This is Scary

The WSJ personal finance blog: The Wallet elaborates on an article in the newspaper (more on the scary advice in that article in another post i will be writing)about financial advisors changing the investing approach in light of the events of last year. I am not averse taking into account recent events. Certainly strategies should take more cognizance of the need for allocations to reliable safe havens for investors, 2 that I use more of than in the past are TIPS and a true hedged fund the Gateway fund (GATEX) which I have written about in the past. But the role of the advisor is to present reasoned changes in strategies. The advice mentioned here seems little more than irrational reaction to recent events. With surverys showing over 80% of investors "unhappy" with their advisors excuse me if I think that many of these strategies are more a short term business strategy for their practice than a long term investment strategy for their clients

Here's one "strategy"

In January, Jerry Verseput, a financial adviser in Sacramento, Cailf., moved from a conventional model using mutual funds to a sector-based approach using ETFs after his portfolios fell significantly in 2008. He decided to make the switch after running an analysis that showed that correlation among the standard asset classes was over 80% over three, five and 10 years—in other words, they weren’t providing adequate diversification.

Now he’s diversifying across nine equity sectors, such as financials, energy and basic materials, technology, and real estate, where the correlation is only about 20%. He’s also using no-load mutual funds to get fixed-income exposure, since bonds throw off regular dividends. Most of his portfolios are up 2% to 2.5% for the year, he says.

I'm not sure what he is referring to, but I did run an 8 year cross correlation of the equity sectors he mentioned. None had a cross correlation of .20 two had correlations of in the 30s .34 for (energy/financials) and .38 for (real estate/energy). I doubt many would expect these low correlations to be the basis of a long term strategy. The other cross correlations ranged from .60 to .79. And it was hardly surprising that it was financials/real estate that had the highest correlation.

Of course if one held all of these sectors anyone knowing anything about equities would know that one simply owned the market. It would also reason that each of these sectors would have high correlations to the overall market, since the most important determinant of a sector's price is the overally market. Thus the correlations of each asset class to the S+P 500 only one was below 70 (69 for energy) one at 79 (reits which are not equities) and the rest in the high 80s.

So to be perfectly forthright, I have no idea what this advisor is talking about except for the short term bond holdings which are in fact an asset class with a low correlation to equities.

The article goes on to describe 2 other strategies with ascending levels of scariness

Mr. Verseput, for example, uses trailing stop-limit orders. If a particular sector drops by a given percentage, then a sell order is automatically generated and the proceeds are moved to cash. “I don’t have to follow the market every single moment, since these [orders] will automatically lock in gains or will allow me to jump into these rallies much earlier,” he says. Another benefit: “It’s a completely unemotional rule. There’s no guesswork involved

.”

This simply a trading strategy and in fact there is quite a bit of guesswork. I also have no idea when he would reverse his sales and get back into the sector. After falling massively the financial sector rallied almost 26% since the end of March and was the best performing sector last month. If Mr Versput sold financials with a stop loss sale several months ago, what is he doing now ?

Also I am not at all sure what he is referring to when he claims his strategy of stop - limit orders both allows him to "lock in gains and jump into rallies earlier". A stop loss limit order is an order to sell when the marke falls to a designated price (to limit losses). If the market drops to the limit level and then reverses course and begins an upward trend, I have no idea how this strategy would allow him to "get into these rallies much earlier." Sorry, it's totally illogical. And of course it's called a stop loss for a reason: since it is below the current market it often locks in a loss rather than locking in a gain. The strategy may impose some discipline (and expose one to whipsaws) it hardly guarantees profits.


The next one is really scary, it reflects basic lack of knowledge of the instrument he plans to use.

Theodore Feight, a financial adviser in Lansing, Mich., has also used stop-loss orders to get clients out of the market for most of 2008 and 2009, and is now talking to clients about using leveraged ETFs to get back in. “The problem we’ve got with the current asset allocation is that it hasn’t evolved,” he says. “The stops allow you to have some protection

Many individual investors have been burned using the leveraged etfs because they don't understand them. But one would expect an advisor to know better.They reflect a multiple of the daily movement in the index not the longer term return one would get in an index fund or etf. Thus the pro shares ultra etf which returns 2x the daily movement is down -8.8% ytd while the S&P 500 is -2.6%. And to make things more aggravating to the investor that doesn't understand the instrument, those who thought using the ultra (2x) etf designed to produce the inverse of the S&P 500 certainly did not give a hedge of the longer term return of the S&P 500. It is -11% ytd, in other words it moved in the same directon of the S&P and produced a return 5x less. Anyone understanding this instrument would conclude it is really only useful for day traders. The idea of an advisor using this as a way to get back into the market (for more than one day) is, to say the least, extremely surprising.

At least saner voices are being voiced by more mainstream observers (except for those hedge funds which are not a reliable "hedge" of anything):

Investors who are unhappy with their financial pro should have “a really intense conversation with their adviser and make sure their adviser understands what they’re looking for and to make sure they’re not missing something their adviser is doing,” says Diahann Lassus, chair of the National Association of Personal Financial Advisors. She says the chief question investors should be asking is: “What are you doing differently to help manage risk?”

“Many advisers are doing things differently,” she says. “We’re building more cash for safety. We’re adding more to short-term bond funds and
hedge-strategy funds.”

Fortunately there are many advisors advocating rational, low cost, long term strategies. While I would allocate client assets somewhat differently, the allocation presented today in WSJ's monthly investing supplement is far from "scary" and is in fact probably the most reasonable of any of the advisor profiles they have presented in this montly supplement.