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Why Cash Is The Best Protection

|Includes: DIS, iShares Select Dividend ETF (DVY), SPY

A lot of ground gets covered in this interview with Jim Lonergan of the Connors Group, including the high degree of correlation between asset classes, and why cash is an effective tool for preserving capital in poor market conditions.

Kate Stalter: Today's guest is Jim Lonergan, CEO of the Connors Group.

Jim, your company has a couple of different areas of businesses that pertain to individual investors, but I wanted to start out today by asking you about The Machine, and how retail investors can take advantage of this unique trading platform.

Jim Lonergan: We launched The Machine, which I will talk about in a minute, about a year ago. The whole idea was to really in some ways help level the playing field for the average investor.

This would simply give them the tools, all the data and models that we built over the years in that expertise, and put it in a software-as-a-service model, a platform for high-net-worth individuals that they can actually access that high-end content and use it to their advantage to invest on an active basis. Active is defined as intraday, weekly, monthly, or even annual, depending on the strategies that they would use.

We have had it out in the market about a year now. For people that are looking to take a more active approach, this is a great tool to get access to information that only high-end hedge funds and so forth would have access to.

Kate Stalter: I am looking at the Web site right now for The Machine. If I were a new client interested in this-walk me through what that process would look like.

Jim Lonergan: Yeah, I think there are a couple of things. We tried to make it as simple as possible.

We are leveraging all the data that we built up over the years, and put it in an application where you can go in and say, "I am looking for a strategy that would combine ETFs and equities that give me some risk protection as well as some upside,"-things like Dow Jones Select Dividend Index Fund(DVY) and a number of ETFs.

You can combine, and go in and take models that we have preset for you already, and use those models as your starting point. Or, you can go in and actually create your own models using a lot of the data elements, like standard deviation and risk, and things like that, and create your own customized models to your specific objectives.

It's a lot of information, but we really simplify it. And with a few clicks of the mouse, you can have your own custom portfolio, custom model, ready to go and basically act and invest on.

Kate Stalter: And is this completely for self-directed investors Jim, or is there a role for advisors in this as well?

Jim Lonergan: One of the tools advisors use for their clients is mutual funds and individual money management, and if you look back at the return coming from those mutual funds and money managers, you'd see they underperform pretty dramatically. We call it the lost decade: If you look at the 2000s, clients have ended up with no return.

So, the whole point of launching, and we just launched The Machine Advisor in January, was to give the advisor the tool to actually start taking on some responsibility of managing the client assets internally themselves by having the right simple tool, rather than having to farm that out.

Kate Stalter: So Jim, you were talking about some of the returns and strategies of advisors. I read a lot, and I talk to a lot of advisors. Many of them believe the best strategy is just to benchmark, to get something perhaps like the SPY, or just go into index funds and hold them over a long term. What do you think about that approach versus something more actively managed?

Jim Lonergan: I think every portfolio has some allocation that could be put towards something passively, so I wouldn't say everything has to be actively managed.

But if you look back at a typical passive 60-40 portfolio, they have highly underperformed over the last ten years. I mean, most of them lost 35% during the 2008-2009 period, and the balanced mutual funds they put them in are down 37%.

The problem with index funds: You're putting clients in indexed funds, quite frankly. One, the client could probably do it themselves. And two, those funds are obviously completely correlated to where the market goes. So, if the market's going up or down, you're going with it.

As an advisor to a client, I don't necessarily think that does much in terms of diversification and protecting clients assets. And I know, as an advisor, I'm not so sure how much value that lends itself to a client who's just in an index fund, which is basically wherever the market goes, I'm going with it. So, we have a different view of that. We really think taking an active approach to managing money is the right way to go, to some extent.

So, using data, behavioral finance, and models-and if you think about it, Kate, almost everything we do in life today has models or data back, whether it be Disney (DIS) Pass, or the weather patterns. What's unique is in finance, a very small percentage of people use models and data to make decisions, and most of its discretionary in nature. And we believe strongly in behavioral finance and using data to make intelligent decisions.

From that, we come out with objectives of beating the benchmarks and also lower risk, lower standard deviation. Most of our model portfolios, pretty much, are about one-third of the risk of the market. Most of them protect your assets and use cash when needed.

So we think active investing is a much more appropriate methodology for consumers today, and I can go deeper if you like. There's a lot of backup on that.

Kate Stalter: I'd be very interested, and I'm sure our audience would, too, in hearing about some of the data behind that. Because it's one of those ongoing debates and people can present data to bolster each side, it seems.

Jim Lonergan: Sure. No, it's true. So buy and hold, just buying and holding positions, even Warren Buffett who buys something and holds it for a long time, will tell you that it's a fool's game. It just doesn't work. Just holding onto something and hoping it's going to turn out good 15 years later isn't necessarily the best strategy.

But you look at most of what's going on and things like MPT [modern portfolio theory] and strategic asset allocation, tactical allocation...they all sound great. But when you really look at it, what's really happened is: Those are all meant to be portfolio diversification, but the reality is the global markets and most asset classes are highly correlated.

I'll give you an example. If you look at a typical mutual fund, balanced fund, they're pretty much 95% to 99% correlated to whatever the market does. So, while you might have some percentage international, small-cap, mid-cap, large-cap, etc., at the end of the day they're pretty much tied directly with what the market does.

I'll give you one more. China, three years ago, was about 25% to 35% correlated to where the market went. Today it's 85%. So everyone thinks they're getting diversification by being in Chinese stocks or equities or ETFs. The reality is, they're almost directly where the market goes as well.

So the whole diversification concept of tactical and strategic allocation is really kind of broken, in that the markets are so highly correlated. You're not giving your client any diversification whatsoever. They pretty much may as well be in an indexed fund, because it's tied to the market.

Kate Stalter: On the subject of correlation, and you alluded to risk management as well-and that's something that is especially relevant in today's volatile market conditions, managing risk. So, what are some of the key tenets of this that investors need to keep in mind?

Jim Lonergan: Especially on the advisor side, but in the consumer side as well, so much money is tied into mutual funds.

And having come from and worked at mutual fund companies over the years, you know and I know, unfortunately, their charter is pretty much to be fully invested. There's nothing worse, as a money manager of a mutual fund, or any fund, that basically feels like the market's going to collapse on them, but they really have to be fully invested.

So, the use of cash at the right time can really reduce the risk, and really the downside of any portfolio, and that's what I think is one of the missing links-to be able to know when to use cash, and when to be in the ETFs or equities and when not to be.

We're not claiming to be market-timing experts; we're just claiming to use data over a long 12-, 15-year history to help predict where we think things will be. And I think that's the difference in the market.

I mean, the tactical and strategic allocation would be fine if they met the objective with diversification. But quite frankly, when everything is correlated, you're not giving your client any diversification, or very limited diversification at best.

Kate Stalter: You mentioned cash. I was trained in a strategy that advocates going into cash in poor market conditions, but a lot of people feel like they're just leaving dead money there-that they need to be shorting, they need to be finding some other asset class. What do you think about that? Do people try too hard sometimes, when maybe cash is the best thing?

Jim Lonergan: Absolutely. I mean, I think people feel: "I can't justify my fee if my client is sitting in cash." I go back to a very simple tenet. A client really comes to an advisor, or a client's own individual is really set on probably two things, right? To grow their asset, and to protect it.

I think everyone's hearing more and more: "Protect" has been even the bigger driver than "grow" lately. I think it's the feel of, "I can't just sit on the sidelines, and I'm following the herd. I feel like I'm missing the first-quarter market, so I've been conservative, it's time to get back in."

Reality is, cash is a great tool. I will tell you: When we look at all our models in our portfolios, we will tend to underperform a big bull-market run for a quarter.

I'll give you an example: Last year, December 2010 to February 2011, the market volatility was almost cut in half and the market yielded about a 12% return. The same thing is showing this year. The first quarter of the year, the market volatility was down almost 50% and it yielded close to a 12% return. So, everyone's starting to feel like, "Oh, it's back to normal."

Reality is, these are cycles that are going to continue on, and you've got to be using your weapons as best you can, or your tools I should say, and cash is absolutely a tool. People get hurt because they end up going down 38%. To make that 38% up, you have to return 70% just to get back to breakeven. So, if you can use cash as a tool, you're protecting clients' assets.

It is the guilt, the feel of, "I have to be doing something," and that's the whole point of discretionary investing versus using data and models in a systematic approach to invest in, and we fully support that.

I come from the buy-and-hold world. I've realized that world doesn't work in today's highly correlated market. So you need to adjust your strategies.