The trend is your friend and every trend will end
Stock markets are arguably in the longest bull market run in history - the saying “the trend is your friend and every trend will end” is a cognizant reminder that we may be in a late stage expansion of this market. In the background of quantitative easing and global debt build-up, we have chosen not to become complacent. Carbon Wealth we are expecting significant market volatility and have positioned the portfolios as such. While some managers may be outperforming over the past year, they could likely get caught off side as central banks run out of options, and interest rates come to almost zero.
The strong US equity returns of the first half of 2019, has contrasted with a potential warning signal from the bond markets of falling yields providing a mixed message. The reason for the strength may just be a rebound from Q4 2018 oversold conditions, and expectations of further loose monetary policy from the Fed. 
European equity returns are no longer linked with historical drivers, and the underperformance can be explained by significant political uncertainty and weak corporate returns. We expect intermittent returns which combined with the highly cyclical nature and mature section composition of European equities provides a weak outlook. 
We believe income generation, is an increasingly important factor in portfolio construction with U.S equities yielding under 2%, there is a need to look outside core asset classes to achieve a growth rate over 4%. Ideally, we look to measure performance on a risk-adjusted basis, which is a technique to measure and analyze the returns on an investment so that an individual can make an informed decision on whether the investment is worth it with all the risks it poses to the capital invested. Commonly used risk-adjusted metrics include Maximum Drawdown and the Sharpe Ratio.
Measuring investment return and maximum drawdown over a full market cycle significantly improves the assessment of portfolio performance - several reasons maximum drawdown is an important metric:
- Drawdowns must be fully recovered before the portfolio can return to growth.
- Investors approaching, or in retirement, might not have the luxury of the time required to recover losses.
- Drawdowns are a key measure of the portfolio manager’s effectiveness in controlling risk.
On an absolute return basis, we also outperform most peers seen below with a significantly reduced drawdown.
The Sharpe ratio is a risk adjusted metric widely known in the industry - helps us measure the risk/return tradeoff. The ratio is the equity-risk premium divided by the standard deviation (volatility), which provides a better measure of how much return we derive from every unit of risk taken. The higher the ratio, the better the risk-adjusted return you will have on the chosen investment.
Since inception our volatility (or standard deviation) has also been significantly lower than benchmarks and peers. Carbon portfolios continue to outperform benchmarks on both a total return and risk adjusted basis since inception. While the trailing 1-year Sharpe ratio has been lower than usual due to uncertainty in the equity markets, our since inception Sharpe ratio across is around double the benchmarks.
Diversification & market cycles
Carbon Wealth aim to build a portfolio with alternative investments that can profit during a recession. Additionally, an allocation to a high grade fixed income investments can remove some systematic risk. By diversifying the portfolio construction across multiple asset classes worldwide with less than correlated cross-sectional allocations. Evidence has shown with this approach, that it is possible to achieve models that perform well in real-time, achieving equity like returns with bond like volatility and drawdowns.
Also, we should look to measure market returns over a full market cycle - as absolute returns only tell half the story during a bull market. No performance appraisal is complete without a complete assessment of risk over full market cycles, as this significantly improves the portfolio performance. 
The key metric in diversification that advisors use is correlation, i.e finding assets or classes with low correlation to common equity or bond markets. However, correlation is not the whole picture and the benefits of diversification have been called into question recently, as during times of market stress correlations can break down leaving investors anxious. If we define periods of market stress over the last 20 years when the VIX reading is in the top decile, correlations between stocks and bonds have been marginally positive. Therefore, at the time when investors most need to diversify risk, the diversification overs no benefit.
As investors need to navigate the later stages of this cycle, diversification will become more critical, and to achieve a proper diversification, we need to think deeper than the traditional ‘stocks vs bonds’ paradigm. An increased emphasis on alternative investing – is increasingly important at this stage in the cycle for diversification benefits, compared to the traditional portfolio stock/bonds composition.
Andreas Kettemann, one of our financial planners, has a wealth of experience with investing, and he is someone I'd happily recommend. Reach out if he can help.
08 6381 2404
The carbon model portfolios are a hypothetical blend of actual managed funds that have reported monthly net performance during the period shown. The model allocates to managers in a strategic asset allocation (SAA) that meets advisor risk profile requirements for clients. The SAA has been fixed for the entire hypothetical track record and rebalances each year to maintain consistency. All managers have been rigorously scrutinised by Carbon and are a targeted constituency of the firm's due diligence process. The performance data presented is a composite return of funds from 2004 onwards. Some funds do not have a performance record for the entire aforementioned period. In these cases, relevant benchmarks are utilised as a proxy for those funds, which keeps the integrity of the SAA entire composite performance. This process removes sampling and some survivorship basis over the hypothetical performance. Please note the portfolio represents a composite of funds and performance may vary from actual accounts based on account management and independent allocation requirements. These reports are a proxy for actual account performance. The report is gross of advisor and platform fees. All fund and benchmark monthly return numbers are extracted from Morningstar (https://www.morningstar.com.au/) or the fund and benchmark provider directly. Please note that relevant benchmark returns are added to the track record of funds that don't start prior to 2004.