The Risk and Reward of Rules-Based Investing
Experienced investors understand that achieving superior long-term investment results necessitate a strategic balance between risk and return. This requires a thorough evaluation of various investment approaches, and acknowledging both their inherent advantages and disadvantages. Institutional and retail investors alike must recognize the fundamental tradeoff: the pursuit of higher returns invariably involves accepting greater risk. However, we all understand this is easier said than done.
The Inevitable Tradeoff: Risk vs. Reward
Seeking maximum gains while minimizing risk can sometimes be an unrealistic expectation. A more prudent approach should involve a realistic assessment of risk tolerance and aligning investment strategies accordingly. Passive index investing, for example, offers market exposure with low costs but also necessitates accepting market volatility and the potential for substantial drawdowns during downturns.
Passive Index Investing: Advantages and Limitations
Passive investing in index-tracking ETFs provides benefits such as:
- Long-term market returns
- Participation in bull markets
- Diversification
- Low costs
However, it also entails drawbacks:
- Inability to outperform the market
- High volatility
- Significant drawdowns during bear markets
- Prolonged recovery periods following market downturns
Active Management and Strategic Allocation: Seeking Enhanced Performance
Active investment strategies aim to outperform passive benchmarks by strategically allocating assets. This involves making informed decisions about asset classes, sectors, or individual securities based on various analytical approaches. These strategies inherently involve tradeoffs, altering a portfolio’s risk-reward profile compared to a benchmark. It is crucial to rigorously evaluate whether the potential for outperformance justifies the associated risks and deviations from the benchmark.
A Tactical, Rules-Based Approach: Prioritizing Risk Management
At McElhenny Sheffield Capital Management, we advocate for a tactical, rules-based approach. Our strategies are designed to actively manage risk by adjusting market exposure based on predefined rules which may involve shifting to a defensive stance (e.g., 100% allocation to cash or cash equivalents) during periods of heightened market risk.
The Rationale for Tactical Management
Our approach is driven by two core principles:
- The Mathematics of Compounded Returns: Minimizing losses is paramount to maximizing long-term compounded returns. Avoiding substantial drawdowns allows capital to compound more effectively over time.
- Investor Behavior and Risk Tolerance: Many investors, particularly institutional investors with fiduciary responsibilities, are highly sensitive to significant losses. Our strategies aim to mitigate the risk of large drawdowns, enabling investors to maintain their investment discipline and adhere to long-term objectives.
Key Tradeoffs in Our Tactical Approach
We acknowledge the tradeoffs inherent in our tactical strategies:
- Potential for underperformance relative to benchmarks in certain market conditions
- Whipsaw trades and associated transaction costs
- Not always capturing all upside during strong bull markets
However, accepting these tradeoffs helps us in working towards our goal to deliver on our primary objective: protecting capital and enhancing risk-adjusted returns over the long term.
What’s Does It All Mean?
It means our tactical, rules-based strategies are designed to navigate these complexities, prioritizing risk management to achieve long-term results. We believe this approach aligns with the needs and objectives in today’s investing climate.
Contact Information
For further information about our tactical strategies, please contact Grant Morris (grant@mscm.net).
McElhenny Sheffield Capital Management (MSCM) is a registered investment adviser with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Important information pertaining to MSCM’s advisory operation, services, risks, and fees is set forth in MSCM’s current Form ADV Part 2A brochure, a copy of which is available upon request or at www.adviserinfo.sec.gov or www.mscm.net.
Past performance is not necessarily indicative of future results. Investing involves risk. Principal loss is possible.
There can be no assurance that the strategy will be implemented as designed, or profitable, or that clients will not lose money. The tactical strategies use a variety of market indicators and stop levels that seek to identify upward or downward trends in the U.S. equity markets. If an indicator or stop level fails to detect significant downturns in the market, the strategy will continue to be exposed to underlying positions that could lose value during such downward periods. Similarly, if the indicators fail to timely identify a reversal of a downward trending market, the strategies will continue to be exposed to defensive Exchange Traded Funds (ETFs) at a time when there is significant appreciation in the equity markets. Either scenario could result in the strategies underperforming other strategies that do not employ these strategies. There can be no guarantee the tactical strategies will correctly or timely identify the industries, sectors, or asset classes that will outperform during a given quarter or that the strategies will correctly or timely identify market trends. The tactical strategies invest in other investment companies and ETFs which result in higher and duplicative expenses. Investing in ETFs are subject to risks that the market price of the shares will trade at a discount to its net asset value (“NAV”), an active secondary trading market will not develop or be maintained, or trading will be halted by the exchange in which they trade. Brokerage commissions will reduce returns. Nothing in this presentation is intended to be relied on as investment, legal, or tax advice. Investors should consult their tax advisor or legal counsel for advice and information concerning their particular situation.