At some point, when (not if) the current market trends change, an understanding of investment styles can be important. Different styles can produce markedly different results based on the way investments are selected and the amount of risk that is embedded in a portfolio. The time for a change may not be right now, but it may be in a few months or years. This topic may seem a little wonkish, but nevertheless is important to understand.

The Economy

Economic growth for the second quarter turned in an unremarkable growth rate of 2%, neither great nor poor by recent standards, but consistent with the long-term slowing that has become a fact of life in this environment of high debt, low interest, and retirement in an aging work force. The trend may be weakening, however, as suggested by short-term interest rates exceeding long-term rates, trade wars, and no progress in leading economic indicators. These are signs of a possible recession in your future. Perhaps we will have a “soft-landing” or continued stable low growth, if the recent easier Fed policy is successful. For now though be merry, for total employment continues to rise and your home value has increased this year, if you live outside of the northeastern US.

The Markets

Gold and bonds have been on a tear relative to stocks recently, as investors have reconsidered their balance between risk and reward in the face of slowing economic numbers. Although large cap and industrial stocks made new highs during the quarter, the performance was not strong enough to carry along their transportation industry brethren, leaving intact the Dow Theory bear market signal that was set last December.

Which Investment Style Do You (or your Advisor) Follow?

There are probably as many different investing styles as there are investors. All of them work well sometimes, but none of them work well all the time. Since the bottom of the last recession, passive investing in index funds has yielded very good results. This is not unlike the so-called "one-decision growth stock" strategy of the late 1960s. The one decision then was to buy, and theoretically hold forever. This newest incarnation is the passive index strategy, which has been aided for years by supportive central bank policy and automatic 401(k) investing.

All things come to an end at some point. The one-decision approach ended poorly in the early 1970s. There are now people suggesting that the popularity and growth of indexing will be an accelerant in the next bear market, when many of the passive investors want to cash out of their large-cap S&P 500 index and target-date funds. One of the benefits of investing in an index fund is that an investor can buy hundreds of stocks in a single transaction. One of the risks is that, if many investors decide to protect capital at the same time, each of them can sell hundreds of stocks simultaneously in a single transaction. This mob-like action could potentially create significant volatility like that which has been previewed in the several flash crashes in recent years.

Volatility is not a problem for young people who have twenty or thirty years to build their wealth. In fact, volatility can be helpful, because it allows them to buy inexpensively when prices are down. For others, who must draw upon their savings, volatility is detrimental. The July 2018 Outlook & Trends discusses sequencing risk, and shows that retiring in (or just before) a bear market when stocks are overvalued, and maintaining a volatile portfolio, results in a lower lifetime return than retiring when prices are low and rise in the first years of retirement.

Another way to view investment styles is "fundamental" vs. "technical". As with the passive vs. active styles, neither the fundamental nor the technical is best all the time. Fundamental analysis is the classic approach, most applicable to buying (or selling) individual stocks or other securities. It relies on an in-depth knowledge of a company, favoring corporate insiders and full-time equity analysts who closely follow management and their guidance to predict the course of the company and the price of the stock, or safety of the bond. An individual using this approach successfully would have difficulty following more than several companies. This limitation can lead to an undiversified portfolio which magnifies volatility risk and could turn out either very well or not well at all.

To rely on a fundamental approach and also diversify well requires a team of analysts, which is exactly the function of an actively managed mutual fund. An index mutual fund (or index ETF) is not fundamentally managed. It simply is a collection of securities that fit some classification, like large company stocks or high-yield bonds. Index funds have typically had higher returns than active funds, hence their popularity, but this fact also casts doubt on the value of the fundamental approach, since most professional teams perform worse than an unmanaged index.

While the component holdings of a mutual fund or index fund may be fundamentally sound and rigorously selected, the collection of securities typically represents an undiversified asset class. There may be diversification among individual components, but if they all are large company stocks, then the fund will perform like a single, undiversified asset class. This problem may be less apparent with "balanced" and "target-date" funds which include bonds as a second asset class. The mutual and exchange-traded fund approach represents a risk-reduction improvement over a few individual holdings, but even greater risk reduction and management is possible.

The technical style can be applied to a single stock or as an overlay to fundamental or passive index fund investing. The theory behind this style is that at any given time, the price of a security represents the current consensus of value among all market participants. Technical analysis attempts to identify continuing trends and changes in sentiment among the crowd of unseen participants. The trends can represent minutes to years. Over the very short term, plotting a graph of a price trend may look like fuzzy "white noise". Over the long term, the trends look more like rising lines with an occasional blip. Although technical analysis is often used to provide an alert to a change in trend, it is best used not to predict, but to observe. It can also be used as a tool to learn from history, creating a framework that prompts an analyst to consider the potential for various outcomes by observing similar past periods.

This is where a good financial advisor can help. An advisor, who knows the needs of their client, can design an individually targeted portfolio in a manner which is not possible for a remote mutual fund manager, and is also not likely to be done well by a mechanical “robo-advisor”. Even advisors will differ though. Most advisors build static portfolios that rarely change their composition. In fact, the advisor may feel that their primary management function is to return the portfolio to its original specification if it changes too much. This is akin to the one-decision approach mentioned before. The advisor may call this a fundamental style. To the extent that it is built from actively managed mutual funds, it may be. If it is built from index funds it is not. It is just a simple static asset allocation.

An advisor who can analyze the markets from a technical perspective can actively adjust portfolio components and allocation mixtures to reflect market trends and better control risk. Better risk management should produce lower volatility. Lower volatility may not be as exciting in rising markets, but should produce better results for people who will need to withdraw funds for income, especially in overvalued markets like we have today.

LFM&P’s MarketAware^SM approach is designed to manage risk by recognizing and adjusting for market conditions as they occur. Investment advice and management is combined with comprehensive financial planning to design and deliver solutions specifically for each client as a fee-only fiduciary in a way most others cannot.