Revamping Your Investment Strategy

Journal reporter Jane J. Kim writes:

The investment community has long adhered to the tenets of modern portfolio theory, efficient markets and diversification. As my colleague Anne Tergesen and I write in Wednesday’s Journal, many financial advisers—faced with angry clients who have seen across-the-board declines last year—are abandoning such traditional approaches in favor of more unconventional ones.

In some cases, the availability of exchange-traded funds has made it possible for advisers to jump in and out of markets and sectors more quickly.

In January, Jerry Verseput, a financial adviser in Sacramento, Cailf., moved from a conventional model using mutual funds to a sector-based approach using ETFs after his portfolios fell significantly in 2008. He decided to make the switch after running an analysis that showed that correlation among the standard asset classes was over 80% over three, five and 10 years—in other words, they weren’t providing adequate diversification.

Now he’s diversifying across nine equity sectors, such as financials, energy and basic materials, technology, and real estate, where the correlation is only about 20%. He’s also using no-load mutual funds to get fixed-income exposure, since bonds throw off regular dividends. Most of his portfolios are up 2% to 2.5% for the year, he says.

Because ETFs are baskets of securities that trade like stocks, advisers are able to use trading tools that can usually only be used on stocks, not mutual funds.

Mr. Verseput, for example, uses trailing stop-limit orders. If a particular sector drops by a given percentage, then a sell order is automatically generated and the proceeds are moved to cash. “I don’t have to follow the market every single moment, since these [orders] will automatically lock in gains or will allow me to jump into these rallies much earlier,” he says. Another benefit: “It’s a completely unemotional rule. There’s no guesswork involved.”

Theodore Feight, a financial adviser in Lansing, Mich., has also used stop-loss orders to get clients out of the market for most of 2008 and 2009, and is now talking to clients about using leveraged ETFs to get back in. “The problem we’ve got with the current asset allocation is that it hasn’t evolved,” he says. “The stops allow you to have some protection.”

Harold Evensky, a financial adviser in Coral Gables, Fla., is still a big believer in traditional asset allocation: “The argument that diversification doesn’t work is baloney.” He says that part of the reason why correlation has been so high among asset classes in recent years can be blamed on the investments themselves—many hedge funds weren’t hedging enough, so their performance was closely tied to the market. “The investments weren’t what they were presented to be,” he says. “The real risk of tactical asset allocation … is that you could miss what would be a robust recovery.”

Today at the Financial Planning Association Retreat in Palm Springs, Calif., Mr. Evensky will be speaking on a panel—along with financial adviser Roger Gibson and Morningstar’s Don Phillips—about whether advisers need to rethink asset allocation in light of the meltdown. Mr. Evensky, for his part, is considering adding a new alternatives category that would more “more proactively manage the volatility of our portfolios.” One option that he’s considering is a fund launched by AQR Capital Management that engages in various arbitrage strategies, including merger arbitrage. (For more on alternative funds, see Brett Arends’ recent column on the Merger Fund.)

Investors who are unhappy with their financial pro should have “a really intense conversation with their adviser and make sure their adviser understands what they’re looking for and to make sure they’re not missing something their adviser is doing,” says Diahann Lassus, chair of the National Association of Personal Financial Advisors. She says the chief question investors should be asking is: “What are you doing differently to help manage risk?”

“Many advisers are doing things differently,” she says. “We’re building more cash for safety. We’re adding more to short-term bond funds and hedge-strategy funds.”