ARE YOU
PREPARED FOR
THE MARKET’S
NEXT MOVE?
Why Chasing the Markets Can Be Hazardous to Your Wealth
ARE YOU PREPARED FOR THE MARKET’S NEXT MOVE?
F
rom its bear market closing low on March 9, 2009, the S&P 500 Index has climbed more
than 210% through February 2015.1 The current bull market is now one of history’s longest
and most profitable for domestic equities. Since 1929, only three bull markets have endured
longer than this one’s 72 months, and only three have seen greater gains. As investors make asset
allocation decisions going forward, are they setting themselves up to repeat history by not incorporating lessons learned in previous market cycles?
Behavioral finance postulates that investors may make irrational decisions in certain market
environments, often motivated by the dueling emotions of “fear and greed.” Unfortunately for
investors, it has been commonly observed that they have been “fearful at times when they should
be greedy, and greedy at times when they should be fearful.”
This repeating cycle has led to the average equity investor significantly underperforming the
market, failing to properly gain from bull markets, and taking disproportionate losses during bear
markets. Have investors learned from 2008? Are things different this time?
This paper provides numerous data points that allow readers to draw their own conclusions to
answer these questions. It examines how investor behavior has unfolded over the past six years
and the resulting impact on risk exposures as this bull market has grown long in the tooth by
historical standards.
THE CURRENT BULL MARKET IS ALREADY AMONG THE
LONGEST AND STRONGEST SINCE 1929
LONGEST U.S. EQUITY BULL MARKETS 1929 – FEBRUARY 2015
PERCENT CHANGE IN S&P 500 CLOSING PRICE
600%
1987-2000
500%
400%
1949-1956
300%
1942-1946
200%
1970-1973
1935-1937
100
%
0
The current bull market, now
entering its 7th year, has
gained over 200% since the
market low in March 2009.
1982-1987
1947-1948
0
12
AVERAGE
1962-1966
1974-1980
2002-2007
1957-1961
1966-1968
24
2009-Feb 2015
36
48
60
72
84
96
108
120
132
144
BULL MARKET DURATION IN MONTHS
Past performance is not indicative of future results. F-Squared analysis using FactSet data. * Bull market defined as 20% or more rise without a 20% correction, using the closing price of the S&P 500.
The thirteen bull markets shown exceed one year. Twelve bull markets with duration under one year are excluded from both the graph and the average.
1
The S&P 500 Index was at 676.53 on March 9, 2009 and closed at 2104.50 on February 27, 2015.
2 | Please see final page for important information.
156
ARE YOU PREPARED FOR THE MARKET’S NEXT MOVE?
How Have Investor Preferences for Risk Changed Over
This Bull Market?
As illustrated by the chart below, many U.S. equity investors were so traumatized by the
losses of 2008 that they literally “gave up” on investing in the stock market. They sought
to protect what money they had left from what they perceived to be the unacceptable
risk of equities, and many missed out on the first four years of this bull market. Thus,
from early 2009, which presented the most attractive valuations and risk/reward, until
the fourth year of the rally, net flows into large cap equity funds were strongly negative.
While net flows turned positive in 2013, four years of substantial gains had passed
before investors grew comfortable enough to return to the equity market. Investors who
returned to domestic large cap equities were rewarded by the S&P 500’s strong gains in
2013, reinforcing their confidence and strengthening their renewed embrace of equities
and market risk. While investors pulled $123 billion out of large cap equity funds
during the first four years of the bull market, a much larger amount, $211 billion, has
flowed into equities in just the last two years.
Studies have shown that individual investors have been so psychologically impacted
by previous bear markets that they have tended to sit out much of the ensuing recoveries. As the memory of losses fade, investors chase returns in the very late stages
of the next bull market. Statistics provided by Dalbar, Inc. suggest that emotionally
driven investor behavior continues to cause them to underperform market results.2
The results show that average investors, even after adjusting for liquidity needs, earn
less-than-market returns because of the poor timing of these decisions.
INVESTMENT INDUSTRY FLOW DATA VS. S&P 500 INDEX RETURN
$120
$100
LARGE CAP MUTUAL FUND & ETF
NET FLOWS
From 2009-2012, retail equity investors
experienced total net outflows of
over $123 Billion despite positive
S&P 500 Index performance.
(in $Billions)
$80
$60
$40
32.4%
28.7%
26.5%
$20
15.8%
10.9%
$0
($20)
($40)
($60)
4.9%
2000
-9.1
%
2001
2002
2003
2004
2005
2006
16.0%
15.1%
5.5%
2007
13.7%
2.1%
2008
2009
2010
2011
2012
2013
2014
-11.9%
ANNUAL RETURN
FOR S&P 500 INDEX
-22.1%
-37.0%
Past performance is not indicative of future results.
F-Squared analysis using Bloomberg and Morningstar data. Net Flows shown are for U.S. Large Cap Equity in mutual funds and ETFs, including both actively – and passively – managed products.
2
Source: 2014 Dalbar Quantitative Analysis of Investor Behavior (QAIB). Since 1994, Dalbar, an independent financial industry research firm, has studied the effects of investor decisions to buy, sell and switch into
and out of stock and bond mutual funds over various timeframes.
3 |
Please see final page for important information.
ARE YOU PREPARED FOR THE MARKET’S NEXT MOVE?
As referenced in the chart to the right, Dalbar’s latest available data (2013) shows a
20-year annualized return of 9.22% for the S&P 500 compared to the average investor return of 5.02%—a performance gap of 4.20% per year. The fund flow data on the
previous page illustrates that this pattern has continued with the current bull market,
and that retail investors seem to be ramping up risk exposures to U.S. equities, even as
we get closer to the next downturn or bear market, whenever one might finally arrive.
Unfortunately, many of those investors have not participated in enough of this bull
market to even make back the money lost in 2008–2009. Strategies offered by F-Squared
allow investors to stay allocated to the markets through a systematic and quantitative
approach that is designed to reduce market exposure when elevated levels of risk can
increase the likelihood of drawdowns.
The AlphaSector® Value Proposition
F-Squared has long championed an investment philosophy, approach and process
that is designed to break the destructive cycle of “fear and greed.” We seek to protect
investors from the dangers of emotion-driven decision-making that historically has
given them the worst of both worlds: experiencing the full brunt of bear markets and
missing out on the best years of bull markets. Our first priority is to protect clients
from large losses with an objective of substantial participation in rising markets.
Investment firms, seeking to serve their clients’ needs, have attempted to end the fearand-greed cycle through investor education. This investor education has taken many
forms, but a common theme has been to support a buy-and-hold approach with
allocation among major asset classes to reduce volatility. The investment industry
flow data cited earlier, however, would seem to indicate limited success. In contrast,
F-Squared’s approach is to offer solutions that deliver a different risk/return profile,
removing the triggers of the problematic behavior.
To understand the power of a risk-managed approach, it is important to keep in mind
that large losses can have a greater impact on long-term investor returns than large
gains. Due to this asymmetry, an approach that consistently protects against large
losses while capturing gains in rising markets has the potential to deliver more attractive long-term results than traditional, benchmark-centric approaches.
Consider the following hypothetical full-market scenarios to see the mathematical
power of a risk-managed investment. As outlined in the chart below, Investor A has
$100 invested in an S&P 500 index fund and Investor B has $100 in a risk-managed
strategy that goes to cash after absorbing the first 10% of a market drawdown. A
hypothetical bear market with a 50% loss would leave the two portfolios with $50
and $90, respectively. This means Investor A would need to make a 100% return on
his $50 just to get back to his initial value, and after a 200% bull market, that portfolio
would rise to $150. Let’s further assume that the risk-managed strategy is only capable
of providing 75% of the market upside as a consequence of being able to provide
downside protection. Thus, while the index fund rises 200%, Portfolio B will only rise
by 75% of that amount, or 150%. However, even after leaving 50 percentage points of
the return on the table relative to the market, Portfolio B still has a vastly superior end
result of $225 vs $150.
4 |
Please see final page for important information.
AVERAGE ANNUAL RETURN:
20 YEARS ENDING 12/31/2013
S&P 500 INDEX
AVERAGE ANNUAL RETURN 1994 – 2013 (20 years)
Returns Achieved by Fund Investors Have Lagged the
Market Over the Long Term
AVERAGE EQUITY
FUND INVESTOR
10%
8%
9.22%
6%
4%
5.02%
2%
0%
Past performance is not indicative of future results.
Source: “Quantitative Analysis of Investor Behavior, 2014,”
DALBAR, Inc. Average equity investor performance results
are calculated using data supplied to DALBAR, Inc. by the
Investment Company Institute. Investor returns are represented
by the change in total mutual fund assets after excluding sales,
redemptions and exchanges. This method of calculation captures
realized and unrealized capital gains, dividends, interest,
trading costs, sales charges, fees, expenses and any other costs.
After calculating investor returns in dollar terms, two percentages are calculated for the period examined: Total investor
return rate and annualized investor return rate. Total return rate
is determined by calculating the investor return dollars as a
percentage of the net of the sales, redemptions and exchanges
for each period.
ARE YOU PREPARED FOR THE MARKET’S NEXT MOVE?
Scenario 1 represents a rather severe bear market, but even a more moderate downturn
delivers similar results. For example, consider Scenario 2 illustrating a 35% loss, which
represents the average decline in bear markets since 1929. Once again, Investor B is still
well ahead with a risk-managed strategy, with $225 versus $195 for Investor A.
SCENARIO 1 Market (or Passive
Investment)
Riskmanaged
Investment
Starting Value
$100
% Decine during bear phase*
SCENARIO 2
Market (or Passive
Investment)
Riskmanaged
Investment
$100
$100
$100
-50%
-10%
-35%
-10%
$50
$90
$65
$90
Market rise during bull phase
200%
200%
Bull market participation rate
100%
75%
100%
75%
Value @ end of bull
$150
$225
$195
$225
Value @ end of bear
Source: F-Squared Investments. *The severity of the bear market and the relative impact on the risk-managed investment
(shown in blue) are the variables that drive the different scenarios.
The hypothetical scenarios displayed above are for illustrative purposes only.
Illustration of the Bear-Bull Market Cycle: Impact on
Risk Management
Obviously, we would all prefer to enjoy the full gains of bull markets and none of
the losses of bear markets. But lacking a crystal ball, this is an unrealistic expectation.
At F-Squared, we believe investors whose portfolios have the ability to de-risk are
likely to have more successful outcomes over time. However, there is an important
distinction with risk-managed strategies: in order to position the portfolio to be able
to deviate from the benchmark in bear markets, the strategy must be able to deviate
from the benchmark in bull markets as well.
As can be seen from the illustration of the mathematical power of such strategies,
an improved investor experience through the full market cycle does not require
capturing all of the market’s upside return—the only way to do that is to also ensure
capturing all of the market’s downside return. Leaving some of the market return “on
the table” during high risk periods is essentially the “price” investors pay for this sort of
downside protection, yet it still positions them for superior full market cycle results.
F-Squared’s quantitative models view risk at the sector level, rather than the total
market level, using volatility as a key driver. As a result, individual sectors with
worsening risk outlooks can be identified rather than being masked by broader
market measures. The strategy will then remove perceived high-risk sectors from
the portfolio, reallocating to those remaining sectors our quantitative models deem
are healthy. This reallocation process occurs when up to five of the nine U.S. equity
sectors are removed, leaving four sectors “on.” When three or fewer sectors remain
“on,” a cash alternative position is used, in increments of 25%, 50%, 75%, or 100%
of the model portfolio. This represents the strategy entering its most protective
mode, with the greatest potential to insulate the portfolio— and the investor—
from downside risk. Volatility reflects risk and uncertainty, and thus we use our
proprietary volatility technology to monitor the ever changing investment landscape
for dangerous changes in volatility.
3
eVestment. Asset Flows Report, 4Q 2014.
5 |
Please see final page for important information.
To understand
the power of a
risk-managed
approach, it is
important to keep
in mind that large
losses have a much
greater impact on
long-term investor
returns than
large gains.
ARE YOU PREPARED FOR THE MARKET’S NEXT MOVE?
A Better Way to Measure Investment Success
Much of the data cited earlier in this paper seems to indicate that many investors
are pursuing the same “fear and greed” behavior through this bull market as in previous cycles. They remain in many cases, with a single-minded focus on benchmark
performance through this period. Yet what question are investors more likely to be
asking advisors a year from now? “Why didn’t we capture the bull market’s last few
months of gains?” or “Why didn’t you protect me when the bear market hit?”
Based on the output of our quantitative engines, the model has detected signs of
increased market risk in U.S. equities, and has been generally de-risking the AlphaSector U.S. Equity portfolios since October 2014. The S&P has been able to generate
gains during that period, but in a very volatile pattern. With the heightened volatility
of these past few months this far into this bull market, what do investors want to be
prioritizing right now?
Typically, our investors have retained us to remove emotion from the decisionmaking process and protect their accumulated gains from being decimated in bear
markets. As outlined below, the AlphaSector U.S. Equity strategy has performed
consistently with its clearly defined expectations.
• The U.S. Equity strategy (represented by the AlphaSector Premium Composite
gross of fees) has an up capture ratio of 81.6% during the current bull market.*
• The AlphaSector U.S. Equity strategies have detected substantially elevated risk
of large losses and de-risked as a result: we held cash alternative positions at month
end for seven months in late 2008-early 2009; four months in 2011; and four
months beginning in the fourth quarter of 2014 through February of 2015.
• As a consequence of our de-risking, the AlphaSector Premium Composite
experienced three periods of significantly lagging the S&P in rising markets
(as measured by rolling 12-month periods since October 2008): March 2009February 2010, October 2011-September 2012, and March 2014-February 2015.
• With the elevated risk we have seen since October 2014, we have been defensively
positioned, and as a result, consistent with similar periods in the past, we have
deviated from the benchmark on a short-term basis. We are confident in adhering
to our value proposition and the benefits provided through the full market cycle.
* Based on Morningstar month-end calculation from March 31, 2009 through February 28, 2015.
Past performance is not indicative of future results.
6 |
Please see final page for important information.
Typically, our investors
have retained us to
remove emotion from
the decision-making
process and protect
their accumulated
gains from being
decimated in bear
markets.
ARE YOU PREPARED FOR THE MARKET’S NEXT MOVE?
Conclusion
Whatever direction investors choose in today’s less certain markets, they cannot
afford to be complacent about the status quo. Our models are indicating elevated
levels of volatility on the heels of one of the longest and strongest bull markets in
U.S. history. The ability to select an investment manager that can provide meaningful
downside protection during a potentially significant market drawdown is an
important consideration for risk-conscious investors.
This paper has focused on two cyclical phenomena that impact investors. First,
securities markets move through repeated bull-and-bear cycles, varying in intensity
and duration. Second, investors react to those bull-and-bear movements in a related
but trailing pattern that leads many to make suboptimal decisions, getting in and out
of markets too late. The market cycle is seen as an unchanging reality. The investor
behavior cycle, while theoretically correctible, seems resistant to efforts at education.
The paper proposes that the most effective tool for addressing both cycles is the use
of effective risk management strategies, focused on reducing drawdowns during
severe market declines. F-Squared believes that the benefits will be seen in objective
risk/return metrics and ultimately, the investor experience. F-Squared’s AlphaSector
solutions are designed to address this need.
7 |
Please see final page for important information.
ARE YOU PREPARED FOR THE MARKET’S NEXT MOVE?
IMPORTANT INFORMATION
Past performance is not indicative of future results. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses,
and is not based on actual advisory client assets. Index performance does include the reinvestment of dividends and other distributions. F-Squared Investments
began managing advisory client assets in February 2009.
The views expressed in the referenced materials are subject to change based on market and other conditions. These documents may contain certain statements
that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or
developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not
be construed as indicative of actual events that will occur. The information provided herein does not constitute investment advice and is not a solicitation to buy
or sell securities.
“AlphaSector®” is a registered trademark of F-Squared Investments, Inc. and is used with permission. This material is proprietary and may not be reproduced,
transferred, or distributed in any form without prior written permission from F-Squared Investment Management, LLC or one of its subsidiaries (collectively, “F-Squared
Investments” or “F-Squared”). F-Squared reserves the right at any time and without notice to change, amend, or cease publication of the information contained herein.
This material has been prepared solely for informative purposes. The information contained herein includes information that has been obtained from third-party sources
and has not been independently verified. It is made available on an “as is” basis without warranty.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer
to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your
tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the
information and F-Squared shall have no liability for decisions based on such information.
F-Squared provides investment advisory services relating to various index products on a discretionary basis to separately managed accounts (the “SMAs”).
F-Squared receives compensation in connection with licensing rights to the AlphaSector indexes to third parties, typically through a Model Manager Agreement.
All information relating to an index is impersonal and not tailored to the specific financial circumstances of any person, entity, or group of persons.
For the SMA’s portfolio, F-Squared seeks to replicate one or more of the AlphaSector Indexes (such replication being a “Strategy”). Although F-Squared generally
does not tailor its Advisory Services to the individual needs of a client, F-Squared may offer custom advisory services upon request. A potential Advisory Services
client may request a Strategy based on an existing Index that offers a greater or lesser allocation to a particular asset class, for example. For its Advisory Services,
F-Squared generally does not allow clients to impose restrictions on investing in certain securities or types of securities.
Composite information
The AlphaSector U.S. Equity strategy (“U.S. Equity”) is designed to provide exposure to the U.S. equity market, and is constructed as an “asset allocation” overlay
onto exchange traded funds (“ETFs”) representing major sectors of the U.S. economy. F-Squared defines the inception date for U.S. Equity, the AlphaSector Premium strategy as October 2008.
F-Squared may change the exposures and strategy compositions reflected herein at any time and in any manner in response to market conditions or other factors
without prior notice to investors.
Risk Disclosure
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
All investments include a risk of loss that clients should be prepared to bear. The principal risks of the AlphaSector Indexes and Strategies are disclosed in the
publicly available Form ADV Part 2A.
F-Squared may change the exposures and index compositions reflected herein at any time and in any manner in response to market conditions or other factors
without prior notice to investors.
F-Squared Investment Management, LLC or one of its subsidiaries is the source and the owner of all AlphaSector indexes and their performance information.
Copyright 2015
F-Squared Investments is an asset manager that provides next-generation investment indexes and strategies
based on its AlphaSector® and Portfolio Replication Technology capabilities. The firm seeks to provide an
investment approach that repeatedly protects clients in down markets and helps them participate as much
as possible in up markets. F-Squared focuses on delivering powerful and innovative investment solutions to
help meet investor’s expectations and financial goals. The firm serves clients in the advisor, institutional,
retail and retirement markets. As of December 31, 2014, F-Squared affiliated entities had over $24 billion in
fee-generating assets. F-Squared Investments is based in Wellesley MA and Ewing NJ.
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