Portfolio
Management:
Montecito
Capital Management's focus is on the active management of nine
(9) asset classes/styles based on Modern Portfolio Management
practices and economic/market prospects. We emphasize a unique
approach (See "Published Article" Bullet
Proof Portfolio) to minimize portfolio volatility/risk while
optimizing a portfolio's risk-adjusted return. Unlike the typical
money manager who focuses on only two asset classes such as
equities and bonds, we have identified nine (9) asset categories
that have unique investment properties to smooth a portfolio's
path through treacherous market gyrations. Indeed, the essence
of this approach (fully examined below) is to identify the best
(low expense, no load) managers for each asset class - capturing
the optimal 'alpha' or portfolio manager performance premium
- coupled with exposure to low correlated asset classes that
have limited covariance around a target return. The goal for
a client portfolio is to have correlation to up-market cycles
and low correlation to down market turns. This is accomplished
by financial engineering a portfolio with a optimal combination
of asset classes: some move independent of the markets, some
perform better in down markets, some move relative to economic
cycles, or some correlate with inflation and interest rates.
We apply a financial model to accomplish a target return relative
to the risk assigned.
While the model portfolio has yielded steady
returns, 'risk-seeking' clients have been encouraged to keep
that portion of their assets elsewhere. To lower portfolio expense,
we utilize exchange-traded funds for a portion of the pure equity
and fixed income classes, then apply macro and fundamental analysis
to overweight sectors or yield curve segments. We believe the
manager 'alpha' is appropriate in only equities for small-micro
cap stocks, international markets and unique 'hedge fund like'
styles. Similarly, for fixed income we subscribe to savvy management
of low-grade corporate bonds and international fixed income
- the higher expense is outweighed by the premium performance
over an index in these categories. Conversely, for mid-to-large
capitalization equities in the 'pure equity' asset category
and investment grade bonds we employ exchange-traded funds to
lower the client's overall portfolio expense.
However,
the methodology of using passive, lowest cost exchange traded
solutions must be executed with prudence. We deem the blind
use of ETF passive benchmarks to be inherently dangerous since
engaging in 'herd behavior' often leads to holdings of the most
'trendy' companies, which may have absurd market values relative
to the intrinsic fundamental value. For example, on March 31,
2000, "five of the top thirty stocks had a P/E (ratio) higher
than 100, and nine more had a P/E between 50 and 100. The market
capitalization (value) of the 14 largest companies with P/Es
higher than 50 summed $3.2 trillion. . by September 30, 2002,
the capitalization of the 14 largest companies had fallen by
$2.5 trillion as part of an overall equity market decline that
trimmed more than $6 trillion from the total US equity capitalization."
(The Research Foundation of AIMR, Benchmarks and Investment
Management, Laurence B. Siegal, 8/1/03. p. 37). This event illustrates
the need for active management of asset classes - in this case,
banking gains from equities by means of rebalancing toward other
asset classes.
We combine fundamental analysis of sectors, market capitalization
and styles (value, growth etc.) with three types of data for
each asset class, in each case based on historical and prospective
data. They are: (1) Expected return, (2) Standard Deviation
& Semideviation (which is a measure of risk, based on the fluctuation
of historical results around the mean &the deviation below the
assets mean return) and (3) Correlation between asset classes
(which measure the performance of one asset class relative to
another). With our vast financial knowledge and advanced modeling
tools we construct customized portfolio with the highest risk-adjusted
return given every client's unique Investment Policy. Further,
we have extensive expertise in alternative equity investments
and have large weightings (often 20-45%) in various low-market
correlated equity strategies that are devised to weather tumultuous
market gyrations. We utilize many hedge fund categories - arbitrage,
merger arbitrage, long/short, neutral, strategic opportunities,
bond arbitrage, convertible arbitrage, REITs, and short - to
constrain portfolio volatility. The attributes of these alternative
classes are liquidity, history of performance, no style drift,
history of management and affordable costs.
In an effort
to offset the costs of alternative styles, we also employ dynamic
passive investment methods for the pure equity allocations via
exchange traded funds or ETF (average expense 0.25% or 25 basis
points). We choose between over 100 styles of ETF equity indices
and construct a portfolio that integrates a low-covariance between
classes. We further optimize mean-variance while constraining
risk with fixed income (TIPS, Corporate & Government bonds)
and hybrid fixed income exposure (convertible, high-yield &
distressed bonds). The typical client has experienced a lower
over portfolio expense - even after our fees are included (which
are tax deductible) - and a higher risk-adjusted return. We
do not believe average investors should be exposed to the degree
of event risk in the market with individual securities and contend
it is wise to pursue this Nobel Laureate (Harry Markowitz) methodology
with pooled holdings of each investment class.
This process
is referred to Modern Portfolio Theory which, through our own
research, necessitates greater exposure to alternative investment
classes. The nine (9) asset classes are: hedge funds, alternative
class, pure equity, hybrid equity, convertible, multiple strategy,
fixed income, hybrid fixed income and liquid hard assets. Finally,
we have gone to great lengths in both identify and apply hedge
fund classes, many of which are not available to the average
investor though they have price transparency, liquidity (easily
sold), no holding periods, nominal investment limits and typically
no ‘qualified investor’ requisites.
Prospective
clients must understand that we must assess the current capital
gain tax impact of reallocation to this approach, which in turn,
often leaves a portion of the existing portfolio intact. We
accomplish this task by undergoing an in-depth fundamental security
analysis of individual securities, the appropriate allocation
for each sector/industry and the minimization of tax consequences
in executing the optimum risk-adjusted portfolio. Also, in certain
circumstances such as for high-income clients, we do select
individual securities such as municipal bonds of high credit
worthiness.
Discretion
versus Non-discretion. We desire our clients participate in
their account management and for this reason our financial/money
management platform operates under a non-discretionary investment
policy - except under trustee circumstances or by client written
request (limited power of attorney). We do not have discretion
over our clients' assets due to the fact that we believe a rich,
participatory environment serves the interest of all parties
involved. In this manner, we avoid conflicts and misunderstandings
stemming from our client turning over all investment decisions
to their planner, which in turn (in our opinion) creates a false
sense of security to the client and usually unrealistic expectations
of performance.
Dynamic
Asset Allocation based on Modern Portfolio Theory (MPT)
Montecito Capital Management employs a
sophisticated portfolio management approach that maximizes an
investors risk-adjusted return with the lowest cost solution
based on clients’ risk tolerance, return requirement and individual
constraints (e.g. taxes, liquidity, retirement etc.) Using a
continuous Dynamic Asset Allocation process founded upon the
time-tested and premier Modern Portfolio Theory approach, our
goal is to move clients to the highest investment frontier for
their given portfolio characteristics. The system and methodology
is clearly outlined herein, and though somewhat technical, is
considered the optimum investment approach given a lowest-cost
expense paradigm. This advancement is achieved through a dynamic
approach to passive investment vehicles, which are carefully
integrated for the optimized portfolio.
In Dynamic
Asset Allocation -Modern Portfolio Theory (MPT) model, investor's
capital will be allocated among various asset classes based
on quantitative and analytical approach taking into consideration
of their possible rate of returns vis-à-vis objectives and/or
risk tolerances. Dynamic approach accommodates changes in investor
circumstances and requires portfolio optimization process on
continuous basis.
MPT advocates
a process first developed by Nobel Laureate Harry Markowitz,
of selecting an optimal mix of asset classes based on past and
forecast returns, volatility i.e., standard deviation and beta
values, and cross relationships i.e. correlations and co-variances
that matches investor's quantifiable risk tolerance and gives
them best possible rate of return.
Asset allocation
based on Modern Portfolio Theory considers that investors are
inherently risk-averse and markets are efficient (note, our
portfolios capture market inefficiencies and anomalies with
substantial hedge fund and alternative investment class strategies).
Main focus is given to portfolio composition rather than individual
security analysis. Risk and reward parameters are quantified
for portfolio then compared and optimized with historical data
and economical forecast for asset classes by using advance portfolio
management software. Different combinations of asset class produce
an efficient frontier curve that provide highest possible rate
of return for every level of risk investor is willing to take.
Any other portfolio not on efficient frontier curve, which exhibits
the same standard deviation (risk) will generate lower returns
and will therefore be considered inefficient.
Portfolio
returns are generally determined by 3 factors: (1) Market timing,
(2) Individual security selection, (3) Selection of asset classes.
MPT has proven that your return can be increased for any given
level of risk via proper allocation between asset classes, and
that the allocation itself is by far THE MOST IMPORTANT determinant
of return; timing or individual asset selection are NOT, contrary
to what the many novice investors think. Studies of large institutional
pension funds have repeatedly shown that:
· Over
90% of the return is attributable to proper selection of and
allocation between asset classes, rather than stock "picking"
· From
1982 to 1987 if you missed the 40 best days, your return would
drop from 26.3% to only 4.3%, so timing is highly suspect.
Don't
Try Market Timing !
If you believe
you can outsmart the stock market, this graph proves otherwise:
Successful Market Timing? S&P Index (December 31, 1982 to December
31, 1998)
Over
the past 16 years, your average annual return on your investment
could have been 14.51% if you were invested in the Standard
& Poor's 500 Index for the entire period. This period consisted
of about 4,000 business days on the Exchange. MISS the 10 best
days during that time, and your return falls to 11.18%. MISS
the best 40 days ( only 1% of the 4,000 trading days), and your
average annual return goes down to 5.63%.
This argues
against undue emphasis on trying to outguess the market, trying
to move in and out. Modern portfolio theory uses 3 types of
data for each asset class, in each case based on historical
data. They are: (1) Expected return, (2) Standard Deviation
(which is a measure of risk, based on the fluctuation of historical
results around the mean) and (3) Correlation between asset classes
(which measure the performance of one asset class relative to
another).
Modern
Portfolio Theory quantifies the benefits of diversification.
Through a mathematical technique called mean-variance optimization,
Markowitz showed exactly how an investor could reduce the volatility
(risk as measured by standard deviation) of portfolio returns
by choosing assets that do not move exactly together. When he
graphed volatility (risk) against expected return, Markowitz
developed a way to view the efficiency of a portfolio. A portfolio
is said to be optimally efficient if there is no portfolio having
the same volatility (risk) with a greater expected return and
there is no portfolio having the same return with a lesser volatility.
The Efficient
Frontier is the collection of all efficient portfolios and is
represented on the attached graph as a solid line. Since your
goal is to increase expected return and to reduce risk, you
will be interested in only those portfolios that lie near the
solid line. Because diversification is a powerful means of achieving
risk reduction, the investment decision is not merely which
securities to own, but how to divide the assets among securities.
The Efficient
Frontier graph below shows the relationship between risk and
return.
Asset Allocation Matrix:
| Cash/Cash
Equivalent |
Equities
|
Fixed
Income |
Mixed
Cap Mutual Funds |
Other
Classes |
| Cash
|
Dow
Industrial |
Investment
Grade Corporate Bonds |
Balanced
|
REITs
Equity, Mortgage and Hybrid |
| Money
Market Funds |
S&P
500 |
Government/
Agency Bonds |
Growth
|
Other
Alternative Classes |
| Treasury
Bills |
NASDAQ
100 |
Treasury
Bonds |
Income
|
Natural
Resources |
| Certificate
of Deposits (CDs) |
Russell
2000 |
High
Yield Corporate Bonds |
Growth
& Income |
Hard
Assets: Commodities Precious Metals |
| Canadian
Dollars |
S&P
Utilities |
Municipal
Bonds |
International
Equities |
Hedge
Funds |
| Japanese
Yens |
Wilshire
5000 |
Mortgage
backed Securities |
Sector
Weightings |
Hybrid
Fixed Income & Equity Strategies |
| World
Money Market Funds |
International
Equities |
International
Bonds |
Total
Return |
Convertibles
|
At first,
investor's financial objectives, risk tolerance and investment
horizon are determined through filling out questionnaires. Our
analytical tools then quantifies risk tolerance and identifies
possible rate of returns making allowance of subsequent planned
addition and withdrawn of funds, income taxes, inflation etc.
After establishing risk tolerance and rate of return expectations
then asset classes are selected for portfolio. When selecting
asset classes, special attention is given to make sure that
there should be some meaningful negative correlation exists
among asset classes so portfolio can be stable in different
market environments.
Portfolio
optimization process starts after initial selection of asset
classes. Minimum and maximum holding range are established for
each asset class to ensure adequate diversification before running
optimization program. We use historical and/or forecasted returns,
standard deviations, correlations, and co variances in calculating
and optimal mix of assets for a portfolio at any level of desired
volatility (risk). Optimization process requires adding and
deleting asset classes and/or changing holding constrains until
optimal mix of asset is achieved that meets investor's risk
tolerance and rate of return. Optimal portfolio then further
compared against other portfolios and/or independent variables
to calculate beta, alpha coefficient, Sharpe ratios values etc.
These values fairly indicate how portfolio will react in different
"what if" scenarios.
Finally
investor's optimal portfolio is implemented by selecting individual
mutual funds, which closely represent selected asset class characteristics.
For example, if 20 percent holdings are allocated for growth
& income class mutual fund then individual funds are to be identified
which best meets growth & income characteristics. Our dynamic
asset allocation approach gives investors an opportunity to
re-evaluate and re-optimize their portfolio holdings on a regular
interval to reflect ongoing changes in their life as well as
changes in micro and macro economical environment.
The reason
for our focus on asset allocation rather than individual security
selection is predicated on the foundation of Modern Portfolio
Theory management which we outline herein. However, prospective
clients must understand that we must assess the current capital
gain tax impact of reallocation to this approach, which in turn,
often leaves a portion of the existing portfolio intact. We
accomplish this task by undergoing an in-depth fundamental security
analysis of individual securities, the appropriate allocation
for each sector/industry and the minimization of tax consequences
in executing the optimum risk-adjusted portfolio.
We recommend
NO LOAD, low expense mutual funds or exchanged traded funds
(along with alternative classes) limit exposure to individual
securities, for several basic reasons:
1) Risk/Diversification.
Owning an individual security brings with it both Market Risks
(Macroeconomics: Economy, Industry, Business risk) and Non-Market
Risks (Company fundamentals). Academically, the way to reduce/eliminate
non-market risk is through diversification. This means you need
to own approximately 20 or more different stocks. A Mutual fund
minimizes much risk and provides diversification.
2) Diversification
Cost. Knowing it takes approx 20 or more stocks to achieve diversification,
the cost becomes prohibitive. A mutual fund eliminates this
need. Further, though academically a 20 stock portfolio is construed
as diversified, we contend that the average investor should
not have 5 percent in any one investment for a financial portfolio.
This concentrated diversification in our opinion would bring
undue risk and isn't appropriate for the average investor. Mutual
funds are the best tool to achieve the highest risk-adjusted
return and using advanced techniques discussed herein, can be
fashioned for any measure of risk tolerance..
3) Research/Management.
Most mutual fund research departments are quite sophisticated
- receiving news/information very timely. As an advisor you
must answer - how good are your research capabilities, how current
are your news sources, and can you confidently make the decision
to either buy or sell a client's security. Mutual funds effectively
solve this dilemma.
4) Trading
costs. The costs of trading in and out of stocks to optimize
performance is cost prohibitive and unnecessary. Trading costs
for individual stocks can become financially cumbersome as Montecito
Capital Management periodically re-balances portfolios to adhere
to the client’s asset allocation plan and/or to adjust for changes
in the portfolio.
5) Tax Efficiency: Trading in and out of stocks
have dire tax implications. The short term capital gains with
high turnover can dramatically reduce the long-term return of
a portfolio (unless held in a tax-differed account)
