Counterpoint Tactical Income June 2017 Fund Update

The investor’s chief problem – and even his worst enemy – is likely to be himself.”

– Famed investor Benjamin Graham

Drawdowns in portfolio value represent a key risk for investors. Humans are loss averse and tend to make numerical decisions by anchoring on memorable numbers such as original balances or recent highs. Thus it’s not unusual for an investor to reevaluate decisions, question process, and potentially make unsound decisions when a portfolio is losing value.

Despite the risks drawdowns pose, this investment characteristic does not figure as prominently as metrics that emphasize expected return such as trailing total returns, performance relative to benchmark, and compound annual growth rate. The Sharpe ratio, the most common investment metric that accounts for risk, doesn’t fully emphasize drawdowns, because it weights positive deviation from average return (pleasant surprises) as risk to be avoided.

This disconnect creates problems. Investors focus on returns rather than drawdowns when evaluating their options. When drawdowns inevitably occur, stoking emotional reactions and cognitive biases, investors are often not fully prepared.

To get a more realistic perspective on the relationship between risk and return, we looked at performance in four major asset classes – stocks, high yield bonds, 5 year Treasuries, and 30 year Treasuries. We also broke down the returns into economic cycles, starting at one cycle’s peak and continuing to the following peak.

Comparisons to indexes have limitations because indexes have volatility and other material characteristics that may differ from a particular mutual fund. Particularly, an Investment Index results do not represent actual trading. It is not possible to invest directly in an index. Index performance does not reflect the deduction of any fees or expenses. Any indices and other financial benchmarks are provided for illustrative purposes only and does not represent fund performance. Past performance is no guarantee of future results.

True to conventional wisdom and to history, stocks represented by the total return on the S&P 500 index produced the greatest compounded returns over the past 27 years. However, we can also see that stocks experienced some major swings – screaming outperformance amid the dot-com bubble, underperformance from the dot-com bubble into the financial crisis, and a more middle-of-the-road showing in recent years. Among bond asset classes, we see what we would expect: Compared with nearly risk-free 5-year Treasuries, 30 year Treasuries compensate investors for taking additional interest rate risk. High yield provides more return as compensation for taking on credit risk.

Now let’s take a look at the Sharpe ratio, which penalizes investments for the kind of swings in return profile that the S&P 500 demonstrated in the chart above.

Adjusting for variance in returns, high yield bonds have demonstrated remarkable investment performance across the past three economic cycles. Setting aside the dot-com boom, stocks have only slightly outperformed 5-year or 30-year government bonds in the most recent cycle, and stocks showed a near-zero slightly negative Sharpe ratio in the period leading up to the Great Recession.

Taking drawdowns as the key portfolio risk metric, stocks performed the worst across all 3 cycles and in 2 out of the 3 most recent ones. Despite its reputation as a risky asset, high yield showed shallower drawdowns than 30 year Treasuries in 2 out of 3 cycles, though it did show greater downside risk in the most recent period.

Among risky assets, high yield often experiences shallower drawdowns than stocks. This is true both during more typical corrections, as seen in the 1990s, and during severe stress, as seen in 2008. While stocks experience periods of extensive outperformance, in some cycles they deliver far below other asset classes on a risk-adjusted basis. Meanwhile, high yield exhibited a more consistent risk-reward across economic cycles.

Although the Sharpe ratio gives high yield credit high marks, we find high yield carries additional benefits with respect to drawdowns. Despite a less than stellar reputation, high yield credit has actually shown a downside profile that’s at least as good as that of the more reputable long-dated Treasuries. Despite this comparable (or perhaps even favorable) risk profile, high yield has consistently offered higher returns relative to 30-year government bonds.

Portfolio managers have created metrics that synthesize the benefits of standard deviation – quantifying the range of possible outcomes – with those of drawdowns – the level of expected downside expect based on past experience. Semideviation measures the range of outcomes below an investment’s expected return; it quantifies unpleasant surprises. The Sortino ratio adjusts returns investors can expect above a minimum threshold for an asset class’s semideviation.

Perhaps surprisingly, high yield has in the past three decades performed very well when measured by semideviation. Meanwhile, deep and frequent drawdowns give stocks substantial semideviation, and 30 year Treasuries show that interest rate risk can exert a powerful force on a portfolio.

Taking a minimum return requirement of the 4.6% risk free rate across the economic cycles, high yield delivers a strong Sortino ratio. This measure appears to penalize stocks more severely than the Sharpe ratio does, and it’s interesting to observe that outside of high yield none of the other three asset classes appear to exhibit consistent performance across cycles.

Counterpoint’s Tactical Income Fund manages risk by allocating to a “risk on” position in high yield credit when prices are rising and shifting to a “risk off” allocation to short-dated Treasury securities when prices are falling. Seeking minimization of downside risk is a key portfolio objective for the Fund. High yield provides us with a “risk on” asset class that has consistently delivered the most reasonable risk-adjusted returns across the three most recent economic cycles, whether measured according to standard deviation, drawdown profile, or semideviation.

This attractive quality makes at least a partial allocation to high yield an interesting consideration regardless. We believe that Counterpoint Tactical Income’s disciplined trend-following risk mitigation strategy further enhances the risk-reward profile of an already attractive asset class.

Definitions

Sharpe Ratio is defined as a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment. The Sortino ratio measures the risk-adjusted return of an investment asset, portfolio, or strategy.[1] It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target or required rate of return, while the Sharpe ratio penalizes both upside and downside volatility equally. Semideviation is a measure of the dispersion of all observations that fall below the mean or target value of a data set. Semideviation is the square root of the average of the squared deviations of values that are less than the mean. Standard deviation is a measure of dispersion of returns from its mean return. Higher deviation represents higher volatility. Drawdown is the amount of capital loss relative to its peak value one experiences in an investment strategy.

Disclosures

BofA Merrill Lynch Current 5-Year US Treasury Index is an unmanaged index that tracks the performance of the direct sovereign debt of the U.S. Government having a maturity of five years. BofA Merrill Lynch Current 30-Year US Treasury Index is an unmanaged index that tracks the performance of the direct sovereign debt of the U.S. Government having a maturity of thirty years. The BofA Merrill Lynch High Yield Bond Master II® Index is an unmanaged index that tracks the performance of below investment grade U.S. denominated corporate bonds publicly issued in the U.S. domestic market. The S&P 500 Total Return Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the US equity market in general, and includes dividend reinvestment in its value. The referenced indices are shown for general market comparisons and are not meant to represent the Funds. It is not possible to invest directly in an unmanaged index.

The value of equity investments in the S&P 500 Total Return Index are more volatile than the treasury investments in the BofA Merrill Lynch Current 5-Year US Treasury Index and the BofA Merrill Lynch Current 30-Year US Treasury Index. Unlike equity investments in the S&P 500 Total Return Index, US government bonds come with a guarantee of the timely payment of principal and interest from the US government.  Bonds within the The BofA Merrill Lynch High Yield Bond Master II® Index have no such payment guarantee, and as such are more volatile and risky than US government bonds.  Long-term US treasury bonds within the BofA Merrill Lynch Current 30-Year US Treasury Index have greater interest rate risk, and are subject to greater price volatility than shorter term bonds in the BofA Merrill Lynch Current 5-Year US Treasury Index.

Mutual Funds involve risk including the possible loss of principal. The use of leverage by the Fund or an Underlying Fund, such as borrowing money to purchase securities or the use of derivatives, will indirectly cause the Fund to incur additional expenses and magnify the Fund’s gains or losses. Derivative instruments involve risks different from, or possibly greater than, the risks associated with investing directly in securities and other traditional investments. There is a risk that issuers and counterparties will not make payments on securities and other investments held by the Fund, resulting in losses to the Fund.  The Fund may invest in high yield securities, also known as “junk bonds.” High yield securities provide greater income and opportunity for gain, but entail greater risk of loss of principal. Past performance is no guarantee of future results. There is no assurance the Funds will meet their stated objectives.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Counterpoint Tactical Equity Fund and Counterpoint Tactical Income Fund. This and other important information about the Fund is contained in the prospectus, which can be obtained at counterpointmutualfunds.com or by calling 844-273-8637. The prospectus should be read carefully before investing. The Counterpoint Tactical Equity Fund and Counterpoint Tactical Income Fund are distributed by Northern Lights Distributors, LLC member FINRA/SIPC.

4512-NLD-6/21/2017