What’s a good investment model?

By Raphaël Mennicken CFA, Chief Investment Officer of Covestor

When looking at the full range of investment models offered by Covestor, our clients naturally ask themselves: “So which are the good models, the ones I should seriously consider?”

The term “good model” will mean different things to different people, so I always encourage clients to pick models that match their personal objectives and outlook. But with an ever-growing number of available models, that itself can seem a daunting task.

I’d like to suggest a two-step process to build your portfolio.

But before delving into that, let’s take a quick look at how investment models generate returns. A model’s performance is the product of three elements:

1. Overall market conditions (for equity markets, bond markets, commodity markets, etc.)
2. The particular strategy used by the model
3. How this strategy is implemented – i.e., the model manager’s skill

Implementation of the strategy is entirely up to the manager, and overall market conditions are determined by a seemingly endless list of factors. As an investor, you have absolutely no influence on those factors.

However, as a Covestor client, you can improve the quality of your portfolio by choosing models with the most appropriate strategy, given your own objectives, risk tolerance and constraints, and given your view of market conditions in the medium term.

Step 1

Determine what strategy or set or strategies are appropriate for your investment goals and outlook. Some questions to ask: How aggressive/conservative are your goals? What sectors or asset classes are you interested in investing in? When do you expect to need the money invested? What’s your outlook for the economy and market?

Once you’ve defined the strategy or strategies you want to include in your portfolio, the selection of models becomes easier.

Step 2

Find good models that match your strategy or strategies. I’ll define a “good” model as one that performs better than what can be expected, given its strategy and also consistently sticks to its stated strategy.

To assess this, it’s important to understand the expected return of the model’s strategy. For example, some of our managers run equity strategies that typically amplify market movements in both directions – on the upside and the downside. So when the broad market is down, one should fully expect to see performance for such these models fall as well. In such cases, negative performance does not mean the model is “bad” – it was explicitly correlated to broad market performance.

Conversely, some models follow a strategy that makes them more resilient to broad fluctuations in the equity markets. This can mean that when equity markets are rallying, these models will rank low in terms of returns and may underperform models that are more closely correlated to market index performance. But again, that does not make these less correlated models “bad”.

So here are the two questions to ask for this step:

1. Has performance has been better or worse than what can be expected, given the chosen strategy?

2. Has the manager stuck to the stated strategy in terms of asset classes, concentration, securities used, etc.? If they didn’t, and outperformed, you can’t draw any conclusions as to why they performed well. It could have just been luck.

If you follow these two steps, you’ll end up with a shortlist of models that you can consider for inclusion in your portfolio. You’re now more than halfway to putting together your portfolio of Covestor models.

It is very likely that those models have different risk profiles, so your next challenge is to decide the dollar allocation to each of them, to match your own objectives and risk tolerance. We will cover that topic in an upcoming blog post.

We’re happy to help you work through your decision-making process, including both steps described above. Don’t hesitate to contact us for a no-obligation discussion about your investment goals – you can reach us right here (https://interactiveadvisors.com/get-in-touch).

~ Raphael