“Good Ideas Can’t Be Scheduled” is the title of a 2019 blog post by Morgan Housel of Collaborative Fund. His point was that deadlines shouldn’t be placed on good ideas, regardless of field, but the execution of good ideas is the opposite.
One of Blueprint’s best “good ideas” presented itself just like that – unscheduled – at a daunting time, during the height of pandemic-fueled market uncertainty. But we felt it would create clear advantages for financial advisors and their clients, so we got to work executing our plan.
Unwrapping the Index to Overweight Strength, Underweight Weakness
Our big, new idea involved rolling out one of the largest enhancements to our investment process since inception. Specifically, we wanted to start utilizing individual stocks in our portfolios instead of a basket or index. This shift was born of a simple question:
If trend following the index is a highly effective approach, would it be more effective to break apart the index and apply this same method to its underlying constituents?
The answer, based on our research, is unequivocally yes; unwrapping an index and applying trend following to the individual securities produces substantially better results over the long run.
We have always utilized trend following as a means of systematically and objectively allocating capital. By its very nature, trend following methodically shifts exposure to stronger performing asset classes and away from those experiencing weakness. In doing so, this process is designed to cut losses quickly and allow positive trends the room to persist. This loss-reducing mechanism is vital to long-term compounding. As Irving Kahn put it, “Considering the downside is the single most important thing an investor must do.”
This is the basis for our allocation-based strategies, which are diversified across global asset classes and shift exposure from weaker to stronger assets based on price trends. Our track record and research provide considerable evidence of the wisdom in this approach when applied at the asset class level, due to its ability to improve risk-adjusted returns and help advisors reach client goals. But, as Housel reminds us, good ideas are one thing, executing on those ideas is entirely different.
2020 Case Study: Capitalizing on the Distribution of Equity Index Returns
To illustrate this point, advisors must look no further back than 2020.
Simply trend following the S&P 500 (ETF: SPY) using the Blueprint process produced a solid risk-adjusted return by sidestepping much of the drawdown experienced during the Coronacrash. However, when trend following was applied to the individual constituents of the index, both the risk-adjusted and absolute returns were superior.
To demonstrate the potential appeal of a strategy that cuts poor-performers and holds tightly onto the leaders, the graph below shows the distribution of 2020 returns for each component of SPY.
While 2020 presented a wider than usual dispersion in annual returns, the historical distribution maintains a similar shape in that the index mostly consists of stocks that deliver close to the average return, but with significant outliers on both tails. For example, 2020 resulted in 54 stocks in the index delivering greater than 50% gains, while 42 stocks fell by 25% or more. The opportunity in 2020 rested in the fact that some sectors, like Technology, performed excellently and were barely interrupted by COVID. Conversely, Energy suffered coming into the crisis, and the negative performance was only exacerbated by the pandemic.
A Longer-Range View
The following table also illustrates the point, but over a longer time period.
Using a trend following approach at the individual stock level accounts for distribution of returns in a way that an index cannot by remaining invested (or even increasing exposure) to stronger assets, while staying out of weaker components.
At this point, an astute advisor may ask, "Why not simply apply trend following to sector-based ETFs rather than individual stocks?" We concede this is an option, but view that approach as only going from the 10,000-foot level to 5,000 feet because it doesn't account for potential distribution of returns within each sector. Said another way, it's taking a hatchet to the problem, whereas unwrapping the index allows scalpel-level precision.
The result can be an even more enhanced experience in terms of returns and managing volatility for both the advisor and client.
Holding Individual Securities Creates More Opportunity to Harvest Losses for Tax Alpha
Under the current tax laws, trend following is an inherently tax-friendly approach to investing because it sells losses quickly and holds winning positions indefinitely if the trend doesn’t change. While the market will always rightfully dictate Blueprint’s exposure in a given year, during most environments our processes will allow us to produce a tax-aware outcome because our systems are generally designed to produce tax alpha by harvesting short-term losses and maintaining exposure to winning positions.
Trend following at the index level wouldn’t allow for opportunities to harvest losses within the index constituents.
Once again, 2020 provides examples of this phenomenon. Sales made due to downtrends observed leading into or during the initial pandemic-related declines had the potential to produce losses, while positions held during the same period continued to move towards long-term gain territory.
As we move nearer to the conclusion of 2021, there has been very little change in trends across equity indexes and any that we have seen are typically conducive to loss harvesting.
Unwrapping the Index & Shining Light on the ‘Black Box’
To wind down this topic, let me close by saying that unwrapping the index also fits well with Blueprint’s core value of transparency. A big motivation behind the founding of our firm was our dissolution with the “black box” that surrounds many systematic investing models.
By applying our trend following discipline to individual stocks, it furthers our commitment to transparency.
Transparency breeds confidence in the way that “showing your work” did for your algebra teacher. It is one thing to say you have a great investment strategy, but a trustworthy manager need not fear showing why; our single-stock approach shows why at a very detailed level.
If you'd like to further discuss Blueprint's approach to trend following individual securities, please reach out; we'd be happy to share more details and our research.