The strategy “opportunity set” is simply the universe of potential investments. Will the tactical opportunity set be broad (i.e., value or growth) or targeted (i.e., sectors or industry groups)? Will there only be a few options to select from or will there be many options to select from? Large, diverse opportunity sets may offer dramatic dispersion and more opportunities to outperform or underperform, and they are also likely to lead to more trading. Smaller opportunity sets may show less disparity in returns but also result in less frequent trading. Both types of opportunity sets are useful, but they will likely result in different strategy characteristics.
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Understanding the design behind the strategy “goal” is essential in identifying market conditions under which the strategy is expected to succeed or struggle. For example, does the strategy have the goal of capturing changes in trends (contrarian) or the goal of capturing continuation of trends (momentum)? Both are attractive goals, but contrarian strategies may get in too early (the risk of identifying a false turn) while momentum strategies may get in too late (the risk of identifying a trend after a large part of the move is over).
Is the strategy’s time frame short-term or long-term? Understanding the design behind time frame is potentially the most misunderstood question. Strategies that capture short-term moves may be unsuccessful in capturing long-term moves, and vice versa. Profiting from short term moves will require a strategy to have very sensitive triggers, while capturing long-term moves typically requires less sensitive triggers. Strategies with a sensitive trigger typically get in a major move in the early stages, but these strategies are also susceptible to more frequent false or “whipsaw” moves. A less sensitive trigger will often result getting in or out later, but it will typically filter out short-term noise and trade less. There are advantages and disadvantages to both short-term and long-term strategies—the design simply needs to properly match the expectation and objective.
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Finally, investors and advisors need to answer the most important question: “How much negative variation from a benchmark is acceptable and for how long will negative variation from a benchmark be tolerated?” Positive variation from a benchmark is desirable and welcome. Long-term outperformance over a benchmark typically requires a willingness to look very different from a benchmark. Periods of outperformance may be followed by periods of underperformance. Patience to look different from a benchmark is a critical design question—less tolerance for variation from a benchmark will result in looking more like the benchmark. An investor expecting outperformance must accept a strategy design that leads to behavior very different (up or down) from the benchmark. One of the reasons that many advisors and their clients do not outperform their benchmarks is that they do not allow carefully designed strategies to do exactly what they are designed to do—which is to look different!
When investors and advisors want answers from their portfolios, they should begin by making sure they are asking the right questions. In the end, it is all a question of properly matching design with objective.