Following the semiannual Tiburon CEO Summit in San Francisco on October 9, 2013, Marie Swift of Impact Communications sat down with four of the attendees for a round table discussion. These executives included Ron Carson, a CFP and founder of the Carson Institutional Alliance; Daniel Kern, a CFA and the president and chief investment officer for asset management firm Advisor Partners; Alex Potts, the president and chief executive officer of asset management firm Loring Ward; and Michael Winchell, a longtime institutional investment strategist who recently established Larkin Point Investment Advisors and rolled out a new equity preservation mutual fund. In the excerpt below, Swift turns the tables by asking Alex Potts if he thought the high-net-worth investors on the Tiburon stage earlier in the day really understood what the industry considers to be basic investment strategies.
Do Consumers Really Understand?
Swift: Alex, during the Q&A period, one of your questions was, I think, intended to see if consumers really understand investing nuances such as tactical, strategic, active and passive.
Potts: Where the question was going was did they have an underlying philosophy; did they even start off with a plan? This became evident; there was no plan. Because there was no plan, there were a whole bunch of risks that were unknowingly taken. Among that panel, every one of them had investments that could go to zero. At Loring Ward, we build diversified portfolios. Just the idea of eliminating bankruptcy risk from a portfolio is one of the easiest things an advisor can do, and it comes at very low cost to do so. I struggle when I hear people build a plan and they don’t even have a philosophy. Or maybe they were sold something, which is even worse.
Winchell: At Larkin Point, we really embrace passive investing except that we also use options. The difference between us and many people trying to create liquid alternatives, or the alternative way of achieving diversification, is a systematic management process. We look at people who buy options on a periodic basis, tactically, as essentially engaging in market timing. We look at people who are consistently selling covered calls as a primary strategy as just basically selling puts—they are on one side of the volatility spectrum, they are selling off the upside. Our core investment strategy is to use low-cost ETFs and to shape our option strategy in a systematic fashion around the ETFs by both buying and selling volatility. We buy it by buying long-dated protection, and we sell volatility by systematically trading straddles around that with additional downside protection. We think of ourselves as indexing in the options marketplace in order to reshape a return distribution that needs to be reshaped given the prospect of fixed income failing to be the protective asset that it was in the last 30 years.
Potts: Something you said really resonates with me. Philosophically, whoever invented the word “passive” was probably an active manager, because passive doesn’t necessarily mean passive. You’re owning an asset class, or you’re owning bits of the market in the purest form of modern portfolio theory. If you have an impure asset class or if you have style drift in your asset class, it can contaminate your entire portfolio. Basically when you’re doing your asset allocation models and understanding volatility, if you bring in an active manager to that, now you have an uncontrollable variable. You have opened yourself up to idiosyncratic risk, which there is no need for. From a Loring Ward perspective, we never want the advisor to have a conversation apologizing for what an asset manager did.
Carson: When it comes to different strategies, I embrace them all. The discussion at my firm is centered around knowing your family index number, the rate of return needed to achieve your goals and objectives and sticking with your investment strategy. There are times when passive works, and there are times when active works. I read a study this morning and the variable where you could add value was having all these other things happen in the planning so you didn’t react or you didn’t change. Once you pick what your appropriate mix is, unless there is a life-changing event, then you don’t change your mix.
Winchell: Some of the buzzwords that I’ve learned over the past couple of years are “goals-based financial planning” and “behavioral finance.” One of my great analogies is this: On CNBC, people will tell you that essentially Warren Buffett is who you should emulate. But think about all the people who don’t have an insurance company to spit out cash every day and can’t double down when the market is down 25%. If you are an advisor and the portfolio you created for that client is down 30%, that could become a life-altering event.
Potts: You build a plan, and you help that investor stay invested. The fact is, any one of us can build the best portfolio in the world, but if an investor cannot tolerate that portfolio, it doesn’t matter.
Carson: Clients always do the wrong thing at the wrong moment if it’s not part of an overarching plan.
Kern: The studies that show the difference between the performance of the market and the average investor’s experience are really telling. The average investor buys high and sells low. That to me is validation of the need for advice. On the passive versus active debate, we at Advisor Partners are largely sympathetic to Alex and Michael’s views of some of the virtues of passive investing. I don’t particularly think passive works in some parts of the market. My firm tends to pave a middle road in the active-passive debate, because there are parts of the market where we think active reduces your risk by saving you money in adverse market environments.
Carson: What about technical versus fundamental? To me, this is driven by the strategy and the disciplined focus that it adheres to on a daily basis. At
Carson Institutional Alliance, we have strategies that are purely fundamental, purely technical and even a combination of each with clearly defined processes and objectives. I used to be a pure fundamentalist and I’ve absolutely changed my tune. Technical analysis will tell you about information that the market hasn’t fully priced in yet, and it is a risk management mechanism.
Kern: When I started in the business, I didn’t really understand the technical side. The market tells you things, and sometimes you can’t articulate what’s causing it but there is information in the data. We try to take that into consideration as well.
Are Bond Indexes Broken?
Swift: Dan will you talk a little bit about bond indexes—did I hear you say that they’re broken?
Kern: Yes, I think that’s the polite way of putting it. In simple terms, most of the commonly used bond indexes reward failure. The biggest borrowers tend to have the biggest index weights. I liken it to being in a neighborhood where you have two people in the neighborhood: one that paid 90% cash on his million-dollar house and another one down the street that only put $100,000 down on her million-dollar house. Bond indexes reward the latter, but to most folks that doesn’t make sense.
Part of that problem ties back into the failure of rating agencies. Here’s a tangible example: In September 2009, arguably the most popular international bond index, the Barclays Global Treasury ex-U.S. Index, had 22% in Italy, Spain and Greece. If you add Japan to the mix, Japan was 24% of the index. This index did really poorly after the debt crisis started. A lot of these indexes are based on how the rating agencies classify bonds. The bond market has experienced many periods in which risk has been mispriced, including the prelude to the sovereign debt crisis in Europe, the years leading up to the housing crisis in the U.S. and several periods in the high-yield market. We think that active managers, while not infallible, do a better job of avoiding these bond bubbles than the indexes.
Carson: We’ve had a 30-year bull market in bond price. Back to the investors not really knowing: They bypass performance and look at return. We’ve talked about the risk of return, but we’ve never had to talk about return-free risk. One of our strategies we call “write income.” We purchase blue-chip sector-weighted companies and sell covered calls and generate a fair amount of income. I just think going forward, advisors are going to have to find alternative ways other than bonds to provide or fulfill that fixed-income portion of the portfolio.
Kern: So here’s the thing: We have three decades of people who manage money for investors, and really they have only known one kind of scenario for bonds. There have been relatively short reversals in the downward trend of interest rates. But now the entire mind set around diversifying portfolios and generating incomes has to change. We need to rethink our relationship with bonds. We are in a low-interest rate environment and the likely trend is for interest rates to rise in coming years. Our clients and many in the industry don’t understand what it’s like to live in a five- to 10-year cycle of mostly rising rates.
Winchell: This is probably the biggest fiduciary gap in the advising space right now: We haven’t had to talk about bond risk. The bigger conversation is what role bonds should be playing. The only reason people don’t have that discussion is they don’t know what to say next. We need innovative solutions and we need to start looking at other tools. That’s why we formed Larkin Point, to help people understand what other tools are out there.
Potts: From a portfolio perspective, at Loring Ward we look at it a little bit differently. As we see it, each advisor is building a custom total return portfolio for their individual investors. We got some grief over the last 10 years because people say that longer durations are getting better return. We say: Don’t take risk on the bond front, take it on the equity side. Buy emerging market value if you really want to go after returns. Many advisors will walk through a client’s statement; they will break out the individual components, and maybe not put them all back together for that client. Great advisors can teach that they are reducing volatility by adding high-quality fixed income, and their clients will understand it forever.
Money is like a bar of soap; the more you touch it the less you have. On the panel today, we heard one of the participants say she looks at her account twice a day. So, on the one hand, you have a complex plan solving for a long-term liability. And on the flip side, a consumer looking twice a day at something that’s likely not meant to be tampered with for another 20 to 30 years.