Individually Managed Market Cycle Investment Management Portfolios vs. ETFs and Mutual Funds as Investment Vehicles in Retirement Income Programs

The purpose of this paper is to describe the many differences between the Market Cycle Investment Management (MCIM) process and the investment process within Mutual Funds and Exchange Traded Funds (ETFs).



History:

The first Market Cycle Investment Management portfolios were developed in the early 1970s, at a time when there was still considerable interest in developing individual security portfolios for retirement income planning purposes, and years before there were Index Funds, Money Market Funds, IRAs, or 401(k)s.

Investment Management entities were mostly employed by wealthy individuals and major company Pension, Profit Sharing, and Savings Plans. Professionals compared their stock market portfolio performance with cyclical market movements --- recognizing and embracing the investment opportunities provided by predictably unpredictable market undulations.

Successful equity managers were those that did better than the market averages over the course of the stock market cycle... generally in terms of Peak to Peak and Peak to Trough measurements. Performance analysis in terms of months, quarters and years was rarely seen, because of the institutionalized "long term" nature of the investment process.

One would think that retirement income planning continues to require a long term focus.

Throughout the 70's and the early 80's, it was clear to investors that the primary purpose of equity investing was to realize profits and that corporate bonds, preferred stocks, and government securities were expected to produce secure income, regardless of their market value.

MCIM portfolios are designed and managed with a cyclical vision and they are all comprised of both growth purpose and income purpose securities; they are not designed for short term comparison with any market numbers. Short term performance evaluation of long term investment programs, particularly retirement income programs, appears to be an oxymoron.

Successful income portfolio managers were expected to produce safe and growing streams of income through both trading and compounding of interest. Quality and safety were the primary concerns of retirement income portfolios and they were never examined with either market value or equity based measuring devices.

When the income was needed for retirement, it was expected to be there... use of capital (i.e., invested principal) was not acceptable, except in annuities, when the investment portfolio was not large enough to produce enough retirement income. Pension plans often included annuity only retirement options for their employees, and there were no variable annuities until the 1980s.

Market prices of "Interest Rate Sensitive" securities were expected to vary inversely with anticipated interest rate movements; income produced from these securities was correctly expected to be stable, regardless of the also expected (and historically natural) fluctuations in market value.

Anything outside the normal realm of stocks and bonds, including: options, futures, IPOs, "Over The Counter" (i.e., NASDAQ) issues, penny stocks, commodities, most ADRs, currencies, emerging market securities, etc, were considered to be speculations. Of these, only a select few foreign company ADRs are included in MCIM portfolios.

Those were the days of "professional only" market influence. Today, markets are influenced by the same forces as they were then, plus the impact of millions of individuals, now heavily invested in all security varietals, both individual and derivative, and in all domestic and foreign markets.

Today's "real time" news and market information, coupled with instant gratification impatience, and a "sound bite" attention span have led to investment markets that encourage market volatility and day to day (if not minute to minute) investor hysteria. Cyclical, long term investing performance evaluation seems to have few friends in or on institutional Wall Street.

Today, Federal and State Government regulations have as much of an impact on markets as do economic conditions, and artificial (even social conscience) manipulation of interest rates has altered the natural relationship between borrowing costs and economic activity.

With the advent of Tax Deferred investment opportunities (IRAs, 401(k)s, etc.) and the growth of the number of potential investors, institutional Wall Street became extremely creative in providing new products for the new mass markets to use as investment vehicles.

Quasi-professional investment management became available to anyone who wanted it, and it wasn't long before there were more derivative securities than individual stocks listed on the major exchanges....

Corporate "Cash Balance" and Defined Contribution programs began to replace (the much more expensive for employers) defined benefit plans, largely because of the inappropriate methodology used to value pension plan income purpose assets. Once the Defined Contribution plans morphed into self-directed programs, the stage was set for speculative decision-making and "mob directed" volatility in the market place.

· NOTE H1: Market Cycle Investment Management programs are designed to take advantages of the market cycle by buying Investment Grade Value Stocks (IGVSI) when prices fall and taking profits when prices rise to target levels.

Self directed programs also set the stage for thousands of funds, ETFs, hedging vehicles, multi-level derivatives, swaps, and IPOs to flood the new investment shopping mall. Then, with a dash of Modern Portfolio Theory, the new formula "speculation x speculation = alternative investment" was created to the open mouthed shock of those with a more conservative, and more cyclical perspective.

Today, we even have an actively followed (and media reported) "Fear and Greed Index"... go figure. MCIM managers buy (IGVSI stocks only) when fear is rampant and take profits when others have become seriously too exuberant.

But, the important realities of investing haven't changed in spite of the new perceptions, products, and impatience that Wall Street has cultivated so well. Market, economic, and interest rate cycles still exist, are still predictably unpredictable, and still seem to be a much more rational framework for total portfolio performance measurement than simple calendar quarters and years.

One of the most significant changes in the past few decades has been in the severity of market corrections. There have been three major stock market meltdowns (35% to 50%) in the past twenty seven years... possibly more than in the entire previous history of the investment markets.

Interestingly, with crystal clear hindsight, it seems likely that a steadfast commitment to the conservative investment styles of the past would have outperformed everything that has been developed since... over any significant cyclical time frame.

· NOTE H2: MCIM portfolios are designed to be performance analyzed cyclically, with a minimum 30% allocation to income purpose securities, and not with an "equity only" ruler.

Risk Minimization:

Every investment text book examines the concept of "risk"... it is inescapable.

Risk comes in various shapes and sizes, none of which will be discussed in any depth here: Business Risk is about company viability; Credit Risk is about the ability to service debt; Market Risk is about price fluctuation.

· NOTE R1: Index Funds are designed to "track" the progress of a select group of securities... they will never move differently (in either direction) than the securities they follow. They do not attempt to "minimize" market risk.

Other forms of "risk" have been identified, the most "interesting" ones to retirement income programs being Regulatory Risk and Tax Risk... pretty clear where these originate. Some say

that the fastest growing industry (and job classification) in the US economy is Compliance; everyone knows that the US taxes its business enterprises (directly and indirectly) at the highest level on the planet...

Every page, every title, every subtitle, of every new regulation, tax, levy, requirement, minimum, maximum, whatever, increases the business and credit risks of the companies that all Americans own a piece of in their retirement income programs.

Most experienced investment professionals would probably agree that there are three basic "Risk Minimizers" that protect investors from business, credit, and market risk They would likely agree, as well, that all investment risk cannot be eliminated.

The "big three" risk minimizers, in both equity and income securities, are Quality, Diversification, and Income... the QDI. We will be looking at all three.

· NOTE R2: In addition to the QDI, Market Cycle Investment Management (MCIM) uses several other strategies, processes, and disciplines to limit investment risk: quality based selection universe requirements, market price based individual selection rules, income requirements, profit taking target disciplines, speculation restrictions, and hands-on, unrestricted, management.

Mutual Funds do a fine job of diversifying by security, but many are over-weighted in particular sectors or specialized in a single sector; ETFs have similar diversification issues, and the overriding principle with each is that the user (including non professional investors) will construct appropriately diversified portfolios using multiple funds and/or ETFs.

There is no way of determining the Quality of the individual securities inside either a Mutual Fund or an ETF without accessing publications like Morningstar and doing additional research to find the S & P rating information. Some of the "what's inside" may be other index or mutual funds.

Only Investment Grade Value Stocks, and a high quality selection of REITs (Real Estate Investment Trusts), MLPs (Master Limited Partnerships), ADRs (American Depository Receipts), and Equity CEFs (Closed End Funds) are included in MCIM portfolios.

· NOTE R3: Wall Street uses the term "Value Stock" for companies that analysts believe are undervalued based on their price relative to earnings prospects and other considerations. The price of the security is the prime determinant of "value". IGVSI stocks are companies rated in the highest quality categories by S & P Corporation that also pay dividends, are profitable, and are traded on the NYSE.

A growing stream of income is rarely a consideration of either Mutual Funds or ETFs and those with high equity allocations are generally compared only with stock market indices. Growing retirement income is generally not an issue.

Income only Mutual Funds may contain "high income" equities as well as bonds, preferred stocks, etc. Typically, they do not generate as much income as income CEFs and cannot add to positions, when prices fall, as readily as MCIM managers can using CEFs.

Upon retirement, ETF and Mutual Fund owners most often cash out their funds and transition into income production programs within IRAs or by purchasing annuity products. So, even a target retirement fund may be victimized by a low interest rate environment at the precise time the income is needed....

· NOTE R4: Annuity payments include both principal and interest; they are not designed to provide any residual estate for annuitants' heirs. MCIM portfolios are designed to payout income only, and to create an estate for investors' survivors.

MCIM portfolios are designed to be producing full retirement income when the investor chooses to retire. The current rate of return of the portfolio (if in an individual 401k environment) can easily be duplicated in a "rollover" IRA portfolio.



Quality Is Always Job #1:

Quality is a judgment measure of the economic viability of a company, its ability to pay the bills, service the debt, maintain market share, grow market value and profitability over time, and provide growing dividend distributions to its shareholders.

Both equities and income securities are evaluated and rated by various entities: Standard & Poor's and Moody's are the main bond, or debt, rating entities, and S & P is the premier common stock quality maven.

The higher the Quality of the securities in a portfolio, the less "business" risk is being assumed by the investor. MCIM portfolios are comprised exclusively of S & P investment grade, dividend paying companies, and ADRs with similarly solid fundamentals.



Equity Quality Selection Standards:

S & P has a letter rating system that has been in existence since at least the 1980's. Common stocks are ranked from a low of "D" (in reorganization) to A+ (highest). B+ is considered "average", and anything B+ or better is considered "investment Grade". S & P publishes changes, additions, and corrections monthly.

· NOTE R5: Neither Mutual Funds nor ETFs specify that they use only a specific level of S & P quality rated companies in their equity selection process, and it would be cumbersome for an investor to determine the quality rating of every security held by the fund.

Instead, mutual fund managers and ETF creators select equities based on capitalization levels, growth predictions, dividend growth measures, market share numbers, sectors, analyst opinions and market value performance guesstimates.

The MCIM equity selection "universe" contains only S & P, B+ or better rated companies. The companies must be profitable, dividend paying, institutionally held, and traded on the New York Stock Exchange. They also have to be priced above $10.00 per share. Less than 340 companies (mid-January 2014) meet these stringent selection requirements.

Additionally, a dozen or so foreign company equities (ADRs), a few REITs and equity CEFs, and some MLPs qualify for inclusion in the equity portion of portfolios. REITs, CEFs, and MLPs are derivative securities, meaning that their prices are "derived" form the prices of the professionally managed portfolios they contain.

· NOTE R6: Multi level derivatives are avoided in MCIM portfolios, since their actual content, payment history, and cyclical price performance is difficult to examine. MCIM portfolio content is available for examination by investors, in real time, simply by accessing their portfolio records on the Internet.

The Investment Grade Value Stock Index (IGVSI) tracks just the NYSE companies that qualify for inclusion in MCIM portfolios... no other index is nearly as quality specific. Interestingly, this index has outperformed the S & P 500 index in both Peak to Peak and Peak to Trough comparisons from June 2007 thru January 2014, and most likely since the S & P 500 ratings were created. So, theoretically at least, there is less risk and more reward with investment grade equities. (See chart. )

ETFs and Mutual Funds make equity selection decisions that often result in the purchase of stocks at the highest price levels in market history; also, their selections may include companies that do not pay dividends, IPOs, and others that have no track record of profitability. Mutual Fund managers are restricted in their buying activities during extended market corrections.