From the September 2010 issue of Investment Advisor • Subscribe!

Overlooked Managers: Two Guys With Two Goals

For Sierra Investment Management, understanding risk inherent in every asset class has enabled it to outperform, while avoiding the worst disasters in financial market history

For David Wright and Kenneth Sleeper, co-founders and managers of Santa Monica, California-based Sierra Investment Management's Sierra Core Retirement Fund, understanding the nature of the risks inherent in every asset class is far more important to proper portfolio management than trying to opportunistically grab the possible returns they offer. Different asset classes behave in different ways at different times, and the duo--who have been managing money in separate accounts for close to 23 years and launched the Core Fund in 2007--spends two- thirds of their analytical time studying risk just so that they can understand these peculiarities. They look to measure how a particular asset class has reacted over time to different market conditions and how it will perform, in light of this, going forward. They follow this diligent risk management practice, Wright says, so that they can come up with their own proprietary disciplines that will then enable them to meet their dual goal of limiting the downside on the $370 million Core Fund by exiting problem areas before they sink, and delivering realistic, consistent returns to investors by taking advantage of any sustained upward movement in a given asset class.

"We have a very goal-oriented approach and these are the two very specific goals that we express to our clients," Wright says. "Everything that we do at Sierra has to serve one or both goals. Even in a very ugly month or quarter, we want to limit the downside of the portfolio to 4% or 5% and our goal is to average 8% or 10% over a market cycle."

Giving great importance to the understanding of individual asset class risk has enabled Sierra--both in its separate accounts as well as in the Core Fund--to avoid some of the worst disasters in financial market history, Wright says. He believes the cornerstone of Sierra's risk management practice is the "trailing stop" discipline that the firm applies to each underlying fund within the fund-of-funds Core Fund portfolio, one that is based upon Wright and Sleeper's in-depth study of economic cycles, the behavior of individual asset classes in different market conditions and the historic volatility of each asset class. The trailing stop discipline allows the Core Fund to limit the impact of any sustained decline in a given asset class or fund to the portfolio as a whole. Rather than attempt to buy at lows and sell at highs, Wright says, the trailing stop approach enables Sierra to participate in any sustained uptrend that an asset class offers and to also step aside during most of any sustained downward trend. Yet this investment approach is tactical rather than active, Wright says, meaning that "we expect to be out of a given asset class on average only twice a year."

Over the years, the trailing stop strategy has been extremely successful, both for Sierra's separate accounts as well as for the Core Fund, which year-to-date, is up more then 3% and has been, since its inception, the top performer out of around 325 funds in its Morningstar peer category. Sierra has also averaged returns of slightly over 10% in all its vehicles over the past 15 years, Wright says, thereby meeting its second goal on a consistent basis.

The Core Fund is designed to meet the needs of more conservative investors such as retirees and boomers approaching retirement, and it invests in a broad range of asset classes--domestic and international equities; high yield and investment grade corporate bonds; foreign exchange and government debt, to name a few--through leading mutual funds (open-ended as well as ETFs) whose managers have outperformed their peers consistently over time.

Currently, Wright says that the Core Fund's more risky holdings--high yield bond funds, emerging market debt funds and floating income funds--are giving off sell signals. He attributes this to another wave of market downturn, one that despite the general market exuberance of earlier this year, is imminent and, in fact, has already begun. This is the third phase of the downturn that began two years ago and it will result, as all other downturns have, to a general flight to quality, Wright says. Sierra's trailing stops enabled the firm to see this trend early, and Wright was able to exit the Fund's riskier holdings before those asset classes started trending down.

Now, with a view to more volatility in riskier asset classes and further downturns across the market, the Core Fund has 52.7% of its holdings in cash. It has 11.5% of assets under management invested in the Putnam Diversified Income Y fund; 11.1% in PIMCO's Foreign Bond Institutional fund; 9.4% in the Nuveen High Yield Municipal Bond R fund and 5.6% in the Managers Bond Fund.

"We were well exposed to risky assets like high yield corporate bonds a year ago but we have gotten out of them, so we've avoided their downturn," Wright says.

The Core Fund has also decreased its exposure toward equities (it only has 3.1% of assets under management invested in preferred shares), another area that Wright believes is risky and always has been, yet has somehow got middle class America in its clutches. "The U.S. is the only country on the planet that believes that stocks are the only good thing to have in a portfolio," he says, "and Wall Street and the mutual fund industry are responsible for this cult of equities, propagating studies about how stocks are good in the long run and how they will always outperform other asset classes and are necessary for the growth part of a retirement portfolio. Looking at market history, though, those theories are all flawed."

In addition to the fact that the dramatic fluctuations in stocks throughout history--movements that can be and have been extremely painful for investors--Wright also believes that there is cyclical reason to be cautious about equities this year, since with just two exceptions in 1986 and 2006, stocks have always trended down in the second year of a presidential cycle. "We have a cautionary respect for the presidential cycle because in the past, the second year of the cycle has resulted in a significant decline in the stock market," he says.

That is most likely to be the case this time around as well, since after several extended rallies that began back in March 2009, the major U.S. stock market indices peaked in late April and then turned down, Wright says. The S&P 500, he says, has declined over 13% in the current downtrend, and most markets elsewhere in the world are down even more than that.

"With a more top-down view, we've seen that China peaked and then turned around in August 2009. Europe peaked and then turned, and finally, the Dow was the last man standing," Wright says. "When you see patterns of successive downturns, it tells you that everyone who was struggling piled into the last category, and this is never a good thing."

Wright expects more stock market decline ahead, punctuated with strong but brief rallies, so his aim is to protect the Core Fund on the downside from experiencing overall declines by steering it away from equities and riskier assets such as high yield bonds that are more correlated to the equity market, and more toward those asset classes that are likelier to benefit from the flight to quality and investors seeking safe havens. U.S. Treasurys, of course, have been doing well over the past months based on the decline in investor confidence and catalysts such as the European debt crisis and the Gulf oil spill. The U.S. dollar, high grade corporate bonds and agency bonds such as those of Ginnie Mae are also benefiting from this change in market dynamics, as are municipal bonds--which may come as a surprise to some given all the press headlines about the teetering solvency positions of states and cities across the nation.

But "when some people got scared of every bond category in 2008, munis were also punished so whatever concerns people might have are already priced into the muni market," Wright says. Wright and Sleeper--both of whom are personally invested in the Core Fund--manage a total of $880 million in assets and they co-founded Sierra Investment Management in 1987.


Savita Iyer-Ahrestani is a freelance business journalist currently based in New Jersey. She can be reached at siyerwriter@yahoo.com.

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