How financial advisors can provide the correct pattern of returns for their clients

By Chief Investment Officer, Chuck Self on August 13, 2014

A financial advisor’s clients have a myriad of needs that he or she continually look to satisfy. For a financial advisor, it all boils down to providing an attractive pattern of returns throughout bull and bear markets. Advisors know that (most of) their clients have an aversion to losses, so keeping portfolio declines low during market downturns is often a primary concern. However, advisors also know that it’s important to participate in positive market environments to help clients reach their financial goals.

Unfortunately, the market volatility over the last ten years has tested advisors’ abilities to meet their investment goals for most clients.  One or more of the following has happened:

• Clients were in “buy-and-hold” portfolios that led to massive declines in value from 2007 to 2009.
• Somewhere in the second half of the bear market, clients called (or emailed) and instructed their advisor to sell out of stocks completely.
• When the equity market turned around in 2009, clients were under-invested, if they were invested at all in the stock market.
• Sometime after the equity market doubled from 2009 to 2011 or began to hit new highs in 2013, clients were finally ready to commit to stocks again.

Investment professionals know that given a long enough period of time, equities will out perform all other investments given the asset class’ tie to economic growth, in general and, specifically with corporate earnings.  Unfortunately, clients do not always allow their financial advisors to keep their allocation to equities steady (with proper rebalancing) through the market ups and downs. Given this reality, advisors can and should take the following two steps to perform due-diligence on investment products once a client’s risk tolerance has been determined:

1. Is the historical pattern of return acceptable to the client and does it meet her/his goals?
2. Is the client comfortable that the investment manager has the ability to repeat positive patterns of returns in future market environments?

One positive aspect of being a financial advisor in 2014 is having the ability to research thousands of products that have been through the 2007-2009 bear market and the succeeding strong recovery.  Analyzing these returns over rolling 12, 24 and 36 month periods can be quite instructive.  The iSectors® Post-MPT Growth Allocations returns from 2004 through the first half of 2014, on a 12 month rolling basis, are categorized in the chart below.

The average rolling returns of the Standard & Poors’ 500 Index and the Post-MPT Growth Allocation when the S&P 500 total return is negative, between 0% and 10%, and greater than 10% are plotted in this chart.

It is not enough to know that Post-MPT Growth has outperformed the S&P 500 by over 200 basis points (net of fees) on an annualized basis throughout this period.  The pattern of returns must be attractive to investors so they will stay with it through thick and thin.  In this example, many financial advisors and their clients would be happy to capture, on average, just 40% of the stock market downside, while earning 15%, on average, whenever the market is positive.  That 15% outperforms the S&P 500 quite handsomely when the market is up less than 10% and captures about 70% of the gain when stocks are up over 10%.

Thus, if a financial advisor’s clients like the downside protection provided by such a strategy while participating in the bull markets at this level of return, then the Post-MPT Growth Allocation has passed the first step in the advisor’s analysis.