More evidence on the dangers of modern-day "wealth management"






















In our previous post, we cited two recent articles giving evidence from the current bear market that backs up the core assertions we have made for years about the financial services industry -- specifically, that the idea of "wealth management" from an advisor who rotates his clients amongst varying investment strategies is not a sound model.

We have previously cited studies that we think make that case very clearly. The articles cited in Monday's post can be seen as supporting that case with more recent evidence from the past twelve months.

One detail we cited from Monday's Wall Street Journal article deserves greater examination, and that is the fact that, "following the advice of investment pros" investors had moved heavily into international funds, which are now down an average of 10% more than even the hard-hit US funds.

We believe in the ownership of individual companies, rather than funds (we explain why in this post from December, among other places). But those who rushed to buy international stocks have been similarly hurt.

We have long disagreed with the idea of "international" as an "asset class" that all investors must have. For starters, the idea has its roots in Modern Portfolio Theory, which has taken over the "wealth management" industry (and which it is, in fact, largely responsible for creating) and which we largely oppose, for reasons explained in this post from March.

The Modern Portfolio Theory idea is that owning international funds adds to your diversification. Further, it was seen as a "non-correlated asset" that would potentially go up when domestic stocks were going down. Until the recent crisis, there was much talk of "de-coupling," wherein the other economies of the world supposedly "de-coupled" from the US and therefore provide a level of greater diversification and non-correlation to portfolios.

The recent financial crisis, however, has exploded that notion.

Our other disagreement with the rush to own international investments is the fact that we have always seen them as unavoidably levered to currency bets -- if you invest in a company that reports earnings in another currency, its performance will be boosted when that currency is going up versus the dollar, and depressed when that currency is falling relative to the dollar.

Thus, international investing becomes a form of foreign exchange speculation. "Wealth managers" and "financial advisors" tell their clients "it's time to get into (or out of) international" just as they tell clients that it is time to switch from value to growth, or from small-cap to large-cap, or from biotech to consumer staples. This entire investment philosophy of timing rotation from one sector or capitalization category or country to another is a form of speculation, as we explained in "The drawbacks of sector rotation."

The graph above shows how dangerous such an investment philosophy can be. It is a graph of the US Dollar Index, often referred to as the "USDX," from June 05, 2007 to November 05, 2008.

The index measures the relative strength of the dollar against a basket of six other currencies (the British pound, the euro, the Swiss franc, the Japanese yen, the Canadian dollar, and the Swedish krona). It was set at 100 in 1973, so that values under 100 mean the dollar has declined relative to other currencies since that time, and values above 100 represent relative dollar appreciation since that time.

While the dollar had been on a multi-year slide (hence the steady rise in interest in international investing from investors and their intermediary advisors), actions by the Federal Reserve in the later stages of the crisis, combined with an international rush to hold dollar-denominated securities (particularly Treasuries) when everything else in the world started to look like a bad credit risk, turned that slide around dramatically.

The enormous dollar-rally shown in the dollar index graph translated into severe losses for international funds. An article in today's Investors Business Daily reports that Latin America funds are down 50.57% year-to-date, China region funds are down 56.30% for the year, Pacific ex-Japan funds are down 52.65% for the year, and that MSCI-Barra data indicate that some emerging market funds focused on Hungary, Argentina, Indonesia, Peru, and Russia dropped between 35% and 43% in October alone.

These topics underscore the importance of investing with a time-tested discipline, and one that is based upon fundamental business characteristics rather than speculative calls about this or that sector, market, interest rate, commodity price, or currency.

For later posts dealing with this same subject, see also:


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