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Special Commentary | March 13, 2020

16 March 2020

Geremy van Arkel, CFA® | Principal

COVID-19 UPDATE

Geremy van Arkel, CFA® | Principal

History may not exactly repeat, but it does seem to rhyme

The impact and reaction that is occurring in capital markets due to COVID-19 is a classic “Black Swan/Fat Tail” event. We have managed portfolios through both September 11 and the Financial Crisis of 2008, and feel safe in saying that while what we are witnessing today is unique to the subject matter, the characteristics and market reaction to the phenomenon seem eerily similar to those we have witnessed before. So, here we are again: the tide is now running out fast, and panic selling is sweeping over capital markets, culminating in what will be characterized as the quickest bear market in history.

In general, investment risk comes in two forms, modeled risk and unexpected events, i.e., “Black Swan” or “Fat Tail” events. Modeled risks are factors that may impact capital markets where data and impact are known, where they have been modeled, and where they can be quantified- think unemployment, earnings, or Gross Domestic Product (GDP). Usually, changes in modeled risk have very little and/or temporary impact on capital markets’ prices, since they have already been factored in by millions of investors. Ironically though, most of what the industry wants to talk about are modeled or low impact risk factors.

Alternatively, it is “Black Swans” – those rare, unpredicted, and explosive events – that cause capital markets’ prices to move wildly. Capital markets’ pricing patterns seem to be rational and efficient, about 95% of the time. But for about 5% of the time, capital markets act irrationally and become unquantifiable. It is at those times, when prices, too, are chaotic. Fortunately, these events have historically been relatively short-lived. Unfortunately, though, they are very damaging, even if they don’t last for long. What we are currently experiencing is one of those times.

These rare events are the cause of modern bear markets, and they seem to rear their ugly heads with striking regularity. Each time the story is the same: no one sees them coming, no one predicts them, and by their very nature, “Black Swan” events are the first occurrence, so most investors don’t know what to do. However, due to the damaging nature and frequency of uncertain events, it would be wise for investment processes to at least acknowledge their existence and their potential occurrence, and to account for them in some manner. To ignore the reality of them, in the light of undeniable evidence of their power, will sooner or later be quite damaging to investors. In practice, though we drift and float with the rising tide of bull markets, the industry tends to forget about these events conveniently.

The potential for loss defines Frontier Strategies, and our entire investment process begins with and considers the potential for loss through almost every step. We are a risk first firm. We are risk-focused because we believe that investors’ first priority is risk management; that capital markets are inherently risky; and that if we can lose less during market declines, investors will come out ahead in the long run- or in the very least will stay investors.

Frontier’s primary definition of risk is the potential for loss of money. Internally, we have two risk goals for our strategies. The first is for each respective strategy not to lose more than the 12-month loss target for 95% of all 12-month periods. However, 5% of the time – or one 12-month period in 20 – during those rare but brief “risk explosions,” anything can happen. The second is for each strategy to outperform their respective benchmark for all 3-month and 12-month periods of loss. It should go without saying, too, that while we don’t like to experience loss, there are no guarantees of these goals being met.

Losses are a natural consequence of entering capital markets – you simply can’t be an investor if you are not willing to be exposed to some level of loss. As the industry is laid out today, there are three common approaches to risk management available to investors.

Get Me Out

The first is what I call “Get Me Out,” or what is more commonly known as the tactical approach. This approach is problematic in several ways. Firstly, to be able to consistently make large moves in and out of capital markets would require clairvoyance or some form of magic that just does not exist. To know exactly when to get in and out, and precisely what to buy or sell – over and over again – requires perfect knowledge, which no one has. Related to market timing is stop losses, which, too, have a major shortcoming. In practice, investors often get stopped out, and when markets abruptly recover, they end up experiencing the loss but not the gain. Further, in some years, investors can be stopped out more than once, compounding the loss for a no-gain problem. Ironically, it is the investor who is more fearful of losses that ends up experiencing the potential for permanent impairment of capital. Or, in the words of Jane Bryant Quinn, “The hall of fame for market timing is an empty room.”

Buy and Hold

The second approach is the strategic buy-and-hold approach, or “Time Will Save You,” and erase all of the damage that the periodic explosions of risk cause. Strategic investors accept whatever markets give them, and then they try to hang on for as long as they can. This approach, to us, fails investors in three ways. First, investors are human beings, most of whom can’t handle the “Fat Tail/Black Swan” risk. Secondly, this exposes investors to extreme sequence risk, and it doesn’t even work for investors taking distributions. The third and most glaring problem is that the longer an investor’s time horizon is, the more risk events they will be exposed to.

Control What You Can Control

The third approach to risk management comes to us by default because the other two methods either don’t work or don’t align with human nature. I call Frontier’s approach to risk management the “Control What You Can Control” approach. As investors, we often face difficult, multi-faceted problems, with limited knowledge in how to solve them. Often, there aren’t even clear answers to be found. What we do is rely on our decades of experience, our common sense, and our quantitative modeling to guide us. At each step in our investment process, we consider and attempt to reduce risk. Our asset allocation process considers risk by evaluating asset classes for their potential for loss. Asset class correlations, too, are considered during extreme market environments. Many of the mutual funds that we utilize in and of themselves are risk-managed or have historically experienced lower levels of loss. Frontier’s unique optimization process tests combinations of funds and is explicitly seeking to quantify the combinations that have experienced reduced levels of risk in the past. We have also developed and actively utilize a Market Anxiety Index that is specifically designed to reduce the risk in our entire process in the event of times like today when capital markets no longer act rationally. Like most grown-up decisions, we do everything we reasonably are expected to do: we utilize our thoroughly tested logical steps and use our decades of experience. Yet, there is always an element of chance.

Therefore, we are not return for risk takers, nor do we predict risk events, but we do acknowledge that risk events happen and account, as best we can, for their possibility. We seek to better understand and quantify risk and account for it in our process. And, ultimately, we want to capitalize on risk.

Risk happens –  it’s unavoidable – and the real damaging risks are unknown. Obviously, the longer your time horizon, the more likely events like these are going to happen. To put it differently: the longer an investor’s time horizon, the greater the need for risk management, and the greater their advantage if they are able to capitalize on poor market environments. We at Frontier believe you should have a plan. But how do you capitalize on risk?

First, you must accept that risk is a part of investing. Acknowledge that while you can reduce risk, you cannot altogether avoid it. If you can enter the inevitable poor market environments in a lower risk posture and avoid some portion of loss, you are able to capitalize on the unavoidable outcome of all bear markets; asset classes with high expected returns. In short, the less you lose when the losing happens, the more you have to invest in the great opportunities on the other side. Therefore, Frontier’s strategies aim for endurance – for the ability to endure multiple market environments. We particularly strive to provide outperformance during poor market outcomes so that we can take advantage of the opportunities that will be uncovered by the damage.

The silver lining in all of this is that for astute long-term investors, volatility can be a good thing. Sooner or later, capital markets’ pricing will calm down, and problems will be behind us. At that time, we will be left with lower asset prices – implying higher expected returns – and extremely low-interest rates. In other words: losing less can be seen as representing future purchasing power when applied at the right time.

Economic Impact of COVID-19

The current “Black Swan” appeared at a precarious time. Firstly, equity market earnings across the first world were already flat or slowly declining through 2019 and into 2020. Secondly, long economic expansions don’t always make businesses and consumers stronger. It could be argued that the longer an expansion, the more debt is accumulated, the more risk is accepted. And most importantly, this long expansion has likely been facilitated by low-interest rates, easy monetary policy, and debt expansion, which all result in arguably high asset prices. At times when asset prices are extended beyond sustainability, bad news tends to have a greater impact.

While quarantining may be good for your health, it is bad for the economy. The extreme quarantining measures that China has undertaken to control the spread of the COVID-19 virus have resulted in a severe decline in consumer and business spending. Quarantining seems to be our best option to stave off the spread of the virus and to protect ourselves from illness, but as more and more people stay home and out of society, this economic activity will drastically reduce.

As if the COVID-19 virus wasn’t enough, Saudi Arabia and Russia picked a fine time to get into an oil price war. The Saudis are effectively flooding the world’s oil supply in an effort to drive down oil prices and to put Russia out of business. Historically, the positive consequence of lower oil prices is far outweighed by the negative impact on U.S. energy-related businesses. While this is not a good economic outcome, it is hopefully temporary in nature.

These unexpected, non-modeled, or predicted events have resulted in global equity prices falling approximately 20% year-to-date. Simultaneously, interest rates have plummeted, leaving the benchmark 10-year Treasury yield below 1%. Investors, once again, run for cover in U.S. treasury bonds. Long-term treasury bonds have gained approximately 20% year-to-date, representing a 40% gain in future equity purchasing power.

In this ‘never recession‘ culture of ours, central banks and governments will certainly jump to and do everything they can to support the prices of risk assets in an effort to stave off the very personal impacts of an economic recession. However, it is highly probable that the first world has monetary policy exhaustion and that lower interest rates or printing money will have a limited short-term impact, other than signaling asset price support. Fiscal relief can come in the form of tax cuts, but, at least in the U.S., the big cuts have already been made.

Strategy Positioning

  • We are relatively light in stocks across the board in all strategies.
  • We implement our strategies using actively managed mutual funds, who, in their own right, can be conservatively positioned as well.
  • Bond positioning has mattered greatly during this decline, as corporate credit and higher yield bonds are showing losses year-to-date, but, conversely, long-term treasury bonds have gained approximately 20%. Our strategies currently hold limited credit exposure, and we hold positions in treasury bonds.
  • We are not currently adding to equity positions.
  • We will be initiating tax trading in our tax-managed strategies in the near future. At this point, global equity markets are in an all-out panic, or that 5% of the time “Fat Tail/Black Swan” type event.
  • It is possible, if not likely, that in the short-run, Frontier strategies will briefly lose more than their 12 month, 95th percentile loss targets.
  • For those clients that really are starting to get shaken up, keep in mind that our Capital Preservation, Absolute Return, and Conservative strategies are our least equity exposed strategies.

As always, and especially at times like this, I welcome further conversation. Please feel free to reach out to me, one of our investment managers, or your Frontier representative to set up a time to talk.


Past performance is no guarantee of future returns. Performance discussed represents total returns that include income, realized and unrealized gains and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses.
 Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice. Frontier obtained some of the information provided herein from third party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. Frontier’s use of external articles should in no way be considered a validation. The views and opinions of these authors are theirs alone. Reader accesses the links or websites at their own risk. Frontier is not responsible for any adverse outcomes from references provided and cannot guarantee their safety. Frontier does not have a position on the contents of these articles. Frontier does not have an affiliation with any author, company or security noted within.
 Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice.
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