Well, I won’t back down

No, I won’t back down

You could stand me up at the gates of Hell

But I won’t back down

No, I’ll stand my ground

Won’t be turned around

And I’ll keep this world from draggin’ me down

Gonna stand my ground

And I won’t back down

— I Won’t Back Down, Tom Petty

It is well understood that people with a

lower tolerance for risk

must accept lower returns than those who have a greater tolerance. By the same token, investors who are willing to bear more risk can expect to reap higher returns than their more conservative peers.

However, this does not change the fact that any rational person, regardless of their tolerance for risk, would prefer higher rather than lower returns given

the amount of risk

they are willing to take. Similarly, they would prefer to experience lower rather than higher volatility given their target rate of return.

This begs the question: For any given level of risk tolerance, what is the optimal path to achieving higher returns?

Live by the sword, die by the sword

Striving for performance that is far better than the norm constitutes a double-edged sword. Doing so can work out as planned, but it also exposes you to the risk of significant underperformance.

The long-term effects of oscillating between strong outperformance and strong underperformance are illustrated in the accompanying table, which incorporates the following data:

  • Monthly returns for the TSX Dividend Aristocrats Index ETF (the benchmark that S&P Global Inc. uses to evaluate dividend-focused Canadian equity funds) going back to 2008, which is the first full calendar year of the fund’s existence.
  • Monthly returns over the same period for an Alternator Fund that switches every 12 months between underperforming the index by five per cent and outperforming it by five per cent.

A symmetrical combination of well-above and below-average returns produces a long-term record that is characterized by

slightly lower returns

,

higher volatility

and larger losses in challenging markets.

The punchline is that managers who strive to consistently outperform by a substantial margin every year are highly likely to deliver subpar results over the long term.

Slow and steady wins the race

Legendary investor Howard Marks once recalled a discussion he had in 1990 with the director of a major Midwest pension plan. Over the previous 14 years, the plan’s returns in any given year had never placed below the 47th percentile or above the 27th percentile relative to its peers. Despite this seemingly uninspiring fact,

its portfolio ranked

in the fourth percentile over the entire 14-year period.

If you swing for the fences and attempt to be in the top five per cent or 10 per cent every year, you will fall victim to the double-edged sword, delivering long-term returns that are (at best) mediocre and that are accompanied by high volatility.

In contrast, if you deliver performance that is slightly above average on a realistically consistent basis with particular emphasis on outperforming in bear markets, your long-term outperformance will be substantially better than average, and you will be subject to lower volatility and shallower losses in challenging markets.

Outperformance stems from how often and by how much you outperform or underperform, as well as when you do so. With respect to long-term compounding and wealth creation, it is far more important to outperform in bad times than in good times.

The late Charlie Munger,

investment guru

and longtime Warren Buffett partner, said, “Invert, always invert.” This entails taking a given scenario and reversing it to evaluate the ramifications of the opposite scenario. He used this approach to manage risk by identifying what to avoid rather than what to seek.

Since its inception in October 2018, the performance of the Outcome Canadian Equity Income fund has consistently adhered to this pattern.

At times when the TSX Dividend Aristocrats Index has risen, the fund has, on average, participated in 85.3 per cent of these gains. Conversely, whenever the benchmark has declined, the fund has, on average, suffered only 67.7 per cent of these losses. In simple terms, our mandate has generally managed to capture most of the upside in the good times while avoiding a very sizable portion of the downside in bad times.

The accompanying table applies these attributes to historical data going back to 2008, which marks the first full calendar year of the Dividend Aristocrats ETF’s existence. In deference to Munger, the table also applies an

inverted strategy

that has symmetrically opposite attributes to those of the Outcome fund’s mandate.

More precisely, the inverted portfolio captures slightly more than 100 per cent of the upside in rising markets while suffering well over 100 per cent of the downside in falling markets.

Being favourably lopsided — that is, participating in the vast majority of rising markets while participating in approximately two-thirds of falling markets — leads to vastly superior long-term returns and far shallower losses in challenging environments.

In contrast, the inverse of these characteristics is nothing short of devastating, resulting in anemic returns over the long term while exposing you to extreme volatility and devastating losses.

Prior to launching the Outcome Canadian Equity Income strategy in October 2018, our machine-learning algorithms were learning the optimal path to achieving superior results over the long term. They concluded there was no feasible way to consistently outperform year after year.

Instead, they determined that the optimal path to delivering value over the long term necessitates consistency and focusing outperformance on declining rather than rising markets.

Accordingly, our mandate has consistently exhibited these very characteristics since its inception in late 2018.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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