Six Questions to ask your Advisor: Our Answers
Lance on Aug 25 2008 at 9:42 am | Filed under: Asset Allocation, Commodities, Developing Markets, Domestic Equities, Domestic Fixed Income, Emerging Markets, Energy, Federal Reserve, Global Equity, Global Fixed Income, Housing Market, Metals, Risk, Valuation, economy, real estate
Hedge Fund manager Doug Kass has some questions that clients should ask of their advisors. I should point out that everybody has a bad year, I assume we will have a point where we will have to ask these questions in a harsher light of ourselves. However, these questions can separate those who you might stick with, and who was riding the wave up and added little value that wasn’t lost on the way down. Also, they illuminate who is learning from experience, and who is merely justifying poor decisions. Given the environment, I wouldn’t wait until year end:
Money tends to go where it is best treated, as measured by an asset class, hedge fund or by a traditional investment adviser. As a result, a lot of money will be shifting by year-end, and it is bound to have a disruptive market effect as well as likely to feed continued volatility.
If you delegate investing to an adviser, here are several questions that you may consider asking during a 2008 year-end review of your investment performance:
1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?
2.
How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?
4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?
5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?
6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?
Briefly, I think I will answer for those of you who do invest with us, how I would answer the questions. Feel free to question us more closely in person. Note: While this discussion applies broadly to all of our clients, it is specifically addressed to the vast majority of our assets under management, accredited and qualified investors (those with a net worth of 1 million and up) in our model portfolio’s.
1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?
In our case this discussion really should not be constrained to 2008. We believe we are in the midst of a long term bear market that began with the bursting of the tech bubble in 2000, especially for US financial assets. We participated in the cyclical bull that began in 2003, with significant allocations to international, emerging market, real estate and other high flying assets. Starting in 2006 we began to become more defensive as valuations became more and more unreasonable, allowing our portfolio to move forward based on those areas we felt were most attractive. That allocation allowed us to post strong results through the third quarter of 2007, but the portfolio was dominated more and more by assets not dependent on the general direction of the market. By 2007 we felt returns were likely to turn negative, the economy would struggle and a defensive portfolio was the most prudent path. We had by February of 2007 scrubbed nearly all exposure to financial stocks from our portfolio.
In general our expectations have been met. The markets, especially financial stocks have struggled. Following our strong showing through the first three quarters of 2007 we had a strong burst in the fourth quarter as the markets in the US fell. We weathered the storm in January with a small gain and when all was said and done had a solid first half of the year, with positive returns in each quarter, with solid gains in June to finish off the second quarter.
We began to have concerns short term with our exposure to commodity stocks, especially energy, and hedged that exposure somewhat. We assumed that some of the relationships in our hedged positions might have a short term reverse as well. Unfortunately all of our main performance drivers reversed from the middle of July to the middle of August. It was unusual that all would reverse at the same time, as opposed to being spread out. Unfortunately most, if not all, of our gains during 2008 were lost, though we were still positive since the downturn in the broader equity markets began in October. We feel that most of what we are doing now is still well positioned, with the most likely trouble spot being our unhedged positions, specifically commodity stocks and Asia. Depending on their relative performance we will have a flat to positive end to the year. Our expectation is we will finish the year with returns in the high single digits, which is what we expected at the beginning of the year.
What about surprises? The relative strength of small cap and real estate stocks stick out. We feel they will resume their under performance going forward. Commercial real estate is starting to roll over and we expect that to weigh on REITs. Small cap stocks are still very overvalued, and earnings likely to continue to disappoint. As credit markets and the economy become even more strained access to credit will hit them hard. If they struggle greatly relative to larger, higher quality stocks we could see our expected return numbers increase markedly.
2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?
We have outperformed broad market indices handily year to date, since the downturn began, and for trailing one, three and five year periods. Heck, we are positive for the year! Accomplishment enough, if unspectacular. Compared to the indices the various areas of our portfolio have performed from okay to fantastic. No major underperforming areas.
3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?
We felt the US faced a high probability of a recession coupled with a worldwide slowdown. We felt the credit markets were the most vulnerable, due to a severe housing downturn, and inflation would be an concern. Interest rates were a bit uncertain since, with inflation an issue and growth vulnerable, the fed would be pushed in both directions. More importantly, due to the difficulties in the credit markets we felt interest rates would be relatively insensitive to the federal reserves efforts and interest rates would remain stubbornly high, with credit spreads likely to widen dramatically. Thus we felt diversifying credit exposure internationally would be prudent and bonds would not be as positive a counter to equity risk as they were in the last downturn.
That has all come true, but our moves to diversify in fixed income have not proven of much benefit. However, our emphasis on other strategies to reduce risk versus fixed income has added value, demonstrating that an over reliance on traditional fixed income to protect in a downturn would not be optimal. In fact, fixed income has been a drag on performance on both the upside and downside of the market over the last two years for us.
4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?
Yes, though our change occurred before the downturn. We have made some small tactical changes as the year has progressed, though our fundamental approach we feel is still sound. We are preparing for some significant changes in the near future, especially if the equity markets weaken substantially from here and we position the portfolio for a more positive market environment.
5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?
This question really doesn’t apply to us since we don’t trade individual securities, though we have hedged positions where one side or the other have struggled. That of course is the expectation for a hedged pair of positions targeting an absolute return. Nevertheless we wish some had been more successful, even if as a pair they outperformed the indices.
6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?
Not only do we, it is a core value at our firm, and that is exactly how we put it. “We eat our own cooking.”
Hat Tip: Barry Ritholtz
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