The streamlined passive portfolio design that seemed “good enough” in the post-2008 era started showing signs of fatigue a few years ago and then broke down when the Fed started tightening.
Suddenly the fixed income allocation wasn’t playing the defensive role we practically promised. Statistical limits bent and bonds flipped. And with clients feeling more than a little betrayed, there’s a sense that assumptions that failed once could fail again.
Meanwhile, the stock side had its own problems at the low end of its performance profile. Nothing inherently wrong with the random walk. It’s usually cheap enough and simple enough to do good enough under relatively normal conditions across the long haul.
But your clients just aren’t paying you to be a passive bystander buying and holding the same index funds as everyone else. When you eat, drink and breathe the index, that’s all you get.
While portfolios that mimic the broad market have their strengths, one share of SPY will always look and act just like all the others. There’s no exclusivity around pouring client money into the $500 billion pool.
And when there’s no exclusivity, it’s hard to add value much less claim you provide differentiated service. Any robot can buy SPY. If your clients are feeling even minimally motivated, they can do it themselves and cut you out of the equation.
Recommending generic index funds is no longer table stakes. It’s trivial. Like it or not, wealth management revolves around giving your clients more. You don’t just want them to end up with average outcomes.
You want them to win, one way or another. If they want higher returns, you want to allocate their investments to make that possible. And if they’re looking for a smoother glide path, you don’t want to strap them into a rollercoaster.
That’s what the efficient frontier is all about. When the core of the portfolio fails to satisfy the conditions you and your clients have worked out together, the models that built that portfolio have failed to correspond with market reality.
And once that core fails to live up to expectations, it’s hard to maintain confidence in its ability to do its job in the future. The solution: refine the models and build a new core that could have held up better.
We want to be able to tell our clients that we can learn from bad experiences and that we’re doing everything we can to avoid repeating a mistake. Hurt me once, shame on the market. Hurt me twice, shame on me.
A Stronger Core
But how do you escape the pull of the core equity benchmarks and the random index walk? One approach is obvious in hindsight: replace the stocks with a basket of options to shift the range of future outcomes up or down that efficient frontier.
Filling the basket and rolling the contracts is complicated stuff, which is why this modified core strategy was once restricted to private bank clients and institutional investors.
That’s it. Naturally, there’s a tradeoff because the upside capture is capped to compensate, but very few truly risk-averse investors are focused on squeezing every percentage point they can when the market is running hot. They’ll settle for a reasonable return in the good times and then feel great when the drawdown threshold kicks in.
The S&P 500 itself doesn’t change. The index is the index. The random walk continues. But you’ve given your clients a slice of that overall market cycle that better conforms to their preferences. You’ve actually made them happier.
Of course, other managers have developed different approaches to strengthening the core allocation. A lot of the cutting-edge managers I talked to are highly sensitive to the way SPY and its copycats have bifurcated into a few gigantic technology stocks (the “magnificent 7”) on one side and everything else on the other.
In their view, Big Tech has gotten too big for the rest of the market to resist its gravity. True diversification becomes challenging, especially if your clients are already overweight these companies. And if that makes you or your clients nervous, nobody truly sleeps well.
You might disagree with the fine points, but the market has clearly changed a lot since Burton Malkiel started pushing the passive approach as “good enough” in the long term. A handful of high-beta giants now loom over the random walk, skewing the risk-return characteristics the index reflected once upon a time.
Yes, it’s been a good ride. These stocks grew to their current scale through years of innovation and outperformance. But as vanilla funds get more concentrated, their innate volatility can become a trap for what’s now a $7 trillion system built around the S&P 500.
When something goes wrong at the top of the food chain, the impact is harder to diversify around. Think of it as a kind of style drift pushing the market as a whole closer to the NASDAQ and all that implies.
Either way, those who think the benchmark itself is broken would rather stack the core with different stocks, which for all practical purposes means this is how active security selection creeps back into the ETF universe.
Is alpha possible? You need to at least be open to it. Otherwise, why are your clients paying you?
We're going to be talking a lot about this here.
