3 Key Changes to Investing Today

02/03/2012 6:30 am EST

Focus: FUNDS

Jeff Montgomery

Chairman and Chief Executive Officer, Al Frank Asset Management (AFAM) / Innealta Capital

Changes in the marketplace have hit the baby boom generation hard, says Jeff Montgomery, who heads up portfolio management firms Al Frank Asset Management and Innealta Capital. He explains how his companies’ funds, and investors, can address these trends.

Kate Stalter: Today, I’m honored to have as our guest for the Daily Guru: Jeff Montgomery, chairman and CEO of Al Frank Asset Management and Innealta Capital.

Jeff, as you know, I’ve spoken with a couple of your colleagues recently about their investment philosophies. But I thought we could get the bird’s eye view from you today. I wanted to ask you about some specific challenges of managing risk in today’s investing environment.

Jeff Montgomery: I think everybody now has tapped in very strongly to the idea that this time, with the most recent market correction and crash, was actually different. There’s the old maxim: be careful to say that “this time is different,” but I think we realize now that it was.

Three things really happened in the marketplace post-2008. One is, we had never had two market downturns of the size and timing that we had in 2001 and 2008 at the same time that the demographic in the United States was changing.

You had the baby boomers having moved into the retirement phase, and to some extent the preservation and income phase of their investing. Never before in the United States, even going back to the Depression, had we experienced market corrections that were tied to such an important demographic factor.

As we know, the baby boomers have most of the assets in the United States, and for that matter, most countries. When you tied two successive market downturns that were very precipitous to that demographic, you had literally permanent behavior changes which I’ll touch on in just a moment.

Then other key things have happened in the past few years. One is that financial advisors and individual investors have gotten a lot smarter about risk management. It’s always fascinating.

You’ll hear these stories from individuals and financial planners about what it was like to go through a risk profile or a risk questionnaire back around the turn of the decade. They would ask the questions and say, “If you’re investments went down 20% in a week, could you sleep at night? How do you view risk?”

Just about everybody overrated themselves. They said “Oh, I can handle or manage that risk emotionally. I can handle or manage that risk financially.”

The truth was, when the big declines occurred, most of those people felt differently about risk. They wished that they had a larger component of capital preservation or a larger component of income.

Because one of the great things about dividend stocks is, you get paid to hold them. So you may purchase the stock, it may go down, but you’re being paid while you hold that stock. That’s obviously a pretty good scenario in volatile markets.

I think the last key factor to consider—and it really has become a part of day-to-day life—is just how everybody’s allocations have changed. When you look at allocations broadly, and you go back just seven or eight years, it used to be that maybe you just had a little bit of real estate, maybe you had some international stocks, maybe you had some domestic stocks, and the allocation to diversify any investor was very vanilla.

We learned that the correlation was excessive and that almost everything went down in 2008. Take a look at 2008 as an example. Real estate was down over 30%. The broader markets were down in the US. The international markets were down. The emerging markets were down. Most alternatives investments were down.

So those allocations quite frankly, failed. We had a failure of typical modern portfolio theory allocation.

Well as we’ve emerged today, both savvy individual investors—and in some cases their financial planners—have learned a tremendous amount about non-correlation and making sure that there is diversification within any portfolio, so that the allocation is safer.

So those have been the three big trends, and really the wrapper to that is that the housing downturn was so deep. We’d never experienced anything like that, that was joined with a market crash. You go back to the 1970s, you go back to 2001, housing basically held steady, or even in some cases appreciated, while the market was crashing.

I think we had the perfect storm the last few years, which is why things have evolved the way they have.

Kate Stalter: Now you alluded a moment ago, Jeff, to perhaps some demographic changes or attitudinal changes among the people saving for retirement. Can you say something about that?

Jeff Montgomery: Yeah, I think that’s a great point to highlight. When you’re a baby boomer, as a great number of people in the United States are today, obviously you go from your capital accumulation years to generally your capital distribution years.

For the most part, you’re going to shift your outlook on whether you want to preserve your capital or how much you want to put at risk. But also you’re going to be creating some tools that allow you to have an income, and that’s whether you’re retired or not.

I mean many, many baby boomers—in fact, probably most of them—work into their 50s, 60s, and even 70s, and beyond. Yet at the same time, they realize because their time horizon is a little bit shorter due to normal longevity, they’ve got to first of all protect capital, and second of all generate some income from that capital, even if they’re still working.

As we all know, those born in 1946 and after represent in the United States the baby boom. It’s our largest population group, and they have shifted into those two considerations to varying degrees.

I think the core point boils down to this: The baby boomers experience first hand, having worked for a lifetime, having been productive, having owned a business, having had a great career and watched a lot of that capital—including their real-estate holdings, no matter what they were, commercial or residential real estate—decline.

So we’ve seen a very, very strong demand in AFAM and Innealta Capital for investments that accomplished two things. From our value division, we offer specialty portfolios and mutual funds that provide dividends. The Al Frank Dividend Value Fund (VALDX) is one example of that.

In our Innealta Division, we went out two years ago and looked to purchase a tactical manager. For those of the investing community who might not be familiar with a tactical manager, a tactical manager simply does this: They’re going to use their quantitative screens to evaluate the market. If the market is deteriorating, they’re going to move out of the market, rather than buying and holding or buying more on the dips.

That tactical approach is becoming very popular. Most investors have a third to a half of their portfolio in tactical investments, so that they can preserve capital and not sustain these big drops during market corrections.

Kate Stalter: Let me follow up on one other thing. This is something you’ve been alluding to as we’ve been talking here, Jeff.

Changes in the financial services industry, either in response to regulation or response to some of the so-called “black swan” incidents that have occurred in recent years…how would you characterize some of the changes in the industry, and especially how it affects advisors?

Jeff Montgomery: I think there are three key elements to answering that question. The first one is—and you made a great reference to it—black swan events.

We almost have to redefine black swan, because we’ve already violated the definition of it multiple times. When everybody was saying last year that we’ve had five black swan events in the last four years, by definition we have to redefine black swan events, because they’re not supposed to occur that frequently.

I think No. 1 is that area of tactical asset management. Getting out of the way of the freight train when it’s coming down the tracks, stepping aside, letting the freight train pass, and then stepping back onto the tracks, which means stepping back into the market. I think the No. 1 element that we’re seeing is this massive evolution of tactical investing.

Now, like anything, you don’t want to go too far. You don’t want to have the pendulum swing too far. I don’t think any investor should have 100% of their investments in a tactical approach.

But we’re finding that the allocations and the portfolios are gravitating towards in many cases 50% tactical, which is why we launched the Innealta Country Rotation Fund (ICCIX) and Sector Rotation Fund (ICSIX) to address that. We happen to have one of the longest standing tactical divisions in the country, with a long track record of handling volatile markets.

No. 2, I think the other evolution is of volatility itself. There is so much program trading, there are so many big, big players in the market now that the small investor comes in, or the small advisor on behalf of their clients goes to make a trade, and you literally have no idea of who’s on the other side of that trade.

It can be somebody’s day trading firms, it could be somebody’s bot program that are program trading devices and computers, or it can be Goldman Sachs (GS), or some European entity that’s making a growth and income fund trade and causes you to get a bad execution.

That leads to really the third point, and that is simply the interconnectivity. It’s been talked about, but it still amazes me every day sitting in front of our trading screens and managing $2.5 billion here at AFAM and Innealta Capital, and watching the differences between today and ten years ago in terms of interconnectivity.

As a matter of fact, if you look at today’s market, we’re experiencing a volatile day today in the markets. What is the reason for that? It’s a small—virtually an island—nation called Greece.

Who would have thought that a small nation—smaller than the state of Michigan, by the way, in terms of population—could affect the world markets? So I think this third element is interconnectivity.

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