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Investment Tips: Income from Where?

Post a Comment November 26, 2009 – 10:24 am | Post Link |  Print This Post |

Many of today’s retirees lived through the Great Depression. Some of them may have felt like they were returning to the bad old days when last October’s fears about a financial system meltdown helped touch off the worst drop in the Dow Jones Industrial Average in 21 years. Despite the federal government’s $700 billion bailout plan, the crisis continued to spread. Almost nothing in the global markets was moving up. Almost being the operative word.

“The only thing that goes up when the markets are really bad is correlation,” says Matthew MacEachern, portfolio manager for Emerald Asset Advisors in Weston, Fla.

Or, to put it another way: “Everything went down. The bonds went down, the stocks went down, the dollar went down,” says John Kroll, managing partner of HKP Financial, a registered investment advisory firm in Miami Lakes, Fla. “We threw everything out the window.”

Even today, though the market has bounced back from its nadir, we’re still nearly 35% off the market’s historic high two years ago. For people at or near retirement who have their savings or retirement investments in a conservative-to-moderate portfolio, the market downturn has proven especially troubling. Where in the past one might expect a downside of 5% to 6%, the downside with a conservative portfolio last year could have been near 18% to 20% because bonds did’t offset equity losses with gains, Kroll observes.

“The bonds weren’t doing their job,” he says. “That has really made me reconsider my strategies.”

The global economic recession has no doubt caused many financial advisors to reconsider their investment strategies as they try to maintain and grow their clients’ retirement income in the face of a nearly unprecedented downturn, coupled with the uncertainty about the strength and duration of the recovery. Most have tinkered with asset allocations. Others have incorporated annuities into their portfolios. Some financial advisors, meanwhile, have become even more creative and abandoned modern portfolio theory (MPT) altogether-at least for the time being.

NO PLACE TO HIDE

The move by some advisors away from the venerable modern portfolio theory is not really a rejection of Harry Markowitz’s efficient frontier; it is a recognition of its limitations. Markowitz’s landmark 1952 paper argued that a portfolio should be diversified across asset classes that are not well correlated in order to reduce the overall risk of the investments. Diversification has been the cornerstone of portfolio construction for financial planners ever since.

The limitations of MPT, however, have been brought to the forefront during the global recession. Namely, the market disruption spread across all asset classes, essentially rendering the diversification strategy futile for a time. Or rather, as Kroll says, “everything went down.”

Morningstar highlighted this shortfall in a November 2008 report: While investment-grade bonds turned in stellar returns between 8% and 11% when the stock market plunged from 2000 through 2002, bond funds struggled in 2008. For retirees, the losses were stressful, and in many cases forced people to return to the workplace. “High-quality bond investing is not the retirement savior it used to be, and that’s really the driver behind why so many advisors and their clients are in search of a different solution,” says Medon Michaelides, managing partner of Emerald Allocation Strategies, which markets separately managed accounts from Emerald Asset Advisors.

NEW EFFICIENT FRONTIER

Of course the basic tenet of MPT—lowering portfolio risk through diversification—remains such a deeply ingrained element of financial planning that many advisors are looking for new solutions that still closely follow this framework. But Peng Chen, president and chief investment officer of Ibbotson Associates, has sought to improve on one of the key components—the mean variance efficient frontier (MVO). Portfolios lying along the efficient frontier curve have the highest expected return for the given amount of risk, while portfolios below the curve are considered inefficient for taking on too much risk with too little expected return.
Chen, however, believes the MVO model is flawed. The main shortcoming, he says, is its focus on a portfolio’s risk-return tradeoff in terms of returns, rather than considering the risk-return tradeoff of a portfolio’s ability to generate sustainable income.

“It’s all in return terms—in percentages and so forth,” Chen says. “It doesn’t necessarily translate to the income and how much it is or how long it lasts.”
He notes that people have traditionally been more focused on returns because most of their money had been managed by defined benefit plans that convert a lump sum into a basic income stream. Because this income stream lasts for as long as a person lives, there was no need for financial investors to think about interest rate implications and how they impact the trade-off across different asset classes.

“But as the DB plan became smaller and smaller and Social Security is playing a smaller role, the investors who are relying on their own savings for retirement income have to decide how much they can spend and how long it will last,” Chen says. “They cannot just ignore these questions anymore. That’s what has changed over the past 20 years.”

Of course, this is a challenge facing investors with retirement savings in 401(k) plans as well, says J. Graydon Coghlan, president of Coghlan Financial Group in La Jolla, Calif. “Because of a lack of investing outside their company 401(k) plan, a lot of people really don’t know what principal amount it’s going to take to generate a desired income.”

Chen’s new efficient frontier, meant to complement the traditional MVO, is established by comparing three numbers: average sustainable income, shortfall income and target income. Say you are planning for a 30-year retirement with an annual income target of $50,000. Using a Monte Carlo analysis, Chen looks for the median annual income the client’s portfolio can sustain over the 30-year target. He then compares that to the sustainable income at the bottom of the Monte Carlo analysis. The differences between the median and the target, and the worst-case and the target, represent the possible shortfall of the portfolio.

The new efficient frontier is customized to each individual investor’s financial circumstance; within this framework an advisor can analyze various investment strategies and products, especially ones that offer nontraditional payouts, like variable annuities with lifetime guaranteed minimum withdrawal benefits.

RETHINKING STRATEGIES

As the markets began unraveling last year, Kroll found that the MPT-based asset allocations he had been using for 15 years were no longer working. So he moved to a more noncorrelated program that includes the mutual fund from Emerald and a short-term investment-grade fund from Vanguard. He will conduct a financial planning analysis using MoneyGuidePro software before building a client portfolio. In one scenario, he will fill about 60% of a client’s portfolio with the Emerald and Vanguard funds if they are close to, or in retirement. By utilizing the hybrid funds, he aims to capture about 65% to 70% of the upside of the market, while not giving up more than 15% to 20% on the downside.

“You don’t hit a home run, but you also don’t strike out,” Kroll says. “The capital preservation is more important than growth. People are in the Depression mentality and I find that the hybrid approach just makes them feel more comfortable.”

If a client is close to, or in retirement, and is going to be living off assets, he typically sets up the portfolio with 25% in bonds-including 5% in cash equivalents. He will use the Vanguard fund as a money-market account to hold the cash. He now splits up the bonds between investment-grade short-term, investment-grade total return, high yield and Treasury Inflation-Protected Securities (TIPS). He creates a sleeve of bonds that allows liquidity and gets a little bit of yield and position against inflation.

With the other 15% of the portfolio, Kroll tries to get as far away from correlation with the stock market as possible by using alternative investments. This includes non-publicly traded real estate investment trusts (REITs), equipment leasing programs and oil and gas programs. “It just balances the portfolio,” he says. “Your exposure to equities is whatever the long-short fund is going to do, which puts a lot of pressure on the long side. But that’s why you pick managers.”

For clients in a systematic withdrawal program, he will try to reduce the amount of money coming out of their annuity account to minimize reverse dollar-cost averaging and make up the difference by finding another source of funding, such as from a CD or an income rider. In some scenarios, he will create a slush fund using a short-term bond product for clients not in a systematic withdrawal program. If they need extra income beyond what they are receiving from their pension and Social Security, it can be pulled out of this fund.

Ronald Saffer, principal of the Phoenix-based Saffer Wealth Strategies, has also realigned his clients’ portfolios from one heavily invested in equities using a relative return benchmark, to one based around an absolute return benchmark. The investments are being managed for risk first and returns second. He’s using tactical money managers for both fixed income and equities, while also investing in private equity and non-correlated alternative investment vehicles.

Saffer now has access to alternative investment vehicles that have historically only been available to very wealthy clients, or institutional investors like foundations and endowments. Kroll finds inspiration in how some of the bigger foundations and endowments—including Harvard, Yale and the Ford Foundation—have heavily weighted their portfolios in assets other than stocks. There are now “ETFs and alternative investments that you can buy for between $10,000 and $20,000,” he says, making true diversification a reality for more investors.

BACK TO WORK

As the markets rebound from their disastrous run, some of the fear gripping investors is beginning to ebb. For advisors, this means putting money back to work, but doing so in a changed environment.

“Advisors have started paying closer attention to asset allocation because over the past 12 months some of the most solid blue chips have not been that solid,” says Tim Boyd, director of institutional trading at TD Ameritrade. “Some clients may be looking a lot closer at their portfolios and asking if they will be able to live on the income they have.”

Lynn Mayabb, senior managing advisor at BKD Wealth Advisors in Kansas City, says that even as the market went into a downturn, her firm never really thought about trying out new approaches to portfolio construction. “Studies have shown that asset allocation is what determines about 92% of the returns,” she says. “We first look at the asset allocation. That is our management style.”

BKD has been significantly increasing its international allocations “because in part of how those economies have been responding during this time frame,” Mayabb says. Specially, the companies have had very attractive valuations and increased dividend yield as compared to domestic equities.

BKD also want to reap the benefits of an increasingly global economy. In addition, a portion of the large-cap weight has also been reallocated into smaller companies because they have historically come out of recessions with higher returns. And Mayabb has even increased allocations to alternative investments and utilized some emerging-market ETFs she had never used in the past.

Coghlan says that several clients’ 401(k)s and pensions were liquidated when they retired last year. He left the cash in a money market fund until April, when he began moving back into equities. Clients are now fully invested again, having saved 28% to 30% to the downside.

“We aren’t buying and selling mutual funds or moving money in and out of the market to time it,” Coghlan says. “But this is retirement money, so you can’t deploy it right away,” especially in a volatile market.

Kroll, meanwhile, says that he remains a believer in Markowitz’s modern portfolio theory, even if he has branched out to new strategies during the recession. He contends that when a shake-up happens, it usually takes two to three years for the global markets’ behavior to return to the norms described in the modern portfolio theory. “I think that by 2012 I’ll get back in there,” he says.