Mfg. data conflicts and confuses • pg. 7

Managing risk A cultural fit • pg. 3

Maximizing seasonal performance • pg. 4

pg. 8

James Hamer THE SACRED TRUST

September 18, 2014 | Volume 3 | Issue12

First magazine focused on active investment management

comfort level with financial institu-

tions for most and many have basically

managed their own money for years,

in the safest of investments. They are

risk-averse and do not want to see their

assets decrease.

For this belief system, active money

management and its risk management

practices makes perfect sense. My cli-

ents are not looking to take big chanc-

es with their assets, their retirement,

or their legacies. The focus of active

money management on controlling

risk and volatility works well for this

market, which is why I am increasing-

ly introducing active management to

clients.”

y advisory practice has

a heavy concentration

of Korean-American clients. Many of

my clients came to the U.S., as I did,

in a wave in the 1970s and 1980s and

have worked hard to establish profes-

sional careers or start their own busi-

nesses. Many are either retired or fast

approaching retirement.

Their needs and attitudes are very

specific to this market. It starts with

language, which is usually not an issue

in most things of daily life, but can be

challenging for complicated matters

such as financial services. This was one

reason I was originally recruited many

years ago by one of the major life in-

surance companies, as they tried to

reach out to minority communities.

The cultural beliefs of Korean-

Americans can have a big impact on the

way they view their finances. They are

a community that tries to save as much

money as possible and want to pass it

on to their children and later genera-

tions. They do not believe in taking on

debt and want to pay off their homes

as soon as possible. There is not a high

Active management: a goodfit for cultural attitudes

Jong OhBlue Bell, PA

FSC Securities CorporationPresident & CEO,

Professional Insurance & Financial Services

M“

Jong Oh is a Financial Advisor with Professional Insurance & Financial Services (PIFS) in Blue Bell, PA, affiliated with FSC Securities Corporation in Atlanta, GA.

Securities and advisory services offered through FSC Securities Corporation, member FINRA/SIPC. Insurance services offered through PIFS, which is not affiliated with FSC Securities Corporation. Investing involves risk including the potential loss of principal.

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September 18, 2014 | proactiveadvisormagazine.com 3

TIPS & TOOLSPOLLS

magine you like to hike and you live in a region where the weather can change quickly. When you go out in early

summer, how do you know what to take with you? Do you pack a parka, snow shoes, and heavy gloves just because the weather might shift?

The answer, of course, is no. Each season has certain characteristics that tend to repeat. So while you may not know exactly what to wear, when you hike in early summer you know you are better off using limited backpack space for a light raincoat and mosquito repellent than using the space for winter gear.

So what does that have to do with investing? More than you might think. As consultants, my

partners and I are challenged with identifying ways to improve our clients’ investment strat-egies, some of which already have reasonably good performance compared to relevant bench-marks. One go-to method of strategy enhance-ment is assessing “seasonal performance.”

In investment lingo, a “season” is often referred to as either a market type, or, for the more academically inclined, a market regime. Adherents of using market type contend something that seems obvious to most market participants: no strategy works effectively all the time.

While definitions vary from source to source, in this article we’ll view a market type as any systematic, macro-level means of

categorizing investment strategy performance using information about market dynamics with a tendency to persist. Sound complicated? Believe me, it’s not—an example will simplify things.

Let’s say you are an investment advisor and one of the strategies you frequently recommend to clients is a momentum-based system, which we’ll call Strategy X. Each month, Strategy X buys the three best performing instruments from a list of Exchange Traded Funds (ETFs). The strategy takes advantage of a well-researched historical market edge (i.e., momentum) and meets long-run expectations, but experiences short periods of underperformance. Is there a way we can we improve Strategy X without

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I

What does alpha have to do with the weather?

Understanding the “seasonal performance” of actively managed strategies using market type

By Dave Witkin

proactiveadvisormagazine.com | September 18, 20144

Market type is any systematic, macro-level means

of categorizing investment strategy performance using information about market dynamics with

a tendency to persist.

significantly reducing the likelihood it will con-tinue to perform well in the future? Exploring alternatives based on market type is one answer.

To consider improvements to Strategy X using market type, first we need a systematic means of segmenting historical system perfor-mance. To keep things straightforward, we will use the 200-day Simple Moving Average (SMA) to define market type since it is commonly used by traders. More specifically, when the slope of the S&P 500 200-day SMA is rising, we place our historical strategy results into a bucket called Market Type A, and when the slope is falling, the historical results go into a bucket called Market Type B.

The numbered circles in Figure 1 show changes in market type based on this defi-nition. Note that market type shifts happen infrequently—there were only seven changes in

the roughly 15 years of S&P 500 data shown—which is often the case with effective market type definitions.

Aggregate “Strategy X” results across both market types are shown in the table: 12.7% compound annual return, drawdown roughly equivalent to the S&P 500, and a Sharpe Ratio of 0.39, metrics which collectively represent noteworthy outperformance versus the bench-mark. But the table also clearly shows all of the alpha—a 75% improvement in compound annual return and a 50% reduction in maxi-mum drawdown—comes during what we’ve defined as Market Type A. So while the hypo-thetical “Strategy X” outperforms the S&P 500

continue on pg. 11

Strategy X Performance1

Metric

Active DuringAll Market

Types

Active Only DuringMarket Type A

(S&P 500 Slope Rising)Areas 1, 3, 5, 7

Active Only DuringMarket Type B

(S&P 500 Slope Falling)Areas 2, 4, 6

Benchmark(S&P 500)

Total Time in Market TypeCompound Annual ReturnMaximum DrawdownSharpe Ratio

100%12.7%-56.3%

0.39

75%13.6%-28.5%

0.55

25%-0.4%

-69.2%0.23

100%7.1%

-56.7%0.23

Figure 1: Knowing that all of the positive system performance occurs in Market Type A enables a new dimension of diversification,capable of delivering higher returns and lower drawdowns.

= 200-Day Simple Moving Average (SMA)= S&P 500 closing price= Market type change

1 For illustrative purposes only. A 3% risk-free rate was used over the 22-year simulation period. For brevity, only 15 of the 22 years are dis-played in the chart. Because “Strategy X” employs a rules-based system for entering and exiting trades, results “During Both Market Types” are not perfectly weighted averages of Market Type A plus B.

September 18, 2014 | proactiveadvisormagazine.com 5

Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun2011 2012 2013 2014

-1.0

-0.5

0.0

0.5

1.0

1.5

50.0

52.0

54.0

56.0

58.0

-0.4

59.0PMI Manufacturing “Survey”Manufacturing Production

Conflicting data continues to present mixed economic picture

onday’s (9/15) report by the Federal Reserve on U.S.

Industrial Production for August came in at a very disappointing -0.1%, which was well below the consensus expectations for +0.3%, and lower than last month’s downwardly revised reading of +0.2%.

On the same day, the Empire State Manufacturing Survey showed perceptions of strength building in New York’s manufacturing sector, as its general conditions index was up nearly 12 points to 27.5, versus expectations of 15.9. But the internals of that report were less encouraging, with employment growth slowing sharply.

The Industrial Production report showed the first monthly decline in seven months, impacted by slowing auto manufacturing.

MSource: Zero Hedge

The output of motor vehicles and parts decreased 7.6 percent, the biggest drop since May 2009. According to Bloomberg, that was most likely payback from a 9.3 percent surge in July that was the largest since September 2009. Industry data, however, shows vehicle sales may keep powering production in coming months. Sales of cars and light trucks rose to a 17.5 million annualized rate in August, the highest since January 2006.

The Industrial Production report runs counter to some recent data indicating an economic pickup is continuing in the U.S. The Institute for Supply Management’s manufacturing survey index climbed in August to the highest level since March 2011 and Q2’s latest GDP numbers beat expectations at a 4.2% annualized growth

rate. Retail sales climbed 0.6 percent in August, the most in four months, with broad-based strength reflected by gains in 11 of 13 categories.

However, as the chart indicates, differences can often be pronounced between “survey data” and “hard data” when looking at economic progress. The OECD (Organization for Economic Cooperation and Development) this week cut its economic outlook for many developed countries, and now forecasts U.S. GDP finishing 2014 at an overall 2.1% growth rate.

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7September 18, 2014 | proactiveadvisormagazine.com

TOPPING THE CHARTS

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There are excellent third-party managers out there with a wide variety of philosophies, and it is a matter of conducting the due diligence and selecting strategies that you think are going to be appropriate for your client base. Since this almost always involves a fee structure for clients, it was a new way of doing business and places a great responsibility on the advisor to make a very careful selection of managers—including making changes in the roster of managers, if necessary.

At the top of my list is setting expectations with clients about active management and how it works. Once we have the appropriate longer-term expectations in place, it has been by and large a successful approach for our practice.

I like to think we did that at a pretty high and sophisticated level, but it was still very much a passive approach to investing with periodic rebalancing.

With the first crash of the early 2000s, I saw both my personal portfolio and those of my clients essentially cut in half. Yes, there was a slow rebound, but I still had to field many calls from clients and give reassurances that things would work out over the long haul. It sounds okay when you are talking about long-term trends and market history that there would be a recovery in client assets, but when you actually look at account balances down 20-40% that is another matter. For many people that represents a very significant portion of their retirement nest egg.

That was the trigger point for me, and we started investigating money managers who employed active management strategies.

How has that process evolved over time?

It really started around 2004 when we introduced our first active manager to client portfolios. That first strategy experience worked well in certain markets and not so well in others. This put our organization to the test and we in turn put active managers to the test.

Proactive Advisor Magazine: James, can you describe your client philosophy?

James Hamer: I have been in the financial industry for 26 years and really have never wavered from why I started in the advisory business. I have a passion for helping people learn about managing their money and not to be intimidated by the world of finance.

Money management is far from easy, but it should be something that a good advisor can simplify to make understandable. My goal is not only to educate, but to make sure people can sleep at night, knowing they have a good financial plan in place. I believe in some of the concepts Steve Jobs used to make Apple so successful. He understood he was not just selling a product but also an experience. I want my clients to have a financial life that is as free of stress as possible.

How does this play out in your invest-ment approach?

Back when I first started my career, I fol-lowed a pretty traditional investing approach for clients—primarily mutual funds, asset allocation modeling, and diversification.

James Hamer

By David WismerPhotography by: Sara Stathas

THE SACRED TRUSTIt begins with frank discussions

about expectations and managing risk

James Hamer can certainly be called a well-rounded guy. Professional development includes the sciences, teaching, and, of course, financial services. Personal interests range from cycling to yoga to ballroom dancing. But when it comes to client relationships, he’s got just one thing on his mind: honoring their sacred trust.

proactiveadvisormagazine.com | September 18, 20148

Talk about how you manage client expectations.

It really goes back to what I said about how I approach working with clients. This business should be about alleviating concerns about money, not adding to them. Clients are affected by everything they read and hear from the media. Active management provides an investment approach where they can be assured that very professional money managers are monitoring the market environment on their behalf every day. That does not mean changes are going to made every day—far from it—but these managers have the ability and the strate-gies to anticipate and react to changes in market conditions.

As part of its underlying principle, active management has a strong emphasis on risk management, which usually has two major im-plications for clients. First, that the risk of those large portfolio drawdowns seen in the early 2000s and 2008 can be mitigated. Secondly, on the flip side, when markets are running very hot to the upside, actively managed strategies—not all, but some—may not see all the gains of the market.

I have very frank discussions with clients about their individual risk profiles, the strate-gies we are recommending to employ, and how those strategies should fit in their overall finan-cial plan. This is the challenge for us as advisors. We need to communicate and explain very sophisticated, quantitative strategies to average

investors. They do not need to know everything that is under the hood, but they do need to fully understand and agree to the overall objectives. They especially need to understand that the majority of actively managed strategies are not designed to track overall market benchmarks.

That is the whole point—to have less-correlated strategies with lower volatility and more risk management. The money managers we are using now are genuinely more tactical, with the ability to go wholly or in part to cash or to use inverse or leveraged strategies. This is diversi-fication taken to another level, with diversifi-cation among asset classes and then tactically managing exposure within an asset class.

continue on pg. 10

September 18, 2014 | proactiveadvisormagazine.com 9

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be performing as well as we would like. The critical factor is whether or not our managers are executing their strategies well. If they are but the performance is still consistently not living up to our expectations, we will make strategy changes. We need to set the expectation of that possibility with clients, and hopefully it is the exception and not the rule.

Bottom line, active management is a great fit for my philosophy of working with clients—it has become part of my belief system. I want to set clear, realistic, and achievable expectations with clients and provide a high level of risk manage-ment. Clients place a sacred trust with us and at the end of the day what matters most is acting in the best interest of the client. That means earning that trust every step of the way—from education to planning to implementation to review.

Do you find issues in introducing active management to clients?

As I mentioned, there is the education piece. We have some very good materials on market history and the historical performance of actively managed portfolios versus the performance of more passive portfolios. While this has to be positioned with care and all appropriate disclaimers, it is a pretty powerful story.

We need to be very upfront about the fees involved with third-party active management. In the big picture, these are not high by any means. But for some clients it is a new factor to be introduced and explained.

Third, we place great importance on client reviews and ask for feedback on every aspect of our performance. Returns are top of mind for many clients, and there are times when some actively managed strategies may not

continued from pg. 9

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10 proactiveadvisormagazine.com | September 18, 2104

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overall through both up and down markets, is there room for strategy refinement to further boost alpha?

An often-overlooked feature of market type is its ability to open up a new, potentially more effective dimension of diversification. Market type allows you to employ each strategy only during “seasons” when they are likely to be prof-itable. By doing so, it enables you to seamlessly rotate capital between strategies specifically designed to complement one another. In the example above, choosing to only use Strategy X when in Market Type A allows you to diversify into strategies designed to work more effectively in Market Type B. When constructed correctly, this under-used diversification method allows you to enhance returns and reduce drawdowns.

In the above table, we’ve chosen a market type methodology with only two possible values: Market Type A (rising 200-day SMA) and Market Type B (falling 200-day SMA).

Note, however, there are a number of ways to define market type, and the table shows a small sample of options. Each technique could be combined with one or more of the others resulting in a matrix of types.

So how do you choose which market typing method to use? As a general rule, a simple solution like using the direction of a key, long-term moving average of price or a relative level of historical volatility is often a good starting

point. Even so, the most accurate answer is market types should be designed to support broad categories of client return objectives and risk tolerance, and need to be carefully matched to strategies. Just as investing a large portion of capital in equities is inappropriate for some categories of clients, so is choosing a universal definition for market type.

Clearly, effective market type diversification has the potential to provide your clients higher returns with the same, or even lower, risk. It allows active diversification not just across asset classes, but also across market types within a given asset class.

Diversification is often primarily viewed as a means of reducing risk, but that doesn’t mean it has to come at the cost of returns. For advisors and the third-party asset managers they partner with, market type-based strategy diversification can be a sophisticated way to boost alpha with-out increasing drawdowns.

continued from pg. 5

Example of Market Typing MethodsP/E RatioReal In�ationNYSE Advance / Decline RatioHistorical VolatilityImplied VolatilityBusiness Cycle StageInterest Rates

11September 18, 2014 | proactiveadvisormagazine.com

The opinions and forecasts expressed herein are those of the author and may not actually come to pass. Any opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. The analysis and information in this edition and on our website is for informational purposes only. No part of the material presented in this edition or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any portfolio constitutes a solicitation to purchase or sell securities or any investment program.

EditorDavid Wismer

Associate EditorElizabeth Whitley

Contributing WritersDave Witkin

David Wismer

Graphic DesignerTravis Bramble

Contributing PhotographerSara Stathas

September 18, 2014Volume 3 | Issue 12

Proactive Advisor Magazine is dedicated to promoting and educating on active investment management. Distribution reaches a wide audience of financial professionals who advise clients on investments and portfolio management. Each issue features an experienced investment advisor who offers insights on active money management, client service, and investment approaches. Additionally, Proactive Advisor Magazine offers an up-close look at a topic with current relevance to the field of active management.

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Proactive Advisor MagazineCopyright 2014 © Dynamic Performance Publishing, Inc. All rights reserved. Reproduction of printed form, whole or in part, without permission is prohibited.

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