A main driver of our investment decision is the 12-month forward view of the US and world economies that continually evolves as conditions change month to month. We have the ability to alter exposure to asset classes and this is an invaluable contributor to the ongoing goal of protecting capital for clients.
ETFTrends: Talk about the connection between volatility of markets and shifts experienced by the global economy.
Frame: Since the start of the recovery (around the second half of 2009) and particularly since the end of quantitative easing, volatility in the U.S. market has increased significantly.
We believe that this has been largely driven by a focus on the Fed and its failure to come up with an effective and sustainable stimulus tool for the economy. The market has been caught in a pattern of believing that stimulus is finally working and then disappointed repeatedly as the economy fails to grow significantly.
ETFTrends: How are stock pickers doing lately?
Frame: Stock pickers have suffered repeated earnings disappointments, both domestic and global. We see this as tied directly with the bigger economic picture.
We look at three economic environments defined by the level of GDP growth, Recession (negative GDP growth), Stagnation (0% up to 2.6% U.S. GDP growth) and Growth (2.6% and greater U.S. GDP growth).
ETFTrends: How has volatility in the markets changed over time?
Frame: The volatility in the markets and in the U.S. GDP growth environments that we have observed in our own GDP data since 1997 have experienced a notable change since the Great Recession.
In the period from 1997 to 2008, we saw either one or two distinct GDP growth scenarios within a 12-month calendar period but never all three. Since 2008, we have observed calendar years having all three distinct GDP environments 42 percent of the time or in three out of the seven years. In addition, since 2008 there has not been a single year where the economy experienced only one GDP growth environment.
The markets are reflecting the uncertainly and instability of the underlying economy; it’s no wonder that volatility has increased dramatically as the U.S. has been moving more frequently between growth, stagnation, and recession scenarios since 2008.
ETFTrends: How does Frame Global go about managing downside risk?
Frame: We offer a modern and logical approach to risk management, recognizing that the definition of risk in the institutional investment management world is widely misunderstood.
The commonly accepted definition is that risk is volatility, measured by the statistical calculation of the standard deviation of returns around an expected or desired return goal. Essentially, this means that risk is defined as uncertainty- the uncertainty of actually earning returns above or below this expected or desired return goal. Asset classes do experience a large distribution of returns over time, typically ranging from losses to returns far in excess of the average return, calculated over the measurement period. Traditional approaches consider both upside and downside deviation from a mean – mean variance or “volatility” as risk. They also assume that losses always exactly equal gains- the “normal curve”. -but this is never true.
While there is no question that there is a general aversion to what we do not know, it is quite flawed to say that returns earned above an expected or desired return goal should be avoided- the goal when discussing risk.
ETFTrends: How should investors best deal with risk?
Frame: The definition of risk has a very different meaning when you ask an individual what they regard as risk when it comes to their investment exposure. The vast majority answer “losing money”. They have no problem with unexpected high rates of return but they do have a problem with seeing their capital eroded.
Managers who define risk as volatility but say that they are focused on downside risk protection are living a contradiction.
ETFTrends: How does your firm use ETFs to find success in the market, no matter the economic environment?
Frame: Our firm’s investment process isolates the probability that an asset class will experience losses in the twelve-month forward period. Unlike the majority of traditional asset managers, we know that ignoring non-normality in equity and fixed income return distributions significantly understates losses that have been experienced and therefore misinforms us on the likelihood that these losses could be experienced in the future. We deal with this by focusing on the unique distributions of asset class returns in various economic environments. We incorporate this exclusive focus on downside risk while embracing upside volatility in each of the asset classes considered. Using this tactical asset allocation approach, we have produced portfolios using an optimal combination of broad asset class Exchange Traded Funds (ETFs) and have demonstrated that there can be success in any market or economic environment.
Deborah Frame was recently a speaker on the webcast, Tactical ETF Strategy in an Easy Mutual Fund Package. Financial advisors who are interested in learning more about ETF investment strategies can watch the webcast here on demand.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.