The bull market that began in 2009 was over and done by 2015. Most would vigorously disagree, contending that we’re still experiencing the longest bull market in history. But veteran wealth manager James E. Demmert is among critics who insist that a bear market barged in three years ago and stuck around for 18 months, as he tells ThinkAdvisor in an interview.
Demmert, 55, founder of Main Street Research, an RIA in Sausalito, California, who invests exclusively in individual stocks and bonds, credits active risk management for his clients’ portfolios performing better than the market during that reversal.
He argues that a “mild corporate profit recession” took hold during the 2015-2016 timeframe coinciding with a bear market in which global stocks dropped 20%. We’re now in the second year of a new business cycle in a new bull market, he maintains.
Managing more than $1 billion in assets in separately managed accounts for wealthy families and foundations, his average account size is about $5 million.
Risk management perhaps tops Demmert’s list of priorities. The chief reason most investors repeatedly underperform the market is “a gross lack of risk management,” he contends. In the interview, the advisor touts a simple, no-cost risk management tool to prevent calamitous losses.
For 20 years, Demmert has been a proponent of the controversial performance-based management fee — long banned by the Investment Advisers Act of 1940 because of broker abuse. Since 1985, RIAs have been permitted to charge such fees to “qualified” clients only.
Demmert has offered this fee structure as an option to his traditional asset-based fee for the last two decades. Today, 60% of his clients compensate him with a performance fee. “They like the value proposition,” he stresses.
The fee has two components: a management fee, which scales down to .25%, depending on asset level, and 5% of clients’ new net profits earned in their portfolio, if that should be the case.
Thirty-five years in financial services and vigilantly keeping abreast of macroeconomic research, Demmert is a featured speaker for organizations including the American Association of Individual Investors and authored “The Journey to Wealth: Smart Investment Strategies to Stay Ahead of the Curve” (New Insights Press 2017).
A Harvard grad, the Rochester, New York, native began his career on the institutional side at Lehman Bros. in San Francisco after interning at L.F. Rothschild. Before opening his own practice in 1993, he was a partner for five years in a small firm, The Belvedere Group.
ThinkAdvisor recently interviewed the RIA, speaking by phone from his Bay Area office on Liberty Ship Way. As a stock picker, he looks for “great companies selling products the world wants,” he says. Think: Amazon, Apple, Costco. Demmert’s philosophy dovetails with that of the hockey player Wayne Gretzky. As quoted in the advisor’s “Journey to Wealth”: “Skate to where the puck is going, not where it has been.”
Here are highlights from our conversation:
THINKADVISOR: What’s your take on the historically long bull market?
JAMES DEMMERT: Most people think the bull market that started in 2009 has been the longest one ever. We say that bull market died in 2015 and in 2015-2016 there was a mild corporate profit recession in a bear market. Today, we’re in the second year of a new business cycle in a bull market.
So did you sell 10% of clients’ stock portfolios in 2014? You’ve written that on the seventh year of an expansion that’s your strategy. This one lasted five years, according to your reckoning.
Yes, we took away 10%-15%. The market was really difficult. So that helped us.
Your clients have the option of paying a traditional fee or a performance-based fee. Please explain the concept of the latter.
We’re saying that if we don’t do well, we’re [advisors] going to make a lot less. If we have a great year, the client pays us a little more. So if the market isn’t good, we charge less.
Does a performance fee encourage FAs to take on more risk?
The SEC is very careful about performance-based fees to make sure the advisor isn’t taking undue risk. We don’t trade any differently in a performance-based fee account as opposed to a traditional account.
Why don’t more FAs offer a performance fee?
A lot of them don’t do it because they’re comfortable getting their 1% or 1.5% fee, and they just don’t want to sacrifice that.
Seems like advisors have to work harder if they charge a performance-based fee.
That’s the whole point – working harder. There are a lot of advisors who just put clients in set portfolios and go sailing.
You’ve indeed said that buy-and-hold is “a lazy man’s approach.”
Most investors think you can just set it and forget it no matter what the market does. That goes back to Modern Portfolio Theory: Diversification will mitigate risk. Anybody who was invested in 2008 knows that did not work. You can’t diversify risk any longer.
How do you manage risk, then?
We use active risk management — the flexibility to have stock exposure in a great market but in a bad market, to have less.
The biggest reason most investors underperform the market and keep making the same mistakes is a lack of risk management, you argue.
There’s been a gross lack of risk management. But you can use simple tools to mitigate catastrophic decline.
What’s “the most underutilized tool,” as you call it?
The stop loss order [automatically selling a stock when it falls to a predetermined price] is the difference between being a risk manager and just setting and forgetting [the portfolio]. It’s amazing how many professional managers don’t employ this simple tool. In 2008, when most people were down 50%, our declines were 12%-14% [by using stop loss orders].
How does the stop loss affect financial behavior?
It can take the human brain out of the equation and create discipline. If a stock falls, people usually say, “I’ll wait till it goes back up.” When it falls further, they say, “I can’t sell now — it’s too cheap.” Eventually, they don’t even want to look at it. The way to mitigate a catastrophic decline is if something falls more than normal, you’re [automatically] out.
You have expertise in macroeconomics. So what’s your forecast for the market and economy for the second half?
Corporate profits are way better than expected, so people will say, “Wow, the market is probably great.” But the market hasn’t been so great this year. It isn’t overpriced; it’s very inexpensive. So barring anything we don’t know, I think that by the end of the year, stocks will be up anywhere from 8% to 12%.
Therefore, equities are the way to go?
I know that investors are nervous, but this is one of those times when they have to dig in and [get] stock exposure. It’s easy for us because we have stop losses that kick in if we’re completely wrong.
What do you foresee for bonds?
Using a bond-laddering strategy, we’re buying individual bonds with short maturity and 2.5% to 3.5% yields. It’s a fabulous time to be an individual bond investor and a terrible time to be a bond fund investor.
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