For Deborah Frame, a modern and logical approach to risk management is necessary to recognizing that the definition of risk in the institutional investment management world is widely misunderstood.
As head of Frame Global Asset Management’s ETF Strategy Team, Frame is involved in all aspects of the portfolio model process.
She has held executive positions over the past 30 years at a number of major Canadian life insurance and investment firms and has sat as a board member of both public and private companies.
Frame spoke with ETF Trends about the U.S. economy, markets, tactical approaches to investing and managing portfolios, and shifts in the global economy.
ETFTrends: What is your outlook for the US market and economy for the remainder of 2016 and in to 2017?
Frame: We’ve maintained our stagnation outlook – U.S. GDP between 0 and 2.6% – for the next 12-month forward period.
The U.S. economy has been marked by slow growth since the recession with disappointing levels of consumption and business investment, high savings rates and a slow recovery in employment. Labor productivity growth has been weak with the capital stock per worker falling since 2012, which is highly unusual.
ETFTrends: Have companies responded?
Frame: Companies have responded, beginning in 2012 by hiring more workers rather than growing the capital stock. While this has contributed to higher employment and higher real wage growth, it has failed to impact overall growth in the economy.
With productivity growth stagnant, a marked acceleration in the growth rate of average hourly earnings will keep upward pressure on unit labour costs, pushing core inflation higher but overall growth of the economy will remain challenged.
ETFTrends: What can we learn from Q1 2016 GDP data?
Frame: The recent activity data indicates that first-quarter 2016 GDP growth slowed to very modest 0.5% annualised gain, representing a significant slowdown on the already moderate 1.4% gain in the final quarter of last year. The was due to a number of headwinds hitting the economy and it appears that GDP growth is on course for another underwhelming gain of around 2% this year.
ETFTrends: When do you think the Fed will raise interest rates?
Frame: We expect the next rate hike will be delayed until December, with the Fed funds rate reaching 1.00% to 1.25% by mid-2017 at the earliest. Markets appear to be factoring in a rate hike in September at the earliest while Frame Global, at this point is less optimistic regarding economic growth as we move closer to September.
ETFTrends: How do you see negative rates implemented in various economies impacting international markets, as well as domestic ones?
Frame: Global financial conditions have continued to ease. Fully 90% of the world bond market trades at a sub-2% yield and about 30% of European debt is now negative. In Japan, Abenomics has hit a wall as the country continues to weave in and out of a recession with consumer spending and incomes stagnant. In the U.S., falling rate expectations have caused Treasury yields to continue to trend lower across the curve. This has occurred despite a marked rebound in breakeven inflation rates caused by the recent rally in oil prices.
Negative rates undermine commercial banks’ profits, lead to asset price bubbles, have an adverse effect on insurance companies and pension funds and have undesirable distribution effects. They are reflected in exchange rate pressures although the strength or weakness of each underlying economy is a bigger influence overall on exchange rates.
ETFTrends: How has the private sector responded since the financial crisis?
Frame: The private sector has demonstrated a willingness to hoard money instead of spend it as a result of the gloomy economy since the financial crisis. The decrease in interest rates, designed to encourage broad borrowing has incentivized investors to do the opposite. This is evidenced by the declining velocity of money. The sharp decline in velocity has offset the sharp increase in money supply, leading to no change in nominal GDP.
Another incentive for corporations when interest rates are very low or negative is to borrow more cheaply by issuing corporate bonds at low yields. They can then use this money to purchase shares in a buyback.
Companies are buying their outstanding shares at the expense of investing in capital projects. In fact, according to data provided by Bloomberg, the S&P 500 earnings growth in the period 2003-2007 was 12.9% while shares rose at an annualized rate of 10.8%. In contrast, the period from 2009-2015 saw corporate profits grow at only 6.9% while stock prices surged 10.9%. The incentive to borrow cheap to effect buybacks is an unintended consequence that drives up earning per share while holding earnings constant, producing upward pressure on stock prices.
[related_stories]ETFTrends: Why do you feel advisors should take a tactical approach to investing and managing portfolios, versus an approach that is more strategic in nature?
Frame: The main benefit of taking a tactical approach to investing is one of flexibility. Too often, an advisor/investor/portfolio manager is held to a strategic mandate that constrains asset mix bands to a narrow corridor and requires portfolios to be rebalanced, forcing a portfolio decision that is suboptimal given the current economy and/or market conditions. Taking a tactical approach allows the advisor to be more adaptive to the state of the world in all economic environments. This is not market timing, to be clear. It’s a way of investing that allows a manager to be active among asset classes, while at the same time passive within asset classes. In recent months we’ve had positions in US equities, US treasuries of varying maturities, international equities, and gold, and through time we’ve had the flexibility to alter exposures as we’ve seen fit.
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.
Related: Tactical ETF Strategy in a Fund Package
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.