The New World of Investing: From practical to tactical
Alan E. Peters, MSFS, MSM, CLU®, ChFC®
As president of Alan E. Peters & Associates, Inc. and Peters Financial Planning Corporation, in Wilmington, Del., Alan has over 43 years experience in the industry. He is a Registered Representative and Registered Principal with LPL Financial. Alan was designated a “FIVE STAR Wealth Manager” in 2010 by Delaware Today magazine.
Day breaks and you ask, “What’s changed?” Over 45 years I’ve seen plenty of change. How we react to change defines who we are and how we help move our clients toward their financial objectives.
These are nervous times with market volatility, record unemployment and 75 million of us moving into retirement. They won’t be passive investors. So forget passive asset allocation, active and tactical money management will replace the traditional buy-and-hold approach. Historically, active management has fared significantly better when markets are trading based on fundamentals and when the economy is coming out of a decline. It also tends to fare well in markets that are deemed less efficient, such as small-cap equities and emerging markets, as shown in Exhibit 1. Over the past 10 years, the average manager’s return in each of the peer groups shown outperformed its respective passive benchmark index. The market-segment indices shown are the Russell 2000 Index for small-cap equity, JP Morgan EMBI Global Diversified for emerging markets debt, MSCI Emerging Markets Index for emerging-markets equity and the Wilshire Real Estate Securities Index (Float Adjusted) for real estate.
A Brinson Partners study in the ’90s taught us that passively managed asset allocation would be responsible for more than 91 percent of return over time. All we had to do was buy and hold. At the time, that advice seemed practical. It worked until economic declines during the past decade, and then aged poorly. Exhibit 2 on the next page clearly shows the advantages of active management within that same time period, with a positive and consistent rate of return on actively managed assets.
Think about it. If you were managing money (not seeing and talking to people), how would you do it? Wouldn’t you want to be in the market when you’re being paid to take the risk, and on the sidelines when risk is high? Avoiding big negatives can avoid the years it takes to recover from big losses. Everyone wants to arrive at their financial destination on time. The last 10 years have significantly delayed retirement plans for many baby boomers. Active management can help bring them back.
In any event, markets are not born efficient; they are made efficient by active managers. Efficient markets and passive investments are dependent on the decisions of active managers. Carried to its logical extreme, if all investors were to become passive, there would be nobody left to buy and sell securities. Markets would become totally inefficient, as purely passive investors would never react to any event. Furthermore, the proliferation of passive investments, such as exchange- traded funds, means that there are fewer actively managed dollars chasing alpha. This may actually benefit active managers, who all else being equal, will be able to fish in a bigger pond of potential opportunity.
Market volatility won’t keep your clients on course in the future unless they are being tactically managed. The need for active management could be here for a long time. Successful investing requires a strategic approach that is also dynamic and changing. Your success will be defined by your clients’ success. Avoiding catastrophic losses should be a priority. At any age, you can’t sit and watch your assets decline 40 or 50 percent.
Passive asset allocation portfolios are a one-size-fits-all approach. Many rebalance only once per year and even then just to return the portfolio to its original allocation percentages.
Active management is predicated on there being another, better way to manage money in direct response to movements within the market. If one asset class is out of favor or overpriced, rotate away to a new theme or investment class that is gaining traction. If nothing is working, get defensive.
Active management is characterized by flexibility. You must develop the ability to adapt to changes in the market. Invest locally or abroad, in stocks or bonds, even cash if nothing else is working. Today’s markets are increasingly fluid. Managers need the ability to overweight, underweight or avoid a market altogether. Short positions, bonds and other alternative investments can be employed to avoid major negatives. When markets get extended and overvalued, a severe pullback can lead to huge negatives in an inflexible portfolio.
This does not mean timing the market. Everyone knows that can’t be done. I’m talking about restructuring a portfolio by rotating assets out of weakening or overvalued themes and into strengthening and under-appreciated themes based on actual market movements. There is no set model, only repositioning to take advantage of undervalued or ignored investments and a concurrent move away from overvalued (risky) themes.
The channel to future wealth won’t have the single focus of chasing gains as it has in the past. Risk-adjusted returns will be more important, as well. Every investment has a standard-deviation (risk) rating made up of the sum of the parts. Chasing higher returns with concurrent higher risk won’t do. The potential for higher returns has to be accompanied with less, not more, risk. That can only happen if the portfolio you’re managing is not always in the market, or in the hottest (overvalued) asset class.
Experience has taught us that when uncertainty and risk are present, it doesn’t pay to rely on guesswork or passive strategies. Turbulence demands a plan, discipline and, most of all, action. That means rotation, not allocation.
The endless quest to discover the secret of calling market turns is driven by the desire to avoid big negatives. We know the dollar’s pain is foreign stocks’ gain and vice versa. We know Dow theory, the three steps and a stumble, and two tumble and a jump rules, and many other once-in-a-generation buy/ sell signals. But how did they help you in the last 10 years? The questions you have to ask your current and prospective clients are:
• Are you tired of making money in up markets only to give it up (and more) during dramatic downturns?
• Are you nervous about retiring during or following the latest market downturn?
• Can you afford to go through another downturn like the one we just had?
If the answers are yes, yes and no, you must avoid big negatives. It can be done. Tax-sheltered retirement funds are perfect for actively managed strategies. You don’t have to worry about taxes. For taxable accounts, measure (estimate) the cost of taxes resulting from gains and reduce the gross return accordingly.
Many investors have losses in their portfolios they can’t use and are being carried forward on their tax return. The faster they can use those losses, the more valuable they are. An actively managed strategy can speed that process until all the losses are used up. Has anyone told you lately they wouldn’t mind paying taxes if they could avoid huge losses of capital? Times are changing, and so are attitudes about investing.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Peters Financial Planning Corporation, a registered investment advisor and separate entity from LPL Financial.
