VOICES FROM THE INDUSTRY: Shouldn't you make money in up, and down, markets?

July 30, 2007

It seems simple, but knowing whether your financial advisor is doing a good job can be a challenge for some.

It's difficult to define what good is, because it depends on how the rest of the market is performing. For example in a bull market, 2 percent is a horrible return. But in a bear market, when most investors are down 20 percent, just preserving your capital would be considered a triumph. In that case, 2 percent doesn't look so bad.

Remember the 1990s were the decade where beating the market was the most important investment strategy. Index funds marketed themselves by saying that since most actively managed funds don't beat the market, investors should just buy index funds. Actively managed fund managers fought back by showing time periods when they did beat the market. Then came the period of 2000-2002, and the market was creamed. Whether you were in an index fund or an actively managed didn't matter-you probably still lost a lot of money.

Did your advisor come to you and say something like this. "Mr. Client, you outperformed the overall market. Your portfolio was only down 20 percent compared to the 20 percent the market was down."

You thought, "Great, I beat the market." Or something more like: "Great, how am I going to pay for my child's college?" or Will retirement have to wait? Although your portfolio was invested in the market, it should have been invested for your goals.

Is this your type of goal-double your money every year without taking any investment risk? Well, this is not one of those get-rich quick schemes and that isn't an obtainable goal anyway, but rather a dream. An obtainable investment goal might be something like, "I want to make money in up markets and down markets. I do not want to lose my money."

That way your life's goals can be funded in whatever the market conditions are whenever the time arrives.

A matter of time

Of course, over very long periods, buyand-hold strategies almost always do well. The problem is the length of time and starting point because it can matter enormously when you buy.

For example, over hundreds of years, stocks returns have averaged about 8 percent a year, but there can be several decades when stock prices don't increase in value at all.

The S&P index, which fell sharply after reaching a peak in 1968, failed to return to its 1968 level in inflation-adjusted terms until 1992! Do you have another 24 years before your goals need to be funded with the exact amount you have today?

Back in the 1970s, these swings in value prompted investment managers to focus on returns relative to benchmarks, such as the S&P 500 stock index. That way, good performance was expressed in terms of asset managers' performance relative to standard asset-class indices, and the better the relative performance, the more investors were attracted. In other words, managers attracted more investors-and were paid more money-even if the fund declined in value, so long as it did not decline as much as the benchmark index.

In contrast, some private wealth managers today focus on risk-adjusted absolute returns-that is, their objective is to maximize the increase in investment value per year rather than to simply perform better than the market average.

Consequently, these managers are paid based on how much they increase investors' wealth.

My belief is that this decade will be a decade of absolute return investing, unlike the 90s, when it was about index investing. Although I may be wrong, I think most investors don't care as much about beating the market as they do about losing money.

Here is your wake-up call. Business fundamentals aren't faring well these days. Housing starts aren't good, the dollar is falling in value, and the auto industry is in trouble. Plus the U.S. has a trade deficit, a balance of payment deficit, and the Fed is making noise about inflation.

What's more, there's no end in sight for the war in Iraq, and the S&P started to head south in the last few weeks. Most analysts say it isn't a question of when we have a correction in the market, but how deep the correction will be.

Absolute return strategy

Absolute return strategies aim to deliver returns in both rising and falling markets. Absolute return differs from relative return because it is concerned with the return of a particular asset and does not compare it to any benchmark. Absolute return investment techniques can include using short selling, futures, options, derivatives, arbitrage, leverage and unconventional assets.

Putting your money in a strategy that can increase your investment whatever the market conditions may be worth looking at. Especially if you listen to the ominous rumbles that say the good times can't last forever and that at some point the strong equity growth seen in recent years will slow down.

An absolute return strategy is a mandate that seeks to achieve positive returns in every market, while minimizing the probability and size of losses. The principle idea behind an absolute return approach is that portfolios are generally managed against a target return, and not versus a benchmark.

This type of strategy is best for investors who are interested in garnering good returns from their investments, but worried about the idea of a stock market crash wiping out all their funds.



Coan is managing partner with Wealth Planning & Management LLC, a fee-only registered investment advisor, and author of "Asset Protection and Wealth Preservation." Views expressed are the writer's.
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