Illustrations By Scott Menchin
Judging by the performance of most domestic stock indices of the last few years, investment advisors should certainly have something to crow about. After completing a five-year run of 20%-plus annual gains, the Nasdaq finished 1999 with a return of nearly 86%, the largest return of any domestic stock index in history. Similarly, the S&P 500 had its best five-year run ever, rising a cumulative 251%.
But then came the millennium, and with it doubts about the future of many Internet-related companies. Rising oil prices, a falling euro, and heightened inflation fears began to erode the confidence of many investors who had grown accustomed to the nearly ideal economic conditions of the last half-decade. The result was a meltdown in the same technology stocks that fueled the rise in the market over the last five years. Through the third quarter of 2000, many tech issues had lost three-quarters of their value.
Even with this year's paltry performance, there is widespread fear by industry pros that investor expectations are still too high. With the prospects of a continued market correction, or a return to more historically normal performance by stocks, investment advisors are now faced with lowering their client's expectations--without turning them off or sending them to their competitors.
"One of my greatest challenges as a financial advisor is managing client expectations--in both good and bad market environments," stated one successful advisor who requested anonymity. "Generally speaking, clients compare their portfolio returns to the best performing asset class of the recent past. Last year it was the Nasdaq; for the past decade it has been the S&P 500 index," he said. "We try to minimize this effect by educating our clients regarding the volatility associated with individual asset classes and securities versus diversified portfolios. We show them the worst performing periods for specific U.S. stock market benchmarks. 'Can you tolerate a 30% decline in the value of your investments, such as occurred to the S&P 500 index in a 60-day period in 1987?' we ask. We then tie the percentage loss to their portfolio value. For a client with a $1,000,000 portfolio we ask: 'How would you feel if you investment portfolio fell by $300,000 in 60 days?'"
But even a comprehensive line of attack like this one fails to allay all investor anxiety. "At the end of this process with our clients, we've talked a lot about risk: at the fund/security level, the asset class level, and the overall portfolio level. They have figuratively and literally signed off on an investment policy that quantifies their return objectives and their risk tolerance boundaries. You would think this process would prevent this sort of erroneous benchmarking. To some degree, it does. Yet, emotions--fear and greed--sometime overwhelm discipline and common sense. The most frustrating experiences I've had as an advisor involve being terminated by a client whose portfolio has met his investment policy return and risk objectives. What does that tell you about your process and/or about your client?"How Did We Get Here?
It is easy to see how investment advisors could get in such a mess. The Internet age has made investors increasingly sophisticated and cost-savvy. And the availability of financial information available on the Web coupled with the ease of online trading is attracting more assets, and maybe some of the clients who hold those assets, away from professional advisors.
The bull market of the 1990s may have done great things for clients' portfolios, but it has also knocked many clients' expectations entirely out of whack. Wondering what to say to them now? Four advisors offer suggestions.
History repeats itself. "People's expectations have gotten so out of line that I've had people come in who truthfully expect that they're going to average 20% a year," says Janet Stanzak of SilverOak Wealth Management in Minneapolis. "I take them back and give them examples of what would have happened to their assets in the early 1970s, or after Black Monday in 1987. I try to give them real, hard numbers and percentages, to show the changes that would have occurred." Stanzak also points out to clients the fact that in the past, it has taken up to four years for stocks to come back to their original value after a major market crash or slide. "That really gets people's attention," she says. "They reflect on the past four years and realize that it never occurred to them that could have happened."
Says Elaine Bedel, a planner in Indianapolis, "Many people, even those who may be fairly sophisticated, haven't paid much attention to the stock market, and we draw their attention to it every time we send a performance report. Rather than letting the negative numbers be a surprise at some point, it's important to let clients know that this is going to happen. I don't know when, but it's not a maybe; it happened before and it is definitely going to happen again."
What's the point here, again? "When things start going in a negative direction, the hair on the back of clients' necks starts standing up, they start wondering, 'Am I still okay? Am I still in the right mix?'" says Bedel. "We try to relate everything back to, 'Okay, what was our long-term strategy?' It's a matter of constant education, reminding them, 'Where did we start? How well has the portfolio continued to grow? Are we still on track to meet long-term goals?'"
Susan John uses performance reports specifically designed to keep clients focused on reaching their goals, not beating the market. "We show the growth of their total portfolio and what that means for the attainment of their goals," says John, a planner in Wolfeboro, New Hampshire. "If their goal was to have a million dollars by the time they're 40, we show how much progress they've made toward that goal. As long as the returns are in the range that still allow the client to attain those objectives, then we're all happy."
Nice meeting you, but... Sometimes clients can't be convinced that 387% yearly returns are unreasonable, and sometimes the best thing to do is simply show them the door. "I'm not shy about telling a client that we may not be a good fit," says Stanzak. "I had someone about two months ago who said he expected returns of 17% and 20% a year. I cringe when I hear those kinds of expectations, because they're so unrealistic ... and I don't want that kind of client hanging over me, with the potential of a lawsuit down the road. I'd rather turn them away now and have them go work with someone else!"
Remember, we're on this ride with you. "Our job, we feel, is to beat the market by a little bit, with slightly less risk," says Robert Rikoon, an advisor in Santa Fe, New Mexico. "If the market's going down, it's nobody's fault. The important thing is that they have an advisor who is being proactive, looking at the whole picture, and handling the portfolio management."--Karen Hansen Weese
The enhanced competitiveness of the investment management business has led many advisors to attempt adding value to their client's portfolio above and beyond plain-vanilla indexing. Many advisors use a process called "tilting," in which portfolio weightings are adjusted according to which market sector has the best odds of producing exceptional returns. The most common tilts overweight toward some combination of small-cap stocks and value-oriented issues, since equities with these characteristics have been shown to outperform large-cap growth allocations over long holding periods.
But the game of investment management is not as easily won as this. As clients' tolerance for poor performance continues to diminish, advisors are faced with a daunting challenge--to get the asset allocation right at the onset, or lose the client at the first sign of trouble. And in a time when investor patience is measured in months instead of years, even the most academically defensible asset allocation strategy will fail to maintain client relationships if short-term results are less than stellar.The Tilting Game
Of all the biases most commonly encountered by investment professionals, one of the most common relates to the relationship between growth stocks and value stocks. Value stocks--those issues that trade at or below their intrinsic value--have been shown to outperform growth stocks by a significant margin over long holding periods. A ton of market research, most notably the seminal work "Value versus Growth: The International Evidence" (Journal of Finance, December 1998) by leading academicians Eugene Fama and Kenneth French, have convincingly demonstrated the presence of a value premium not only in domestic equities, but in many foreign bourses as well.
Many financial experts believe that a value premium arises because the market undervalues distressed stocks and overvalues growth stocks. When these pricing errors are corrected, value stocks tend to have high returns and growth stocks tend to have low returns. Fama and French, on the other hand, hold to a much simpler explanation--in their view, value stocks outperform growth stocks because the former is riskier, and an efficient market usually rewards risk-taking with higher returns over long holding periods.The Value Story
Regardless of cause, financial experts largely accept the existence of a value premium. Unfortunately, no one has told the stock market, which has for years rewarded investors who favored speculative Internet-related issues, leaving value-oriented advisors with egg on their faces and their clients with portfolios that have failed to keep pace with the broad market indices.
How bad have value investors fared in the last five years? The current market cycle, which began in late 1997, marks the first time that value has underperformed growth since 1979. It is also the first time that value has posted a negative return for a full market cycle. Quarter-ending three year total returns reveals the largest negative divergence for value relative to growth in history (See sidebar on right).
As a result, advisors who have overweighed the value sector in their client's portfolios have been left behind by those who rely more on pure indexing or have a penchant for growth stocks.
Value-oriented advisors have dealt with this underperformance in a number of ways. One of these involves redefining the definition of growth and value, to better incorporate high-flying stocks in their client's portfolios.Style Drift or Not?
Addison Capital Management LLC is one such firm. Faced with potentially losing millions in client assets due to the lagging performance of traditionally defined deep value stocks, the advisor started its Blue Chip Value Portfolio in 1998. "We are still value-oriented, but we look for the best values in the largest capitalization sectors of the market. In years like 1998 and 1999, these stocks can look pretty expensive when viewed from a traditional value-style perspective," says Addison's chairman, Jim Kelly. "In fact, the price/earnings and price/book ratios of our Blue Chip portfolio are roughly comparable to the S&P 500 index."
Kelly scoffs when detractors of this approach accuse him of "style drift," the tendency of advisors to talk up the value approach but invest in growth stocks. "Big companies with good products, good management, a consistent earnings stream, and good ratios will always make money over time," he says. "When the markets are in a narrow-focus mindset (i.e., a few large-cap stocks drive up index returns), the large-cap stocks tend to command a premium price. During these periods, investing in the 'mega-cap' stocks can appear like style drift until the portfolio's characteristics are compared to various market indices. At that point, it becomes obvious that we are purchasing high quality stocks at relatively attractive prices."
|Time for Value to Shine?|
Value investors have been largely left out of the most recent runup in the bull market. True believers in value investing, which involves buying companies that trade at or below their book value, have been calling for such stocks to rise above pricey growth-oriented issues since 1997, the last year the value stocks as a group outperformed growth. Has the tide finally turned for value stocks? One market indicator, called the advance-decline (or A/D) line, seems to say so.
A/D lines are one of the oldest and most commonly known market indicators. To create an A/D line, one subtracts the number of losing stocks from the number of winning stocks each week over a multi-year time period.
The A/D line above shows that the number of declining stocks outnumbered advancing issues from 1994 to 1995. From 1995 to the beginning of 1998, many more issues gained than lost. The trend reversed until this year, where it looks like a broadening market may indeed emerge.
A/D lines really become interesting when one compares which sectors perform the best during broad and narrow markets. During 1994, when many more stocks declined, growth stocks ruled the roost. The next three-year period, which was characterized as a much broader market, was dominated by value stocks.
Although 1998 and 1999 look similar, the market psychology of each year was quite different. The 1998 market was dominated by greed, a period where Internet stocks with no earnings commanded stratospheric premiums. The 1999 market, however, was more dominated by fear. But in both cases, growth stocks outpaced value stocks by a huge margin. Growth issues were so much more profitable, in fact, that a significant number of value managers was forced out of business.
As the A/D line shows, the market seems to be widening out this year. With more stocks outperforming the S&P 500 index than underperfoming, it seems that the era of a few stocks driving the price of market indices into the stratosphere is gone--at least for now.
But even though this is a clear indication of the reemergence of value investing, it may not be prudent to over-commit to value. As always, varying too far away from a passive strategy can come at a big price to advisors, unless their timing is flawless.
The Small-Cap Approach
The approach has met with success with clients. Kelly estimates that 25 percent of the firm's $300 million in assets are now dedicated the Blue Chip Strategy.
Besides value over growth, many advisors have tilted their portfolios in favor of small-cap stocks over large-cap issues. Conventional wisdom has held that investing in small stocks (i.e., those with a market capitalization of less than $5 billion) provides investors with higher returns. This has certainly held true over the long run; from 1929 to 1998, the compounded annual return for small company stocks was 12.7%, compared to an 11% return for the Standard and Poor's 500 index. But for shorter time periods, the small versus large game resembles little more than a gamble.
For instance, in the last fifteen years big stocks have walloped their smaller siblings by more than six percentage points per annum. And the last three years haven't been nearly as kind, with large-cap stocks dominating over small-cap stocks by a huge margin.
Advisors who held to these time honored strategies in an attempt to add value to their client's portfolios have found themselves holding the bag during the latter one-half of one of the longest running bull markets in history.A Passive Approach
Some investment advisors prefer to dance around the value versus growth and small versus large conundrums, and instead concentrate on other services that can improve their clients' lives. One believer in this approach is John Bowen, CEO of Creative Equity Group, a consulting firm that works with advisors in business planning and client management. (Bowen offers advisors a free newsletter at www.creatingequitygroup.com).
Bowen's prior successes with the San Jose, California advisory firm Reinhardt, Werba, and Bowen convinced him that putting client needs ahead of spurious market-beating strategies is essential in maintaining client relationships during the inevitable hard times. The firm, which managed to raise $3 billion using a purely passive approach to asset allocation, was eventually acquired and is now Assante Asset Management.
"The key to managing client expectations is to start with a firm foundation," says Bowen. "We begin by asking a series of questions to potential clients. We show them the historical performance of active management versus passive, small-cap stocks versus large-cap, and international equities versus domestic. The goal is to discern both the investor's comfort levels toward risk and their performance expectations."
Bowen says that if clients "have a need to beat the market," their portfolios are tilted slightly toward value, small stocks, and international investing. "The tilts are based on the client's desire to look different from the rest of the world," he says. "And we are quite careful to discuss the risks of this strategy to our clients, in the event a worst-case scenario actually occurs. As an advisor, one of our most important roles is to help investors through all the noise in the financial markets and make informed decisions."
But according to Bowen, "most clients are willing to take the recommendations of the advisors in their entirety." That being the case, "we start off recommending a 100% passive approach, but are willing to tilt as much as 30% to active management for more aggressive clients."
Bowen is especially careful of using the recent past in setting investment objectives. "The key to managing client expectations is how you use the last five years. The advisors that have leaned on the exceptional returns of the domestic indices during this period may have been able to bring in a lot of clients, but these assets will be nearly impossible to hold onto when equities return to more normal return levels." (To learn how other successful advisors manage client expectations, see sidebar.)
Bowen's main objective is to simplify his client's lives, not complicate them. "A five percent tilt is not going to make a big difference in a client's lifestyle. What's more important and valuable is the coaching that they receive from you. There will always some strategy that manages to outperform the overall market for some period of time. But is it worth the extra risk and the complication? What about fees and taxes? Is the extra risk worth a little extra return?"Final Thoughts
The best laid plans of investment advisors in adding value to their client's portfolios often result in only sporadic success. And when one considers the limited patience of most investors, the true risks of such tactics become even more obvious--namely, the loss of a hard-won relationship if returns aren't up to snuff even in the short-term
"It's simply impossible to know which sectors will provide the best returns in the future," says Paul Merriman of Merriman Asset Management in Seattle. "The best thing to do is to leave your ego at the door, diversify among all possible asset classes, and not over-promise the potential returns of the portfolio."
"And remember," says Merriman, "that there's no risk in the past. Take market prognostications based on previous year's results with a very large grain of salt."