The pandemic pushed many investors’ confidence to the limit. Are they really willing to go through that ordeal again?
When the market crumpled with the COVID-19 shock in March 2020, it wasn’t business as usual. We all got a fresh sense of how fast the market can turn.
But conventional wisdom is always evolving, which is why it’s crucial to keep innovators like Frontier Asset Management on your screen and in front of your clients.
After all, when your clients filled out the risk survey, they weren’t thinking about a once-in-a-century viral outbreak. Their heads were full of hypotheticals and Monte Carlo probabilities.
Now they know how bad it can get. They’re looking harder at maximum drawdown levels under catastrophe conditions and want to make sure their advisors can build a portfolio that could potentially spare them from the brunt of the next black swan.
Some nominally “low-risk” balanced funds (look at PCEF, AOM and AOK) crashed 35% in the COVID shock and are only recovering now. Frontier’s variation on the theme was designed to shield investors from all but 2% of the downside, while leaving them open to the boom that followed.
Put it to your clients in those terms. No projections, statistical jargon or success probabilities: here’s how much money they stand to lose when the market’s random walk goes over a cliff. Are they comfortable with that?
The answer may or may not surprise you. But it’s sure to be a more realistic gauge of their real risk tolerance than any abstract survey score.
Extreme Challenges Require Innovative Response
Frontier CEO Rob Miller, CFA tells me the firm built a very low target drawdown profile into its Capital Preservation strategy to ensure that the expected risk floor lines up with investor psychology.
There aren’t any artificial assumptions here about the way asset class allocations interact. We’ve all learned recently that the wrong bond-heavy portfolio can crash just as hard as the S&P 500.
There’s no “perfect pie chart.” The Frontier team picks outside managers to provide a satisfactory worst-case scenario and then optimizes the mix to maximize the return under current market conditions.
The methodology has taken Frontier through all the major upheavals of the last 20 years, including 911 and the 2008 crash. A manager needs to beat the benchmark on the worst day of the cycle to make the cut.
Frontier believes only approximately 200 have what it takes. Then Frontier reaches for upside. The floor is firm. The ceiling is open.
That’s extremely important in a world where cash, annuities and fixed income look increasingly vulnerable to inflation. While their return paths are by definition fixed at issuance, in this environment locking in a low yield amounts to locking in a real loss.
I can’t say that enough. Avoiding risk isn’t enough. In the absence of a return profile, it’s likely that your clients ultimately surrender purchasing power in exchange for eliminating uncertainty.
Even on the low end of the efficient frontier, Miller’s team has scraped enough alpha out of the market to keep up with middle-term Treasury debt in the long run and mostly cover RMDs for retirees.
Other strategies naturally open up higher return profiles but will generally be more volatile from year to year. The most aggressive are managed to deliver 6-7% before inflation and up to 9-10% a year after inflation on average but require investors to tolerate up to a 25% decline in value in a crisis.
Integrate Investments Into The Financial Plan
It’s a lot smoother than a true random walk. And that additional layer of consistency helps to smooth the planning process as well.
Miller notes that using these strategies for various life goals can give retail investors more confidence in their ultimate success than any Monte Carlo simulation can provide.
Use the Capital Preservation strategy to fund current lifestyle requirements. With a maximum target drawdown of zero, there’s little real chance the bills won’t get paid.
Then layer the allocations to achieve longer-term or more aspirational goals: wishes as opposed to needs.
The drawdown target makes it easier and more intuitive to calculate recovery times after a market shock. When you know that it could take up to 7 years to repair a worst-case loss, you can figure out how long your reserves need to last.
No style box or standard asset mix can grant that level of clarity. Frontier doesn’t fit into any of the style boxes. Its strategies are built around a specific definition of risk.
If you have clients who seem psychically bruised by last year’s extremes, traditional solutions aren’t likely to restore their confidence. They’re worried the current market boom is a mirage.
After all, conventional wisdom failed them. Now they’re a year older and many are simply “too old for this.” Others were more taken with the upswing that followed. Frontier has more aggressive strategies for them, which we’ll focus on in the months to come.
Either way, many investors never understood the probabilities that drive modern portfolio theory even under normal circumstances. With the memory of an extreme event fresh in their minds, they’ll welcome a clearer proposition in basic English.
And if it works for them, maybe it’s time to think about reworking your entire suitability and proposal process to make sure everyone’s expectations are on the record.
How bad can it get? How long will it take? Provide real answers to those questions and expect to make a lot of investors happy.
It’s a strong differentiator. It means thinking a little outside the style box. But Rob Miller and team are eager to give your clients the new math.
