Mesa Air plunge doesn’t deter local market index

The Scout Partners Index of Western Colorado stocks rose +7.29% while the broad market gained +5.13% in April (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Market), Exxon Mobil, StarTek, CRH (United Companies), and the Union Pacific Railroad.

Arch Coal(ACI) rose +31.9% in April. The stock is up nearly 28% since the beginning of 2008, while the broad market has fallen -4.8% during the same period of time.

Doug May, President of May-Investments, a Grand Junction-based registered investment advisor, noted that, "coal has been strong lately and Arch Coal was a strong performer all month.” May added the company's April 21 earnings release was reassuring to investors. "Earnings were more than 20% above consensus, revenues beat expectations, and the company is talking about supply tightness in the eastern united states that is resulting in declining stockpiles."

Mesa Airlines (MESA) was the worst performer in the index, falling -71.9% in April. "The stock has all the earmarkings of a sinking ship," May said. "It paid out huge bonuses to management at the end of last year. It lost an $80 million lawsuit with Alaska Airlines, which just settled for 65 cents on the dollar as long as it was paid immediately in cash. They have $100MM of bonds that bondholders could force the carrier to repurchase as soon as June 16, assuming they haven't filed bankruptcy by then, they operate in an industry where it seems that a new carrier is going belly-up each week, and they are looking to raise a fraction of that amount by giving away half the company in a new share offering in a distress sale to new investors, assuming they can find anyone willing to pony up the money."

Mesa has lost almost 80% of its value thus far in 2008. "I'm sure glad that the Board paid up for that bonus money at the end of last year to lock the current team up for the long-term, though in this case it looks like "long-term" might just be a matter of weeks."

Scout Partners equal weighted index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in Industrial stocks, which comprise over 20% of the portfolio. Local stocks are up +7.33% over the past 12 months while the overall market has fallen -4.44% over the same time period. Year-to-date, local stocks are up +3.32% while the broad market is down -4.8%.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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A New Era: How Supermarkets De-Throned Wall Street

The 80 year-old woman seated across the table from me came from one of the city's finest old money families. She and her husband had been raised in Little Rock during an age where World Wars were numbered. They'd seen the tough times when President Eisenhower ordered federal troops into Little Rock to enforce de-segregation at Central High. But they'd also seen the entire state celebrate young Governor Clinton's move to the White House. Together they'd watched the city grow, living on land her husband had developed into a community of beautiful homes overlooking Arkansas River.


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But her husband was gone, now. He'd died a few months before, quickly but not without warning. He'd had time to arrange his financial affairs, and as she sat before me she pondered his last words to her. "Be prudent," he'd said. She wondered if her money would last. We assured her that the money they'd saved, a liquid portfolio of almost $3 million, was more than enough. Her husband had amassed a fortune. They had developed a lifetime habit of living well within their means. She was going to be just fine. She was one of the lucky ones.

Do you have financial concerns about retirement? Are you lucky enough to have accumulated several million dollars? You don't need that much, but when it comes to the question of "how much?" the answer is usually that "more is better!" What are you doing to follow this wise man's advice? Are you being careful to "be prudent" with your money? Where are you going for help to prepare for your retirement? What kind of life will your spouse have after you are gone? What can you do, now, to prepare? Are you dependent on one of the thousands of advisors working for a big bank or Wall Street brokerage firm? Are they really taking care of you? Are they prudent with your money?

If you can do it, increasing your portfolio's investment return is by far the easiest way to reduce your financial worries about retirement. But how do you get help in this area if investing is not something that comes naturally to you? Many people fall into a trap of either over-paying for traditional advisors, or being reluctant to pay anything they achieve disappointing results following bad, free advice. There is no shortage of people willing to take your money in exchange for helping you manage your savings program (yes, even including authors). Most of these people are honest and hard working professionals doing the best job they can for you. But most "financial consultants" are salesmen first and foremost. Their companies trained them in how to use pre-approach letters, cold calls and seminars to generate leads. They are not handed a book called Classics: an investors’ anthology and told to study it so that they will learn how to make money for their clients. They study, and are paid for, their ability to sell you an intangible product called financial services.

The longer I’m in business for myself, the more I realize that sales is an honorable profession. However, do you want to put a salesman in charge of your financial future?

The world is not static. It is dynamic; it changes constantly. What may have been the best alternative, yesterday, is not always still the best choice today.

• What is a mutual fund supermarket?

A supermarket (soo-pur-mar'kit) is a large self-service retail bazaar that sells food and household goods and, thanks to Schwab's innovation, now mutual funds. Granted, the mutual funds aren't found next to the carrots and tomatoes, or even in the general merchandise aisle. But the large selection, oriented toward self-service end-users (i.e. retail buyers) is the same. The market owner receives a small percentage of each sale and like in a traditional supermarket the vendors pay the supermarket to get their products merchandised on store shelves.

John McGonigle was one of the people at Charles Schwab who led the effort to develop the new supermarket of mutual funds. McGonigle believes the true financial innovation occurred in 1984 when Schwab's Mutual Fund Marketplace was invented. Prior to that time most of the industry assumed that a central marketplace for mutual funds wouldn't have been legal. The Investment Advisor Act of 1940 prohibits the sale of mutual funds at anything other than the offering price in the prospectus. The industry read this as a prohibition of any transaction fees levied in conjunction with the purchase or sale of mutual funds.

In late 1983, however, Charles Schwab sought and received a ruling from the SEC which permitted them to charge transaction fees for managing the purchase and sale of mutual funds. Even after resolving the legal obstacles, however, Schwab had to overcome the formidable technological hurdle associated with developing electronic links with the fund companies and developing the operating capabilities required to implement the Mutual Fund Marketplace.

For Schwab, however, the push to develop a Mutual Fund Marketplace has always come from the top. Charles Schwab and other senior executives of the firm, mutual fund investors themselves, were saying, "I hate getting all of these statements! Let's develop a marketplace which creates an exchange where these funds can be traded." Charles Schwab, the discount brokerage firm's founder, said, "I'm an investor. I'm in the business. Here's something our firm can do to make this work better."

Rich Arnold led Schwab through a 1987 management buyout from BankAmerica. In early 1989, about two months before Arnold retired, McGonigle joined Schwab and

Arnold told him, "We've got this little jewel called the OneSource marketplace." At that time, there was less than $1 billion invested in the Mutual Fund Marketplace. Schwab's product was in an awkward market position at the time. Because Schwab was forced to charge a transaction fee on all no-load mutual fund purchases, the nation's largest and most aggressive discounter was, ironically, the most expensive place to buy a no-load fund. Moreover, they were selling this service to Schwab's notoriously fee-conscious clients. But Rich Arnold knew that as industries mature, the manufacturing sector becomes more of a commodity and distribution becomes more important. Consequently, as industries mature, profits shift toward distributors. He knew that Schwab was perfectly positioned to become the world's more significant purveyor of mutual funds. In early 1990, Schwab asked the Boston Consulting Group to help the company figure out how to keep growing in the 1990's. John McGonigle was one of four people from Schwab given an opportunity to work on that effort. The BCG study concluded that to keep growing in the 1990's, Schwab was going to have to get its mutual fund act together. Direct stock ownership was being replaced by mutual fund ownership. Schwab had pioneered the concept of a mutual fund marketplace, but it would still have to act quickly to get in front of the curve. The BCG study created a lot of passion at Schwab to get going. Others at the firm began to realize how important the Mutual Fund Marketplace was to the firm's future growth. The study confirmed that demographics favored further growth in the investment industry, and that the trend toward mutual funds replacing individual stocks would be long-lived. BCG also concluded that industry economics dramatically favored firms which could take advantage of economies of scale. The study helped build a case for change, but the development of the no-transaction fee fund supermarket required additional study.

Price below cost and make it up on volume?

At the outset, the economics of the Mutual Fund Marketplace were not obviously attractive. In the early 1990's, Schwab's clients had invested a little more than $1 billion through its Mutual Fund Marketplace funds. Total transaction revenue divided by total fund assets indicated that it was a 60 basis point business at the time. (In other words, total revenues equaled about 0.6% of assets under management.) Instead, McGonigle and other proponents of the new OneSource supermarket were suggesting to Schwab's prestigious and powerful Management Committee that Schwab trade in its 60 basis point gross margin for a 25 basis point margin, and make up the difference in the higher volume that the price cut would foster. Instead of charging customers transaction fees to cover costs which equaled 0.60% of assets under management, the new product would charge the fund companies the equivalent of 0.25% of assets under management (investors would pay nothing).

At first glance, it appeared that the OneSource proponents were willing to give away more than half of the firm's existing revenues. McGonigle and others argued that the popularity of the product would attract so much additional money that the firm's fixed costs could still be covered, even at the drastically lower gross margin. The OneSource camp developed a financial model which showed that the current 60 basis point revenue stream was contracting. Whether the Management Committee liked it or not, they argued, the gross margin was headed lower. The 60 basis points was not a sustainable long-term margin.


No matter how logical these arguements seemed, McGonigle was still faced with the daunting task of quantifying the model and proving his argument with the numbers. He worked with Barbara Heinrick, then head of mutual fund marketing for Schwab, to develop these all important projections. Racing between meetings in Washington D.C. taxicab while attending a busy Investment Company Institute (ICI) conference in May, 1992, they estimated how many customers they'd have, how many funds each customer would use, and how much money would flow into these funds.

These guesstimates formed the basis for the formal asset growth and total revenue projections used in the financial model's five-year plan. Even going into the final Management Committee meeting, it was not clear which camp would win. Not until Charles Schwab spoke would McGonigle know that he and Heinrick had been successful.

The firm's dynamic Chairman paused a moment, considering what he'd heard and the details that McGonigle had presented on how they expected to roll out this new program. Finally, with everyone in the room straining to hear, he asked, "Why is it going to take you guys so long to make this happen?"

Next post: Change Doesn't Come Easily

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Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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BJ Services Tops Performance Derby

The Scout Partners Index of Western Colorado stocks fell -0.77% while the broad market fell -0.43% in March (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Market), Exxon Mobil, StarTek, CRH (United Companies), and the Union Pacific Railroad.

B.J. Services (BJS) rose +9.9% in March, following a +19.4% increase in February. The stock is up about 18% during the first quarter of 2008, while the broad market has fallen almost 10% during the same period of time.

Doug May, President of May-Investments, a Grand Junction-based registered investment advisor, noted in February that, "natural gas prices have reached their highest prices in 26 months.” May added that prices are nearing $10 per MMbtu and that, "Merrill upgraded the stock on the 17th and a couple smaller firms either upgraded the stock or raised target prices recently."

Qwest Communications (Q) was the worst performer in the index, falling -16.1% in March.

Scout Partners equal weighted index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in Industrial stocks, which comprise over 20% of the portfolio. Local stocks are up +3.5% over the past 12 months while the overall market has fallen -5.1% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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The Advantages of Investing in Mutual Funds

The old guard firms, banks, retail brokers, and hobby investors are competing against the Fidelity's of the world, trying to guess what Fidelity will do next. In the meantime, the mutual fund giants are adopting new technology to reduce commissions, cross shares, and lower transaction costs even further. They are opening overseas offices from which to expand their global presence. The world has changed. Mutual funds are the victors. Savvy investors will take advantage of the opportunities created by this new reality.

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Forget the mutual fund scandals that helped Elliott Spitzer win the Governor’s office. Were there some dunderheaded mutual fund companies out there who sacrificed retail investors in order to bring on more assets? You bet! There are idiots in every profession, and a hungry marketing executive at the helm can ruin just about any business. For retail investors, however (and that means anyone with less than $10 million to invest), mutual funds remain the most economical way to access professional money management talent.

Many mutual fund companies now have access to better research than the sell-side investment banking houses that make millions of dollars underwriting (manufacturing) and selling new stocks and bond issues. The big corporate underwriting clients put a lot of pressure on analysts to keep a positive recommendation on their stocks. A large corporate client concerned about the negative opinion an analyst has on its stock can get an appointment with the investment bank's Chief Executive Officer and will be able to air its concerns.

"I was sweared at, yelled at and screamed at and told to clear out in two hours," says Ronald Baron (portfolio manager for the highly successful Baron Asset Fund), describing his first job as an analyst for the branch office of a regional brokerage firm. He'd made the mistake of writing up - and panning - one of the firms underwriting clients. It doesn't happen all of the time. And it doesn't happen everywhere. But it happens often enough. If you want to avoid this conflict, like Ron Baron you might have to abandon the old system and join the new world of mutual fund investing.

Mutual funds also benefit from being able to execute trades at a fraction of the cost faced by individuals. They get research from all of the top brokerage houses, not just one, and can subscribe to investment databases that can cost more money than most individuals make in a year. Even in the small trust company I joined, we spent more than $100,000 a year on getting information to our desktop. (And that firm was positively primitive compared to what most of our competition was getting.)

Competing against these professional investors is a "Loser's Game." Trying to outsmart them is a little like trying to out-shoot LeBron James on the basketball court. It could happen, I suppose, but the law of averages combined with the fact that he practices more, has more experience, has more support resources and probably more at stake in the matter suggest that it's a long, long, long-shot.

Investors need professionals on their side – to act on their behalf. Just as Charles Schwab took their side in the trade execution business, resulting in dramatic reductions in the price that investors pay for commissions to buy or sell shares of stock, investors need an agent on their side to research individual investments on their behalf. They need a separate, independent agent to help them monitor that program and evaluate its success.

It may be heresy, but the most economical way to find this buyer’s advocate for retail investors is through a mutual fund company. Ultimately, fund managers are mostly on the same side of the table as investors. The managers want to put together a great track record because that is what sells. Since funds are paid as a percentage of assets under management, a large fund pays its manager much better than a small fund. Manager fees are often about one-half of one percent (0.5%). On a $10 million fund, this is about $50,000 and wouldn’t pay for the office space. On a $1 billion fund, this amounts to $5 million and covers country club dues both at the main homestead and at the beach house as well.

In the world of mutual funds, performance is almost everything. This means that for the most part, investors and their hired guns have similar goals. They are truly sitting on the same side of the table. This is a huge advantage over a traditional brokerage relationship in which a trusting client sits opposite the financial product salesman and hopes that the nice, personable individual sitting across the table will ignore the myriad of financial incentives to sell him too little for too much.

I first wanted to write this book in 1997. A decade ago, however, investors only knew up markets. They thought their broker was a genius, when it was really just a rising market that was making the broker look good. Indexing was the rage. The books were mostly about how active money management was a waste of time. The technology bubble was merely a gleam in the eye of a couple of young Janus Fund portfolio managers while everyone else talked of “efficient markets.” Elliott Spitzer hadn’t collected a billion dollars in penalties from Wall Street. Silicon Valley hadn’t yet pumped and dumped itself a fortune. In short, nobody cared about Wall Street’s inefficiencies during the good times.

Since that time, however, the stock market has only appreciated about 6% a year, far below investors’ retirement assumptions. Fortunes have been made and lost, but insiders have been making most of the money while retail investors have been funding those fortunes. Investors are frustrated by the dishonesty at Wall and Broad. Wall Street and Fortune 500 execs, internet company founders and venture capital investors cashed in by selling high hopes to excitable investors. But who was looking out for the interests of investors during this roller coaster?

I would have thought that by now the Wall Street hustle would be on its last legs. Instead, it has reinvented itself as a purveyor of outside managers and, the ultimate, of exotic hedge fund strategies. I would have thought that by now this book would have been written by a half a dozen other authors. I can hardly believe that the myths which so irritate me are still accepted as fact to the detriment of millions of investors nationwide.
If your advisor hasn’t challenged these myths, then maybe it’s time you changed advisors. The Catholic Church didn’t give up its practice of getting paid indulgences on its own accord. It was faced with a certain inevitability. Some realized the world had changed and move quickly. Most drug their feet, with those beneficiaries of deceit moving last of all. If you’re waiting for your broker to tell you the gospel truth about why your investment program isn’t working, you’re on a quest for financial martyrdom. Is that really the end result you had in mind?

Next post: A New Era: How Supermarkets De-Throned Wall Street

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Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Most Local Advisors Can’t Compete

I used to work for a bank-owned advisory firm which competed with the mutual fund behemoths of the world. While we had decent performance during my tenure there, a depressing reality haunted me because I knew that in the long run there was no way that we could compete effectively with our mutual fund competitors.

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We were a small trust department. When I joined the shop, we had 1,800 clients and about $300 million invested in our trust department common trust funds (which are like mutual funds except that they can only be used by internal trust department clients). We managed three stock funds and four bond funds. When I arrived in at this shop in 1995, the bank's long-term investment record was pretty sad. During the previous five-year period, while stocks generally were increasing 15% a year, the bank’s stock portfolios were appreciating at a 10% clip. While some investors were pleased by double-digit returns, more knowledgeable investors were beating us up (and closing their accounts) because of our underperformance relative to the broad market. By the time I got there, only "brain dead" clients, who didn't know enough about investing to know that they should fire us, remained.

We junked our existing stock selection process which picked stocks by committee. Instead, a single portfolio manager was assigned to manage our stock portfolios, and another portfolio manager was picked to manage most of our bond funds. Portfolio managers were given authority and accountability for their decisions. The frightening part was that these fund managers had no staff support, inadequate technology, and no analytical support. Moreover, these individuals were also assigned various other duties. Our bond fund manager also coordinated mutual fund company relationships. Our equity manager also traveled throughout the Ozarks to meet with clients and prospects and was also required to participate in various administrative meetings. He had no analysts researching investment alternatives. Because of his other duties, he was not even a full-time portfolio manager although we did the best we could to protect him from the bank's substantial bureaucracy.

Contrast this structure with that of a good mutual fund company. The mutual fund company has several analysts who usually specialize by industry. These analysts research individual companies. The analysts read the financial press, have access to the research of numerous Wall Street brokerage houses, and read the industry trade journals as well. A large fund company will have little problem getting access to senior management at a company. Frequently company management, and Wall Street analysts, will travel to the fund company's offices for presentations. Analysts have the freedom to travel to industry conferences, call on customers and visit company sites. They research that firm, and its competitors. This information is synthesized and summarized for the benefit of the portfolio manager, who must decide whether or not to invest in a particular company's stock.

A small shop has essentially a part-time portfolio manager who barely has time to keep track of his own current investments, much less evaluate new ones. Many small investment shops claim to visit company management and research company customers and the competition. Few actually do it. I was embarrassed when senior managers of our bank sometimes made such representations to clients and prospects. Aside from our portfolio manager's frequent trips to McDonald's, however, I can't really say that I ever saw us do these things. Small shops can't afford to!

The industry has changed dramatically from the time when a "customers man" (what they used to call brokers sixty years ago) sold stock to individual investors. These brokers offered clients recommendations which were guided by the stock broker's research department, which maintained proprietary research data. Now, however, the sort of information over which retail brokerage houses once had exclusive domain is easily attainable by anyone with a computer. The competition for information has become intense. It is no longer sufficient to be able to retrieve the data, now the spoils go to those who get it first. Whoever gets the "first call" has an opportunity to cash in on big news. Anyone else is too late.

Local trust companies, individual brokers, small investment shops and certainly individuals play second fiddle to the fast growing and cash rich mutual fund and hedge fund complexes. These institutional investors are generating enormous commissions, even at extremely low institutional commission rates. These commissions entitle them to special consideration.

With more than $3 trillion under its roof, if Fidelity wants its brokers' analysts to give them a first call on new recommendations, Fidelity gets it. By the time that a retail broker gets the story explained to them, Fidelity has already decided whether or not to invest a part of its treasure chest in that idea. (In other words, it's too late.) In fact, Fidelity's own marketing blitz emphasizes this factor. Several years ago the company set the advertising industry abuzz by creating commercials which aired each night that included the day's headlines in them. The commercials implied that for viewers, the headlines are news. For Fidelity, they're history. Fidelity's analysts have already anticipated the news and its consequences, watched the story unfold, and traded securities based on the news long before retail investors even heard the headline.

Fidelity brazenly asked for and received access not only to brokerage analyst reports and recommendations, but also to the spreadsheets which the analysts use to develop their conclusions. And Fidelity didn't just ask for a copy of those worksheets. Fidelity was able to get permission to go online and look at the analysts' worksheets live, via an internet connection. No retail broker in any company would receive permission to inspect its analysts’ spreadsheet assumptions.

SAC Capital Advisors is a multi-billion dollar multi-strategy private asset management firm founded by Steve Cohen in 1992. SAC trades so frequently and aggressively that on some days SAC is said to comprise a meaningful percentage of daily trading volume by itself. If there is an analyst on Wall Street with anything meaningful to say, which is in and of itself a questionable premise (but I’ll leave readers to Andy Kessler’s “Wall Street Meat” to address that question) then SAC has heard the news and traded on it before your local broker has even opened his Outlook software to glance at the morning e-mails.

Next post: The Advantages of Investing in Mutual Funds

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Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Local stocks rise while broad market falls

The Scout Partners Index of Western Colorado stocks rose +1.72% while the broad market fell -3.25% in February (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Market), Exxon Mobil, StarTek, CRH (United Companies), and the Union Pacific Railroad.

Natural gas prices rose and many local energy companies were up 10% or more during a month where the broad market indices continued their 2008 declines. B.J. Services (BJS) rose +19.4% in February, but close behind were Arch Coal (ACI), +16.4%, Halliburton (HAL), +15.7%, Encana (ECA), +15.1%, Williams (WMB), +12.7%, and Bill Barrett Resources (BBG), +11.2%. Doug May, President of May-Investments, a Grand Junction-based registered investment advisor, noted that, "natural gas prices have reached their highest prices in 26 months but investor sentiment about the sector remains pretty cautious,” May said. "Gas inventory levels remain under control and the lower drilling rig activity we've had over the last year suggests that inventories will decline from here." Concern about a possible recession is overshadowing the positive industry fundamentals, however, so valuations in the sector remain depressed.

Mesa Air Group (MESA) was the worst performer in the index, falling -31.1% in February. The stock closed the month at $2.42 and has fallen 68% in the last 12 months. Mesa was as high as $12.87 as recently as 2006, recently re-signed several senior executives to long-term contracts to reward them for their service to the struggling carrier.

"High energy prices have hurt Mesa," May observed, "and the company reported a $2.8 million loss mid-month on lower revenues and higher legal expenses. Including losses earned at its Air Midwest subsidiary, the company managed to lose $4.2 million." Mesa Air Group has announced that it is selling the money-losing Air Midwest subsidiary. "Mesa said that it is planning to boost its cash reserves by financing its spare parts inventory," May noticed, "which makes investors feel good until they realize that it's sort of like an alcoholic taking out a home equity loan to put money back into the family bank account, nor does it make me feel better about climbing onto one of their planes which might be needing one of those spare parts to stay right-side up."

Scout Partners equal weighted index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in Industrial stocks, which comprise over 20% of the portfolio. Local stocks are up +6.9%% over the past 12 months while the overall market has returned -3.6% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Risk and Return

Risk and return are related; when something looks too good to be true, it often is. However, the correlation isn’t absolute.

How many times have well meaning but misguided investment advisors excused long-term underperformance with the comment, “well, we’re very conservative investors.” There is a misconception that successful track records must necessarily incorporate tremendous risk taking.

This myth says that if a strategy returns $2 for every $1 that the market goes up, it will necessarily fall $2 for each $1 lost in a market sell-off. Risk and return are thought to be inextricably linked over the market cycle. And with certain strategies (i.e. leveraging a portfolio), this is true. But it’s not true in all cases.

We use the term “flexible Beta” to convey the controversial notion that one of the things for which you pay an investment manager is to vary the portfolio’s risk profile depending on what is happening in the market. When markets are rising, Beta (volatility) is a good thing. In falling markets, Beta should be lowered.

The ETF Scout portfolio increased in value $2 for every $1 during the bull market lasting from May 31, 2003 to October 31, 2007. We enjoyed strong markets in small cap growth stocks (initially) and in later years in the natural resource and international sectors. Then the market finally peaked. As the stock market priced in a recession, financials, cyclicals, and eventually the broad market sold off. However, the subsequent portfolio shifts in the ETF Scout portfolio reduced portfolio Beta so that the portfolio protected profits better than the market during the sell-off.

In mid-January, for every $1 lost since October 31, the ETF Scout portfolio lost only $0.85. As a result of going up faster during the boom, and falling less during the decline, the overall outperformance improved so that over the entire cycle the ETF Scout Portfolio gained and held onto $2.45 for every $1 of market gain in the S&P 500.

We call this active management. Others say it can’t be done. We’ve been doing it nearly 5 years now.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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