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Portfolio Manager Perspectives

Jeff Benjamin

Why all the fear about the stock market?

Dec 19, 2012 @ 11:56 am

By Jeff Benjamin

equities, volatility, risk, options
+ Zoom

One need only look at the steady pace of outflows from equity mutual funds over the past few years to recognize that financial advisers must be longing for a better strategy for keeping investors in the markets.

Evidence of investor fear is obvious but in many respects unjustified, given investment options and strategies available to manage risk.

Even as the S&P 500 has gained more than 16% from the start of the year, net outflows from equity mutual funds have exceeded $126 billion.

That's on top of $128 billion in net outflows last year, when the broad-market index gained 2.1%

What's happening, according to pundits, prognosticators and economists, is that investors are embracing the concept of the so-called new normal, which is supposed to involve lower returns and higher volatility.

Whether this turns out to be reality or just some smart-sounding forecast, it is certainly contributing to current investing patterns.

This is where Mitchell Eichen, founder and chief executive of The MDE Group Inc., a wealth manager, is planting his flag, because he believes financial planning is ready for a wake-up call.

Mr. Eichen, whose firm manages $1.5 billion, is pushing the advice industry toward a new way of managing and embracing risk.

The relatively simple strategy has been dubbed Risk 3.0, representing the evolution beyond both modern portfolio theory and some of the popular alternative strategies designed to control risk.

By using put and call options on broad market index positions, Mr. Eichen is managing the risk and return profiles of core portfolio positions.

Risk 3.0 Asset Management, which has been established as a $450 million unit of The MDE Group serving registered investment advisers, manages three strategies designed for various market outlooks.

For moderate growth and potential volatility, such as today's environment, the options are used to eliminate the first 12% of losses and enhance returns into the double digits.

In a more bullish market cycle, the emphasis shifts to enhancing returns more aggressively. And when fear and caution are paramount, the options can be used to place tighter limits on losses.

“There is almost universal agreement throughout the financial services industry that the financial markets are not performing like they were in the 1980s and 1990s,” Mr. Eichen said. “Yet people keep falling back on what they have always done, and have always been comfortable with.”

Mr. Eichen is not shy about challenging the financial planning industry, but his specific target is often the 60-year old principles of modern portfolio theory, which promote diversification as a means of maximizing return.

“We think there is a new paradigm of investing out there, but advisers keep falling back on what they've been so comfortable with,” he said. “I think the real problem is advisers are afraid to approach their clients and say, 'I was only kidding about all that diversification stuff I've been talking about for the past 20 years.'”

An MDE Group-sponsored survey of wealth managers earlier this year showed overwhelming support for new strategies but a significant reluctance to move away from traditional models.

Of 130 advisers surveyed, 92% said they are seeking strategies to enhance performance without taking on more risk, 91% said they are seeking consistent and predictable returns, 90% said they are wary of opaque strategies, and 86% are skeptical of hedge funds.

Meanwhile, 81% also believe active management is a way to reduce risk, 78% describe fixed income as low risk despite record-low interest rates, 68% believe equities carry below-average risk, and 68% also describe asset class diversification as an effective way to reduce risk, even after the 2008 financial crisis that saw high correlations across virtually every asset class.

“The two lessons which surprisingly seem to remain unlearned for a set of wealth managers in the wake of the credit crisis are that there is a fresh set of risks out there, and traditional investment paradigms have lost their effectiveness,” Mr. Eichen said. “Let's face it; the most important thing about building wealth over time is not getting creamed when markets are down.”

Portfolio Manager Perspectives are regular interviews with some of the most respected and influential fund managers in the investment industry. Please visit InvestmentNews.com/pmperspectives for more information.

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