Investment Process. The Filla Latzke Group at Morgan Stanley. 2 Active or Passive. 3 Navigating Today s Markets. 4 Choosing Investment Managers

Transcription

1 2 Active or Passive 3 Navigating Today s Markets 4 Choosing Investment Managers 5 Retirement Income Strategy The Filla Latzke Group at Morgan Stanley Investment Process

2 Active or Passive? We Prefer Active AND Passive. There has long been a debate in the investing world about which method of investing is better: active or passive. In stock investing, active management is an attempt to outperform either the broader stock market or a segment of it by allocating money to stocks or sectors of the market that the portfolio manager believes will perform particularly well. Conversely, it also allows the portfolio manager to avoid those stocks or sectors they feel will not perform particularly well. Benefits of such an approach include the potential for better than market returns as well as the ability of the fund manager to, theoretically, monitor the risk of the portfolio. Detractors will point out that the increased fees of active management are not justified by the uncertainty of the fund outperforming its benchmark. Passive management, or indexing, occurs in funds that attempt to mirror their underlying benchmark. For example an index fund that mirrors the S&P 500 will buy proportionately the same amount of every stock that is in the index. No trading will take place in the fund unless the benchmark changes its holdings which typically happens once a year. Proponents of indexing like the low cost and tax efficiency they provide. They will also argue that the market is efficient and therefore any outperformance achieved by active management is just luck. Criticisms include little attention to risk and when factoring even the generally lower internal costs of index funds and commissions it is likely that an index fund may do worse than its underlying index each year. So which is better? Wanting to have as many tools in our tool box as possible, we would say, It depends. We are in favor of using both methods with the decision coming down to which method better addresses the goal of the particular opportunity we are looking at. We are in the camp that believes high-quality active management, monitored closely, can produce better risk-adjusted returns over the long-term; often called a strategic investment. Generally speaking, we favor active management for asset classes that we plan on holding for long periods of time. view, however, it is important to understand the process the fund manager has for selecting securities and appreciate that the market does not always reward every type of stock selection criteria. For example, several very good stock managers looked foolish during the dot com boom of the late 1990 s because their process prohibited them from buying the types of stocks that were driving the overall market higher (i.e. stocks of companies with little more than a good idea). Frankly, managers that did underperform during this time might be just the ones we would favor. Conversely, we often look to passive vehicles for exposure to shorter term or tactical investments. While never trying to time the market we do feel shorter term opportunities present themselves as the market and economy go through their typical fits and starts. To use the late 1990 s as an example again, our philosophy would dictate that while we would not give up on a long-term active manager that was not buying dot com stocks, we would have no problem allocating a small portion of a portfolio to a passive, technology-focused fund to capture at least some of that momentum. As we have often said, investing is part art and part science. With the advances in technology and new platforms available at Morgan Stanley we feel more confident than ever we have the tools necessary to optimize both active and passive approaches. To pick just one would be like throwing away half of our tools just before we are going to build a house. The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the road stock market. An investment cannot be made directly in a market index. This is not to be confused with a traditional buy and hold philosophy. We have screening processes in place and a disciplined, ongoing method of reviewing all managers we use to make sure they continue to do what attracted us to them in the first place. We will most certainly fire a manager if need be. To be sure, there are periods of time when even the top stock managers underperform their benchmarks. When taking a longer THE FILLA LATZKE GROUP 2

3 Navigating Today s Markets with Strategic and Tactical Investing The markets have changed over the last 10 years. Advances in technology mean that global news stories are obtained instantly by everyone. Any individual, hedge fund, or institution wishing to adjust their portfolios to that news can do so rapidly. As a result of this and other factors, volatility in the markets has increased significantly over the past 10 years and even more so over the past 3 years. Consider the following study done by research firm Crandall and Pierce: As of December 31, 2010, 40% of the 200 most volatile days (up or down) on the Dow Jones Industrial Average over the last 50 years have occurred since the end of Additionally, more than 25% of those days have occurred since the end of We believe this volatility will stay with us for the foreseeable future. How have we responded to this increased level of volatility? We believe that client portfolios should use a combination of strategic and tactical investing to better navigate today s markets. While strategic and tactical investing are complex topics we ll do our best to simplify them here. The differences between strategic and tactical are subtle but important. For our purposes, strategies are more about the big picture and tactics are more about the details. At the extreme, a purely strategic portfolio would assume that historic long-term returns should repeat themselves in the future and allocate assets accordingly. A purely tactical portfolio would constantly reposition itself in anticipation of what might happen over the next number of months or quarters. How do we implement these styles of investing in a clients portfolio? The first step we take after understanding a clients unique financial situation is to develop a long term strategic allocation. The goal is to align the long-term goals of our clients with appropriate allocations to stocks, bonds and cash. Getting your long term strategic allocation right is very important. Studies have shown that your long-term allocation to stocks, bonds, and cash dramatically impact the variation of portfolio returns*. However, this is not the whole story. While holding onto high quality investments over long periods of time is still a vital part of any investment plan we feel that portfolios also need some flexibility to better navigate today s markets. This is where tactical investing plays an important role and is the second step in our investment strategy. We adjust the long term strategic allocation slightly to reflect our shorter term view on the market. We view tactical investing much like we view the gas and break pedals in our car. While we want to get from Point A to Point B as quickly as possible we also want to get there as safely as possible. If road conditions are good and traffic is low we may speed up a bit. If, however, we hit road construction or bad weather we would slow down until conditions improved. When we add a tactical layer to a portfolio we are trying to, on the margin, improve portfolio performance from both a return and risk perspective. We use tactical ideas to increase participation in assets that may perform particularly well in favorable markets and decrease participation in assets that may perform particularly poorly in difficult markets. Much like our decision to implement both passive and active investments, we advocate building portfolios with investments that are both strategic and tactical. *Ibbotson Associates: Study based on ten years of quarterly data. Brinson, Hood & Beebower Study conducted in 1987 and updated in 1991, found that 91.5% of the variation in pension funds returns from 1977 to 1987 were attributable to the asset allocation decision. Asset Allocation does not guarantee a profit or protect against a loss. Past performance is no guarantee of future results. 3 THE FILLA LATZKE GROUP

4 Choosing Investment Managers from a Sea of Options According to investment research firm Morningstar there are over 26,000* mutual funds and nearly 1300 exchangetraded funds (ETFs) available to investors in the U.S. Some are good and some are bad but even eliminating the bad ones would leave you with a substantial list of funds to choose from. So how can we narrow down such a list to a more manageable length? There are several ways to do this and, to be sure, this exercise is equal parts art and science with a little bit of luck thrown in too. All the analysis and number-crunching in the world isn t going to accurately forecast which managers will perform best over any given period. Often times when deciding which mutual fund to use, investors will primarily and sometimes only look at returns. Whichever fund of the group they are looking at that had the highest returns over the most recent time period is the one they will invest in. As our industry is fond of saying past performance is not a guarantee of future results. So rather than start with performance we typically end with it. There are several other factors we need to be comfortable with before we even look at how a fund has performed. Simply knowing that a fund returned 20% last year tells us nothing about its quality. The first factor we consider is the firm that the managers work for. Does it have a good reputation in the industry? Is it a large multi-national asset manager or is it a small independently owned firm? How do they compensate their employees (i.e. are they paid on money that comes in the door, on retention of assets or on performance)? Do they have the best interest of the client in mind? Second are the people in charge of the fund. Is it an individual or a team? How long has this structure been in place? How did they perform in both good and bad markets? What is their overall feel for the market and how do they analyze securities? How frequently do they communicate with investors? Third is the process the manager or team uses to manage a portfolio. How many stocks do they typically hold? How often are they trading in the portfolio? Do they take large bets on any one stock or sector or is a certain level of diversification maintained? Are they picking stocks from anywhere or are they constrained by company size, location or other factor? The answers to these questions won t by themselves tell us to hire or fire a manager but they help paint the picture. Once we feel comfortable with the firm, the manager and their process we then look at how the fund performed relative to the broader market and its peers from both a risk and return perspective. While performance is obviously important it must be looked at in context. In other words, if a fund did well, why did it do well? If it performed poorly, why did it do so? Was it, in fact, manager skill (or lack thereof) or was the fund just any old boat benefitting from a rising tide? There are many metrics that try to separate skill from luck, the definitions of which are beyond the scope of this article. And much like the more qualitative factors listed above these quantitative factors should not be viewed as silver bullets. But the picture does become clearer once they are considered. Finally, it is important to consider how each fund compares to the others in the portfolio and how it helps you achieve your overall objectives. Building a portfolio strictly based on recent performance will often time result in overlap and less diversification at the most inopportune time. Likewise, someone who considers themselves a conservative investor can end up with a portfolio that carries more risk than they bargained for by chasing the most recent best performers. * Morningstar. (2012). (Advisor Workstation 2.0) US ETF Universe, US Mutual Fund Universe. Available from /awse20/awsemain/awse-main-frame.aspx THE FILLA LATZKE GROUP 4

5 Retirement Income Strategy Prior to retirement, your work is the provider of your income. Once you cross that retirement threshold however, your assets and pensions (including Social Security) become the provider of your income. Retirement, of course, is not a singular event but a multidecade period of time that requires a long-term view. We feel implementing a structured plan is a great way to guard against our tendencies as humans to focus on shortterm risks. When you are working, the primary objective of your investments is growth. When you are retired, your investments take on a second and equally important objective of income. So how do we balance those two objectives? To be sure, it varies for everyone. We all have our own risk tolerances and time horizons and we are all asking our money to do different things for us. We have developed a strategy that we think addresses these issues for most people. Much of our focus this year has been talking about assets in terms of time horizon. The money you need for income over the next few years (income) needs to be looked at differently from the money you won t need for 6-8 years or more (growth). In order to better separate these time horizons we suggest that you view them as if they were in separate buckets or accounts. The near-term bucket being focused on preservation, the middle bucket being focused on income and the long-term bucket focused on growth. This type of plan is very flexible. How much goes into each bucket is entirely dependent of the needs and preferences of the individual. Some people are comfortable with 2 years of income set aside in cash and CDs while others prefer 5 years or more. However, the primary benefits of structuring a portfolio this way is that it allows us to look beyond the daily noise of the market and focus on the long-term health of the assets. Decisions are made based not on the next several days or months but rather the next several years. Periods of increased volatility in the stock market become easier to ride out when there is a cushion of much more conservative investments being relied upon for income in the near and intermediate term. Investors who find themselves face-to-face with the market tend to make short-sighted decisions that can result in a buy high, sell low method of investing. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in the material may not be suitable for all investors. Morgan Stanley Wealth Management recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular strategy will depend on an investor s individual circumstances and objectives. In bucket #1 is money that will be used over the next 0-5 years. For that we generally recommend taking little or no risk. We take comfort in knowing that we don t have to worry about the money set aside for year 3 of our plan being worth less than what we need to spend. The second bucket is designed to generate an income stream intended to partially supplement the funds being withdrawn from the first bucket. Income can be generated from things like dividend paying stocks or bonds. Finally, the third bucket holds the money that won t be needed for several years and is designed to generate longterm growth. We advocate a diversified portfolio of equities that has a long-term risk tolerance consistent with the objectives of the overall plan. 5 THE FILLA LATZKE GROUP

6 Morgan Stanley Smith Barney LLC offers a wide array of brokerage and advisory services to its clients, each of which may create a different type of relationship with different obligations to you. Please visit us at or consult with your Financial Advisor to understand these differences. Morgan Stanley Smith Barney LLC ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors or Private Wealth Advisors do not provide tax or legal advice. This material was not intended or written to be used, and it cannot be used, for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters. Morgan Stanley Smith Barney LLC ("Morgan Stanley") is a registered broker-dealer, not a bank. Where appropriate, Morgan Stanley has entered into arrangements with banks and other third parties to assist in offering certain banking-related products and services. Unless otherwise specifically disclosed to you in writing, investments and services offered through Morgan Stanley Smith Barney LLC, member SIPC, are not insured by the FDIC, are not deposits or other obligations of, or guaranteed by, banks and involve investment risks, including possible loss of principal amount invested. Asset allocation and diversification do not guarantee a profit or protect against loss. Dow Jones Industrial Average is a price-weighted index of the 30 blue-chip stocks and serves as a measure of the U.S. market, covering such diverse industries as financial services, technology, retail, entertainment and consumer goods. An investment cannot be made directly in a market index. All fixed income securities are subject to market risk and interest rate risk. If fixed income securities are sold in the secondary market prior to maturity, an investor may experience a gain or loss depending on the level of interest rates, market conditions and the credit quality of the issuer. The investments listed may not be suitable for all investors. Morgan Stanley Smith Barney LLC recommends that investors independently evaluate particular investments, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment will depend upon an investor s individual circumstances and objectives. Investors should be willing and able to assume the risks of equity investing. The value of a client's portfolio changes daily and can be affected by changes in interest rates, general market conditions and other political, social and economic developments, as well as specific matters relating to the companies in which securities the portfolio holds. This material is intended for use only in Morgan Stanley's Advisory Program. Mark Filla, CIMA Senior Vice President Financial Advisor Portfolio Management Director Morgan Stanley Wealth Management North Port Washington Road Mequon, WI (262) (888) Morgan Stanley Smith Barney, LLC. Member SIPC. Scott Latzke, CFP Senior Vice President Wealth Advisor Senior Portfolio Manager CRC March 2014