avoidance was merely an asset-gathering sales tactic used to capitalize on people’s post-crisis fear.

“Wouldn’t you prefer to not have to watch the market, and your money, get cut in half EVER AGAIN?”

Of course I would. There are lots of things I would prefer to avoid. If I follow this logic all the way down the rabbit hole I may never get out of bed in the morning.

As investors, we must accept a certain level of risk. Otherwise it is not investing, it is simply protecting yourself from losses. That is a strategy; it’s just not one with much upside.

If a large portion of your portfolio is made up of bonds, structured products or positions covered with call options, understand that these are not protecting you from downside, but upside. These are fixed investments which, quite literally, limit an investment’s upside. An investment is something that has the potential to appreciate over time. None of the aforementioned positions have the ability to appreciate beyond a cap.

“But a bond cannot depreciate if held to maturity,” you might say.

Sure it can. In fact, I would argue that all bonds depreciate if held to maturity because 100 cents today is not the same as $1 in 10, 20 or 30 years. Inflation is not only likely, it is mandated by the Federal Reserve in an effort to keep a certain amount of money velocity and credit extension in the system.

I’m not saying investors shouldn’t own fixed assets, not at all. Fixed assets are more than just a help-you-sleep-at-night insurance policy against stock market volatility. Fixed assets are a bet that, on an annual basis, your money is well utilized being loaned out at a given rate against some form of collateral. I just think investors need to know what it is they really own.

Is the trend really your friend?

The irony is that I think it’s a great time to be discussing downside protection. What’s really interesting is that it feels the U.S. stock market has become a sort of catch-all for assets that need a safe place to stay for a while. As the “cleanest dirty shirt” analogy seems to be resurfacing, I think it’s important to note that downside is not limited simply because a market seems to have positive momentum.

I don’t think there are too many who would dispute that fundamentals here in the U.S. are looking far stronger than just about anywhere else in the world today. But does that make the U.S. market the best place to put your capital? Or even the safest? Not necessarily.

There are many places for investors to put their money. Perhaps it is a good time to just remember that each asset class has an associated risk and reward. Sure, U.S. fundamentals look good, but they have improved exponentially from whence they came just five years ago. What is the potential reward at this point? I don’t know the answer, but I can tell you our exposure to U.S. stocks is as close to zero today as it’s ever been.

If our clients are going to have equity exposure, they had better be getting paid for the risk they are taking. We are looking overseas for better valuations and opportunities.

If you have questions or would like to engage in a dialogue, please don’t hesitate to give us a call.

Adam B. Scott
Argyle Capital Partners, LLC

www.argylecapitalpartners.com
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main

Adam Scott’s profile on RealMoney can be found here.

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