By Joseph Hosler, Auour Investments
The number of tactical ETF Strategists has increased since the 2008 Financial Crisis as advisers look for managers able to navigate uncertain market conditions. According to Morningstar, as of the end of the first quarter of 2016, there were 156 ETF strategists managing $76 billion in client assets. Over 67% are characterized generically as tactical managers. As the market for ETFs grows, so does the demand for tactical managers, and the need for a system by which to evaluate managers grows.
Below we offer six factors that should be considered when assessing a tactical manager.
1. Live and Backtested Performance:
When evaluating a tactical manager, compare the manager’s live performance track record to their hypothetical backtest results. This will help assess the efficacy of a manager’s philosophy and process. Backtests are often ridden with errors, but they do offer a glimpse into the rigor and durability of a manager’s strategies. If the manager’s live track record does not demonstrate similar values to those predicted by the back tests, it may suggest that the manager is still attempting to solve the last problem that the market encountered rather than focusing on the next one.
2. Riskiest Portfolio:
A tactical portfolio manager will reconstitute his portfolio over time, attempting to best navigate the market’s waters. This will lessen the value gleaned from metrics of skill based on averages, like Sharpe ratios. We believe average-based skill metrics only tell part of the manager’s story. You should have an idea of what a manager’s riskiest portfolio looks like and make sure you are comfortable using that portfolio for your clients in any environment. An improved understanding of a manager’s riskiest portfolio will help you understand the risk you take on if the manager’s algorithms fail to accurately capture the market.
3. Batting Average in Both Up and Down Markets:
What are you looking for in a manager? If you’re looking for aggressive upside in good markets or protection in down markets, the importance of assessing a manager’s skill in these regimes is imperative. As part of this evaluation, you should check that a manager’s historical returns match the desired application by calculating their batting average. A batting average looks at a manager’s ability to outperform the benchmark but does not evaluate by how much the manager outperforms; it only takes into account the number of months the manager beat the benchmark in rising and falling markets. If the manager is focused on downside protection but has a poor batting average in down markets, you may need to dig deeper into the validity of their strategies.
4. Upside and Downside Capture:
Upside and downside capture go hand in hand with batting average; they detail the magnitude of a manager’s outperformance. The data allows you to see a manager’s magnitude of relative outperformance or underperformance in both up and down markets. Using upside and downside capture in concert with batting average will enable you to gain a better understanding of the durability of a manager’s process.
5. Drawdowns:
Drawdowns quantify a portfolio’s absolute decline in value by measuring the percentage change between the peak and its associated trough. No client likes to see a large percentage of their wealth disappear in down markets, no matter how good the manager may be in rising markets. Evaluating a manager’s past drawdowns will give you an indication of the risks of placing a client’s wealth under their management.
6. Turnover Over Time:
Turnover for a tactical manager indicates how often and by how much they rebalance their portfolio, giving you an idea of the portfolio’s stability and success over time. Turnover will also indicate the appropriateness of the manager given your clients’ tax implications.
Choosing a tactical manager involves taking into account a lot of data and information, and every adviser and every client brings his or her own goals and priorities to the table. Every person chooses to weigh certain factors more than others. However, the six points mentioned above apply not only to tactical managers; they are important to any type of manager. It’s important to consider all six as you consider entrusting assets into an investment program. In the end, you share fiduciary responsibility with the chosen manager, and you should therefore do everything in your power to ensure a desirable outcome for both you and your client.
This article was written Joseph Hosler, Managing Principal at Auour Investments, a participant in the ETF Strategist Channel.