pinnacle's dynamic quant strategy · that the core dmg portfolio has also...

Pinnacle'sDynamicQuant

Strategy

| Pinnacle's Dynamic Quant Strategy | www.pinnacleadvisory.com

Revised 2/2015

www.pinnacleadvisory.com | Pinnacle's Dynamic Quant Strategy | 1

The Dynamic Quant Strategy.The Dynamic Quant strategy uses Pinnacle’s Dynamic ModerateGrowth (DMG) portfolio as the core, and then adds on a purelyquantitative satellite allocationof theportfolio. TheDMG’s activelymanaged core portfolio is 62.5% of the total portfolio, while thequantitative satellite allocation makes up 37.5%. This fixed alloca-tion to the strategies within the portfolio allows investors to takeadvantageof thebenefitsofferedbyDMGandQuant,whilemitigat-ing the risks of both.

DynamicQuant is a one-size-fits-all approach to investing.At ‘neu-tral’ the portfolio is benchmarked to a 75% equity and 25% fixedincome benchmark. We believe this tilts the portfolio to a growth-orientedmission and is suitable for investors who need capital ap-preciation as a basic objective of their portfolio. However, both theDMG and the Quant allocations of the portfolio are actively man-aged. The DMG targets a 60% allocation to equity at neutral and atvaluation extremeshas historically reduced risk by asmuch as 50%of the benchmark target. The 37.5% of the total portfolio allocatedto the Quant strategy can go100% to cash. As a result, whenPinnacle analysts are bearishand the quantitative rules dic-tate that the allocation goes tocash, the overall portfolio couldhave a total allocation to risk as-sets of less than 20% of the total(or even less, depending on howbearish theDMGportfolio is po-sitioned).

In bull markets the opposite is true. If the DMG core portfolio isbullishly positioned and the allocation is 50% above the 60% risktarget at neutral, then the total portfolio, including the Quant allo-cation, could be invested upwards of 90% in equities or other riskassets. The ability to rotate from as much as 90% equity to as littleas 20%equity gives theDynamicQuant portfolio the unique abilityto serve the needs of both growth investors in bull markets andconservative investors in bear markets.

What is "Quant"?Quant or “quantitative analysis” is a sophisti-cated method for making investment deci-sions. Where traditional investment decision-making is based on the analytical skills andsound judgment of investors, a quantitativeapproach uses mathematical rules to makedecisions about portfolio construction.

The benefit of this approach is that it’s immuneto the fear and greed that often influences thehuman participants in the financial markets. Itis a scientific fact that humans are geneticallyprogrammed to make decisions emotionally.Behavioral psychologists tell us that humansare subject to many biases and heuristics(short cuts or rules of thumb) that can lead tosystematicmistakes inmaking investment de-cisions.

Quantitative decision-making takes the emo-tion out of investing. It substitutes the power ofcomputer algorithms to sort through moun-tains of confusing and often conflicting data.As a result, those who use it are able to findinvestment opportunities that are often sweptaway by the ‘madness of crowds’ and theemotions of the moment.

2 | Pinnacle's Dynamic Quant Strategy | www.pinnacleadvisory.com

How we manage risk.The freedom to reshape the asset allocation of a portfolio changeshow risk is typically managed. The traditional method involveschoosing abenchmark for theportfolio that has awell-defined allo-cation to risky assets — typically stocks, commodities, and real es-tate. By pre-setting the target, the manager can forecast portfolioreturns and volatility based on the past performance of those riskmarkets. In theory, as long as the manager owns the target assetallocation, the client can use past results to plan for future returns.Recent history has shown the danger of this approach.

At Pinnacle, we are not constrained to buy and hold a single assetallocation that is presumed to be efficient in all market conditions.Instead,we target a rangeof volatility for eachof ourportfoliomod-els, allowing our analysts to select only those classes that offer ourclients the best value. The volatility targets for our portfolios aredetermined by the historical volatility of their specific benchmarkportfolio. By changing the investmentprocess to include thenotionofevaluatingthevaluecharacteristicsofassetclasses,wereducetherisk that markets can misbehave over long periods.

Pinnacle offers a range of portfolios, and we establish the volatilitytargets for each by back-testing different benchmark portfolios toestablish a base range. For example, the volatility of our DynamicUltra Appreciation (DUA) portfolio is comparable to the volatilityof a portfolio with 72% S&P 500, 20% MSCI EAFE Index, 6% DJUBS Commodity Index, and 2% 3 Month T-bill Index, even if theDUA portfolio actually owns a different asset allocation than thebenchmark.

At any point in time, depending on how we view the weight of theevidence (basedonour research),we can increaseor reduce volatil-ity relative to our portfolio benchmarks. These changes allow us toreduce portfolio volatility in anticipation of bear markets, or in-crease volatility in anticipation of bull markets. In all cases, assetallocation changes aremade incrementally.While our analysts arefree to find the best value propositions anywhere in theworld, theyarenot free to turn a conservative portfolio into an aggressive port-folio with high amounts of potential volatility.

Our SafeguardsWebelieve the solution to the problems of buyand hold investing is active portfolio manage-ment. However, active management has itsown unique set of concerns. We change ourportfolio construction based on our researchand analysis of what asset classes offer thebest value, but we can never be sure in ad-vance that our view is correct. Unless an ana-lyst really can see the future, thebest he or shecan do is assign probabilities to future eventsand then allocate the portfolios based onthose probabilities.

Of course, like everyone, we sometimesmakeforecastingmistakes. That’swhywedesignedour investment process to include a series ofsafeguards that prevent major errors.

» We make investment decisions as a team.Our strategy doesn’t depend on a single su-perstar manager who might go on a coldstreak and make a series of investment blun-ders.

»Weuseaweight-of-the-evidenceapproachto decision-making that requires a significantmajority of factors in reaching investment con-clusions. This helps defend against the possi-bility that dogmatically following any one fac-tor will lead to an incorrect conclusion aboutthe markets.

»Wefind investment valueusing fivedifferentmethods, which defends against the possibili-ty that any one method might give a false sig-nal.

» Wemake decisions using both quantitative(rules-basedmathematical models) and qual-itative (judgment, experience and intuition)methods.

» We typically make only small, incrementalchanges to portfolio asset allocations, believ-ing that sudden, major shifts put our clients’money at risk.


Aggressive StanceThis hypothetical illustration showsthe Dynamic Quant portfolio whenthe strategy has an overweight tostocks and underweight to fixed in-come. Assuming that the core Dy-namic Moderate Growth (DMG)portfoliohasalsobeenpositionedag-gressively, and assuming that Pinna-cle analysts position the portfolio eq-uity exposure to 1.33% of bench-mark, then the fixed incomeexposurewould be reduced to 12.5%, and theequity exposure would be increasedto 87.5% of the total portfolio.

Neutral StanceAt neutral market conditions, the Dy-namic Quant strategy is bench-marked to 75% equity and 25% fixedincome. The portfolio allocation to thequantitativemodel is fixedat 37.5%ofthe portfolio and is 100% invested inU.S. equities (unless the model sellsequities and buys cash or bonds). Atneutral the core DMGportfolio is 60%equity and 40% fixed income. Com-bined with the Quant positions, theequity allocation is 75% of the totalwhile the fixed incomepositionmakesup 25%.

Defensive StanceThis hypothetical illustration showsthe Dynamic Quant portfolio whenthe Quant allocation sells stocks andinvests in cash or bonds. Assumingthat the core DMG portfolio has alsobeenpositioneddefensively, andas-suming that Pinnacle analysts posi-tion the equity exposure to 50% ofbenchmark, then the fixed incomeposition would be 81.3% of the totalportfolio and equity exposure wouldbe reduced to only 18.8%of the port-folio.

The Dynamic Quant strategy will always be investedsuch that 37.5% of the total portfolio is in Quant. TheQuant allocation rotates between ten U.S. equity sec-tors and fixed income,dependingonhowthequantita-tive model evaluates current market conditions.

The quantitative rules are designed to evaluate U.S.equity sectors on twodifferentmetrics–valuationandmomentum – where valuation is given a much higherweight thanmomentum in the overall decision. Equitysectorweightings are tied to each sector’sweight in theS&P500 Index,where the allocation canbe asmuchasIndex+15%,Index,or Index-15%.Since themodelwillnot short a sector or actually own a negative sector

weight, the result is that the Quant allocation of theportfoliowill typically own4 to8of thebestU.S. equitysectors at any one time.

The Quant allocation utilizes a methodology that willsell all U.S. equity sectors and move to either cash orbonds, depending on whether the trend in the broadindex is intact or broken (determined by a range oftechnical indicators). In this case, all sectors are soldand will be allocated to either U.S. bonds or cash, de-pendingon thecurrentmarket environment.The rulesfor going to cash create a binary decision where theQuantallocation is either fully invested inU.S. equitiesor is fully invested in cash or bonds.

Under the hood.


At Pinnacle, we change the allocation of our portfolios based on our fundamental beliefthat asset classes will earn the best returns when we buy them at prices that representgood values. But whatmakes an asset a "good value"?We use five differencemethods todetermine that.

The economy and financialmarketsmove in a never-ending pattern of economic expan-sion to economic contraction, and back again. When the economy is expanding, riskassets like stocks, commodities, and real estate tend to earn their best returns. On theotherhand,when theeconomy is contracting,non-riskassets like cash, bonds, andotherstrategies with low volatility tend to outperform and protect investors from steep de-clines. The challenge is determining where we are in the cycle at any given time.

Pinnacle analysts look at more than 100 economicindicators each month and pour through stacks ofindependent investment research to determine ifthe economic trend is about to shift. In practice,financial markets tend to move in advance ofchanges in the economy, so the ability to forecasteconomic adjustments is critical.

Technical analysts believe that the behavior of in-vestors offers the single best insight into the cur-rent state of the markets. Instead of studying fun-damental indicators like interest rates, profits, in-flation,monetaryand fiscalpolicy, technical analy-sis examines the movement of security prices.

What is the trend of the market? Are prices over-soldoroverboughtand likely to revert to themean?Are there divergences between different sectors ofthe market? What do investor sentiment surveystell us about investor attitudes? What does thetrading volume tell us about investor enthusiasm?These are the questions of technical analysis.

1.Determining themarket cycle

2. Technical analysis

Market Cycle

Technical Analysis

Traditional Valuation

Quantitative Analysis

Buy Side Research

The five building blocks of Pinnacle's


The most famous value investor in the world is Warren Buffett, and his investmentstrategy is to buy abusinesswhenhebelieves themarket has underpriced it.Whenvalueinvestors purchase a stock—or in our case, an asset class— at a steep discount to its fairvalue, they feel theyhaveabuilt-inmarginofsafety thatprotectsagainstmarketdeclines.Weusemany of the tools of traditional valuation analysis in ourwork, including earningand non-earnings-based ratio analysis, competitive methods of value (like comparingdividend yields to interest rates), andmeasures of intrinsic value (like Tobin’s QRatio).

Pinnacleutilizes aproprietarymodel that scores avarietyof valuation techniques tohelpus find value opportunities.

3. Traditional valuation

Pinnacle integrates numerous quantitative models in the decision making process forourportfolios. In-housequantmodelsareused toassess implied futureportfoliovolatili-ty, market valuation, the U.S. business cycle, and more. In addition, we utilize severalthird-party sources of quantitative analysis.

Quantitative decision making is a necessary balance to qualitative, subjective decisionmaking. We believe that the combination of "rules-based" quantitative analysis andsound judgement, experience, and informed intuitionmake a powerful combination forsound portfolio construction.

4. Quantitative analysis

Pinnacle supports our investment team with the best ‘buy side’ institutional qualityresearch. Buy side research is not biased because the firms that sell it do not also sellinvestment products. Pinnacle analysts follow many different institutional researchfirms and notewhen they agree and disagree aboutmarket issues.When our reads forma consensus, it becomes a significant part of our decision making process.

5. 'Buy side' research

proprietary investment process.


Here at Pinnacle, we're always trying to beat ourbenchmarks and earn excess returns for our clients.Our first strategy for doing so is to change the over-all asset allocation of the portfolio with the inten-tion of making significant changes in its volatility. As-setallocationtradeswould includesellingriskassets infavor of less risky asset classes to defend against a bearmarket. Selling stocks, commodities, or real estate toown bonds or cash are classic changes to asset alloca-tion that have a major impact on portfolio returns.Conversely, buying stocks, commodities, or real estatefrom cash or bonds in anticipation of a bull marketsignificantly increases our ability to makemoney dur-ing those periods.

Our second strategy for earning excess returns is toutilize sector rotation in our portfolio construc-tion. Instead of selling stocks to own bonds, we mightsell more volatile sectors of the stock market to ownmore defensive, less volatile sectors. These trades oc-

cur in both the equity and fixed income sectors of theportfolio and are utilizedwhenPinnacle analysts wantto make more subtle changes to the portfolio's riskcharacteristics.

We're also able to earn excess returns through securi-ty selection. Pinnacle analysts first decide what kindof security to invest in — an exchange traded fund(ETF) or a mutual fund. They must then determinewhich ETF or mutual fund to buy. The answer oftendepends on our analysis of a particular manager ormarket sector.

We typically use ETFs when we feel we have enoughresearch tomake good investment decisions using ourin-house resources. On the other hand, we usemutualfunds when we need to 'hire' a fundmanager to investin a particularmarket or specific strategy. Security se-lection can have an important but subtle impact onoverall portfolio returns.

How we can earn excess returns.

Telecommunication

Health Care

Staples

Utilities

Financials

Technology

Discretionary

Materials

Industrials

Energy

SectorRotation

EXPANSION CONTRACTIONLATE

CYCL

ICAL

EARLY CYCLICAL

DEFENSIVE


A word about "market timing."In the minds of status quo investors, "market timing" is akin to gambling. They believethat thedecision tosellbasedonthevaluationof securities is tooriskygiven thepossibili-ty that timers will improperly assess value and sell too early or too late.

We disagree. Active management, by definition, requires an element of market timing.After all, while selling an overvalued security to buy an undervalued security is a risk-reducing strategy, it requires an investor to 'time' the sell and the buy.

The critics are right that taking portfolios to asset allocation extremes is an unnecessaryandrisk-increasing strategy.That'swhywereject theday-tradingandshort-termswing-trading approaches that advocate keeping 100%of your capital in cash and only deploy-ing itwhena tradingopportunitypresents itself.Takingaportfolio to100%cashpositionmeans that you are 100% certain of your investment forecast, and no one can rea-sonablymake that claim. In addition, it wouldmean abandoning one of ourunbreakable investment rules, which is to always own a diversifiedportfolio. Our investment time horizon is much longer than the one-day period of the day-trader. We invest portfolios to outperform overa typicalmarket cycle,which isusually two to sevenyears.Whilewedoanalyzeshort-termmarketmovementswhentimingouracquisitionorsale of specific securities, our fundamental strategy is to take advan-tage of bull and bear markets over long periods.

When used reasonably and with safeguards in place to prevent majorinvestment errors, market timing is a tool to use in earning excessreturns, and not something to be feared or denigrated.


Who is Pinnacle Advisory Group?Pinnacle Advisory Group is a private wealthmanagement firm, founded in 1993 andheadquartered in Columbia, Maryland, with a secondoffice inNaples, Florida.Weworkwithmore than 900families and manage over $1.4 billion in assets forclients both in themid-Atlantic region, andaround theworld.

We serve as our clients' personal Chief FinancialOfficer, and ensure their financial goals are met in aresponsible way, through the combination ofcomprehensive financial planning and active portfoliomanagement.

Our team has a single mission: To help our clientslive the lives they’ve worked so hard to enjoy.When we take on new clients, they become part of ourextended family, and in the past two decades, we’vedeveloped multi-generational relationships withmany of them.

Those we work with include successful professionals,corporateexecutives,businessowners, entrepreneurs,and individuals and families with substantial andcomplex assets. While our clients’ investable assetstypically exceed $1million, we are able to serve clientsat every asset level.

The Pinnacle difference.We believe we offer something unique in financial services.

If you'd like to find out more about Pinnacle,please call us at 410.995.6630,

or visit us on the web at:www.pinnacleadvisory.com

» A complete focus on you and your life's goals.» Financial guidance without a hidden agenda.» Risk-managed investing for peace of mind.» Financial planning that is both thorough andenjoyable (yes, really).

» A client concierge to help you through theplanning process.

» A suite of technological tools to make yourfinancial life easier.

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