Surf’s Up! Why We’re Paddling Into the Waves

The close of spring in the U.S. and the onset of summer usually brings much talk about extreme weather events, from hurricanes to heat waves. The financial markets are another fertile ground for extreme behavior.

It doesn’t take much digging to uncover examples of markets or assets exhibiting movement outside of their accepted norms. Here are a few as we enter July:

• The top five holdings in the S&P 500 now make up 27% of the index, the highest concentration going back to 1980.
• The outperformance of U.S. large caps (S&P 500) over small caps (Russell 2000) is now at its most extreme level since November 24, 1999.
• The outperformance of growth versus value is at its highest level since 2000 (Russell 1000 Growth versus Russell 1000 Value).

In these cases, most traditional methods of portfolio management have little opportunity to adapt to these realities because these events are inherently difficult to predict. Our brains tend to minimize the likelihood of outlier events, especially when using historical data as a guide. At best, a traditional management approach might approach these extremes by ignoring them, assuming that extremes will neither cause damage nor be worth the upside. At worst — and we believe this is the more typical reaction among the public — an investor might attempt to react on the fly without a tested process, resulting in emotional (i.e., irrational) decision-making.

We believe a strength of a trend following approach like the systematic investing process we use is the ability to adapt to extremes. By focusing only on price, our strategies seek to accomplish what Munger illustrated in the quote above: catch even extreme waves and surf them. We do not attempt to predict where a wave will occur. Rather, we try to put ourselves in a position to react quickly and enjoy it as long as it lasts. We may hold significant exposure for years and then ignore an asset, or we may enter and exit quickly. There is no emotional connection either way. We view all assets simply as the instruments to which we apply our rules, with our aim being to help investors reach their financial goals.

Evidence of this approach can be easily illustrated in our current and historical holdings. Our portfolios continue to overweight the top-weighted stocks in the S&P 500 while also overweighting U.S. equities generally and growth names in particular. Value, income, real estate, and fixed income instruments of any duration remain underweight.

Most of the clients we partner with tell us they value the way our strategies adapt to market movements. But occasionally we endure some criticism for taking certain positions or for holding too long. We acknowledge there can be small costs associated with our investing style, but the tradeoff is the ability of our strategies to take advantage of extreme events by leaning into exposure for outperforming assets.

In our opinion, the benefits of consistently capturing a greater percentage of outlier trends far outweigh the small cost of holding assets that have yet to sustain material trends. There is little cost to riding a wave that doesn’t materialize if you have a process for hopping off and catching the next one.

In fact, let us take it a step further and say we couldn’t do one (catch the extreme events) without the other (ride a few waves that don’t materialize). While other asset managers might tweak their trading rules in an attempt to weed out lower probability trends, we think that at some point a model can become overfit. In other words, to catch the big waves, you sometimes have to paddle for the smaller ones that look promising but don’t always swell up.

As we enter the height of vacation season in the U.S., we hope you and your families can enjoy some time outside in great weather with few extremes. We also hope you are able to surf some waves — whatever that looks like in the context of your life— while relaxing and having a memorable summer. The team at Blueprint Financial Advisors will continue to keep watch on your portfolios and diligently execute the strategies that help us catch and ride the market’s various movements.