Filed Under:Your Practice, Regulatory

Advisors Eye Portfolio Changes Following S&P Action, Market Dip

The unprecedented downgrade of U.S. debt by credit rating agency S&P on August 5 and subsequent steep decline in stock values are raising concerns about the strength of the U.S. recovery. The bad economic news, sources tell National Underwriter, may also lead to a rebalancing of investment portfolios as risk-averse clients seek safer havens for their retirement nest eggs.

Assessing the Impact

"The so-called S&P downgrade is a non-event," says Raymond Benton, a financial planner and principal of Benton & Company, Denver. "Of greater importance is the prospect of a global economic slowdown. And that [contraction] is more than likely what the market is currently discounting."

Patrick Collins, a financial planner and principal of Greenspring Wealth Management, Townson, Md., concurs, adding that investors and the public should not expect a 2008-like reprise of massive government intervention to boost economic activity because of Washington's focus on slashing the nation's spiraling red ink.

"The economy is having a hard time standing on its own two feet," says Collins. "If the federal government pulls out the crutches in the form of anti-growth legislation, that will be good long-term for attacking the nation's debt problem. But it could make it tough-going for investors in the short-term."

The economic uncertainty--many economists are now warning of a double-dip recession--could worsen an already long bear market. Mark Singer, a financial planner and principal of Safe Harbor Retirement Planning, Lynn, Mass., says the U.S. is now in the 11th year of a "secular bear market"--the 4th since 1900--wherein the prevailing trend of stocks is downward. If past secular bear markets are any guide, says Singer, the current one is likely to last for another three to five years.

Of more immediate concern to investors is the market's steep declines--initiated by the S&P downgrade, then fed by news about Europe's own debt crises--which could prompt advisors and clients to rethink long-held investment strategies for funding financial goals and objectives. One possible outcome, sources say, is a ratcheting down of investors' risk tolerance for exposure to equities and a flight to safer havens: bonds, certificates of deposit, money market funds and, yes, Treasuries.


Indeed, sources note, Treasuries have enjoyed an influx in capital since the S&P's action, an irony noted by market-watchers, as the agency's downgrade was the catalyst for the Dow Jones Industrial Average's 635-point drop on August 8 and cumulative dip of 1,147 points--9.13% of the Dow's value--over the next two trading days.

Some clients are making a hasty exit from the market on the belief that equities are due for a yet steeper plunge.

"I received a call from a woman who was so panic-stricken by the market drop that she insisted on moving all of her assets out of equities and into cash," says Lee Baker, a financial planner and principal of Apex Financial Services Inc., Tucker, Ga. "I've never experienced this before with a client. She just couldn't stomach losing any more money."

This reaction, however, seems to be the exception. Advisors say that most clients, though concerned about the market's volatility, are holding fast to recommended investment strategies. That's partly because the portfolios contain a mix of "uncorrelated" assets that don't all move in sync with the market's swings. Advisors say they've also cautioned clients to expect market slides; and to not act rashly following a big drop because the portfolios are custom-built to perform well over the long-term.

That may be, but Singer insists that investment decisions can no longer be guided by traditional asset allocation strategies: purchasing and holding particular classes of stock or debt instruments. Such a strategic approach must be supplemented by tactical investing that entails "minor and more frequent adjustments" to portfolios to insulate them against market fluctuations.

Benton agrees. "If they have not already done so," advisors should structure clients' portfolios to "reflect a thoughtful commitment to tactical, as opposed to directional, approaches, in recognition that we are in a secular bear market that started in 2000," he says.

Keys Tinney, a financial planner and principal at Littleton, Colo.-based Aveo Capital Partners, adds that tactical investing also entails holding client assets "locally"--buying and selling, for example, individual exchanged-traded funds or securities, as opposed to whole asset classes.

In years past this hands-on approach was inaccessible to individual advisors. But new software and a decline in custodian costs have enabled them to more proactively manage portfolios. Whatever the approach, Tinney cautions, investment decisions must be guided by factors that advisors can control.

"Many advisors mistakenly take credit for rises in the clients' portfolio values," says Tinney. "In reality, the one thing you can't control is market performance. What you can control is risk tolerance, expenses, taxes and liquidity. When you focus on controlling the controllables, then you can build a portfolio that minimizes the impact of market volatility while maximizing the return for a given amount of risk."

What might such a portfolio look like? Depending on the client's age, risk tolerance, and financial objectives, sources say, the portfolio should comprise a diverse mix of assets that tends not to fluctuate in tandem. Thus a precipitous decline in Dow Jones Industrial Average, as happened after the S&P downgrade, will be reflected in stocks and mutual funds that generally move in concert with the Dow. By contrast, fixed income securities--corporate bonds, money markets, CDs and Treasuries that make interest payments on a fixed schedule--tend to do perform well in bear markets.


A well diversified portfolio, experts say, will generally underperform the market when stock prices are rising, but outperform the market when equities are falling.

"This is exactly what we're seeing now," says Greenspring's Collins. "Our clients' are dramatically outperforming the market. By structuring accounts to underperform in bull markets and outperform in bear markets, we're able to reduce portfolio volatility. This is the reward--and price--for a balanced approached to investing."

Dollars Going into Alternatives

Increasingly, sources say, advisors are turning to "alternative investments" to minimize portfolio volatility. Among the favored vehicles: exchanged traded funds and "alternative mutual funds" (such as those that invest in commodities like gold and oil) plus various other alternatives. Among them: real estate investment trusts and collective trust funds, hedge funds, private equity, currency funds, exchanged-traded notes, limited partnerships and structured products.

Safe Harbor's Singer says that alternative investments should represent between 15% and 35% of a client's portfolio. He notes these vehicles can "potentially help protect portfolios against further downgrades."

Apex's Baker adds that he avails clients of such investment alternatives--and they're enjoying positive returns as a result. Yields on certain REITs, he says, now exceed 7%. But Baker cautions that selling the solutions may entail a longer education process than for traditional investments because of clients' unfamiliarity with the products.

Education concerns aside, investment in alternatives is skyrocketing. Alternative mutual fund assets grew 60% in 2010, ending the year at $201 billion, according to a new report from market research firm Cerulli Associates, Boston. While representing just 2.6% of total long-term mutual funds assets (up from 1.9% in 2009), alternatives grew at a much faster rate last year than other mutual funds, which rose only 16%.

More than three-quarters (76%) of assets managers polled in the study report the financial crisis of 2007-2009 increased their interest in investment alternatives, a sentiment reflected in the inflow into alternative mutual funds in 2009 ($31 billion) and 2010 ($51.9 billion).

To be sure, vehicles apart alternative investments are expected to benefit from the jittery investment environment. Among these are protection products. Apex's Baker says that many of the risk-averse will find very attractive a fixed or fixed-indexed annuity that locks in a minimum guaranteed interest of 4-5%. He adds he would "not be surprised" to see an "uptick" in fixed annuity sales in the year ahead.

Henry McGee, a Greenville, S.C.-based agent and registered rep for New York Life, adds the market's volatility is prompting many of his clients to re-allocate a portion of their portfolios into single-premium permanent life insurance. The reason: Doing so lowers a portfolio's "standard deviation of return"--a proxy for risk in modern portfolio theory--while also increasing investment yields.

"The couple retains complete liquidity over their cash value, and as well, if the husband and wife were to die, a death benefit will be paid to their beneficiaries that will help to offset the impact of any income taxes owed on the Traditional IRA portion of their portfolio."


But some observers question whether the market environment will make insurance less attractive than in years past. Apex's Baker suggests the S&P downgrade could, to the extent that carriers are invested in Treasuries or other once sterling-assets that have been downgraded, negatively impact their financial strength and performance.

Wendy W. Spencer, a principal of Spencer Capital Strategies Inc., Arvada, Colo., adds that if interest rates were to rise, insurers may be forced to offer "poorer deals" to policy holders until they can jettison the low-yield assets in their portfolios for higher-yield ones.

Connecting with Clients

However sound the investment strategies, observers say that advisors need to be proactive about communicating with clients during this turbulent time to assuage their concerns about the markets--and to keep them loyal to the practice. Depending on the size of the firm and clientele, personal phone calls/meetings, e-mails or newsletters might be best suited to the outreach effort.

In cases where many clients share similar portfolio strategies and financial objectives, a conference call may be preferred for its efficiency and personal touch. John Comer, a consultant to advisors at Comer Consulting, Plymouth, Minn., says that he favors this approach for many of his advisor-clients. And he recommends that advisors stay on message during the call.

"To build trust with clients, advisors need to communicate a consistent message, both when equity markets are stable and volatile, as they are now," he says. "And for those clients who are reacting emotionally to the markets, they should recommend waiting a week or more before suggesting a rebalancing of portfolios to allow passions to cool."

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Nichole Morford

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