Active portfolio management provides a great opportunity to grow your practice.

    I have visited a lot of RIA Web sites. My unscientific estimate is that more than three-quarters of them describe an investment style anchored in the Markowitz/Sharpe concept of efficient market theory, which essentially espouses a portfolio permanently diversified across all "asset classes" more or less consistent with their shares of global market capitalization. By adjusting the proportions allocated to debt and equity, client portfolios are typically customized or "risk-adjusted" to suit their age, liquidity needs and the likelihood that they will remain confident in their manager despite quarterly reports showing that their assets have shriveled (we call this their "risk tolerance").
    Modern Portfolio Theory is the only thing I can think of from the 1950s that we still call "modern." One would be foolish to suggest that MPT scholars have not advanced the art of investing; they clearly have, and we have all benefited from their development of the ideas of diversification and portfolio efficiency. But it may also be foolish to consider the theories complete and definitive. You may not agree with Horace "Woody" Brock (www.SEDinc.com) who maintains that the MPT paradigm is in meltdown mode. But isn't it sensible to believe that their early work can be built upon and improved?
    The 1980s and 1990s provided an investment environment tailor-made for MPT's broadly diversified portfolios of both stocks and bonds; interest rates were falling and P/E ratios were rising for almost 20 years. But in the "oughts," many thoughtful and respected practitioners and academics expect a much less amenable investment experience; one of low- or mid-single-digit average returns for both equity and debt ... perhaps with painful volatility. If they are correct, are there implications for the efficient frontier indexer's business model? I think there are.
    I propose the following syllogism, for which I will offer some support:
    a) Broad market returns of the sort that, by definition, will accrue to MPT portfolios are likely to be low, and probably volatile over the next five or ten years despite a manager's efforts to achieve low costs and tax efficiency.
    b) Retired investors require steady, positive investment returns, and for valid reasons. If your business cannot provide what they need, they will go elsewhere.
    c) Therefore, to retain and attract retired clients, you will need to invest their nest eggs so as to achieve better and steadier returns than "the market" is likely to provide.; i.e. you will need to become an active manager.
    Many advisors do not believe they can successfully transition to active management. In an environment where stocks are expensive (very high P/E on peak cycle earnings) and bonds are expensive (narrow quality spreads with low real and nominal yields) the portfolios described in most of those RIA Web sites have a good chance of disappointing their owners. If you can successfully transition to an absolute return style of management, there is a very good chance that you will gain share in the fast-growing retirement market.
    For dyed-in-the-wool efficient frontier managers, the main obstacle to considering an active management style is the MPT dogma that one cannot "beat the market" and should not try. I propose that in a long bull market such as we experienced in the '80s and '90s you don't need to beat the market; and in a long bear market you can. Indeed, if you want to serve the booming retirement market, you must!

Charlie Needs Cash Flow
    Classic efficient frontier portfolio optimizers are doctrinally agnostic regarding bull and bear cycles. Yet a curious advisor, squirming in the pew of the MPT cathedral, might dare to ask, "What made those earlier returns so great for so long?" What's been different recently? How long might this famine last? Is there really nothing I, or my retired clients, can do to earn a decent return in an unrewarding market environment?
    If you were responsible for matching Motorola's pension portfolio with its long-term liabilities, or if you were a 39-year-old surgeon saving $200,000 a year toward retirement, maybe you'd be content to dollar-cost-average through a decade of market "adjustment." But if you were 65-year-old Charlie, a Safeway manager retiring tomorrow morning on a $1 million IRA, you wouldn't have the luxury of taking the philosophical long view. "Just my luck," Charlie worries, "I retire and the market goes down for three years." That's what happened to his brother the CPA, who hung up his calculator in 2000.
    Here's Charlie's concern. Over the next three years he withdraws $150,000 to live on (5% annual withdrawal). The $400,000 he allocates to cash and bonds earns $50,000 (4.2% a year) and his $600,000 of stocks shrinks to $500,000 (-6% a year). Then he'll be 68 and have just $800,000 to live on for maybe 20 to 30 years. Charlie's retirement prospects will have been diminished dramatically and he will not be consoled by your assurances about long-run expectations. Charlie needs regular cash flow. Can you help him ... even if the market does not?

We're Not In Kansas Anymore, Toto
    As everyone knows, returns from 1982 to 1999 were exceptional for both stocks (large caps returned 18.5% per year for 18 years) and bonds (the ten-year Treasury returned 10.5% per year). Since then, investing has been less rewarding. For 2000 to 2005, large caps returned a sad -1.2% a year compounded, and intermediate Treasuries, 6.5%. Last year, the S&P 500 total return was 4.9% and bonds about 2%. Don't you sometimes feel like Dorothy, stranded in a strange and scary land, longing for the good ol' days on the fertile plains? What if the good times are still years away, as many believe?
    What do you tell your retired clients about future expected returns? Ed Easterling, founder of Crestmont Research, hedge fund consultants in Dallas, recently asked an audience of investment advisors how many years it would take to be certain that a broadly diversified stock portfolio invested today would earn the historic 10.4% average equity return. After folks suggested from ten to 20 years, Ed announced firmly that today's portfolio will NEVER earn 10.4% on average over the long term. Never!
    There are, he explained, only three components to the equity return: corporate earnings growth, the change in the P/E ratio and dividends. The 10.4% long-term return that we find in Ibbotson's annual volume comes from 5% earnings growth, 4.5% dividend income and an extra 0.9% average annual return from the roughly doubling of the P/E over the last 80 years. Even if earnings grow as fast as they always have, and if the P/E stays as high as it is, the future return is burdened with the reality that the dividend today is only about 2%. And it's not low because of a low payout ratio but because of the high P/E.
    So, the all-things-being-equal expected equity return, Ed would contend, is just 7%, rather than 10.4%. But what if the P/E should normalize over the next ten years? We would be looking at 3.4% a year. And that's before fees and expenses! The question it raises in my mind is, "How long will a retired client pay his advisor 1% for a 2.4% (net) return?

Valuation Then And Now
    Retiring in 1982 was not the same as retiring in 2006; there are compelling differences in the investment environment that should influence the way a nest egg is diversified today. The difference is valuation.
    Stocks were selling at eight times earnings in 1982 and sported a dividend yield north of 6%. Today the DJIA commands a P/E of 19, and its dividend yield is 2.2%. Also important, the "E" in today's P/E represents extraordinarily high profit margins. Corporate after-tax profits that were only 4.4% of GDP at the beginning of 1982 are now 8%, almost twice the share of the pie they were at the start of the bull market, and I should add, as high as they have ever been. Caveat: Profit margins are cyclical. Bonds have enjoyed a similar valuation upswing in the past 24 years. The real, inflation-adjusted yield on the ten-year Treasury was almost 8% in 1982 ... it is around 1% today! If rates should creep up, Charlie wouldn't even earn the 4.5% coupon (before fees).
    As he drives home from his last day at the store, Charlie realizes that from now on his only paycheck will come from his IRA. As his advisor, you understand that investment opportunities are constrained by the preconditions for low returns-bonds with low yields and narrow quality spreads, and stocks selling at above-average P/Es on cyclically high corporate profits. What kind of return should you tell Charlie to expect?
    Clearly, shifts in valuation have had a big influence on returns. Is there anyway to get our arms around that concept? Any way to understand how it is likely to impact future returns? Any way to build those expectations into our investment selection? I know, if you are a classic passive manager you don't ask these questions. But suppose the answers might help Charlie solve his problem?

Understanding The P/E Cycle
    In fact, valuation has tended to shift rhythmically over the years; working with this dynamic can help you add value to portfolios. The best analysis I've seen is by Adam Hamilton, publisher of the Zeal Intelligence newsletter. He uses historic data developed by Yale's Robert Shiller, who published Irrational Exuberance just before the bubble burst in year 2000. You can find Hamilton's provocative and compelling work at www.zealLLc.com. (See chart on preceding page.)
    History actually provides us a dependable map of the range of investor enthusiasm and pessimism as reflected in how much investors will pay for a dollar of earnings. Nearby is a chart of the P/E for the DJIA over an entire century. It's a very busy chart, but it is the best summary representation of stock market behavior I have ever seen.
    The red line is the DJIA on a log scale. What is unique and terribly interesting to me is the erratic blue line superimposed on the Dow. It shows the P/E ratio at each point in time (left scale). During these 104 years there were three long periods of P/E compression, each lasting 17-20 years, and each followed by a long period of P/E expansion.
    Since the current valuation compression began, just five years ago, the P/E has contracted from a previously unheard of 44 times SEC reported GAAP earnings to about 23 recently. The long-term average P/E has been about 14, well below current levels.   
    Even more sobering to me, each long cycle of P/E compression has ended in single digits! Regression to the mean is a dependable phenomenon, but the mean reflects overshooting in both directions. History suggests that the end of this P/E cycle is quite a bit below our current perch.
    Were I Charlie's investment advisor, I would want the obvious risk of valuation compression to have significant influence on the composition of his equity exposure. The same may be said for the fixed-income portion. Constrained as we are by the space limitations of a magazine article, I offer this brief summary of concepts that could be incorporated in a retirement portfolio to defend against a lengthy compression in valuations.

Active Management Concepts
    Keeping in mind what we believe to be the unsustainable valuations of the current environment, and free from the taboos of efficient market theory, we attempt to build the following characteristics into our retirement portfolios:
    High cash reserves
    Short duration, high-credit-quality bonds
    Minimal correlation with large-cap indices
    Modest market short positions
    Respect for the advanced stage of the credit cycle
    Emphasis on value and small company styles
    Distressed securities
    Diversified cash-income generators
    Nonpublic investments
    Theme investing (noncorrelated earnings drivers)
    Demographics (especially of an industrial country aging)
    Commodity supply and demand trends, especially energy
    Debt leverage risks, paper currency risks: Gold
    Asian, Eastern European prosperity
    Many advisors will agree with the premise that "market returns" seem likely to be of the low-single-digit variety. While they would like to be more adventurous, they feel inadequate in terms of knowledge and experience; that is an understandable concern.
    But seasoned and knowledgeable veterans of active management are eager to assist by way of their open-end mutual funds. An advisor can make a good start on the road to active management by swapping large-cap indexes and "closet index" funds for an array of funds that have demonstrated success independent of the S&P 500-funds such as First Eagle Global, Hussman Strategic Growth, Julius Baer International, Keeley Small Cap Value, Longleaf Partners, Scudder Dreman High Return, Third Avenue Value and T. Rowe Price Capital Appreciation.
    As you read their thoughtful shareholder letters you will begin to think like an active manager. Charlie and his friends will thank you!

J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.

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