Adaptive Portfolio Management  In the Real World

Adaptive Portfolio Management In the Real World

Posted on January 07, 2019
Market State – Transitional: Transitional Market State environments are volatile, counterintuitive, and are loaded with large one day outliers of 1.5% to 3% or more. A Transitional market typically stays in place for 3 or 4 months before it shifts to either a Bullish or Bearish Market State environment.
Transitional Market States require careful and timely adjustments in the portfolio’s holdings. There are two primary objectives during a volatile Transitional environment.
  1. Avoid getting whipsawed when deciding to sell, following a sharp short-term decline. Sharp declines are followed by sharp rebound rallies. These rebound rallies typically occur when least expected. For example, the S&P 500 declined -11% over 7 days ending with the Christmas Eve massacre. Those who followed their emotions, sold into the days that followed. To the surprise of most, the S&P 500 rebounded +7.7% over the following 7 days.
Those who sell their securities, following an emotional drop, can end up compounding the damage. Selling after the fact, will result in the investor having more money at risk during the decline, and less invested when the eventual upward rebound occurs. As a result, the positive impact of the rally will be reduced. The impact from this mistake can turn a difficult few months into an ordeal that could take years to recover.
  1. Transitional markets typically begin, with a surprise spike down, that occurs during a time when volatility has been stable and low. A portfolio should own some alternative ETF’s, (that move different from the portfolio’s equity holdings). Some of these alternatives should be owned during the bullish environment, prior to the spike down, as a precaution. The first downturn, could cause the portfolio to experience a correction that would fall within the range of normal market noise for a market environment that is in transition.
Canterbury studies show that sharp declines are followed by sharp advances. Most adjustments, within the portfolio’s holdings should be made during and immediately following these short-term rebounds. Meaning, not during or immediately following a big decline. These adjustments should be made with the objective to stabilize the portfolio’s volatility. In most cases the stabilization process will include the purchase of some “inverse” ETFs. An inverse ETF is designed to move in the opposite direction of the underlying asset. In other words, when the NASDAQ 100 ETF is in a bearish environment and begins declining in value, the NASDAQ “inverse” ETF will move up in the opposite direction. The proper use of alternative and inverse ETFs has led to a breakthrough in the ability to manage bear markets.
All markets and securities will experience bear markets from time to time. An “adaptive portfolio management strategy, like the Canterbury Portfolio Thermostat, is designed to adjust its holdings to match the reality of the existing market environment. Such adaptive portfolio management processes are designed to move in concert with the everchanging financial markets – bull or bear.
The Canterbury Volatility Index (CVI) is currently at CVI 128: As a point of reference, volatility at or below CVI 45 is considered to be extremely low. Volatility between CVI 46 and CVI 75 is within the optimal range. Volatility exceeding CVI 90 and increasing is a risky environment. The current CVI 128 is irrational and can move several percentage points in either direction, and fast.
S&P 500 Index – Chart Below
  1. One day outlier (10/10/18) caused a shift to Transitional Market State 6
  2. Trading Range was outlined following shift to the new Transitional Market State environment.
  3. Trading range broken by an outlier day.
  4. Break in trading range was followed by a sharp 7 day decline of -11%.
  5. Sharp declines act similar to an over stretched rubber band. The “snap-back” rally will typically almost as large and occur as fast as the drop. So far, the rally has covered 7.7% in 7 days and counting.
  6. Canterbury Volatility Index was at an extremely low level on 10/9/18. Canterbury studies show that periods with extremely low volatility are resolved by an outlier spike in volatility. 

Source: AIQ

Bottom Line:
Portfolio management should be a science and not an art form. The best way to manage a Transitional or Bearish market environment is by maintaining certain benchmarks within the portfolio’s construction. Meaning that the portfolio’s volatility should be in the optimal range. The combination of securities held should be capable of making adjustments in order to maintain a high benefit of diversification to maintain an “efficient portfolio” to reduce risk. The maximum portfolio declines should be held to the level of a “normal correction” of about 8% to 12%. Any outliers, beyond a normal correction should be the result of a series of daily, back to back outliers of -1 to -4%. These additional outliers should be small, and quickly recouped (within days).
Canterbury Investment Management: Tom Hardin

More About Tom Hardin

As Chief Investment Officer, Tom has more than 30 years of experience in the investment management industry and has a broad breadth of knowledge. He is known as an innovator, educator and has been revolutionary in the advancements of portfolio and risk management.

Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.