From the March 2013 issue of Research Magazine • Subscribe!

February 22, 2013

Scared Stockless: How Advisors Calm Jittery Clients

Client enthusiasm for equities has evaporated since the crisis in 2008, with stock ownership at its lowest point since 1998

Back in January, advisor Jeffrey Smith received an email from a relatively new client who was worried about how the debt ceiling negotiations and potential government shutdown might affect her portfolio.

Smith’s response was swift—and pre-emptive. He scheduled a face-to-face meeting for the next day and dispatched to all clients a letter he hoped would build a “sound and proper perspective” as events unfolded in Washington.

In closing, Smith, who heads North Shore Investment Consulting in Wilmette, Ill., cautioned: “Again, the media is going to have a field day with this. Try not to let it jar you. Should volatility emerge, throw a hard shoulder toward it. Portfolios need not, and should not, be de-risked as this event approaches.”

The tough conversations that dominated the advisor-client relationship during the 2007-2009 meltdown have not gone away. Far from it. Even though inflows into stock mutual funds and exchange-traded funds surged—finally—at the start of the year at the hands of suddenly bullish investors, advisors across the nation report what some are calling a historic pullback from stocks, and they are using words like “raw,” “shell-shocked” and “skittish” to explain their clients’ continuing malaise.

As Dan Carlson, chief financial officer of New York City-based Toroso Investments, puts it: “Something that’s not talked about a lot is that when we had the tech bubble blow up in 2001, everyone knew it was a high-risk environment. In 2008, it was my bank and my home that blew up. That’s a totally different psychological blow-up that people have to get over. That gets to the core of what a person’s emotional psyche can handle.”

Statistics paint a fairly bleak picture. A Gallup poll released last April—at a point when all three major stock indices were in a sweet spot—showed that only 53% of American households owned stocks, down from 65% in 2007. It marked an all-time low since 1998, when Gallup first began tracking stock ownership. More recently, in June, the Federal Reserve’s Survey of Consumer Finances revealed that stock ownership had slipped under 50% for the first time in decades.

Between January 2000 and the end of last year, individual investors pulled a net $900 billion from U.S. equity funds, according to EPFR Global. And while renewed enthusiasm over stocks created a lot of buzz in early 2013, market watchers say each of the last four years has started off with investors shifting money into U.S. stocks—only to do a U-turn. And many advisors, like Jeff Smith, won’t be surprised if the continued bickering on Capitol Hill causes already jittery clients to stay on the sidelines.

“Since the popping of the dot-com bubble, we’ve had the recession, the credit crisis, the flash crash, the IPO fiasco with Facebook, and now we’re looking at all this brinkmanship and rancor in Washington, D.C. This proverbial wall of worry is not going away anytime soon. I don’t think it ever will,” says Smith, a certified financial planner who manages $144 million in assets for 160 clients. “Sometimes, I think about getting rid of the table in my office and making room for a couch.”

Rethinking Stocks

The anti-stock sentiment has increased the need for hand-holding and educational outreach to clients, of course. But it’s also important to note that it is not just the client who is on a journey of reexamination. The advisor is as well.

For some, it has meant a dramatic shift from modern portfolio theory to other disciplines. Others are taking a look at self-directed retirement platforms that utilize alternatives like private placements, rental property and second mortgages.  And many advisors, not surprisingly, have adjusted their own thinking at fairly basic levels as they rethink stocks through today’s lens.

“The trend in our practice is to emphasize sustainable fixed reliable income investments along with the equities. It used to be growth and income. It’s now switching more to income with growth,” says Victor Hazard, a CPA who heads Hazard Financial in Lomita, Calif. “A lot of clients are coming back and saying ‘I don’t want to take my wealth and double it every five or six years like I wanted to do in the past and what I really don’t want to do is have my wealth contract by 40% like it did in 2008.’ The middle ground is: Let’s get something dependable.” For Hazard, who has $105 million in assets under management, “dependable” translates to master limited partnerships, publically traded REITs and, on occasion, dividend-paying stocks.

Donald Cummings Jr., managing partner of Blue Haven Capital in Geneva, Ill., says most of his clients are reluctant to maintain anything above 60% in equity exposure today.

“Should advisors convince clients to have equity exposure? Absolutely. Should it be a sensible allocation that is in line with a client’s volatility tolerance? Absolutely,” says Cummings, whose firm oversees $30 million-plus for a few high-net-worth clients and small family foundations. “My question to clients often is: ‘How would you feel if equities dropped 40%?’ Actually, in most cases I am more conservative than my clients. They really have to wrestle hard for me to raise their allocation in stocks. We are seeing more volatility than ever and more periods of single- , double- and triple-year losses in the S&P in the last 10 years than in any preceding decade. Advisors need to pay attention to that. These are people’s livelihoods we’re involved with.”

Patrick Hejlik, CEO of Fourth Quadrant Asset Management in Danville, Calif., says getting clients to re-engage out of a cash position or fixed income instruments remains a challenge. “After 2008, they felt they’d been hit over the head with a sledgehammer,” he observes. “Trauma like that will wear on you for a long time.” Hejlik, a former head floor trader on the Pacific Options Exchange whose fledgling firm has $5.5 million in assets under management, says he has successfully coaxed timid investors back into equities by using options paired with a standard portfolio structure equipped with equities, exchange-traded funds and fixed income vehicles.

More than one-third of the prospects he has converted to clients have had a “decent” amount of cash on the sidelines—probably more than they should. “You have to say to Mr. and Mrs. Client that you have a long-term period of growth you need in a portfolio to fight off inflation. Health care costs, already expensive, are rising. A lot of clients don’t realize they are in for a shock. Plus, you’re looking at possibly increased taxation,” he adds. “There’s a real risk of them de-risking themselves out of the market and increasing the odds of running out of money—the worst thing that could happen. That’s a lot of red flags. It’s not a way you grow wealth.” 

Exploring New Paths

In talks today with advisors, Broad Financial CEO Brian Finkelstein says he has observed one dominant theme: a re-assessment of their definition of diversification.

“For years, it was what is the proper mix between stocks, bonds, mutual funds and maybe money markets and commodities,” adds Finkelstein, whose firm facilitates self-directed retirement platforms from headquarters in Monsey, N.Y. “Advisors are beginning to see that diversification means a lot more than that and that there are other ways people can help create healthier portfolios.”

Finkelstein says Broad Financial has seen a burst of interest from advisors—particularly certified financial planners—who want to place clients in a plan that can be structured either as a solo 401(k) or an IRA held within an LLC. The most common alternative investments the vehicles hold are real estate or real estate-related products such as second mortgages and tax liens. In either case, the advisor may continue to act as overseer.

“I worked on Wall Street most of my career and I don’t want to knock stocks, bonds or mutual funds—they’re wonderful products. The question is: What is the proper mix and what can advisors achieve with just those products? Since 2007-2009, people are looking for at least a portion of their portfolio that can give them comfort and control,” Finkelstein says. “This is a way for advisors to do that.”

The rethinking of stocks after a decade of volatility has also caused a whole cadre of advisors to abandon modern portfolio theory in favor of other disciplines. 

Tony Fiorillo, president of Fishers, Ind.-based Asset Management Strategies, uses exchange-traded funds, just as he did before, but now he is a fan of trend following, a strategy that looks at price movement. With trend following, Fiorillo, with just under $50 million under management, says his clients have an exit strategy when the market gets tough.

“When the governor says the hurricane is barreling across the coast and get off the beach, we don’t want to be that last couple boarding up the house and saying we’re going to ride it out,” says Fiorillo, who covers all trading costs for his clients. “If the market doesn’t decline as much as we think it will, all we are guilty of is not making as much money as we might have. It was very difficult to make such a philosophical change but 2007-2009 should have caused every advisor to re-examine everything they ever thought about modern portfolio theory and diversification. You don’t have to take whatever the market throws at you. My clients sleep better at night now, and as their advisor, so do I.”

One new advisory firm worth watching: Toroso Investments, launched in December by three industry veterans as an express challenge to modern portfolio theory. Toroso, which works closely with financial advisors who outsource model portfolios, uses exchange-traded products to access asset allocation strategies intended to perform well in all economic climates (prosperity, recession, inflation and deflation). Based on the Harry Browne permanent portfolio theory, portfolios emphasize future objectives rather than past correlations.

“We look at economic conditions that drive returns—and geometrically weight them in the portfolio so you are always offsetting the plusses and minuses in those economic conditions. The conversation is no longer about an antiquated definition of risk tolerance. It’s about what investors are seeing on TV and what they are thinking about today,” says Michael Venuto, chief investment officer. “Plus, we talk about a client’s economic point of view and we help them express that. Do they want a prosperity portfolio or one that protects against a recession? These are terms they understand versus aggressive and moderate.”

Venuto says he realizes Toroso represents a minority view.

“Probably $20 billion is allocated to Harry Browne and $5 trillion to modern portfolio theory. It’s almost like questioning a religion. But when things went bad, it didn’t save a lot of people and lots of existential decisions were made,” he said. “I believe in Harry Browne because it is forward-looking. Investing is a social science. It’s not a piece of paper. It’s not physical. We want to give the advisor and the client the ability to talk about something that isn’t focused on return but what’s going on around them.”

See sidebar "We Have Met the Enemy."

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