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Buying The Next Hot Idea

If you want to know what is the core problem of the average person approaching the market (though this applies more to males than females, women have more native caution on average), it is chasing a hot idea. This can take a number of forms: Getting tips from friends who have bought some stock that is currently popular in the market. Doing the same thing with investors who talk or write about investing. The best investment advice is not flashy, and does not make for good video. Looking at charts and buying something that is rising rapidly, because popular media say this is “The Next Big Thing.” Buying the mutual fund or other pooled vehicle of some manager who has done very well in the past, and seems to never fail. (If you buy a mutual fund, don’t buy one that has had a lot of money pile into it recently… usually a bad sign. Spend more time to see if the manager thinks in a businesslike way about assets that he buys.) Going to a broker who is very well-dressed and confident, and talks really well, but who has no obligation to act in your best interests. If you don’t know how he is earning his money from you, avoid him, because it usually means investments with high fees or hidden ways that you can lose, e.g. structured notes that offer a nice yield, but where possibilities to lose are more significant than you think. At best, he will give you consensus ideas and managers that deliver him above average remuneration. Buying the newsletter of some overly confident person who claims to know the secrets of the market, which he will share with you and 100,000 other close friends for a mere $299/year! (Please read Mark Hulbert before buying a newsletter.) Worse yet, giving into the fakery of those who try to bring you into a hidden opportunity. It can be a Ponzi scheme, a promoted stock, but they suggest returns that are huge… or, like Madoff, decent but not exorbitant returns that are altogether too regular. Many of these appeal to our desire to get something for nothing, which is endemic – we all have it to some degree, and marketers play off this regularly by offering us “free” this, and “free” that. Earning returns from your investable assets is a business in its own right, and there are costs to doing it well. You should not be surprised that doing well with it will take some time and effort. You also have to avoid the impulse that there is some hidden knowledge, or group of insiders that have found an easy road to riches. The markets aren’t rigged in any material way. The principles of investing are well-known, but applying them takes creativity, time and effort. There are no significant players with a new theory who make amazing money investing in secondary markets for stocks and bonds. Most of the things that I listed above involve low-thought imitation of others. There is little advantage in investing to mimicry. Even if it worked for someone else, the prices are different now, and easy gains have been made. You will do worse than the one you are trying to imitate with virtual certainty, and likely worse than average. You need to plan to take an independent course, and learn enough such that if you do choose to use advice of any sort, that you can evaluate it rationally. If you choose to do it yourself, you will need to learn more than that. It takes effort, but that effort will pay off, if not in investing itself, but there are spillover effects in intelligent management of your finances, and in improving your abilities in the businesses that you serve. In most areas of life, most things that pay off well take effort. If people present you with easy or hidden ways to make above average money, be skeptical. Doing it right takes discipline and effort. (If you want the easy route while avoiding all the pitfalls see the postscript. It is boring, but it works.) As an aside – you can always index, and beat most average investors over the long haul. Buy broad funds that invest in a large fraction of all of the stocks that there are, and those that replicate the bond market as a whole. Make sure they have low fees. Buy them, hold them, and be done. You will still face one hurdle: will you be able to maintain your strategy when everything is in a crisis, or when your friends tell you they are earning a lot more than you, and it is easy to do it? Size the bond portion of your assets to the level where you can sleep soundly in all circumstances, and you will be fine. Disclosure: None

Franklin Templeton Launches Flexible Alpha Bond Fund

By DailyAlts Staff Market pundits are nearly unanimous in their assessment that bonds are unlikely to deliver returns in the future that fixed-income investors became accustomed to in the past. For some, this means getting out of fixed income altogether – for others, a “flexible” approach holds promise. Investors in the latter camp have a new option as of August 3: the Franklin Flexible Alpha Bond Fund (MUTF: FABFX ). The new fund, which is managed by Franklin Templeton Investments, is designed to provide attractive risk-adjusted total returns over a full market cycle. The fund’s managers pursue this end by means of allocating the fund’s portfolio across a broad range of global fixed income sectors and risks, such as credit, currency, and duration. In pursuing this strategy, the fund’s managers have the flexibility to capitalize on opportunities across national borders, market sectors, credit grades, and bond maturities and durations, without reference to a benchmark index. “Given the recent concerns with respect to rising interest rates and the related desire for additional diversification in the fixed income markets, we believe Franklin Flexible Alpha Bond Fund should fulfill investors’ rapidly growing demands for an alternative to traditional core fixed income allocations,” said Michael Materasso, co-lead manager of the fund and senior VP of the Franklin Templeton Fixed Income Policy Committee. In a recent statement, Mr. Materasso also noted the fund’s diversification benefits: “The fund seeks to complement traditional fixed income asset classes by potentially providing low correlation to conventional holdings.” Mr. Materasso manages the Franklin Flexible Alpha Bond Fund alongside fellow co-manager David Yuen. Together, the pair employ their 68 years of combined industry experience in a “top down” analysis of macroeconomic trends and a “bottom up” fundamental analysis of individual opportunities. Positions may be held long or short to navigate market cycles and tactically manage risks from interest rate, credit, currency and country exposures. “We take an unconstrained investment approach with dynamic sector rotation, active currency management, security selection and relative value positioning, while aiming to manage various risks, such as duration,” said Mr. Yuen. Under normal circumstances, at least 80% of the fund’s net assets will be invested in bonds and other instruments that provide exposure to bonds. The fund’s weighted average portfolio duration may range from -2 to +5 years. Shares of the fund are available in A (FABFX), C (MUTF: FABDX ), R (MUTF: FABMX ), R6 (MUTF: FABNX ), and Advisor (MUTF: FZBAX ) classes, with net expense ratios ranging from a low of 0.71% for R6 shares to a high of 1.50% for C-class shares. For more information, download a pdf copy of the fund’s prospectus .

Diversification Is Not Sufficient

Strategy diversification may be superior to traditional methods. Momentum and trend following could provide protection during down markets. We demonstrate a simple system that can be replicated using low cost index funds. In a follow up to our recent article, Value Based Asset Allocation , we wanted to introduce you to our method for diversification. Unlike financial theory, we do not believe that diversification is sufficient for shielding a portfolio against large declines. Our view is that strategy diversification goes a long way to properly diversify a traditional asset allocation, especially during periods of market stress. Momentum is simply using price to determine the appropriate allocation. Price works as the ultimate indicator because of supply and demand. The irrefutable law of supply and demand has been the ultimate guide to navigating markets for centuries. Supply and demand governs how prices move. Therefore, price tells the true story. For example, if there are more buyers than sellers, prices will rise. If there are more sellers than buyers, prices will fall (Dorsey, 2007). Understanding what force is governing the market is critical to making allocation decisions. If supply is in control, you will want to avoid that market. On the other hand, you will want to invest in a market where demand is the stronger force. Momentum investing, by our definition, is allowing price to determine the investment allocation. It is about maintaining a harmonious relationship with the market. The idea is that the market is the sum total of all the investment experience and expertise of the market participants. The collective knowledge of the group is, in theory, superior to the individual’s over the long term. It is better to exist within a synchronous association rather than in opposition. As John Maynard Keynes suggested, “The market can stay irrational longer than you can remain solvent.” According to a trend follower, “Mr. Market” is always right, no matter how seemingly irrational. Momentum strategies have delivered superior performance to buy and hold investing (Berger, Israel and Moskowitz, 2009) . Meb Faber used a simple moving-average system to allocate to the S&P 500 or cash, demonstrating that he could reduce the correlation of his strategy to the S&P 500 in down markets to -0.38 and maintain a positive correlation of 0.83 during positive years (Faber & Richardson, 2009) . The implications of this study are profound. They indicate that by using a simple trend-following system, one can create a strategy to reduce correlation to equities when most other correlations are rising. When correlations rise during periods of market uncertainty, portfolio risk increases. Faber provides a simple solution to this particular conundrum despite using the S&P 500 as the investment vehicle. Momentum and trend following are strategies used to diversify a portfolio and cut market risk through the avoidance of large slumps. We use momentum in order to take advantage of positive herd mentality and avoid negative herd mentality. We alternate between risk-on and risk-off, dependent on the price trend of stocks and bonds. Capitalizing on the short term and herd mentality allows the investor to gain access to a return stream that does not always move in tandem with stocks and bonds. For example, during the time period from 2007 to 2009, the stock market (S&P 500) collapsed over 55 percent. Many managed-futures managers or commodity-trading advisors (CTAS) showed positive returns. Managed-futures managers are largely trend followers. Consequently, the managed-futures traders were negatively correlated with stocks and provided the ultimate diversification to a traditional portfolio. The time period from 2007 to 2009 is not unique. During several other market declines and reductions in traditional asset classes, trend-following traders demonstrated the ability to take advantage of the scrambling herd and capture impressive gains. Trend following seems high risk to many investors who still look at risk as volatility. Many momentum systems actually have higher volatility than the market. The fact is that volatility is not risk, and “the acceptance of higher risk in a trend-following investment can actually lower the risk of your stock and bond portfolios because when trend following zigs, typical stock and bond investments zag.” (M.W. Covel, 2009) Trend following appears to be an elixir for the behavioral ills of investing. Herd mentality, overconfidence, representativeness, anchoring effects, and loss aversion are all dealt with through systematic trend following, or momentum investing. We can use a simple system with indexes to replicate a strategy that protects during market declines without sacrificing the upside. In our strategy we use indices (baskets of securities tracking a particular market) to gain exposure because of their relatively low costs and high transparency. To illustrate the effectiveness of trend following historically, we are going to provide a simple, rules-based system as an example. The rules are as follows: Rank the S&P 500, Russell 2000, and the US 10-Year Treasury bond based on the three-month performance. Pick the strongest index based on the ranking. Run the ranking system each month. The important information to gather from the historical results is the performance of the momentum strategy during the years when the market declines. The ability to rotate away from the stock market when the price deteriorates allows for better performance when trouble is present. The core tenet of trend following and momentum investing is the protection of capital. Hence, the momentum strategy demonstrates the most significant outperformance during periods in which the overall stock market is experiencing large declines. The strategy performs well during positive stock market environments as well. The portfolio can be invested in the stock market when the trend is positive and stocks are stronger than bonds. In other words, the simple momentum system acts as a risk reducer during the down markets without sacrificing profits during up markets. The momentum strategy has done well compared to the S&P 500 since 1972. In the chart below, we illustrate the results to better demonstrate the benefits of incorporating trend following. If you had invested $1 million in the S&P 500 in the beginning of 1972, your investment would have grown to over $72 million by the end of 2014. If you had invested your $1 million during the same period using our momentum strategy, it would have grown to over $335 million. That is significant outperformance. Remember that the model can only maximize returns up to what the market earns. The outperformance comes from avoiding the down markets. (click to enlarge) The momentum system does not avoid declines. Since the end of 1971, there have been nine years in which the S&P 500 declined. Over the past forty years, the momentum strategy declined seven times. The beauty of momentum strategy lies in avoiding the big declines. The strategy never suffered a loss of greater than 7 percent in any given year. In comparison, the market suffered five declines over 10 percent, of which three were over 20 percent. Investors have to minimize the big declines to succeed when investing. The momentum system is able to accomplish the task of protecting the investors during big market declines, helping the portfolio grow more over the long term. As we have outlined above, momentum has historically worked to participate in up markets and protect against deep market declines. While we cannot predict the future trajectory of prices, we know that markets will fluctuate, and we have designed portfolios to potentially take advantage of market volatility. Trend-following traders have demonstrated their ability to navigate the uncertain markets and capitalize on turmoil. Trend following is not only reserved for the Wall Street elite or the ultra-rich. You can apply the same principles to diversify your portfolio using simple index funds and at a fraction of the cost of paying a manager. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. PAST RESULTS DO NOT GUARANTEE FUTURE RETURNS. HYPOTHETICAL PERFORMANCE FOR ILLUSTRATION PURPOSES ONLY.