Executive Summary
Enjoy the current installment of "weekend reading for financial planners" - this week's edition highlights a number of articles on interesting industry trends, from the ongoing movement towards tactical asset allocation (now used by a majority of advisors), to the difficulties in the variable annuity marketplace suggesting that perhaps annuity expenses have not been too high but in fact were too low in recent years, to the rapid growth of independent advisors in recent years that threaten to overtake the wirehouses by 2013. In addition, we look at the latest from John Hussman on a looming US (and global) recession regardless of recent positive data "surprises", along with John Mauldin on US Federal deficits and the problems in Europe, another piece on Europe by PIMCO's Mohammed El-Erian, and a fascinating - albeit scary - piece about what's really been going on with the "missing" customer funds at MF Global. We wrap up with what is sure to be a controversial article by Bill Bachrach, suggesting that the primary reason financial planners lack trust with the public is because too many don't have the integrity to walk their own talk and use a financial planner themselves. Enjoy the reading!
Weekend reading for December 24th/25th:
Not Going Tactical Could Pose Real Business Risks, Advisors Fear - This article from Registered Rep highlights the recent and ongoing trend towards the adoption of tactical asset allocation. As markets continue to be difficult, advisors continue to shift their focus, and an increasing number now believe that their greatest risk is not the "danger" of being active, but the danger of having clients forsake investing entirely and just say "I'm Done" (according to Ron Carson) if a 3rd severe bear market manifests in 2012 on the back of a US recession and the ongoing European debt crisis (an issue previously highlighted on this blog, "Has the Financial Planning Profession Bet Its Future On The Stock Market?"). In fact, the article notes that more than 60% of advisors are using some form of pure tactical asset allocation strategy or a tactical overlay, and 75% of advisors now believe that active portfolio managers can outperform an index over the long term. Critics still point out the dangers of being more active versus a traditional buy-and-hold approach, but with recent support for tactical asset allocation like the recent article in the Journal of Financial Planning "Improving Risk-Adjusted Returns Using... Tactical Asset Allocation Strategies", and a majority of advisors supporting tactical strategies, a dramatic shift appears underway.
Does The Trend Matter? - This article by financial planner Kay Conheady on Advisor Perspectives highlights some ongoing research into the use of valuation to make tactical portfolio shifts, but also notes that it's not just the absolute level of valuation that matters; it's also the trend. Even if markets happen to be at "reasonable" valuation, the long-term results are dramatically different if markets an average value because they were overvalued (suggesting the trend is still down), versus because they have risen up from being undervalued (suggesting the trend is still up). Some in the industry have called these trends "Secular" Bull and Bear Market cycles, and they can have significant planning implications; as Conheady points out, the average annualized 10-year return for markets in uptrends is 12%, while the average in downtrends is less than 1%, which to say the least can materially impact the viability of a client's long-term plan.
Reality Check - This article by Investment Advisor's Bob Clark discusses the recent Cerulli data showing that independent firms continue to gain market share over wirehouses in the fight for delivering retail advice. Clark notes that according to the Cerulli data, independent advisors (including independent B/Ds, dually registered advisors, and independent RIAs) have boosted market share from 29% to 35%, while wirehouses have dropped from 50% to 43%. If the trends continue independent advisors will pass the wirehouse channel in 2013. And Clark believes that the trends will continue, as he suggests the large top-heavy structure of wirehouses render it virtually impossible to be competitive with leaner, more flexible and more efficient small independents - such that wirehouses are engaging in a last-ditch effort to "level the playing field" by pushing up the compliance burden for everyone. I'm not sure I agree with all of Bob Clark's perspective and predictions, but as I've written previously on this blog as well, there certainly is a strong trend underway towards fiduciary retail advice.
VA Carriers Hunkering Down - This article from Investment News highlights the ongoing recent trend of variable annuity carriers pulling out of the business - beginning with Genworth earlier this year, and more recently Sun Life. Other companies remain active in the variable annuity marketplace, but have pared back their living benefit riders, such as John Hancock, Jackson National, MetLife, and Prudential. The fact that variable annuity companies are leaving the space - and in the face of significant inflows from consumers still eager to buy the guarantees - paints a striking contrast to the common criticism of advisers that annuities are too expensive. After all, if the contracts were really overpriced, then annuity carriers should be thrilled to continue raking in the profits; instead, the trend suggests that many annuities may actually have been underpriced for years, offering more in benefits than they were charging in expenses - a problem the companies are trying to rectify by eliminating variable annuities (or at least many of their guarantees) from the product line.
MF Global and the great Wall St re-hypothecation scandal - This article from Thomson Reuters discusses an ongoing issue plaguing the resolution of the MF Global debacle and the approximately $1.2 billion of "missing" customer funds. As the article highlights, the issue may be that the funds aren't actually missing, but that they were pledged as collateral for an investment bet that MF Global made on European sovereign debt... and as their investment bet went bad (as margin calls came in while the value of various countries' sovereign debt eroded), brokers laid (valid) claim to assets of MF Global's customers. And through a loophole of differences in how the rules are enforced between the US and the UK, it appears that MF Global took advantage of the different regulatory structures (in a manner very similar to what Lehman did in 2008) to make what may have been as much as a $6.3 billion gamble that European bonds wouldn't default, many multiples in excess of the entire company's net worth. The article explains the legal details in some depth (you may just want to skim after the first few sections), but overall it's a chilling story that suggests the problem is not merely that MF Global "misappropriated" client funds, but that they actually lost client funds by pledging them as collateral for their own investment bets. (Thanks to Jason Close for passing along this article.)
The Center Cannot Hold - This week's investment piece by John Mauldin on Advisor Perspectives starts by looking at the economic implications of the 2-month extension to the payroll tax, and the overall trajectory of US deficits and government debt. Mauldin paints a striking - albeit concerning - picture about how, if a country's debt rises too far, even austerity cannot save it, as the short-term impact of spending cuts or tax increases slow growth so much that it necessitates further spending cuts or tax increases in a never-ending spiral... suggesting that the US needs to get control sooner rather than later, before the country passes the point of no return. Mauldin also shares some interesting thoughts on the ongoing European debt crisis - it's not over, there is more to come - and the recent debates in Congress about the Keystone XL Pipeline and US energy policy - especially that if the US wants to get control of its trade deficit, investing in our energy policies may be wiser than starting a tariff/protectionist trade war with China.
Downward Spiral - This article by PIMCO's Mohammed El-Erian on ForeignPolicy.com discusses the ongoing downward spiral in Europe. El-Erian suggests that within the next few months, the European crisis will morph into a fourth phase... and should it materialize, the only options will be either a disorderly fragmentation of the eurozone, or the establishment of a smaller eurozone within Europe that has a new relationship with the rest of the European Union. The choices are only bad and worse, but while a smaller "refounded" eurozone may be less than imperfect, it's still better than the alternative. But as El-Erian points out, the longer European leaders wait, the less flexibility and fewer choices they will have.
When 'Positive Surprises' Are Surprisingly Meaningless - In his weekly market commentary, Hussman makes a number of striking points about the current economic and market environment. First, he notes that while recent economic data has delivered a number of positive surprises, they are only positive relative to what have otherwise been severely negative expectations. In other words, the data isn't "good", it's merely "less bad" than we feared... at least, so far. Hussman suggests that the US (and likely global) economy is still heading for a recession, one that will likely begin to appear in the data imminently. As a result, Hussman still suggests that this is a time to be highly defensive.
Higher Ethics - This article by Bill Bachrach in Financial Advisor magazine will strike a nerve with many planners. Simply put, Bachrach suggests that for advisors to really be acting with integrity with their clients, they need to walk their own talk. In other words, we need to work with financial planners ourselves to have our own plans, live within our means, be adequately ensured, etc. In short, we need to have our financial houses in order, if we want to claim the ethical integrity to advise others. Bachrach suggests that the core of the industry's problems are because so few advisors really do this; as Bachrach puts it, most consumers don't trust financial services because "at some basic, intuitive level they know that too many of us are full of crap." Bachrach's concern echoes the debate within the profession that erupted a few weeks ago in regard to financial planner Carl Richard's NY Times article "How a Financial Pro Lost His House", which included an active discussion on this blog regarding the importance of the credibility of planners with the public.
I hope you enjoy the reading! Let me know what you think, and if there are any articles you think I should highlight in a future column! And click here to sign up for a delivery of all blog posts from Nerd's Eye View - including Weekend Reading - directly to your email!
Michael,
Regarding the 60% of advisors who are implementing tactical asset allocation, is it your impression that at the moment they are mostly all on the same side of the same trade? I.e. underweight risk assets? If so who is on the other side of the trade? Investors without advisors?
Steve,
I don’t have any hard data for this… just some volume of anecdotal evidence from what I hear talking to people. But here are common tactical tilts I see:
– Planners own more commodities than they used to, as a tactical shift to handle inflation risk
– Planners own more gold than they used to, as a tactical shift to handle inflation and currency risk
– Planners hold a shorter bond duration than they used to, in anticipation of rising rates, either due to inflation or sovereign credit pressures
The first item above has tended to come from equity allocations. The second sometimes comes from equities, other times from bonds. The third is a bond shift.
In general, I’ve found planners are more willing to be tactical around equities, than tactical WITH their equity allocation, although this is slowly changing.
As for overall exposure to risk assets, I would definitely say that I see moreplanners who have gone underweight to some degree than overweight. But bear on mind that it’s not irrational to have both – risk-INCLINED clients may wish to try to invest this market, while risk-ADVERSE may not view the risks as worth the opportunity. Efficient markets assume (unreasonably, in my opinion) that all investors have the same risk profile. They don’t. You can rationally have some investors increase risk exposure in these markets while others decrease it. Different risk attitudes and different financial capacities for risk certainly allow for that.
I hope that helps a little!
– Michael
Michael,
I own more commodities than I used to. There hadn’t been any vehicles and no research, really, to support the asset class. I consider this a permanent, strategic and not a tactical allocation.
Don’t own any gold other than whatever gold stocks are in the funds I hold.
My bond durations are shorter, due to the managers of the funds I use shortening up their durations. My impression is that the indexes themselves have shorter durations, because investors in general are shortening their durations.
If this is the evidence of a large scale shift to tactical it’s not persuasive to me.
To my mind, examples of tactical are:
-using PE10 or something like that as a forecasting tool to consistently vary equity weightings based upon preceived valuation.
-varying allocations to large cap vs. small cap (or domestic vs. international, etc.) based upon forecasts of under/over valuation.
-varying allocations to sectors, i.e. underweigthing or eliminating financials, etc.
-significant devotion to momentum, i.e buying stocks or sectors that show strong upward momentum and selling those that show strong downward momentum.
I certainly have never understood the proposition that efficient markets assume that all investors have the same risk profile. MPT suggests that investors vary their allocation to risk assets DEPENDING on how much risk they want or need to assume in order to achieve their goals; by combining the market portfolio with the risk free asset in different proportions.
Hi Michael,
Can you point me to the most comprehensive discussion of your JPF “tactical allocation” article? I don’t want to take much of your time but I am hoping to see what the best CFA-brains say regarding your testing methodology, and whether they’ve reproduced your results.
Thanks!
Mike,
I haven’t seen any discussion of this type on our JFP article yet. Realistically, it’s too soon. The article has only been out a few weeks; no one has yet had any time to reproduce it.
That being said, we’re all using the same historical data, so I’m not sure having others reproduce it from that same data does anything to enhance the validity of the results anyway.
The real issue, for better or for worse, is whether you think the conclusions and results we found are likely to persist in the future, or whether they are merely data-mined artifacts of history. Obviously, we strongly believe the former and not the latter, or we wouldn’t have published the article, but that’s where I would anticipate whatever criticisms may come.
Respectfully,
– Michael