Core Investments - What You Need to Know

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
March 22, 2011

IN THIS ISSUE:

1. Passive vs. Active Management Revisited

2. Core Investments – Your Portfolio’s Foundation

3. Examples of Core Investments

4. The Columbus High-Yield Bond Program

5. The CHYB Trading Strategy

6. Performance Evaluation

7. Comparing Core Investments

Introduction

“Core” investments, as a general rule, don’t get much attention in the investment world, which is unfortunate considering their importance in a diversified portfolio. As the name indicates, core investments serve as the basis or foundation of the portfolio and are usually considered those investments that have consistent performance, year after year. That being the case, here’s a quick pop quiz on core investments:

When considering alternatives for use as core holdings, which would be more attractive?
__	A passively managed investment where you risk losses of over 40% of your investment to obtain a potential long-term annualized gain of 10%.
__	An actively managed investment where you risk less than 8% of your money to obtain a potential long-term annualized gain of 10%.

Let’s see…there’s the potential to make 10% in both cases but you take on five times the loss potential in one of the strategies. Seems like a “no brainer” to me. When put in these terms, it looks crazy to take on more risk in exchange for the chance to earn the same level of investment returns. However, investors are taking this risk every day when they follow Wall Street’s conventional wisdom on core investments.

But what if I told you about an active investment strategy for your portfolio, one that alternates between bonds and cash as market conditions change? And what if I told you that this strategy is managed for capital gains and not yields, and that it has the potential to take advantage of bond price movements instead of being victimized by them? Finally, what if this bond strategy may be suitable as a “core” holding in your portfolio?

The good news is, such an investment does exist and it merits your serious consideration as a core holding in your portfolio. This week, I’m going to focus on exactly what “core” investments are, why they are so important to your investment goals and why Sojourn Financial’s Columbus High-Yield Bond (CHYB) Program fills the bill.

As of the end of February, the CHYB Program has produced a 10.11% annualized gain since its inception (October 2002), net of all fees and expenses. Better yet, it has accomplished this level of return while holding its worst losing streak to less than -8%. That’s phenomenal! While past performance can’t predict future results, this may be just the core strategy you have been looking for in your portfolio. Read on and see if you agree.

Passive vs. Active Management Revisited

In my March 8 E-Letter, I discussed the differences between actively managed investments and passive, buy-and-hold strategies. We had a number of readers respond to our analysis saying that they had been victims of the “no brakes” losses that buy-and-hold investors often experience. The worst part was that some of these investors made emotional decisions to get out of the market at the bottom and have not yet had the courage to get back into the market, thus missing the huge rally since March of 2009.

While the emotional decision to exit investments at exactly the wrong time has been well documented in studies conducted by Dalbar, Inc. and others, it’s the opposite emotional decision that often concerns me in relation to investors. Not only do investors often pick the worst times to get out of the market, but many also pick the worst times to get back in.

Considering that Halbert Wealth Management offers money managers who make objective decisions about when to get in and out of the stock and bond markets, my clients appreciate the ability to leave that decision to a seasoned professional.

One of the best examples of an actively managed investment can be found in the Columbus High-Yield Bond Program. With an annualized return of over 10% and a worst-ever losing period of only -7.84%, every time I review the numbers on this program, I want to put more money in it.

With these performance statistics, the CHYB Program seems to be a natural fit as a core portfolio holding. However, many investors don’t pay attention to core investment strategies because they tend to be less “sexy” than other parts of the portfolio, such as aggressive-growth or alternative investment strategies. Considering that the bulk of your portfolio should be in core investments, focusing your attention on aggressive growth is like putting the cart before the horse.

“Core” Investments, Your Portfolio’s Foundation

Financial Planning 101 tells us that the whole purpose of saving and investing is to meet specific long-term investment goals, whether they be retirement, college education for children, buying a business, etc., etc. One of the critical factors in designing a plan to meet your financial goals is the return expectation. The general rule is that you should not take any more risk than necessary to meet your financial goals.

In other words, if you need only a modest growth rate to meet your financial goals, you shouldn’t “swing for the bleachers” by investing in aggressive programs with higher return potential, but also considerably higher risk. With this idea comes the concept of “core” investments. Morningstar^® defines core investments as follows:

A core holding is just what it sounds like: It's the central part of your portfolio. The core requires investments that will be reliable year in and year out. They're the solid foundation for the rest of a portfolio. To reach your investment goals, your portfolio needs a solid, reliable core. The rest is often frills.

In other words, core holdings tend to be boring. Unfortunately, someone has forgotten to inform Wall Street and major mutual fund companies about this basic financial planning rule. That’s because they routinely counsel investors to put their money into buy-and-hold asset allocation programs where even some of their “core” recommendations have “no brakes” when it comes to limiting losses.

While buy-and-hold core holdings do typically work well in straight up markets, they fail the first test of risk management in down markets. Thus, they tend to only be “reliable” in the way that they perform relative to their benchmark, which is one of the major weaknesses of a passive buy-and-hold investment strategy.

Buy-and-hold supporters, however, counter that the stock market has produced long-term growth in the 10% range, which is needed to build wealth. From January of 1970 through the end of February 2011, the S&P 500 Index, including dividends, grew at an annualized return of 10.1%.

However, if you want to consider an S&P 500 Index fund as a core investment, you’d have to be comfortable saying that you are willing to lose over 50% of your account value in the pursuit of a 10% annualized gain. I’ll take it one step further; you’d have to say that you’re confident that you expect the stock market to average 10% gains from now until the end of your time horizon, whatever it may be. Do you really believe that?

You’d also need to be certain that another bear market won’t come along and decimate your portfolio just at the time you need to use your money for the investment goals intended. Because of the inherent risks in buy-and-hold, I have expanded the definition of core investments to include actively managed investments that seek to participate in up markets but move to cash or hedge positions to limit losses in down markets.

Producing consistent positive returns is a concept known as “absolute returns,” but this term could never be used to describe what most Wall Street firms and mutual fund companies try to pass off as core investment strategies.

Examples of Core Investments

If you ask someone about what constitutes a “core” investment under the above definition, you’ll probably get a wide variety of answers. In researching this article, I came across a number of different investments listed as core, from a variety of equity classes to intermediate bonds and even gold and silver. However, most frequently, I saw large-cap blend and large-cap value mutual funds listed as the most typical core holdings.

While using these types of funds is Wall Street’s conventional wisdom for core investments, I must disagree. It is widely known that the S&P 500 Index is essentially a large-cap blend index. Any investment strategy that is highly correlated to major market indexes is going to be anything but low risk. If the S&P 500 Index posted losing streaks of 45% and 51% during the last two bear markets, what do you think an investment highly correlated to this index is going to do?

Actually, it’s even worse than that. Since the index fund must charge a management fee for certain expenses, it’s virtually guaranteed to perform worse than the underlying index. This isn’t a boring investment, unless you happen to think that roller-coasters are boring amusement park rides.

As I noted above, I define core investments as those that seek to provide absolute (positive) returns in all kinds of market environments. I actually think that active management brings more sizzle to core investment holdings. After all, what is more exciting than seeing your account participate in up markets, and then move to cash when the market falls? Believe me, after two major bear markets within 10 years, capital preservation can be something to brag about!

The Columbus High-Yield Bond Program

You would be hard-pressed to find high-yield corporate bonds on any list of core investment alternatives, at least not the buy-and-hold variety. Chief among the reasons is the increased default risk of these bonds, as well as significant price volatility in certain market conditions. So you’re no-doubt wondering why I’m writing about a high-yield bond program in an article about core investments. Read on and I’ll fill you in.

Portfolio Manager, Steve Landis, of Sojourn Financial Strategies has developed an actively managed strategy trading high-yield bond mutual funds with the objective of producing absolute returns with minimal risk. We have offered his Columbus High-Yield Bond (CHYB) Program to our investors for a number of years, and consider it to be among our best core strategies.

The most significant difference between a typical buy-and-hold high-yield bond investment and one that can qualify as a core portfolio holding is the way it is managed. As you know, buy-and-hold does just what it advertises: buys bonds and holds them, subjecting investors to significant price swings along the way.

As a general rule, actively managed high-yield bond programs have two objectives: 1) manage for capital gains rather than yields; and 2) seek to minimize losses. Their goal is to take advantage of upward price movements while moving to the sidelines during price declines. The historical price trends in high-yield bonds make them good candidates for tactical asset management where risk-managed growth is desired. Plus, the use of high-yield bond mutual funds helps to diversify the portfolio and reduce the risk of default by any given issuer.

The Columbus High-Yield Bond Trading Strategy

The CHYB Program moves in and out of the high-yield debt market based on signals generated by Steve’s proprietary methodology. His model uses technical indicators to determine the direction of the high-yield market and the most opportune times to enter and exit. However, Steve is quick to point out that his model does not try to predict tops and bottoms in the high-yield market. Instead, his strategy is reactionary in that he seeks to identify and follow established trends in the high-yield market and position accounts accordingly.

Client accounts may be fully or partially invested in a variety of high-yield related investments, including traditional high-yield bond mutual funds, high-yield index mutual funds, multi-sector bond mutual funds and even mutual funds investing in floating rate bank loans.

By including traditional high-yield bond mutual funds, Steve is able to combine his tactical allocation know-how with the bond selection expertise of the mutual fund manager. Plus, traditional high-yield bond funds typically pay a higher “coupon” rate of return than specialized index funds.

The CHYB trading model does not use leveraged funds nor does it use specialized inverse funds that provide a net “short” exposure to the high-yield bond market. Best of all, Steve’s strategy employs the use of trailing stop orders that close out trades should losses exceed a pre-determined percentage. In winning trades, these stop-loss orders ratchet up with gains, providing the potential to lock in any positive returns over and above the stop-loss trigger percentage.

If I had to describe our observations of the CHYB trading model, I’d have to use the term “patience.” Steve does not employ any discretion in his trading, so he will allow the system to stay in cash as long as necessary until the high-yield bond market environment improves. For example, the CHYB Program was in cash for much of 2008, which is why it ended the year with only a 2.9% loss rather than a drop of over 26% as was the case in the Barclays High-Yield Credit Bond Index.

Performance Evaluation

The historical performance of the CHYB Program can probably best be described as “slow and steady wins the race,” which is very much in line with the goals of core investments. The CHYB Program does not necessarily try to “beat the market” over the short run, but rather seeks to participate in market gains while also minimizing losses. From the historical performance statistics provided below, it is evident that Steve has attained this goal in the past, though past performance cannot guarantee favorable future results:

CHYB Performance Summary

CHYB Returns

CHYB Annual Performance (after fees)

The CHYB Program is available through the Purcell Advisory Services platform. Accounts are held at Trust Company of America (TCA), an independent trust company located in Denver, Colorado, where you have online access to your accounts via the TCA website. Both TCA and Purcell issue quarterly statements and TCA produces year-end tax reports. TCA charges a custodial fee of 1/10^th of one percent (ten basis points) of the account balance.

The minimum account size for the CHYB Program is $25,000 per account. Management fees are billed quarterly in advance based on the following annual percentages for various sized accounts:

First $500,000	2.50%
$500,000 to $1 million	2.25% (entire account)
Over $1 million	2.00% (entire account)

It is important to remember that all performance information provided above is net of both the management fee and custodial fee charged on the accounts.

Comparing Core Investments

As I noted above, the S&P 500 Index has produced an annualized gain of 10.1% from 1970 through the end of February. This is why many buy-and-hold supporters argue that if you are patient enough (read: live long enough), you should earn a 10% return on stock investments over the long haul.

However, if you compare the S&P 500 Index to the CHYB Program since its inception in October of 2002 through February, you’ll see that CHYB also produced a double-digit return of 10.1%, handily beating the S&P 500 Index’s return (including dividends) of only 8.1% over the same time period. The real kicker is that the CHYB Program produced this annualized return while also managing losing periods to less than 8%, even during the credit crisis, while the S&P 500 Index lost over 50% of its value during the same period of time.

These results were no surprise to me since I have often said that buy-and-hold strategies are a “no-brakes” way of investing. What is a surprise is that too many investors are still subjecting themselves to huge losses by investing in the mutual fund industry’s version of core investments.

Conclusions

We have been offering the Columbus High-Yield Bond Program for several years and I continue to be impressed with the way it can participate in market gains and then move to the safety of the money market fund when the risk of loss becomes too great. I also like the fact that it is a non-discretionary system, which is an important factor when the model has been in cash for an extended period of time.

Over the years, I have seen money managers disregard their trading systems when their signal to be in cash extends for weeks or months. Overriding a trading system can also result from clients calling to ask why they are paying a fee to sit in a money market fund. Steve stuck to his guns during the program’s extended cash position in 2008, and we didn’t hear many clients complaining about having lost only 2.9% for the year when the stock and high-yield bond markets were in free-fall.

When evaluating alternatives for the core investment portion of your portfolio, it is important to consider investments that have the potential to give you the kind of results that you need to meet your financial goals rather than one that just happens to fit the right spot on the Morningstar Style Box™. If core investments are defined as being those that are reliable year-in and year-out, I think the CHYB Program definitely fits that definition.

While bonds in general may have fallen out of favor recently, I think there’s a good case for investing in the CHYB Program right now based on its active management strategy and the tendency of high-yield debt to be less sensitive to interest rate changes than other types of bonds. Don’t let the word “bond” scare you away from a core investment that has the potential to profit even in a rising interest rate environment.

The CHYB Program is available at a low minimum investment of $25,000, making it available to most serious investors. If you would like to learn more about the Columbus High-Yield Bond Program or any of our other risk-managed AdvisorLink^® investment programs, please feel free to contact us in one of the following ways:

Give us a call at (800) 348-3601 and ask to speak to one of our Investment Consultants;
Send an e-mail requesting information to info@halbertwealth.com;
Visit our website at http://www.halbertwealth.com/ and click on the “Contact Us” button at the top of the page; or
Click on the following link to access one of our online information request forms.

As always, past performance is not necessarily indicative of future results. Be sure to read all offering materials and Important Disclosures before making a decision to invest.

Wishing you profits,

Gary D. Halbert

IMPORTANT DISCLOSURES: Halbert Wealth Management, Inc. (HWM), Sojourn Financial Strategies, LLC (Sojourn), and Purcell Advisory Services, LLC (Purcell) are Investment Advisors registered with the SEC and/or their respective states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors. HWM receives compensation from the Advisors in exchange for introducing client accounts to the Advisors. For more information on HWM, Sojourn or Purcell, please consult their respective Form ADV II, available at no charge upon request. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor's 500 Stock Index (which includes dividends) and the Barclays High Yield Credit Bond Index were used. Both represent unmanaged, passive buy-and-hold approaches, and are designed to represent their specific market. The volatility and investment characteristics of these indexes may differ materially (more or less) from that of the Columbus High Yield trading program since they are unmanaged Indexes which cannot be invested in directly. The performance of the S & P 500 Stock Index (with dividends reinvested) and the Barclays High-Yield Credit Bond Index is not meant to imply that investors should consider an investment in the Columbus High-Yield trading program, which is actively managed, as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the high yield investments that comprise the Barclays High-Yield Credit Index. Historical performance data from October 2002 through December 2005 represents a track record compiled by MoniResearch, an independent corporation, Steve Shellans, President. It is based on the signals provided by Steve Landis, is net of fees, with no initial sales charges assessed. Performance from January 2006 forward reflects the return of a representative account in Purcell Advisory Services Columbus High-Yield Bond Program. The representative account has the maximum fee (2.5%) withdrawn, has been in the strategy for no less than two consecutive months with no withdrawals, distributions or additions. Should the representative account fail to meet the criteria, another account that complies with the requirements will be substituted. Neither set of these performance numbers have been verified by HWM, and therefore HWM is not responsible for their accuracy. Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Columbus High-Yield Bond Program.

Purcell utilizes research signals purchased from Sojourn, an unaffiliated investment advisor. The signals are generated by the use of a proprietary model developed by Sojourn. Assets in the program are allocated 100% to the appropriate mutual funds or 100% to the money market according to the purchased research signals. Statistics for "Worst Drawdown" are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results. The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Columbus High-Yield trading program.

In addition, you should be aware that (i) the Columbus High-Yield trading program is speculative and involves risk; (ii) the Columbus High-Yield trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Purcell will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) the Columbus High-Yield trading program’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

Any investment in a mutual fund or money market fund carries the risk of loss. Mutual funds and money market funds have their own expenses which are outlined in the fund's prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency. Returns illustrated are net of the maximum annual management fee of 2.5%, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. Management Fees are deducted quarterly, and are not accrued on a month-by-month basis. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Individual account results may vary based on each investor's unique situation. No adjustment has been made for income tax liability. Consult your tax advisor. “Annualized” returns take into account compounding of earnings over the course of an investment’s actual track record. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.