Should downside protection be put back on the table?
By Don Wilkinson
DFW & Associates
Buy-and-hold investment theory is not dead in this economic downturn, but advisors should keep protection strategies close at hand to protect their clients.
Any way you cut it, the August drop is a wake up call for advisors to be sure their clients are protected from wild market swings.
A few Thursdays ago, stocks dropped in their single worst day since the 2008 financial crisis. The Dow tumbled 512 points — its ninth deepest point drop ever — as knee jerk reaction fears spooked investors.
Since then, the rollercoaster ride is leveling out, but it should be a lesson to financial advisors that this market does not offer any free lunch. In fact, if you’re an advisor with anxious clients, it’s your responsibility to lighten the stress load by steering your clients to safer havens in this stormy market.
How do you do that when our economy is in the basement, unemployment is over 9 percent, a debt crisis is blooming and the global economy is on the skids? First, there are basics like: don’t try to time the market, watch out for fees, know your clients’ (and your) limitations, diversify your assets, etc.
Also, very important advice: Get your clients out of mutual funds. Capital gains taxes are one of the biggest reasons investors should not be in mutual funds. Running a close second are low returns and high fees — open and hidden — which caused investors’ return on investment to bottom out after a taxable year.
Mutual funds will certainly continue with unnecessarily high fees (visual and hidden), high add-on capital gains taxes and a blatant lack of transparency by the fund companies. Financial advisers and investors alike for the most part ignore this downside of funds across the fruited plain.
As you know, because of the way mutual funds are bought and sold, it’s all too possible to lose money with your clients' investment and also have them paying significant taxes. During this last year mutual fund investors had it better. Yet low returns and capital gains taxes — the double whammy — have occurred each year since 2000. And, if my predictions are correct, excess taxes will continue to punch holes in your clients' portfolios in the future.
There are much better returns-generating vehicles that are more secure, more transparent financial strategies such as exchange traded funds and what we recommend: separate managed accounts that put the genie in your corner and grow/protect your clients’ portfolios.
Notice I didn’t earlier list the theory of buy-and-hold, as this protection strategy is being questioned in the wake of the brutal bear market we are experiencing at present. I don’t advise completing eliminating buy-and-hold, but I do believe it can tie in well with utilizing downside protection as a duel asset management strategy for your client base. You will recall that downside protection is a cushion against the potential loss resulting from a price decline in a security or market. Hedging with tactical asset managers is another good and popular way to help reduce losses for clients in a choppy market. Tactical investing as an overlay on a long-term strategic approach makes a lot of sense, and separates you from the crowd, which is the key when gathering assets. The combination of strategic and tactical managers with alternatives is the place to be today.
Another strategy is inverse ETFs, which can be used in certain indexes in sectors or industries or within the context of a separate account portfolio. You have to watch the real returns because of daily compounding. This does require some active management but may be worth it in down markets for advisors.
Offering these kinds of protection techniques for prospects and clients in a dropping market is a flexible indicator of true wealth management advice matched with the traditional buy-and-hold strategy. There is no reason that these counter strategies cannot coexist, if market conditions dictate.
The proven way to do this is in a unified managed account, the latest in high-end asset management. The advisor can blend institutional managers and ETFs with downside protection on the same platform. Also, this comes with a timely 24/7 view of your account that is called full transparency, something Madoff did not offer to his clients. Wonder why?
Most wealthy and affluent clients want to preserve capital first and achieve returns second. Tactical asset managers are able to reduce losses in down markets and provide an excellent hedging approach in tough times. Combine with alternatives ETFs and you are home free.
Be sure you are up-to-date with these techniques. The buy-and-hold days are not over but presently, portfolios need to be fully supported by downside protection which, if communicated properly to your clients and prospects, will bring in more assets and quickly separate you from stock brokers who are holding most of the assets today.