Broker Check

Can You Handle the Heat? How to Invest in an All-Equity Portfolio without Getting Burnt

| September 08, 2015
Share |
Investments

Question: How much can you lose in a down market on your way to earning a good overall return? See answer at the end of the blog.

Selected excerpts form the book "Investment Strategies that Work" (2015) - by Brett Machtig & Josh Gronholz

Over the last century, the investment returns on stocks (i.e., equities) have outperformed other asset classes like bonds, commodities, and gold. One valid approach is to invest only in equities. Investing all in equities is how one of the wealthiest asset managers does it – Ken Fisher invests only in stocks. Fisher is an author and has been a Forbes columnist for more than twenty years.

Let’s examine how stocks in general have done and then we will look at how Ken’s mutual fund has performed, as compared to its benchmark.

Over any ten-year period, S&P 500 has outperformed more than 95 percent of all-equity fund managers with similar benchmarks. It has costs of less than 1/10th of one percent. S&P 500's performance over time is shown in Exhibit 4.

The question to ask yourself: Can you be comfortable with losing more than 42 percent of your assets in any given year in the pursuit of greater returns? The answer is different for different people.

Consider Ken Fisher with $2.9 billion. If he loses half of his assets, he is still a billionaire.

By contrast, consider a retired investor who has $1 million in all-equity retirement funds on October 17, 2007 had her retirement funds drop to $498,650 by March 22, 2009. Her lifestyle would be irrevocably weakened. Even though S&P 500 did recover in 2012, if she were drawing seven percent per year of her original amount since 2007, she would be down 43.8 percent by the end of 2012.

To better understand how to look at one asset allocation strategy versus another, we need to define three financial terms: market risk, company-specific risk, and other avoidable investment risks.

  • Market Risk: The risk inherent in any given market or an entire market segment. Market risk, also known as systematic risk, affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to avoid altogether. Market risk cannot be mitigated by adding more stocks. It can only be reduced by investing in other asset classes or market segments. Source: Investopedia.com
  • Company-specific Risk: A company-specific hazard is inherent in each traded stock. Company risk, also known as “non-systematic risk,” can be reduced through diversification. An example of company-specific risk is the drop in Enron, BP or Citigroup. The company-specific risk is virtually eliminated by owning exchange-traded index funds versus a small basket of stocks. Source: Investopedia.com
  • Other Avoidable Risks: This is the risk associated with paying more in management fees, adverse asset selection, and in other high fund An investor can be exposed to the same asset class using different funds, but instead of the rewards going to the investor, they get eaten up by investment costs. An example of other avoidable risks would be investing in a mutual fund with high fees and a front-end load.

 

To understand how Market Risk” and “Company-Specific Risk” and “Other Avoidable Risks” work, let’s look at Exhibit 3:

Both funds invest in U.S. Large Cap Growth Stocks; have diversified away the company-specific risk and both have similar market risks, but they had different growth results because of high fees and management performance.

Dave Ramsey also uses all-equity investment strategies in his books, including Financial Peace and The Complete Guide to Money. He recommends investing in a growth fund but only after emergency funds are established and only under the watchful eye of a competent financial advisor.

Brett Machtig has appeared on Ramsey’s show several times. Machtig believes Ramsey’s Financial Peace University is one of the best programs to turn people’s situation around: going from in-debt to being debt-free. Ramsey suggests using ROTH accounts, not using credit cards, maximizing the contribution to retirement plans where possible and using term insurance over whole life. Where Brett disagrees is on the expected returns from an equity-only portfolio. Ramsey suggests returns of 12 percent and retirement withdrawals of eight percent during retirement. Our research indicates that these expectations are high, depending on when you retire. For example, if you invested in S&P 500 and received 8% per year of your original investment since 2007, by 2014 you would be down 44.1%. Source: Wikipedia.com

In summary, you cannot eliminate the market risk of a given sector or asset class, which is why asset allocation is so important. We CAN reduce company-specific risk by diversification within a sector or asset class by using exchange-traded index funds. Moreover, we can minimize the adverse impact of “Other Avoidable Risks” such as high fees and poor modeling by looking at cost-effective ETFs and by using third-party scoring systems like Guru Focus, Morningstar, and FI360.

 

How Can You Improve Your All Equity Returns and Reduce Drawdown Risk?­

  1. Use Exchange-Traded Funds (ETFs)

This may seem obvious, but the fees can run as much as 1,000 percent higher, depending on your share class and investment type. Higher fees make it harder for your investments to grow. The very same mutual fund can charge the same investor more, just depending on the share class. According to Investopedia, the fund “share class” indicates the type and number of fees charged for the shares in a fund. Although mutual fund companies can have as many as seven or more classes of shares for a particular fund, there are four main types of mutual fund classes that are most popular: A, B, C, and institutional shares (also known as A-shares, B-shares, C-shares and institutional R6-shares).

Each of these classes has various benefits and consequences. A-shares tend to have front-end loads, B-shares tend to have back-end loads and higher 12b-1 fees, C-shares do not have loads, but tend to have higher costs, and institutional shares are lower in fees but may have minimums that need to be met.  Let’s examine the fees and their impact on returns in Exhibit 36 below:

 Source: FI360.com. This illustration is being used for example purposes only. Past performance in not guarantee of future results

 

Notice the return difference between the share classes. In the first year, the institutional client got 3.9 percent, an “A” share investor receives a 2.45 percent loss, a “B” share investor receives a 2.26 percent loss, and a “C” share investor makes 1.69 percent. So, the first-year returns vary by as much as 6.35 percent!

Also, note that the exchange-traded fund made 7.66 percent more than the institutional shares in one-year and 14.75 percent without compounding (2.95 percent x 5 years) or 15.65 percent with compounding more than the institutional shares over a five-year period. In summary, fees matter and must be minimized. Curious about how your funds stack up? Call CAG to provide a free review at 952-831-8243.

Bottom Line: Mutual funds are expensive relative to the value they actually bring to the investor, and there are equally or better-performing alternatives that are less expensive.

 

  1. Diversify Your Holdings

By investing in different types or groups of equities, you can benefit to buying low and selling high, since all groups do not move together. Consider using industry-rotation strategy to sell high and buy low in your asset allocation.

Some experts divide the economy into nine areas or sectors – health, energy, technology, financial endeavors, consumer staples, consumer discretionary spending, industrials, materials, and utilities. Each year some do well, and others do poorly. One way an investor can increase their return is to buy the sectors that have the worst returns as of January 1. Then the investors reallocate to the ones that are lowest the following year.  Exhibit 34 shows the one-year returns ending March 13, 2015.

In this example, you would buy into basic materials and energy, and then look at the list in a year, sell current sectors, and then buy those that are now at the bottom of the list.

In Exhibit 35, we illustrate the key sectors and how they behaved in the last ten years. The first column shows the sector selected as a result from buying the worst performing sector the prior year. Notice that in 2008, if you were not applying our timing signal you would have lost more than 50 percent. Even with that enormous drawdown, the strategy did well in most time frames.

 

In Bad Times, Get Out.

Sometimes, it is not high investment returns but capital preservation that is most important. Using tactical asset management strategies, one can reduce the risk in down markets and then increase the market exposure after significant pullbacks have occurred. The trick is to determine when to make the correct adjustments.

Our signaling system for adjusting the clients’ portfolios was created by the Investment Committee of The Capital Advisory Group (CAG). David Denniston, Chartered Financial Analyst; heads the investment committee. Dave was instrumental in developing our proprietary system of timing signals and is responsible for implementing our investment strategies. The ultimate goal is to help reduce market risk and help minimize the fluctuating value of other assets in times that we perceive as risky and increase stock market exposure in times that we see as less risky. Also on the Investment Committee are Mark Foreman, CPA; Roger Anderson, CFP®; and Brett Machtig, AIF®, CWS® and RMA.®  For more information go to www.brettmachtig.comor www.cagcos.com.

 

Four Keys to Know When You Should Reduce Market Risk or When to Increase It

  1. Time. Markets do not just go up. They go up and down. They breathe. On average, the markets go up for three to five years for every year that they are down. So if the markets have been moving up for three, four, or five years in a row, plan for a signal change. As you can see in Exhibit 23, we are nearly at a five-year high in May 2015. Looking for highs and lows helps in identifying false signals that occur around a signal change.
  2. 200-Day Moving Average. A 200-day moving average is an institutional measure of the average price of the stock over the last 200 trading days. This value is updated each trading day to include the most recent data. If the current price moves above the 200-day moving average, then it is a good indicator to buy. If the price moves below the 200-day moving average, then it is one indication to sell. To avoid false signals, we use a proprietary algorithm to lower the amount of signal changes.
  3. Buy Low, Sell high. More specifically, you have to sell high in order to buy low. We do this by tracking the five-year highs and lows. A five-year high indicates more of a sell (RED) signal. As you can see, we are near a five-year high. If this high occurs and then you get a 200-day moving average cross-over by more than three percent for more than three days, we have a Red Signal.
  4. Volatility Index. The Volatility Index (VIX) measures the fear and greed in the market. A high VIX (greater than 25) indicates that a great deal of fear exists in investors, which is a good time to buy. A low VIX (under 25) indicates that greed is high, signaling it may be time for the savvy investor to sell.

These signals are to be used in conjunction with one another, not in a vacuum. When ALL of them trigger at the same time, it is the strongest signal to either buy (a green signal) or sell (a red signal).

 

Application of CAG’s Tactical Asset Allocation Timing Signals

So, is the U.S. Stock market at a market low, in the middle, or near a market top? Here is an illustration of how to find out. As of the summer of 2014, here is what the signaling system has been telling us:

  1. Sell high, buy low – We were at the 5-year high that indicates a sell. Indicated a RED Signal as of July 31, 2014.
  2. We have had a five-year rise since our last pullbacks, indicating a “stale signal” or it is time for a withdrawal. Indicated a RED Signal as of July 31, 2014.
  3. The Volatility Index. The VIX is at a near low of its trading range, indicating a greedy market, a sell signal. Indicated a RED Signal as of July 31, 2014.
  4. The 200-Day Moving Average. As of writing this, the S&P 500 has not yet moved below its 200-day moving average, the sell has not triggered on this indicator. We use 3% below the 200-day moving average for three days at a market closing to trigger our signal, to avoid false signal changes. At both tops and bottoms, there are times where market signals bounce between red and green several times. This “bouncing” is another validation that change is coming, so we keep the new signal Indicated a GREEN Signal as of July 31, 2014.

It takes ALL four triggers to agree to have a confirmed signal change. As of summer 2014, we have three triggers signaling a Red Signal and one still in green, so the timing signal stays green. No crossover of the 200-Day moving average has occurred. In Exhibit 25 you can see plotted over the last 17 years, our signal changes and its performance impact. Also, note that as of May 13, 2015, this is still a green signal.

In this illustration we will use (For example purposes only):

In Exhibit 25, the purple curve is the percent change with time of the S&P 500 allocation held for the entire 17 years which resulted in a total gain of 208.1%.  The red curve shows the ups and downs of a portfolio composed of 60% S&P 500 and 40% Bonds that was rebalanced each year to maintain the 60/40 ratio.  The final result after 17 years was a net gain of 175.6%. The green curve shows the changes in a portfolio composed of S&P 500 and Bonds where the ratio was adjusted based on our signaling system (or algorithm). When the algorithm indicated a Green condition the allocation was 80% S&P 500 and 20% Bonds. Other times, when the algorithm indicated a Red condition the allocation was 30% S&P 500 and 70% Bonds. The signal timing portfolio total return was much greater at 405.7%.

Observe in Exhibit 25 how making the allocation switch during the Red time spans significantly reduced the loss in the green curve compared to the other two curves.  Note that the three curves in Exhibit 25 are the actual percentage values not the 200-day moving average.

In Exhibit 26 are the signals since June 1997.

 Over a 17 year period, there were 11 signal changes, causing very little in short-term capital gains, as most of the short-term holds were losses or tiny gains. The tabulated portfolio gain and loss values correspond to the green curve in Exhibit 29. By utilizing our timing model  and applying them to S&P 500 and Bonds, we were able to more than double the returns from its benchmark of owning the very same two portfolios invested in 60 percent S&P 500 and 40 percent Bonds as buy and hold positions.

Alternative tactical asset allocation strategies are worth noting. The first is using the crossover of the 200 day moving average and the 50 day moving average, which is used by some institutions and gets nearly the same return as CAG’s model; but this strategy creates more signal changes, or more short-term trading, which increases the tax consequences in taxable accounts.

Another tactical asset allocation, is outlined by Michael A. Gayed, CFA and Charles V. Bilello in their 2014 3rd Place Wagner Award-Winning paper, “An Intermarket Approach to Tactical Risk Rotation: Using the Signaling Power of Treasuries to Generate Alpha and Enhance Asset Allocation.”  Their model compares the total return of the 10-year U.S. Treasury to the 30-year U.S. Treasury on a monthly basis. If the 10-year is higher than the 30-year total return of the prior month, they suggest going 100% into stocks. If the 30-year is higher than the 10-year total return of the prior month, they suggest going 100% into 10-year or 30-year U.S. Treasury bonds.

The result, according to their paper, their strategy between 1977 and 2013 adds .8% using 10-year U.S. Treasuries, adds 1.4% using 30 year U.S. Treasuries over a 100% stock portfolio’s 11.8%; or 3.7% and 4.3% over a relative index (50% Stock / 50% bond) using 10-year and 30-year U.S. Treasuries. Its disadvantage is it requires monthly trading. Its maximum drawdown is about half of the maximum drawdown of the all-equity model (24.6 versus 50.4%). Their paper is great and the only disadvantage is the short-term holding within a taxable account would have increased tax consequences over our strategy. They also made a great case against the hypothesis that alpha cannot be generated and the markets are so efficient that all market risk is reflected in stock price. This model is for illustration purposes only. Results have NOT been tested and past performance is not guarantee of future results, Source: Jun. 15, 2015 8:00 AM ET seekingalpha.com/article/3258295-the-feds-last-excuse

  

Results as compared to other methods

This method would have returned much more than each equity model by more than 3% on average for the past five years, and would have significantly reduced the drawdown risk, as the stock position was much lower in 2008 which would have been the only Red Signal year. Instead, of being down by 41%, by reducing the stock portion to only 30%, the 2008 drawdown risk was cut down to 8.4%. So by using these funds (although past performance in no guarantee of future results, return was increased by 20% and downside was reduced by 80% in 2008.

Do It Yourself, or Get Help – Some people like to do it themselves and others want help. And others need help (you know which one you are). If you need help, give us a call 952-831-8243 and we will help find the best asset allocation for you!

Answer to the Question: How much can you lose in a down market on your way to earning a good overall return?

You are the only one to answer this question, but you can make an informed choice. Ask yourself:

  • How much am I seeking to make on my investments? Are you O.K. with making 2%, 4%, 6%, 8% or 10%?
  • How much am I willing to lose in a down market? Are you O.K. with losing 10%, 20%, 30%, 40% or 50%?
  • How does my existing portfolio stack up to my answers. If you want to know, we will run a Monte Carlo simulation to see how your portfolio matches up for FREE by calling 952-831-8243.

by: Brett Machtig, & Josh Gronholz

     # # #

We Can Help.

If you want a review of your situation, we will do it for free. The Capital Advisory Group Advisory Services is an asset manager that helps guide wealth accumulation and management. Our team helps executives, retirees, and business owners with financial planning, asset management, tax guidance, risk mitigation, and estate planning. We help clients create wealth by analyzing income, cash flow and taxes with the goal of each becoming great savers. We scrutinize what can derail the plan. Finally, we help clients grow into investors with realistic expectations, giving them strategies to reduce the impact of market downturns and helping them create plans to meet their future income and asset objectives.

As a Registered Investment Advisory (RIA) firm, we are held to the highest standard of financial service firms.  We are held to the “fiduciary” standard of care. The Center for Fiduciary Studies states that: “Advisors held to the fiduciary standard must employ reasonable care to avoid misleading clients and must provide full and fair disclosure of all material facts to your clients and prospective clients.”(1)

According to the SEC, “advisors held to the fiduciary standard have a fundamental obligation to act in the best interests of the clients and to provide investment advice in the clients’ best interests. Under the fiduciary standard, advisors owe clients undivided loyalty and utmost good faith.”(2)

We take our fiduciary standard very seriously at The Capital Advisory Group Advisory Services.  We search for ways to better our clients’ current and future financial situation.  We want the best for you and your family.

The Capital Advisory Group Advisory Services uses independent research to identify low-cost investment options, as high fees have an adverse impact on returns. We analyze fees and fund performance using programs like Fi360 to select better investment options and doing side-by-side peer comparisons improve results.(3) 

 

Our Approach

Our goal is to help avoid you expensive financial lessons and become your “Personalized Chief Financial Officer.” The philosophy we have is to take our three decades of client and personal financial experiences and apply workable solutions to help you better manage your financial needs. We are an independent group with no proprietary investment products or sales quotas.

We are a fee-for-service advisor.  We have found that just commission-based asset management can be an obstacle that may not always work in your best interests.

Our approach rewards us over time, where we have to earn our relationships every day. Our fees vary depending on portfolio size, type of assets, and asset management style. Because our fee-based compensation increases only if portfolios grow, our interests are aligned with yours. We focus on financial objectives and your future growth.

 

Our Investment Process

Before we develop a personal investment strategy, we take a hard look at where you are currently. We assess investment goals, available resources, desired rate of return, and risk tolerance. Our research allows us to customize a plan to help fit your individual needs and develop your unique “Investment Policy.”  Once the blueprint is in place, advisors provide personalized investment advice. We allocate assets in a way that is intended to enable you to obtain an expected return for a specific level of risk. We believe that asset allocation is responsible for more than 90 percent of the variations in investment portfolio performance – so choosing the right asset allocation for you is our top priority. Each of our models is actively managed and back-tested to help manage risk.

Along the way, we monitor your progress including client statements and reports that summarize investment activity and compare your current portfolio results to your goals. We make periodic adjustments to re-balance your portfolio, adjusting our strategies to fit your individual needs. Through-out, we maintain constant vigilance over market awareness with our investment committee. Thank you, and please give us your feedback. We can be reached at 952-831-8243.

 

About the Authors:

Brett Machtig has authored several books and is the founding partner of The Capital Advisory Group, a private asset management and retirement planning services firm located in Bloomington, MN. Their firm manages more than $400 million in assets for 83 institutions and about 850 families as of December 31, 2014. He has been helping affluent investors execute financial strategies, meet income objectives and realize life visions for more than 30 years. Approachable, genuine and down-to-earth, Brett holds himself to a high standard of accountability and seeks to achieve positive financial results on behalf of each client. In this article, Brett shares the effectiveness of each strategy and how to improve it. 

 Josh Gronholz graduated Summa Cum Laude from the University of Minnesota’s Carlson School of Management and is a Registered Asssitant. He has worked in asset modeling with The Capital Advisory Group and has spent the bulk of his career modeling various investment scenarios and assisting individuals along their way to financial success and personal wealth.

We can be reached at bretmachtig.com or cagcos.com; 952-831-8243 or[email protected] or [email protected].

Source:

(1)finra.org/web/groups/industry/@ip/@reg/@notice/documents/noticecomments/p118980.pdfas of 8/2014
(2) www.sec.gov/divisions/investment/advoverview.htm as of 8/2014
(3) www.fi360.com/products-services/tools-overview, as of 8/2014, Results not guaranteed.

The information contained does not constitute an offer to buy or sell securities and is provided for illustrative purposes only. The information comes from reliable sources, but no guarantees or warranties are given or implied to its accuracy or validity. The strategies listed do not necessarily reflect those of its publisher, MGI Publications or its authors. Information obtained from publicly available sources listed herein and footnoted where applicable. Securities offered through United Planners Financial Services of America, a Limited Partnership, 480-991-0225 member FINRA/SIPC, 7333 E Doubletree Ranch Rd, Scottsdale, AZ 85258. Advisory Services offered through The Capital Advisory Group, LLC 5270 W. 84th Street, Suite 310, Bloomington, MN 55437, 952-831-8243, an independent registered investment advisor, not affiliated with United Planners Financial Services of America. ADV, Part 2A as of 3/26/2015, available upon request. Many investments are offered by prospectus. You should consider the investment objective, risks, and charges and expenses carefully before investing. Your financial advisor can provide a prospectus, which you should read carefully before investing. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund. Diversification does not guarantee a profit or protect against loss. Please consult your attorney or qualified tax advisor regarding your situation. Asset allocation and rebalancing do not guarantee investment returns and do not eliminate the risk of loss.

Share |