From the May 2008 issue of Investment Advisor • Subscribe!

May 1, 2008

Making Volatility a Retiree's Friend

J. Michael Martin's goal for his clients, about 80% of whom are retirees or those getting ready to retire, is not to have a negative return, or to handily outstrip inflation, and he does this by making volatility his friend.

His first rule at Financial Advantage, Inc., a fee-based Columbia, Maryland-based firm he founded in 1987, is to "do no harm" in managing clients' nest eggs. "Retirees have a shorter time horizon and not only are not putting new money in, but taking money out. So it is appropriate to have a very different investment strategy for retirees," he says.

Thus, Martin strives to harness the risk in overvalued sectors. Financial Advantage uses double inverse-index funds to short market sectors his analysis identifies as most overvalued. These are volatile funds that move double the amount in the opposite direction from the corresponding index. Martin is also a judicious user of inverse-index funds, which, he says, rise when the stock market falls, and can help protect investors against both short- and long-term market declines.

When a stock index falls and the inverse fund rises, pushing its allocation past the target, Financial Advantage trims its position back to the original allocation and takes profits. Conversely, when the index rises and the inverse fund falls, the firm buys more shares to get back on target. "This method cuts the average cost per share for our clients," Martin says. "Our two inverse funds are up 41% and any day now we are going to take those chips off the table," he explains.

At press time in early April, the firm had a 5% hedge evenly divided between a 2-1 inverse on the Russell 2000 and a 2-1 inverse on the Nasdaq 100. These inverse funds increased in value by 30.4% in January and February while the S&P 500 fell 9.4%. Thanks to inverse funds, plus an allocation to gold and cash, the firm's average client portfolio earned 1.8% over the two months, according to the company.

Martin also has a novel way of looking at his most important investment assignment: diversification, using something called "fundamental market drivers" rather than the standard asset boxes everyone else seems to be using. "Most people think about diversification in terms of market cap or style boxes. We got rid of that concept about four or five years ago. I don't think that is a valid way to diversify."

Real diversification is spreading the risk among categories of fundamental market drivers so that not all your investments are marching to the same drummer, he says. His firm created seven different themed asset classes to own, such as energy, commodities, and emerging economies, which all move on different market conditions. Two of them are stable--they both have yields less than the current inflation rate now, and the other five are opportunistic.

In addition, Financial Advantage only owns about a dozen stocks outright, he says, part of a strategy to pick out a stock or a mutual fund that is particularly good. For example, Apache Corp. is the best oil company "I have ever seen," he says. To participate in emerging countries, he has picked Tata Motors in India, because it is part and parcel of the growth foreseen there and can deal with the entrenched Indian bureaucracy. He is also a fan of gold. "It is great for doing our rebalancing. It is impossible for the government not to keep watering down the value of money. You can't reduce Social Security and not expect to have riots in the street. I want to bet against paper currency."

"If you diversify among 200 stocks, you are just diversifying away your ignorance. When we buy a mutual fund as part of our portfolio--we only have four or five equity mutual funds. We are hiring their research and management," Martin says.

In dealing with his clients, not just their money--Martin's retirement money is in the same pool as his clients--he offers them a long-term spending/cash flow model for the next 30 years, and uses it as a vehicle for getting into a discussion about the nitty-gritty, such as an aged mother dying, an inheritance, or perhaps the excessiveness of owning two beach houses. This approach helps clients when it comes to investing their assets, he points out.

Financial Advantage has $250 million in assets under management, but is planning for a surge in clients. After all, he says, "one of the best things for us is down markets because so many people approaching retirement have never had an advisor and have been comfortable doing it themselves and then they see themselves lose 10% in two months." That is when the unsolicited calls come in.


Elizabeth D. Festa is a freelance business writer based in Washington, D.C. She can be reached by e-mail at elizabeth.d.festa@comcast.net.

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