“The best investors in the world do not target returns; they first focus on risk.”
- Seth Klarman
One of the things we believe sets us apart from others in our industry is our proactive approach to Downside Protection. Our entire portfolio management methodology is based on the believe that “the best offense is a good defense”, and that the best way to achieve return objectives over time is by mitigating large capital losses that come from “riding out” steep downturns in risk assets.
Downside protection at Season is accomplished in two steps. The first step is to create truly diverse portfolios made up of a variety of different assets (beyond just stocks and bonds) that have low correlation to each other. We classify assets into three different segments based on the role they play in the portfolio.
A portfolio built on this foundation has a better chance of minimizing drawdowns and producing better performance over a full market cycle. The second layer to our downside protection process is to proactively manage the exposure to risk assets within the portfolio since these have the largest potential for capital loss and volatility. This is accomplished through our proprietary risk management model called MarketVANE.
MarketVANE is a quantitative Downside Protection Program based on mathematical signals from various Fundamental, Technical, Volatility & Economic factors. It is built using a multi-step process which monitors and scores each factor based on how positive or negative each one is for risk assets (equities and commodities).
The first step in the process is to identify the market Season by comparing Fundamental valuations to historical norms. This measure is slow to change and long-term in nature. Stretched valuations (expensive) are akin to a “Winter” season, while depressed valuations (cheap) would be considered “Summer”.
The second step in the process is to monitor the market’s Weather Patterns by tracking Technical, Volatility, and Economic indicators that are faster-moving and more responsive to the prevailing short and mid-term trends.
The final step is to combine the Seasonal and Weather Pattern indicators to determine where our exposure should lie relative to long-term targets (overweight, fully invested, underweight or in cash). What Season the market is in will determine how sensitive we are to changes in the Weather Patterns. For example, if the market is in Winter it will only take a slight deterioration on the Weather Pattern to move us to underweight whereas if the market is in Summer it would require a more significant change.
The embedded table lists three theoretical scores for an equity Weather Pattern. The Volatility signal is firing on all cylinders (10 out of 10) indicating a positive environment for equities. The Technical and Economic signals, on the other hand, are mixed indicating a more neutral environment for equities. The aggregate Weather Patternscore is simply a summation of the underlying components, which in this example is 20 out of 30, or 66.7%.
This score is then judged through the lens of the fundamental market Season. During a Winter season (late 90’s as an example), a 66.7% would be interpreted as neutral to slightly negative for equities since equity fundamentals would be stretched and due for a correction. With a neutral score we would reduce exposure to equities to a level below the target outlined in each investor’s Investment Policy Statement (IPS) and increase our cash holdings. On the other hand, if the market was in a Summer season (early 2009 as an example), a score of 66.7% would be interpreted as a positive signal since equity fundamentals would be depressed and downside risk would be limited. Exposure to equities in this scenario would be adjusted up to the target level outlined in each investor’s IPS.
40-YEAR BACK TEST
We back-tested MarketVANE using 40 years of historical index data for both equities and commodities. The results confirmed our belief that a well-defined mathematical approach to proactively managing exposure to stocks and commodities not only reduces downside risk but also improves returns over full market cycles. For a more detailed description, and to view results from our 40-year backtest, please contact us directly for more information.
We want Transparency to be one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. Regular Macro Updates will address our economic and capital market viewpoints and discuss top-down portfolio positioning. Also watch for Micro Updates which convey our reasoning behind specific investments.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.