Advisers Ditch 'Buy and Hold' For New Tactics

From the Wall Street Journal
http://online.wsj.com/article/SB124096109870565775.html

The broad decline across financial markets in the past year has persuaded a small but growing number of financial advisers to abandon the traditional buy-and-hold strategy -- which emphasizes long-term investing in a mix of assets -- for a new approach geared to sidestep future market plunges and ease volatility.

Jeff Seymour, an adviser based in Cary, N.C., used to counsel clients to buy a diverse menu of stocks, bonds and commodities, and hold on for the long run. But early last year, he says, he recognized that "the macro-economic climate has changed.

"Today, Mr. Seymour keeps about 90% of his clients' money in such low-risk investments as short-term bonds, cash and gold. With some of the small amount that's left over, he uses leveraged exchange-traded funds to place magnified bets both on and against the Standard & Poor's 500-stock index."It's a complete rethink of how to do asset management," Mr. Seymour says.

Most of his clients are within a few percentage points of breaking even since the shift, he says, while his firm, Triangle Wealth Management LLC, has more than doubled in size.Buffeted by steep declines in stocks, many bonds, commodities and real estate, many advisers are questioning their faith in long-standing investment principles, such as controlling risk by building diverse portfolios. Some are adding increasingly exotic investments, including products that offer downside protection, to client portfolios. Others are trading more actively -- and say they plan to continue to do so until they see evidence of a new bull market.

To be sure, most advisers are staying the course. They point out that frequent trading leads to higher trading costs and tax bills, and that so-called alternative investments come with some serious downsides. Because the markets for many of these products are relatively undeveloped, for example, investors may face high fees, poor liquidity and a high degree of complexity.

Critics also contend that advisers who scale back on stocks are essentially trying to time the market, and are exposing their clients to another type of risk -- that of missing out on future rallies that could recoup recent losses."By abandoning time-proven prudent techniques, they run a serious risk of destroying their own credibility and their clients' portfolios," says Frank Armstrong, president and founder of Investor Solutions Inc., an independent financial advisory firm in Miami that still practices buy-and-hold investing.

The changes come at a time when financial advisers are coming under pressure from clients who are tired of paying fees only to watch their savings evaporate. Advisers have "a lot of cranky clients," says Mr. Armstrong. "They want to see something happen," he says.Certain advisers have long placed small tactical bets on sectors, countries or regions they expect to outperform the broad market.

Many have also placed a small portion of clients' portfolios into alternative investments, such as commodities and real-estate investment trusts.Offsetting RisksNow, some are adopting even less-conventional approaches in an attempt to more effectively offset the risks of investing in stocks -- and generate returns in a market they expect to remain depressed for some time. Some have ramped up their use of opportunistic trading to try to profit from short-term rallies and selloffs. Others are turning to "structured products," which are complex investments that often employ options to provide downside protection. Still others are using investments such as currencies or managed futures that they believe will rise when stocks fall."Asset allocations built on stocks and bonds are best suited to secular bull markets," says Louis Stanasolovich, founder of Legend Financial Advisors Inc. in Pittsburgh. "But the past nine years have proved that nontraditional thinking makes more sense in secular bear markets."

Last October, Mr. Stanasolovich revamped one of his portfolios that is aimed at delivering relatively consistent returns with low volatility. It currently consists mainly of government and agency bonds, hedge-fund-like mutual funds and a long-short commodities fund. It also holds "managed futures" funds, which seek to profit from gains and losses in commodities and financial futures, including a range of currencies, government securities and equity indexes. From Oct. 10, when Mr. Stanasolovich completed this makeover, through April 27, he says Legend's low-volatility portfolios are "essentially break even." The S&P's 500 is off about 3% over that period.Such unconventional approaches appear to be gaining sway. About 15% of the 500 advisers polled between December and March by consulting firms GDC Research LLC of Sherborn, Mass., and Practical Perspectives LLC of Boxford, Mass., say they have made significant changes in the way they manage retirement money over the past year. Among those who have made a change, 21% report increasing their use of opportunistic trading strategies. Eighteen percent say they have become more reliant on structured products and related investments, and 11% say they're incorporating other types of alternative investments.

Two prominent networks of financial advisers -- the National Association of Personal Financial Advisors and the Financial Planning Association -- are sponsoring panels at conferences this year on the subject of rethinking conventional approaches to investing and building client portfolios.'A Seismic Change'"There's a seismic change in the market," says Will Hepburn, president of the National Association of Active Investment Managers. "The people who were buy-and-hold-oriented lost a lot of money, and they don't want to do it again."Meanwhile, financial-services companies are rolling out products designed to lure gun-shy advisers.

Last July, Portfolio Management Consultants, the investment consulting arm of Envestnet Asset Management Inc., introduced seven portfolios that invest in ETFs based primarily on signals from quantitative models. Advisers -- who have invested over $200 million since the launch -- can select how much of their clients' portfolios to allocate to this tactical asset-allocation approach. Although many will put between 20% and 40% of client assets in them, some have shifted 100%, says Richard Hughes, group co-president.Helios LLC of Orlando, Fla., expects to start offering customized portfolios this summer that will enable independent advisers to use options strategies to get exposure to riskier asset classes, such as stocks, with limited downside. In exchange, they give up some potential appreciation.DWS Investments, the U.S. retail unit of Deutsche Bank AG's Asset Management division, says more financial advisers are using its so-called buffered notes, which offer limited principal protection.

"A lot of investing over the last 40 years has been done around traditional asset classes," says Chris Warren, head of structured products at DWS. "But over the last 18 months, the correlation among those asset classes has gone up a lot, so much of the benefits of portfolio diversification really aren't there."All these structured products add a layer of fees. Helios, for example, plans to charge a maximum fee of 0.95%.In October, Matthew Tuttle of Tuttle Wealth Management LLC in Stamford, Conn., gave up on buy-and-hold investing. He hired Murray Ruggiero Jr. -- who developed trading systems for managed-futures traders and funds -- to develop similar computer models for the ETFs and index funds he favors. Now, Mr. Tuttle decides what to buy and sell for his clients based on market trends."We trust the computer," he says.

He has been able to sidestep recent market slides while reducing the volatility of clients' portfolios, he says.Paying More in TaxesTo be sure, his clients will pay more in taxes. But Mr. Tuttle says no one is complaining. "Would you rather be tax-efficient and have losses?" he says.Other advisers are looking even further afield for alternative investments. Today, the average client of West Financial Consulting Inc. of Huntsville, Ala., holds about 20% in domestic and international stocks, down from 40% last year. Founder Larry West is currently using bond funds that make tactical bets. He is also recommending greater exposure to alternative investments, including managed-futures funds, bonds that back construction and expansion projects at churches, hedge-fund-like mutual funds, gas-drilling projects, and private partnerships that invest in real estate. He also holds positions in two private partnerships that invest in railroad cars.

There is some evidence that advisers who practice the traditional buy-and-hold philosophy are losing clients to managers trying new approaches. Jeff Porter of North Canton, Ohio, left his buy-and-hold-oriented planner last year and moved his account to Brenda Wenning of Newton, Mass. Ms. Wenning had been a financial adviser for years at a firm that practiced a buy-and-hold approach, but started actively managing clients' money -- in part by using leveraged ETFs -- when she opened her own practice in May 2008."I realized when I saw the market starting to change that the old buy-and-hold strategy just doesn't work," says Mr. Porter, whose account was already down 20% last year by the time he went to Ms. Wenning.

She immediately shifted his investments to cash -- a move he calculates saved him about $80,000. Since then, he says, Ms. Wenning has been slowly moving back into the markets. His old adviser hadn't bought or sold a single investment in his account last year."You're paying these people a fee to manage your money," Mr. Porter says. "They're really not earning their keep."Write to Anne Tergesen at anne.tergesen@wsj.com and Jane J. Kim at jane.kim@wsj.com

Laissez-Faire Capitalism Has Failed

The financial crisis lays bare the weakness of the Anglo-Saxon model.

Nouriel Roubini, 02.19.09, 12:01 AM EST

http://www.forbes.com/2009/02/18/depression-financial-crisis-capitalism-opinions-columnists_recession_stimulus.html

It is now clear that this is the worst financial crisis since the Great Depression and the worst economic crisis in the last 60 years. While we are already in a severe and protracted U-shaped recession (the deluded hope of a short and shallow V-shaped contraction has evaporated), there is now a rising risk that this crisis will turn into an uglier, multiyear, L-shaped, Japanese-style stag-deflation (a deadly combination of stagnation, recession and deflation).

The latest data on third-quarter 2008 gross domestic product growth (at an annual rate) around the world are even worse than the first estimate for the U.S. (-3.8%). The figures were -6.0% for the euro zone, -8% for Germany, -12% for Japan, -16% for Singapore and -20% for Korea. The global economy is now literally in free fall as the contraction of consumption, capital spending, residential investment, production, employment, exports and imports is accelerating rather than decelerating.

To avoid this L-shaped near-depression, a strong, aggressive, coherent and credible combination of monetary easing (traditional and unorthodox), fiscal stimulus, proper cleanup of the financial system and reduction of the debt burden of insolvent private agents (households and nonfinancial companies) is necessary in the U.S. and other economies.

Unfortunately, the euro zone is well behind the U.S. in its policy efforts for several reasons. The first is that the European Central Bank is behind the curve in cutting policy rates and creating nontraditional facilities to deal with the liquidity and credit crunch. The second is that the fiscal stimulus is too modest, because those who can afford it (Germany) are lukewarm about it, and those who need it the most (Spain, Portugal, Greece, Italy) can least afford it, as they already have large budget deficits. The last reason is that there is a lack of cross-border burden sharing of the fiscal costs of bailing out financial institutions.

With its aggressive monetary easing and large fiscal stimulus putting it ahead, the U.S. has done more. Except for two elements, both key to avoiding a near-depression, which are still missing: a cleanup of the banking system that may require a proper triage between solvent and insolvent banks and the nationalization of many banks, even some of the largest ones; and a more aggressive, across-the-board reduction of the unsustainable debt burden of millions of insolvent households (i.e., a principal reduction of the face value of the mortgages, not just mortgage payments relief).

Moreover, in many countries, the banks may be too big to fail but also too big to save, as the fiscal/financial resources of the sovereign may not be large enough to rescue such large insolvencies in the financial system.

Traditionally, only emerging markets suffered--and still suffer--from such a problem. But now such sovereign risk, as measured by the sovereign spread, is also rising in many European economies whose banks may be larger than the ability of the sovereign to rescue them: Iceland, Greece, Spain, Italy, Belgium, Switzerland and, some suggest, even the U.K.

The process of socializing the private losses from this crisis has already moved many of the liabilities of the private sector onto the books of the sovereign. Among these liabilities are banks, other financial institutions and, soon possibly, households and some important nonfinancial corporate companies.

At some point a sovereign bank may crack, in which case the ability of governments to credibly commit to act as a backstop for the financial system, including deposit guarantees, could come unglued.

Thus the L-shaped, near-depression scenario is still quite possible (I assign it a 30% probability), unless appropriate and aggressive policy action is undertaken by the U.S. and other economies.

This severe economic and financial crisis is now also leading to a severe backlash against financial globalization, free trade and the free-market economic model.

To paraphrase Churchill, capitalist market economies open to trade and financial flows may be the worst economic regime--apart from the alternatives. However, while this crisis does not imply the end of market-economy capitalism, it has shown the failure of a particular model of capitalism. Namely, the laissez-faire, unregulated (or aggressively deregulated), Wild West model of free market capitalism with lack of prudential regulation, supervision of financial markets and proper provision of public goods by governments.

There is the failure of ideas--such as the "efficient market hypothesis," which deluded its believers about the absence of market failures such as asset bubbles; the "rational expectations" paradigm that clashes with the insights of behavioral economics and finance; and the "self-regulation of markets and institutions" that clashes with the classical agency problems in corporate governance--that are themselves exacerbated in financial companies by the greater degree of asymmetric information. For example, how can a chief executive or a board monitor the risk taking of thousands of separate profit and loss accounts? Then there are the distortions of compensation paid to bankers and traders.

This crisis also shows the failure of ideas such as the one that securitization will reduce systemic risk rather than actually increase it. That risk can be properly priced when the opacity and lack of transparency of financial firms and new instruments leads to unpriceable uncertainty rather than priceable risk.

It is clear that the Anglo-Saxon model of supervision and regulation of the financial system has failed. It relied on several factors: self-regulation that, in effect, meant no regulation; market discipline that does not exist when there is euphoria and irrational exuberance; and internal risk-management models that fail because, as a former chief executive of Citigroup (nyse: C - news - people ) put it, when the music is playing, you've got to stand up and dance.

Furthermore, the self-regulation approach created rating agencies that had massive conflicts of interest and a supervisory system dependent on principles rather than rules. In effect, this light-touch regulation became regulation of the softest touch.

Thus, all the pillars of the 2004 Basel II banking accord have already failed even before being implemented. Since the pendulum had swung too much in the direction of self-regulation and the principles-based approach, we now need more binding rules on liquidity, capital, leverage, transparency, compensation and so on.

But the design of the new system should be robust enough to counter three types of problems with rules. A tendency toward "regulatory arbitrage" should be kept in mind, as bankers can find creative ways to bypass rules faster than regulators can improve them. Then there is "jurisdictional arbitrage," as financial activity may move to more lax jurisdictions. And, finally, "regulatory capture," as regulators and supervisors are often captured--via revolving doors and other mechanisms--by the financial industry. So the new rules will have to be incentive-compatible, i.e., robust enough to overcome these regulatory failures.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.

Valuing banks through the looking glass

Sometimes a blog posting has such delicious irony, as this one does from Professor Krugman, that it is worth repeating in full.

So the accounting rules say that a decline in the market value of a bank’s debt thanks to increased credit default swap spreads — that is, because investors think you’re more likely to fail — counts as a a profit. On the other hand, if your bank looks stronger, the spreads fall, and you book a loss.

FT Alphaville has the story. Citigroup reported

A net $2.5 billion positive CVA on derivative positions, excluding monolines, mainly due to the widening of Citi’s CDS spreads

while Morgan Stanley reported

Morgan Stanley would have been profitable this quarter if not for the dramatic improvement in our credit spreads - which is a significant positive development, but had a near-term negative impact on our revenues.

So Citigroup is profitable because investors think it’s failing, while Morgan Stanley is losing money because investors think it will survive. I am not making this up.

The only point I would make is that Lewis Carroll would have loved this story but might have favored it more for Alice Through the Looking Glass rather than Alice in Wonderland .