From the September 2008 issue of Wealth Manager Web • Subscribe!

Does Volatility Equal Opportunity?

Investors and advisors alike can commiserate over all the stress the short-term volatility in the global markets is causing their long-term investment plans. But the jagged growth line of the global economy has, at the same time, created numerous investment opportunities for advisors and their clients. (Actually, helping a client stay true to a long-term investment plan just might be an advisor's greatest opportunity.) But capitalizing on those opportunities is not as easy as simply buying what's worked lately--just ask the last guy to jump on the gold bandwagon--or just as importantly, not buying what hasn't worked lately. Deciding which asset categories to own and what allocations are reasonable takes a lot of careful thought. And that often requires a willingness to be a little contrarian.

We think the market turmoil has created a number of opportunities for investors willing to "anticipate the herd." At the moment, the best example of this might be the current REIT market. After a sharp run-up between 2003 and 2006, REITs were one of the worst performing sectors in 2007. But the near 20 percent drop in the Wilshire REIT Index last year also increased that indicator's yield from 3.5 percent to a very interesting 4.8 percent by the end of 2007. At the same time the P/E ratio of the index dropped from more than 44 to just over 28. In our view, these changes could make the REIT sector an excellent candidate for a minor tactical overweight in a longer-term focused asset allocation plan.

Another example of potential opportunity is the bank loan market, which, like the REIT market, has been down sharply over recent months. At the core of the decline has been the perceived risk of just about any spread credit category across late 2007 through early 2008. These unreasonable credit fears had investors selling with abandon, driving prices down and yields up. But the fact is that while these loans were made to companies with less than investment-grade credit ratings, they are at the very top of the issuing firm's capital structure. The loans are virtually always secured directly by firm assets--not future revenues--and usually have adjustable rates that reset more than once per year. This takes much of the interest-rate risk out of the portfolio and allows the funds to hold up better during a rising rate environment. The median trailing 12-month yield right now in the bank loan mutual fund universe is a whopping 6.8 percent and rising. From where we sit, the increased yield--along with a substantial diversification benefit--makes this asset class very attractive.

These are just two opportunities we see in this volatile, and sometimes irrational, market. Actually, any area of the market where valuations have been impacted by sentiment rather than by fundamentals presents a potential opportunity to add alpha to a portfolio. At least it is for those investors willing to keep a thoughtful eye on the long-term horizon and not on yesterday's headlines.

J. Gibson Watson III (watson@primacapital.com) is president and CEO of Prima Capital, a Denver-based firm that conducts objective, institutional-quality research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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