All posts by sellwood

Welcoming Taylor Cuzzort

Sellwood is pleased to announce the newest member of our team, Taylor Cuzzort.

Taylor joins us from the University of Oregon, where she recently earned a Bachelor of Business Administration, Finance, from the Lundquist College of Business at the University of Oregon. She also earned a minor in Spanish.

At Sellwood, Taylor will create and analyze client investment performance reports, prepare analytical materials for clients, and assist with the firm’s overall research effort.

Outside the office, Taylor is passionate about travel and the outdoors, and she enjoys running and playing tennis.

The Right and Wrong Way to Design a Portfolio

“Our research department believes that the President’s agenda will stall in Congress, the Fed is on pace for two more rate hikes this year, and that we are seeing really promising economic growth out of Asia. As a result, we recommend that you shift a bit of money out of core bonds and into international equities for the next six months.”

“The futures market is flashing a panic signal, so we are going to de-risk your portfolio for a while and wait out this storm.”

“Valuations are getting a bit stretched in REITs. We should remove them from the portfolio.”

“Our tactical model recommends a near-term overweight to small-cap.”

Statements like these sound compelling. Unfortunately, they are absolutely the wrong way to design a portfolio.

To understand why, we must take a few steps back and start not with the portfolio but the client. Every client’s portfolio has a purpose, an objective, a reason for being. Pension plans exist to ensure that funds are available in the future to pay promised benefit payments. Defined contribution plans exist to provide participants the tools they need to map a financial future. Endowments set aside long-term assets to provide stability and enrichment to the operation of the associated nonprofit.

In other words, portfolios never exist in a vacuum, and investing them is never an end unto itself. Before investing a single dollar of a client’s portfolio, the first necessary question to ask is: why does this portfolio exist? Only after doing so can a proper investment strategy be established. Without knowing a portfolio’s purpose, investing a portfolio resolves to a purely academic exercise.

Instead, we propose the following framework for designing an optimal investment portfolio for an institutional client. First, the client’s purpose of the portfolio – the reason it exists — must be assessed. Then, the specific objectives and constraints of the portfolio must be taken into account, to provide guidance for portfolio design. With this information, we can use the tools at our disposal to construct a strategic investment portfolio that addresses its purpose, objectives, and constraints. Finally, tactical decisions can improve outcomes at the margin.

When we assess a client’s portfolio, we start on the left side of this diagram and move rightward. We believe that strategic decisions flow from client-specific purpose, objectives, and constraints, and that tactical decisions should be pursued in service of those strategic decisions. We believe that tactical decisions cannot be properly made unless, and until, all of the other questions have first been addressed.

Another approach, favored by many investment advisors with different philosophies, is to start at the right side of the diagram and move leftward. We believe this is the wrong way to design a portfolio. Let us examine why.

“Tactics Win Battles. Strategy Wins Wars.” – Pierce Brown

We differentiate strategic from tactical decisions by asking whether or not they acknowledge and take into account the portfolio’s specific purpose, objectives, and constraints. If they do, then they are strategic; if they do not, they are tactical.

Let us illustrate with two examples of how a client might end up with the same 40% equity allocation in the portfolio:

  1. A strategic (left to right) process

The portfolio is an open defined benefit pension plan (purpose), meaning that future liabilities will grow with the sponsor’s employee headcount and with their wages (objective). A 40% equity allocation provides a hedge against this method of liability growth (strategic decision). We should choose manager “X” rather than manager “Y” to manage those equities (tactical decision).

  1. A tactical (right to left) process

Because the Fed will only raise rates twice this year, and because the unemployment rate is low, and domestic manufacturing is enjoying a renaissance, we believe that we know better than the market does that equities will rise over the coming year; therefore all our client portfolios should have 40% in equities (tactical decision). We think that this portfolio will suit an open pension plan (objective) because over time it has equity-like risk. We like manager “X” to manage the allocation (tactical). Next year, the data will be different, and so will our portfolio (tactical again).

While both portfolios ended up with the same equity allocation, we suggest that the first got there with methodical analysis – a strategic asset allocation plan that considered the client’s unique characteristics – and the latter got there by accident. The second approach may have been equally methodical, and it arrived at the decision to have 40% in equities for a variety of reasons, but none of them had anything to do with the client. The inputs to a tactical asset allocation strategy are fundamentally incompatible with customized, client-centric portfolio design. There is no room in a tactical asset allocation approach for input about the client portfolio – all of the input variables are related to market forecasts.

Situating Risk Appropriately

We believe that the importance of investment decisions diminishes as you move from left to right on the chart. Fully understanding a client’s return objective is going to affect client outcomes more meaningfully than the selection of US or European equities to fill the equity portion of a portfolio. Incorrectly measuring client risk tolerance tempts portfolio disaster, whereas selecting a sub-optimal rebalancing strategy risks mere discomfort. A left-to-right investment process works well in practice, because though client-specific portfolio purposes, objectives, and constraints can be difficult to tease out, they are fundamentally knowable. Investing within a left-to-right portfolio design framework concentrates the most impactful portfolio decisions where the inputs can be determined with the highest relative certainty. This is a strategy for placing the biggest bets where they are most likely to be rewarded.

Contrast this with right-to-left portfolio design approaches – made up of decisions that favor one security over another, or one market over another, or decisions based on political events or monetary policy. These decisions are based on inputs that are inherently unknowable and thus riskier, especially after considering that to succeed in making those decisions, one must not only be right, but more right than the market is. Starting with tactical decisions inappropriately situates the source of client/portfolio risk where it is least likely to be compensated.

In contrast to our preferred framework, where the most impactful portfolio decisions are concentrated in the most knowable areas of portfolio purpose, objectives, and constraints, a tactical asset allocation approach concentrates those risks where portfolio decisions are most unknowable and tenuous. While never easy, it is far easier, and therefore introduces less investment risk, to know a client’s liquidity needs and risk tolerance than it is to pick one market over another or forecast interest rates more correctly than the market does.

Tactical Scales, and Sells

Why do some practitioners employ a right-to-left process for allocating a portfolio? Because it’s easier! And more fun! And more profitable! Who wouldn’t want to skip past all the boring discussions of client liquidity tolerance, time horizon, and legal restrictions, and go straight to the fun part – thinking about relative valuations, politics, and the investment implications of whatever is in the latest issue of The Economist? And why take all the time to understand unique client needs when you can instead design a single one-size-fits-all tactical strategy that you can market to everyone?

This approach may work well for the advisor, but we are convinced it does not work well for the client. It occurs to us that tactical asset allocation is, fundamentally, a generic approach to investing, at dramatic odds with the client-customized approach we favor. If one’s investment process takes as its inputs things like congressional politics, or the level of the VIX index, or forecasts of economic growth rates in Asia, the process necessarily excludes any consideration of the client and the portfolio’s unique needs.

A tactical asset allocation “strategy” is not “strategic” at all, if we accept that strategy flows from client-specific objectives and constraints. It is, according to our diagram, as far removed from the client and the client’s unique needs as it could be.

Because of this, any tactical portfolio design approach carries the substantial risk of allowing the portfolio’s overall asset allocation to become inconsistent with its long-term objectives. Most portfolios have a long-term set of liabilities that the portfolio exists to match. If the tactical model indicates an allocation that deviates substantially from the expected return of these liabilities, not only does the model’s forecast risk being incorrect, but the portfolio risks underperforming the very liabilities it is intended to hedge. It risks neglecting the very purpose for which it exists.

Why Are Tactical Pitches Persuasive?

The world can be a scary place, and portfolios are very important to the clients that own or sponsor them. Innately, we want to believe that an uncertain world is knowable. We want to think that there are genius forecasters who know which direction the stock market will go this year, or how many times the Fed will raise rates this cycle, or how to invest a portfolio based on Asian GDP growth.

There may be some people who do know some of these things. In aggregate, however, forecasters are notoriously terrible. Study after study, most notably Tetlock’s landmark Expert Political Judgment, have proved predictions of the future of all types –weather, politics, and yes, financial markets – extremely unreliable.

Perhaps some tactical asset allocation strategies work. But put simply, we believe that portfolios should never be designed using inputs that are extremely unreliable.

Falling Apart Under Scrutiny

“We have long felt that the only value of stock forecasters is to make fortune-tellers look good.” — Warren Buffett

Despite all evidence, perhaps one reason that tactical investment approaches persist at the level of client overall portfolios is that clients who own them aren’t aware that they aren’t working. Tactical investment approaches are inherently difficult to benchmark. If the nature of an investment approach is to vary allocations between assets, it is very difficult to assess whether the manager has done a good job doing so, because the composition of benchmarks cannot incorporate the manager’s tactical decisions. It’s harder still to assess whether the manager has done a good job based on good luck or repeatable skill.

We suggest that quality of performance reporting is essential for monitoring the efficacy of any asset allocation program, tactical or not. We have seen many plan sponsors allow their advisor to propose or implement tactical decisions without a reporting structure in place to evaluate the outcomes of those decisions. In most cases that we have seen, the introduction of comprehensive reporting and attribution have revealed that tactical decisions at the portfolio level have subtracted, not added, value.

Tactical asset allocation strategies have existed in mutual fund form for decades. The following chart depicts the entire universe of “Tactical Allocation” funds, as reported by Morningstar, back to the universe’s inception in 1976. The gray area represents that fund universe. Although it is difficult to benchmark these types of strategies, we have compared them against a simple portfolio consisting of 60% global stocks (MSCI ACWI) and 40% US investment-grade bonds (Bloomberg Barclays Aggregate), represented by the blue line. Not a single tactical allocation fund has outperformed this simple benchmark over the long term. Nor did the universe of tactical strategies offer much portfolio benefit in any meaningful market decline – including 1998, 2000, or 2008– in their history.

Source: Sellwood Consulting, Morningstar Direct.

Additional challenges present themselves when considering tactical asset allocation programs for institutional clients. Not only does the analysis of any tactical portfolio decision have to be correct twice (on both the buy and sell, or sell and buy, decision – a very tall order), but the execution and evaluation horizon must be matched to the often-uncertain schedule of an institution’s Board and other governance structures. In our experience advising institutional clients, the disadvantages inherent in a tactical asset allocation (TAA) program at the portfolio level are most often too difficult to overcome.

Maybe, in Limited Doses

This is not to say that we do not find portfolio value in multi-asset portfolio strategies that allocate in ways other than with client-centered strategic allocations. In fact, we do find that client portfolios benefit from some of these approaches in measured doses. The fact that their approaches to asset allocation differ from our own provide benefit to the client in the form of diversification and risk mitigation. We have many clients who employ managers of multiple asset categories, in rotating or value-based allocation strategies that some might call “tactical” in nature.

But we maintain that these types of strategies would never be appropriate for a client’s entire portfolio, because whatever the inputs to their allocation – value, momentum, etc. – those inputs never take specific individual client circumstances into account. It is fundamentally inconsistent, and we believe impossible, to design a tactical asset allocation approach to offset a client’s specific set of liabilities. The liabilities themselves are never tactical, so therefore neither should the portfolio that hedges or offsets them.

Tactical may add value, but only at the margin. In our framework, it should be the last step of an allocation process, not the first. It should be the servant of a strategic allocation approach, not its master.

Back to Basics: A Client-Centered Approach

We do not believe in tactical management of client portfolios, at the plan level. Instead, we have had success recommending individual multi-asset managers to clients, to provide the overlay of a different allocation method to the portfolio, at a reasonable cost, and always in service of the broader strategic portfolio aim.

We note that our dynamic approach to asset allocation is designed to capture the same inefficiencies that a tactical approach purports to, only without the risks described above. Constructing a portfolio using realistic, well documented, frequently updated, long-term capital markets assumptions that are anchored in market fundamental forces (as ours are) delivers portfolios that change as markets do, but remain firmly connected to the essential, unique structures of each client and their portfolios. As well, a disciplined rebalancing approach, which we recommend to every client, takes advantage of shorter-term market dislocations or opportunities – much as a tactical approach might – without introducing the risks that a tactical approach would.

Ultimately, we believe that every portfolio decision – especially one as consequential as asset allocation – needs to take into account the broader picture of the client and their portfolio. The elements that make up this broader picture are not always readily apparent. They can be difficult to decipher. But uncovering them makes the difference between a portfolio that meets the client’s needs and one that only pretends to.

The work is harder, and the cocktail-party conversations less interesting, but the results are worth it.

Further Reading:

2017 Capital Market Assumptions

Note: These assumptions are now outdated. Our current capital market assumptions and our white paper documenting their construction can always be found on our Capital Market Assumptions page.

Sellwood Consulting’s 2017 Capital Market Assumptions are available. These 10-year forward looking assumptions of asset class return, risk, and correlation are the key input variables for our client asset allocation work.

Our process for creating the assumptions incorporates market-based information, so when markets move, our assumptions do as well. We revisit our forward-looking assumptions annually based on changes in underlying variables over the course of the prior calendar year. Over the course of 2016, we saw:

  • A rise in inflation expectations, which, all else equal, tended to increase our return assumptions across the board;
  • A flattening of the real (after-inflation) US Treasury yield curve, causing higher return forecasts for shorter-term fixed income and lower return forecasts for longer-dated bonds;
  • Higher valuations in the US equity market, as stock prices, especially in small cap, rose faster than earnings did; and
  • Relatively unchanged valuations in the international equity markets.

The following chart depicts Sellwood’s 2017 compound return assumptions, relative to those we created for 2016:

This year, we updated our methodology for assuming long-term earnings growth rates, a core building block of expected return, for all equity categories except US Large-Cap Equity. Our updated methodology provides us with higher confidence of the forecast because it relies more on relationships to US Large-Cap Equity, where we have more than a hundred years of robust data, than the absolute values implied by shorter data series. The methodology change contributed to lower return forecasts for US Small-Cap Equity (and consequently, US Equity) but a higher return forecast for Emerging Markets Equity (and Non-US Equity, Non-US Large-Cap Equity, and Non-US Small-Cap Equity). These methodology changes are outlined in detail in our white paper documenting the 2017 Capital Market Assumptions.

Presented in annual arithmetic average terms, our 2017 assumptions are depicted in the following chart:

Our assumptions continue to imply a prospective low-return environment for financial assets relative to historical averages. Further evidence of this environment has recently been highlighted by several credible industry researchers. Our assumptions are consistent with this analysis. Please also see our post, Realism in Forecasting, which explains our comfort with having forecasts outside the range of many of our peers.

Though we have made incremental enhancements to our methods for gauging the future value of assets, we have maintained our focus on the primary, reliable drivers of risk and return. Our assumptions are anchored in the empirical facts presented by long-term capital markets rather than speculative observations on recent market conditions. We avoid unnecessary complexity, preferring instead to rely upon transparent strategies that work reliably. Our analysis is comprehensive, but not complicated, because we are convinced that the most robust solutions have no hidden constraints and few moving parts. These same principles – pragmatic research and simplicity in execution – guide all of our work for clients.

We invite you to review our updated 2017 Capital Market Assumptions white paper.

Nick Woodward, CFA, joins Sellwood Consulting

We are pleased to announce that Nick Woodward, CFA, has joined Sellwood Consulting, as a Consultant.

Mr. Woodward had previously worked with Sellwood’s founders for more than five years at R.V. Kuhns & Associates (RVK), where he advised a broad spectrum of clients, including retirement plans, endowments, foundations, corporations, labor groups and tribal accounts. Like all of Sellwood’s consultants, he will also participate in the firm’s investment manager due diligence and research.

Mr. Woodward earned a Bachelor of Arts degree in Finance from the University of Portland, where he was an Entrepreneur Scholar, and he holds the Chartered Financial Analyst® designation.

You can download a PDF of a press release announcing Nick Woodward’s addition to our team of investment professionals.

Season’s Greetings

Every year, in the spirit of the Holiday Season, Sellwood Consulting invites its employees to research, nominate, and vote on one local charity to receive an annual donation on behalf of each of our clients. This year our employees elected to support Outside In‘s mission “to help homeless youth and other marginalized people become healthy and self-sufficient.”

Launched in 1968, Outside In now serves more than 10,000 people a year in Portland, Last year, Outside In successfully empowered 798 homeless youth to find stability, safety, education, and jobs. Graduates from its transitional housing program remained in stable homes with a 92% success rate.

Additionally, our staff spent one recent afternoon volunteering our time at Free Geek, responsibly recycling donated computers. Free Geek sustainably reuses technology, enables digital access, and provides education to create a community that empowers people to realize their potential.

If you are in the giving spirit this holiday season, we encourage you to learn more about Outside In, Free Geek, and the other worthy nonprofits we have supported.

Best wishes for a wonderful 2017 from all of us at Sellwood Consulting!

Celebrating CFA Success

Congratulations Ryan Fitzgerald, Associate, who was recently awarded the CFA charter.

The Chartered Financial Analyst (CFA) exam program is among our industry’s most rigorous and demanding. Additionally, according to the CFA Institute:

Earning the charter requires demonstrating four years of professional investment experience, committing to uphold a comprehensive code of ethics, and passing three levels of rigorous exams that test an advanced curriculum of investment management and analysis skills. This achievement takes multiple years of persistent effort and hundreds of hours of study per exam level.

Having accomplished all this, charterholders are tested and trusted professionals with the skill and insight to uphold high standards across the global investment industry and serve the best interests of investors and society.

Sellwood Consulting strongly supports our professionals’ continued intellectual advancement via the CFA program. All of our employees, CFA charterholders or not, adhere to the CFA Code of Ethics & Standards of Professional Conduct.

Thoughts on the “Brexit”

UK voters shocked the world last night by voting, in a surprise, to leave the European Union. The nation will be the first to leave the 28-nation bloc, of which it has been a member since 1973. The vote was followed by British Prime Minister David Cameron’s announcement that he will resign, and by global equity markets declining meaningfully. In the UK itself, substantial losses early in the day have partially reversed course, and in local currency terms the FTSE 100 index is up more than 2% this week.

In a flight to safety, both the US dollar and US Treasury bonds have posted meaningful gains. The 10-year Treasury yield briefly fell below 1.5%, its lowest level since 2012. The British Pound plunged to a 30-year low versus the US dollar, declining 6% in the first trading day following the vote. This decline represents the currency’s worst day in its history.

While the EU represents approximately 24% of global GDP, or total economic output, the UK represents only 2.4% of global GDP.

As of 12 pm pacific time, today’s returns for various indexes stood (all in US dollar terms):

MarketIndexLocal Currency Return Return in USDLowest Index Level Since (USD)
US Large CapS&P 500N/A-2.9%6/17/2016
US Small CapRussell 2000N/A-3.6%5/23/2016
Non-USMSCI ACWI ex USN/A-2.8%4/7/2016
Non-US DevelopedMSCI EAFEN/A-7.7%2/29/2016
United KingdomFTSE 100 (GBP) & MSCI UK Index (USD)-3.1%-11.1%2/24/2016
GermanyDAX (Euro) & MSCI German Index (USD)-6.8%-9.9%2/24/2016
FranceCAC 40 (Euro) & MSCI France Index (USD)-8.0%-11.4%1/20/2016
SpainIBEX 35 (Euro) & MSCI Spain Index (USD)-12.4%-16.1%7/24/2012
ItalyFTSE MIB (Euro) & MSCI Italy Index (USD)-12.5%-14.9%7/26/2012
Emerging MarketsMSCI EMN/A-6.0%5/24/2016
US Treasury Yield10-Year Treasury BondN/A1.6%6/16/2016

Note that the UK market has declined today only 3.1% in local currency terms, but after accounting for the British pound’s decline against the US dollar, the loss is magnified to -11.1%. Currency aside, the large magnitude of today’s losses in the UK and other European markets is substantially the result of unwinding the run-up that took place prior to the Brexit vote, as investors bet that the UK would choose to remain in the EU. The rightmost column in the above table shows that while today’s losses are significant, in most cases the indexes (with the notable exceptions of Italy and Spain) are merely reverting to recent levels.

The amount of market volatility suggests two things: first, that the outcome of the British vote to leave the EU was a surprise, and second, that market participants are still digesting the implications of the vote. While we are doing so as well, we offer a few points for consideration:

First, the vote itself does not trigger any immediate action to separate Great Britain from the European Union. The vote merely represents the will of a deeply divided nation to leave the EU. It will be up to the next Prime Minister, whomever that will be, to invoke Article 50 of the Treaty of Lisbon, which outlines a two-year procedure for a nation’s exit from the Treaty, and the European Union.

While markets were surprised by the vote to leave the EU, the process from here forward is more clear now that the decision has been reached. The terms of exit will be messy – they will be negotiated between Britain and its 27 EU counterparts, each one of them holding a veto – but the endpoint is more certain. Markets do not deal well with surprises, as evidenced by today’s volatility, but to the extent the political path toward Great Britain’s exit from the EU is less surprising than the vote itself, we expect markets to absorb that news in a more orderly way. The fact that no exit will occur for at least two years, and that any decisions made from here will be less dramatic than the decision to leave the EU, makes us believe that near-term volatility should subside.

The vote brings a cloud of tremendous economic uncertainty over Britain and Europe. Great Britain could very well fall into recession after withdrawing from its largest trading partner. Today’s declines in peripheral European countries suggest that their economies may be hit hardest. Markets, however, do not always follow economies. European markets entered this political crisis at deeply discounted valuations, some of which reflected broad uncertainty and the potential for events like this one in the region. The market losses associated with future economic losses may have already occurred.

Which is all to say that today is a dramatic day in the markets, but our sense is that future days will be less dramatic.

We have long advocated for globally diversified equity portfolios precisely because no single country or even region should dominate a portfolio’s returns. While today that global portfolio diversification is detracting from portfolio values, we believe the concept of geographic diversification remains sound. The world outside the United States accounts for 84% of global economic output (as measured by GDP) and 47% of global stock market capitalization. Political events cause near-term stress, but valuations win in the long run.

In late 1939, just after the outbreak of the second World War, the British Government formed a new department, responsible for publicity and wartime propaganda, and tasked it with an outreach campaign designed to boost morale across the country. Its campaign centered around a simple phrase: “Keep calm and carry on.” Wise words for today as well, in our view.

It’s No Secret: The Importance of a Defined Investment Philosophy

We would like to share with you our secret formula for delivering superior investment advice. Few other investment advisory firms share it, and most clients overlook its importance. This secret formula allows us to recommend better managers, avoid the common mistakes we see our peers making, and deliver client portfolios that regularly outperform their benchmarks and peers.

That secret is our defined Investment Philosophy.

All right, it’s not so secret. We developed our Investment Philosophy on our first day in business and it’s been publicly posted to our website ever since. While its content is not secret, though, what may be less obvious is why we have chosen to construct, document, and publish our Investment Philosophy. If that’s such a good idea, why doesn’t everyone do it? Why do so few investment advisory firms document their investment philosophy? And of those who do, why do so few of them publish it for the world to see?

Before revealing the mystery’s answer, however, let us explain why we believe that operating under a defined investment philosophy is so critical to our practice of delivering superior investment advice.

The Importance of a Defined Investment Philosophy

“Through discipline comes freedom.” -- Aristotle

First and most obviously, a defined philosophy imposes investment discipline on us. We have chosen to align our investment process with the principles that our experience and the accumulated body of academic research have proven to work. We know, for example, that a long-term focus is a sustainable advantage in investing. Having this principle documented allows us to organize our entire investment practice, from our capital market assumptions to our manager research principles, around a unified focus. It means that our research is internally consistent, and therefore positioned to inform better portfolios.

Furthermore, a defined investment philosophy brings consistency of advice to clients, and it ensures that our clients know what to expect from us. In investing, this is not a trivial concept: we know that every strategy will be tested, and even the best long-term portfolio can make the client and consultant look dumb — or worse — for uncomfortably long intervals of time. As we have written separately, the best investment strategy that a client abandons at the wrong time is inferior to an average investment strategy that the client holds for the long term. Clients need to understand their portfolios, and they can better understand them if those portfolios are developed under a consistent philosophy.

The best investment advice comes through long-term relationships between the advisor and the client, and these long-term relationships are only possible through consistency of thinking and recommendations. Clients are diverse, and organizations change over time. We believe, philosophically, that our primary objective is to craft customized portfolios for our clients that meet their individual objectives and constraints. In contrast to an off the shelf, model portfolio, a bespoke portfolio that is designed by an experienced advisor in a long-term relationship with the client gives that client the highest probability for investment success. But this approach carries risks – risks that the client’s Committee can change, that the person providing their advice changes, or that the advisory firm changes.

A defined investment philosophy guards against these risks. Operating under a defined philosophy means that whatever happens, our advice remains consistent. It guards against the temptation of chasing fads or listening to everyone’s inner market-timer voice. It leaves no room for excuses.

“If you don’t stand for something, you will fall for anything.” – Peter Marshall

We expect investment managers to show the same philosophical discipline we do. Our primary manager research database includes more than 19,000 distinct investment products on offer – about four times as many investment products as there are publicly traded stocks in the United States. In our paper Common-Sense Investment Manager Research, we documented a few of the traits that we prefer to see in active managers that we include in client portfolios. One of them is the manager’s clear understanding, and lucid explanation, of their own investment philosophy. We know that clients are best positioned for long-term success when they can invest with managers for the long term. This long-term focus confers a certain competitive advantage, but we can only have confidence that the great managers we recommend will remain great if they have a solid, grounded, stable world view. To invest with a manager that lacks one would be to set our clients up for failure in manager selection.

Operating under a shared set of research principles also serves as a filtering mechanism against the onslaught of strategies that managers are pitching to us every day. If our consultants and researchers can agree that market valuations matter, for example, we can choose to spend our research time on those strategies managed by people who understand and agree that they do. Investment managers who aren’t responsive to changing valuations may be excellent managers in their own right, but even the mere misalignment of philosophies introduces its own set of risks that our clients are not paid to take.

Advisory Baggage

Which brings us back to our mystery: why don’t more investment advisory firms document and publish their investment philosophies? We believe the short answer is that they don’t have investment philosophies, and they don’t want to have them. Firms that have been around long enough to have amassed hundreds of clients and turned over dozens of consultants or advisors have likely told those clients just about everything:

“Low fees are a proven driver of outperformance.”
 “The level of fees doesn’t matter as long as the manager outperforms the fees.”

“Focus on the long term.”
 “Back in 2008 we advised clients to change their allocations in response to the market.”

“Markets are efficient.”
 “Small-cap managers tend to outperform their benchmarks.”

Consultant A, to Client B: “This manager is an outperformer experiencing a rough patch.”
 Consultant C, to Client D: “You should fire this manager.”

For these firms, it would be impossible to adopt a defined investment philosophy that takes a stand on these issues without alienating many of their clients. They choose, instead, to continue to operate without a philosophy, hoping for the best. They have accumulated advisory baggage.

We prefer carry-on luggage, in the form of a simple, concise statement of what we agree that we know. Avoiding the potential for advisory baggage is why we adopted our Investment Philosophy on our first day in business, before our first client hired us. It would have been tempting to leave ourselves wiggle room on the hundreds of complex topics and questions that arise in the management of each client portfolio, but it wouldn’t be right. A stable and documented philosophy forces us to do the harder job of leading our clients rather than following them. It means that we can’t always tell our clients what they want to hear – but it also means that every client will hear what we really believe.

Moreover, we believe that transparency improves our investment process. While we could have chosen to document an investment philosophy and keep it private, we chose instead to publish it publically. Having our Philosophy (and our capital market assumptions, and all of our topical research) available for the world to see exposes our thinking to the rigors of public scrutiny. We are proud to sit in an academic tradition of peer review, and we believe that the investment questions our clients face are substantial enough to warrant a process no less serious. A statement of philosophy should not be “proprietary,” its inner workings secret. Only germs are killed by exposure to sunlight.

Publishing our Investment Philosophy on our first day does not mean that we stopped thinking about it after that first day; our thinking is always evolving. But the principles that underlie good investment advice and sound portfolios are relatively stable, and so too should be our interpretation of them. We set an appropriately high bar for altering our Investment Philosophy.

Solving the Mystery

It’s not a secret that the best advice is consistent and based on research, not opinions. If we were building an investment advisory firm from scratch, we would actively debate and settle our investment opinions, based on research and our experience, then document them, and only then advise our clients based on them — which is exactly what we have done. Our defined Investment Philosophy imposes rigor, discipline, and consistency to our advisory process, to the benefit of our clients’ portfolios.

Our defined Investment Philosophy is our “secret” formula only because it is so rare in our industry. The best explanation we can find for why most of our peers have not adopted one is that the weight of advisory baggage has become too cumbersome. To those firms, the idea of stable, consistent advice under the framework of a defined investment philosophy is too complicated to execute. That the simplest notion can be too complicated is the true mystery.

2016 Capital Market Assumptions

Note: These assumptions are now outdated. Our current capital market assumptions and our white paper documenting their construction can always be found on our Capital Market Assumptions page.

Sellwood Consulting’s 2016 Capital Market Assumptions are available. These 10-year forward looking assumptions of asset class return, risk, and correlation are the key input variables for our client asset allocation work, including mean-variance optimization, Monte Carlo analysis, and risk budgeting.

We update our assumptions annually. Over the course of 2015, we saw Treasury yields rise, and yield spreads for higher-risk fixed income rise as well. These two factors caused an upward adjustment to our return assumptions for fixed income securities, generally speaking. For US equities, a flat market in the face of higher cash returned to investors in 2015 provided for lower valuations, resulting in slightly higher return projections. Internationally, lower valuations were overwhelmed by a decline in earnings and their long-term growth rates, resulting in lower forecasted return.

The following chart depicts Sellwood’s 2016 compound return assumptions, relative to those we created for 2015:

A change in methodology for calculating a proxy for market-expected inflation meaningfully changed our return projections for cash equivalents and low-duration fixed income. For all asset classes, we have replaced CPI with Core CPI for calculations of expected inflation in periods prior to 2003, before a TIPS breakeven spread was published. We found that core CPI has been a better predictor of future inflation than has CPI. As with all fixed income asset categories, our forecasts imply a partial reversion to a long-term average real yield, and our updated methodology changed that long-term average. Due to their sensitivity to inflation, cash equivalents and low-duration fixed income were affected most by this methodology improvement.

Our assumptions continue to imply a prospective low-return environment for financial assets relative to historical averages. Further evidence of this environment has recently been highlighted by several credible industry researchers. Our assumptions are consistent with this analysis. Please also see our post, Realism in Forecasting, which explains our comfort with having forecasts outside the range of many of our peers.

Though we have made incremental enhancements to our methods for gauging the future value of assets, we have maintained our focus on the primary, reliable drivers of risk and return. Our assumptions are anchored in the empirical facts presented by long-term capital markets rather than speculative observations on recent market conditions. We avoid unnecessary complexity, preferring instead to rely upon transparent strategies that work reliably. Our analysis is comprehensive, but not complicated, because we are convinced that the most robust solutions have no hidden constraints and few moving parts. These same principles – pragmatic research and simplicity in execution – guide all of our work for clients.

Presented in annual arithmetic average terms, our 2016 assumptions are depicted in the following chart:

2016 Capital Markets Line

Sellwood Consulting updates its capital markets assumptions on an annual basis. Our 2016 assumptions reflect information as of December 31, 2015, unless otherwise noted. Our assumptions are forward-looking in nature and reflect a ten-year investment horizon.

We have comprehensively documented our methodology and process for creating these capital markets assumptions in our updated 2016 Capital Market Assumptions white paper.