August 2009 |
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For too many professional investment managers, their focus is on their relative performance or how the investment returns of their clients’ portfolios compare with an index over a certain period of time. We think about this business differently. We believe that our mandate is to first protect our clients’ money and only put it at risk when we see a good opportunity for significant gains. This approach has brought comfort to our clients during the recent bear market because they know that our focus is on them.
Over the past year or so we incorporated a rather bold and, some might say, unorthodox strategy to protect our clients’ portfolios in this bear market. By reducing their exposure to stocks and hedging the rest we were able to limit most of the losses during the worst of the storm but then participate in some of the recovery, at least up until June.
The rally continued in July and now the stock market has risen about 50% since early March. While it is still down about 20% from one year ago and 33% from its high in 2007, we do not enjoy looking so out of step with the current market action.
Despite this strong rally off the bottom, we remain non-believers that this is the start of a new secular bull market. Our analysis continues to lead us to the conclusion that the secular bear market lives on and that this cyclical bull market run could end badly for investors who have jumped in. For that reason, we remain uncomfortably protective of our clients’ portfolios.
It would be so much easier to be like everyone else. Most investment professionals do not have the authorization to take the actions that we took to protect portfolios. We suspect that they wouldn’t want it if it was offered to them. With the authorization to protect comes a natural sense of accountability. This requires a different way of thinking.
Investment advisors or mutual fund managers who only care about relative performance talk to their clients about “investing for the long-term” and then leave their portfolios exposed to the market through the ups and downs of a market cycle. Their goal in a bear market is to lose less than the market. This explains why we often hear comments about our industry’s annoying habit of “spinning” things in the best possible light.
In the many years that I have managed other people’s money, I have learned that talking to clients about “good relative performance” when they lost a lot of money falls on deaf ears. Their minds are spinning with thoughts of “how did my investment advisor let this happen to me”? It seems that Einstein’s theory of relativity doesn’t apply to the money management business.
People hate losing money more than they like making it and they expect their hired professionals to at least try to protect their portfolios in difficult times. That is a big reason why they pay them to manage their money. Seeing one’s life savings take a big hit is not only an emotional experience but also can have some life-changing consequences, especially for those near or in retirement. There are times like today when the management of risk for clients supersedes the reach for returns.
Front Street was founded on the principle that it was our job to protect our clients’ money when economic and market conditions warranted such action. We knew that by taking this different approach there would be periods (like in the last few weeks) when we could look overly cautious and maybe a little out of touch with reality.
The risk to our approach is that we get too comfortable with our defensive stance and we miss a real opportunity to make money in a rising market. With that said, we recognize that we cannot achieve our clients’ financial goals for retirement by being stuck in a protective state of mind. We will have to be more aggressive (as we have been in past years) but only when the odds of success are more clearly in our clients’ favor.
We are very competitive professionals who were itching in late February and early March to begin to switch gears. We sensed that a rally could start at any time. However, our analysis was telling us that there was 20 - 30% more downside risk from even those depressed levels. In the end, we knew we had to put our egos aside and do what we thought was in the better interest of our clients.
The economic news has continued to show “less bad” data and it is possible that the recession is almost over. Corporate earnings were better than expected in the second quarter but that was primarily achieved through drastic cost cutting and more layoffs.
Our concern about the stock market is that at current prices it seems to be discounting a more normal economic recovery with significant earnings growth. We don’t see how that is possible if consumer spending remains as weak as we think it will be over the next two years.
As always, there are many uncertainties and challenges today that investors are forced to reconcile and navigate through. The well-known list of issues doesn’t require repeating.
In this era of widely disseminated and forcefully stated opinions, this stream of information requires a filter that is based on sound and consistent judgment. With all humility and considerable accountability, we know it is much easier said than done.
