March 12, 2015 | Volume 5 | Issue 10

Active investment management’s weekly magazine

Does good employment news foretell bad news for markets?

ETFs vs.mutual funds debate

Community involvement promotes business growth

Professional trader Ian Naismith: Market cadence as a trading tool

Steve Molesky

Smart retirement: It’s all in the math

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Advisor perspectives on active investment management

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LOUD & CLEARChuck Bigbie • Tulsa, OK Woodland Wealth Management • Geneos Wealth Management Inc.

3March 12, 2015 | proactiveadvisormagazine.com

LOUD & CLEAR

The mutual fund industry is still the 800-pound gorilla of the financial market, but it is a gorilla on a diet. The growth trajectories of do-mestic equity mutual funds and Exchange Traded Funds (ETFs) are dramatically different. Since 2000, domestic equity ETF assets have increased by more than 1520%. Comparable mutual fund assets are up 70%.

Naturally, there is a fallacy to those numbers that every small cap investor can explain: It is much easier to exponentially grow from a small beginning than as an established mammoth. But the growth in ETFs is undeniable, with a recent Ernst and Young report calling for “annual growth rates of 15-30% globally in the next five years … with active and smart beta ETFs two of the hottest growth areas.”

ACTIVE MANAGERS DEBATE

VS.

BY LINDA FERENTCHAK

U.S. ETF domestic equity

1,000

900

800

700

600

500

400

300

200

100

0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

U.S. mutual funds domestic equity6,000

5,000

4,000

3,000

2,000

1,000

0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Growth trajectory of ETFs vs. mutual funds

$Bill

ions

$Bill

ions

Source: 2014 Investment Company Institute (ICI) Fact Book

proactiveadvisormagazine.com | March 12, 20154

ETFs continue to gain popularity with fund managers, investment advisors, and investors—reflectingever-increasing familiarity and diversification—but they also have their drawbacks

Jeremy Siegel, senior strategy advisor with WisdomTree Investments, currently the in-dustry’s fifth largest ETF provider in the U.S., foresees a time when ETFs will overshadow mutual funds. Driving that growth, he main-tains, will be the ETF design compatibility in the indexing space and tax advantages, but most of all the flexibility people want in managing their money.

The timing was perfect for the emerging ETF industry. Investors still wanted to be able to buy and sell at their discretion. The structure of an ETF removed the potential for a fast-trading investor to impact the returns of longer-term holders. Because ETFs trade similar to stocks, with prices continually adjusting to market conditions and the funds’ underlying holdings, late trading and stale price arbitrage became a non-issue. In addition to trading flexibility, ETFs offered tax advantages and lower expense ratios. By late 2007, ETFs were outpacing the mutual fund industry in terms of equity fund flows.

In the active management arena, the trading flexibility of the ETF has made them the go-to tool for many strategies. But whether they are a superior trading vehicle is far from consensus

continue on pg. 11

opinion. “The reflexive notion that ETFs cost less simply based on their low expense ratios, and are more cost-effective than mutual funds, is not entirely true,” Guggenheim Investments points out in its Rydex Funds report, “A Comparison of ETFs and Mutual Funds—The True Cost of Investing.” (Note: Guggenheim provides a variety of both ETFs and mutual funds.)

Guggenheim acknowledges the significance of the ETF vs. mutual fund debate for manag-ers and investors, saying, “The key idea here is that buy-and-hold strategies and active trading strategies can have different cost profiles when taking into account all of the relevant costs and the trading frequency.”

In addition to internal expense ratios, the report explains, ETF investors typically must

The key idea is that buy-and-hold strategies

and active trading strategies can have very different

cost profilesMutual funds were the original investment

vehicle of choice for active managers and remain so for many. As the fund families added invest-ment categories and balanced equity funds with bond and money market funds, reallocating client assets in response to market conditions became cost efficient. No-fee mutual fund plat-forms allowed managers to move beyond using the funds of a single investment company to utilize the funds of several different companies, picking and choosing among the best-perform-ing options.

But the popularity of using mutual funds for active management suffered a setback from the “timing” scandal of 2003. Mutual funds began imposing restrictions and early redemption penalties designed to limit the fre-quency of exchanges between funds. Even some brokerage firms began imposing penalties for frequent trading in mutual funds, regardless of whether or not the fund itself restricted trading frequency.

Equity holdings shift from mutual funds to ETFs

1,000

800

600

400

200

0

-200

-400

-600

Cumulative equity fund �ows from 2007

2007 2008 20102009 2013 20142011 2012

ETFs

$Bill

ions

Mutual funds

Source: 2014 Investment Company Institute (ICI) Fact Book

March 12, 2015 | proactiveadvisormagazine.com 5

Value Line geometric compositeU.S. civilian unemployment rate

12 of previous 13 occurrences saw the Value Linelower one year later with a median return of -14.8%

1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014

Source: J. Lyons Fund Management Inc./My401kPro.com

12

10

4

2

8

6

Does good employment news foretell bad news for markets?

lthough last Friday’s (3/6) jobs report had its detractors, its headline numbers handily beat consensus expectations. However, the report fueled concerns

the Fed will raise interest rates sooner rather than later, sending stocks to weekly losses of about -1.5% on the SPX and DJIA.

The U.S. added a better-than-expected 295,000 jobs last month, while the unemploy-ment rate edged down to 5.5%. There was disappointment in the continued weakness of the labor force participation rate and the very slow pace of wage increases. Despite those concerns, the improving employment backdrop has sparked fear that the Federal Reserve could be motivated to act on its “data dependent” stance and move to a rate hike this summer or early fall.

Barron’s said, “While U.S. stocks plunged, Treasury yields shot to their highs for the year and the dollar traded at levels not seen in over 11 years—all on the prospect for a nudge higher in the Fed’s key policy rate.” They also noted sig-nificant movement in the June fed-funds futures contract, which priced in higher probabilities of a rate hike at the June FOMC meeting.

Bespoke Investment Group analysis affirmed the recent linkage of positive jobs numbers to rate hike jitters, noting, “After gaining on 17 of 20 ‘Jobs Fridays,’ the S&P 500 recorded its third straight decline on a ‘Jobs Friday,’ and all three of those non-farm payroll (NFP) reports were beats.” Bespoke also points to the fact that the unemployment rate at 5.5% “hit a new cycle

A

low and is equal to the Fed economic staff’s most recent projections of NAIRU, or the ‘natural’ rate of unemployment.”

Both Barron’s and Bespoke, as well as many analysts, considered the initial market reaction to be overblown, as the Fed will likely remain accommodative with small, incremental rate hikes for some time and improving employment should be a long-term net positive.

Or is it? Analysis cited by MarketWatch points to a chart from J. Lyons Fund Management, saying, “An unemployment rate at a six-year low

has met with a 12-month high on the Value Line Geometric Composite exactly 13 times since 1969. In 12 of those instances, stocks have been lower a year later, with a median decline of -14.8%.”

However, the chart’s author, Dana Lyons, won-ders himself if that is an interesting market data quirk or if it is really saying something about the “current proximity of the end of the market cycle.” With unprecedented global monetary easing and world economies that are far from overheated, the data points may have less relevance than in prior market cycles.

UNEMPLOYMENT HITS 6-YEAR LOW WHILE STOCKS AT 12-MONTH HIGH

7March 12, 2015 | proactiveadvisormagazine.com

TOPPING THE CHARTS

ThesmartretirementIt’s all in the mathQuantitatively based investment strategies are designed to build assets over the long term—a cornerstone for retirement.

By David WismerPhotography by Mike Morgan

8 proactiveadvisormagazine.com | March 12, 2015

Steve Molesky ChFC®, CLU

President, Stephen M. Molesky & Associates Ellicott City, MD

Broker-dealer: Kalos Capital Inc.

Licenses: 6, 7, 63, 65

Estimated AUM: $100M

Proactive Advisor Magazine: Steve, what types of clients do you work with?

Steve Molesky: I initially learned the busi-ness in my days at CIGNA, which ran one of the first national financial planning businesses and had a terrific training organization. Back then our prime prospects were small business owners who had the multiple needs of their business, their personal assets, and, in many cases, employees who could also benefit from our services.

I continue to have an affinity for owners of small- to mid-sized businesses, but that has nat-urally led to focusing on clients of all kinds who are facing planning for retirement. We used to joke around many years ago that a client would come to see you on a Monday and announce they were retiring on Friday, and could you please help them plan for it!

Retirement planning has obviously become much more of a top-of-mind and long-range concern for people, and pre-retirees and those already in retirement are the focus of our firm. Despite all of the publicity around the challeng-es of retirement, I firmly believe that the vast majority of people need professional assistance in putting together and managing a smart retirement plan and its associated investments.

What core investing principles do you use for clients?

I think we were well ahead of the curve in terms of recognizing that there was more to investment planning for clients than just pure asset allocation models that may not have a thorough consideration of the risk side of the equation. I have been exposed to the efficient frontier analysis for many years—which tries to ascertain optimal portfolios for delivering the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.

However, in the last 20 years or so, the ad-vances in portfolio construction, risk manage-ment, and strategy implementation have truly been phenomenal. It is my goal to make sure I am offering clients cutting-edge investment solutions. So, I am a big advocate of quanti-tatively based, actively managed strategies for clients, certainly on the public equity and bond side.

We implement a lot of different approaches for clients based on their needs and objectives. I have also been thoroughly exposed to the

endowment model of asset management—the kinds of investments that large universities might use. I believe there can be significant value and diversification benefits in many forms of alternative and private investments.

We discuss each of the asset classes with clients, talking about the pros and cons and where they fit in to a portfolio. Education is a high priority and value-add for our practice and I spend time explaining some sophisticated concepts as simply as I can. One of my favorite clichés—which is more than a cliché—stresses the importance of diversification at all times: “There’s nothing that’s so good it is worth all of your money, but there are a lot of things worth some of your money.”

Describe how you educate clients on active investment management.

I tell clients that the most successful endowment funds endorse the quantitative approach to investments. These funds consider

continue on pg. 10

Steve Molesky has been in the financial planning and investment management business since 1983, enter-ing private practice in 1991. He is president of Stephen M. Molesky & Associates Inc. and prior to founding the firm worked for CIGNA Individual Financial Services Inc. Mr. Molesky specializes in helping pre-retirees and retirees build, preserve, and protect their retirement assets, offering securities through Kalos Capital Inc.

After graduating with a degree in psychology from St. Joseph’s University in Philadelphia, he received his MA from Catholic University in Washington, D.C. Mr. Mole-sky has also earned the ChFC and CLU designations, and has completed training to be an Elite IRA Advisor under Ed Slott & Company Inc. A widely recognized financial educator and planner in the greater Baltimore-Washington, D.C. area, Mr. Molesky’s seminars have taught many who are planning for retirement how to increase their retirement income and reduce their taxes. He has been married to his wife Carole for 42 years and they have four children.

He says, “I have been greatly influenced in my advisor role by my Jesuit educational background and psychological training. Both of these teach a disciplined and thoughtful process of approaching problem-solving and the impor-tance of considering the many sides of an issue.”

risk management a top priority, as they cannot afford to see their absolute asset levels go down significantly—just as a retiree cannot afford it either. They understand the fundamental math—it is a lot easier to build assets over lengthy periods of time when you do not have to recover from major losses. There are a number of illustrations I use with clients that make that point crystal clear, beginning with simple mathematical relationships that most people do not know—for example, that it takes a 67% gain to overcome a 40% loss.

I tell clients that we want to enhance risk management in their portfolios by using

There’s nothing so good it’s worth all of your

money, but there are a lot of things worth some

of your money.

March 12, 2015 | proactiveadvisormagazine.com 9

Securities offered through Kalos Capital Inc. and Investment Advisory Services offered through Kalos Management Inc., both at 11525 Park Woods Circle, Alpharetta, Georgia 30005, (678) 356-1100. Stephen M. Molesky & Associates is not an affiliate or subsidiary of Kalos Capital Inc. or Kalos Management Inc.

continued from pg. 9Steve Molesky

quantitative analysis, or algorithms, to lower the downside exposure. The highs of the returns may not be as high as the overall equity market is capable of achieving, but the lows should be nowhere near as severe as the kinds of losses the S&P 500 has taken during a severe bear market decline.

In addition to the risk management aspect of active management, the real strength of the third-party managers I use is their ability to po-tentially generate positive returns in both rising and declining markets.

The basic message to clients is that we are not trying to hit home runs. We are trying for greater consistency of returns and to take some of the volatility of returns out of the equation. That cannot always be done perfectly, of course, but sound mathematical principles support how this can benefit client portfolios over the long haul.

How does your practice benefit from using third-party managers?

With technology being what it is today, these money management firms have become very good at what they do—managing risk and volatility while delivering competitive returns. I am allocating more and more client money to this approach, allowing me to focus on what I do best: Education on all aspects of the retire-ment planning picture.

There is also a strong psychological client benefit to having risk-managed portfolios. Behavioral finance studies, and research such as DALBAR, show how individual investors tend to create their own impediments to success.

Proactive investment management, in my view, enhances the odds that a client will stick with a plan for the long term, and not feel they have to panic over a short-term event. That is a

major benefit for the client in the absolute. But it also leads to our practice being able to design and implement a client investment plan with measurable and defined goals that has a high probability of success.

10 proactiveadvisormagazine.com | March 12, 2015

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navigate transaction or brokerage commission fees to purchase and sell ETFs, bid/ask spreads (which represents the cost for selling and buying the ETF), and the potential for intraday pricing premiums or discounts based on supply and demand.1

When comparing the cost of using mutual funds versus ETFs in an active strategy it is easy to focus on the known costs—expense ratios and commission costs. The expense ratio includes manage-ment fees, 12b-1 fees and other expenses that are deducted from a fund’s assets or charged to all shareholder accounts. ETFs, because they trade on exchanges similar to stocks, incur a sales commission, while No Transaction Fee (NTF) mutual funds can be traded com-mission free. Not all funds are NTF, however, but these costs can still be known in advance and factored into an investment decision.

Other costs mutual fund investors need to consider include whether or not the fund imposes transaction fees if shares are not bought and sold directly through the mutual fund provider or on an NTF platform, holding period penalties such as redemption fees, sales charges, exchange fees and account-related fees.

For mutual funds, the biggest unknown is the actual cost of the fund’s shares at the market’s close. Because mutual fund orders are processed based on the Net Asset Value (NAV) at the U.S. market’s close at 4 p.m. EST, the final transaction could be priced higher or lower than the manager might have anticipated.

continued from pg. 5

continue on pg. 13

ETFs vs. mutual funds

Why gold matters nowThe reality is that when paired up with other asset classes and strategies, an overall portfolio might produce better risk-adjusted returns with a healthy allocation to gold.

Advisors’ clients driven by losses, not gainsThe “father” of behavioral finance on the perils of hindsight, the power of client regret, and what sets apart Warren Buffett.

How to invest for market volatilityDespite the bull market since 2009, volatility has actually been higher than the period 1988-2007. Portfolio approaches blending non-tactical and tactical strategies help smooth out the bumpy ride for clients.

L NKS WEEK

March 12, 2015 | proactiveadvisormagazine.com 11

Listen to the market music: The cadence tool

Ian Naismith founded Investment Portfolio Solutions in 2012 and has been trading the markets since the early 1990s. He licenses trade signals and portfolio construction consulting to financial institutions. A member of the National Association of Active Investment Managers (NAAIM), Mr. Naismith has also served as board member and president. www.linkedin.com/in/investmentportfoliosolutions

n musical terms, cadence is the rhythmic sequence of notes or chords that signals the momentary or complete end of a phrase or section, or of the whole com-

position. That analogy to the markets and their components, when transposed, can help identify different market rhythms and their transitions from one to another. I want to share a very simple tool for your toolbox that can help measure the macro pulse and early behavioral detection of any tradable item and in any time interval: the cadence tool.

This tool simply establishes “at least percent-age” movements in price to create inflection points. Reviewing shorter price rhythms helps assess the health of a longer trend. The second element of the cadence tool is the length of time. By quantifying the peak-to-trough price decline and peak-to-trough time distance—the discipline of monitoring an established cadence and detect-ing an emerging cadence can bridge some gaps on what can be done in a money management system to reduce volatility and drawdown.

The real-time tracking methodology measures the price decline since the last closing price peak date while counting the trading days during that decline (please refer to the table). In this example, the S&P 500 decline must be 2% or worse from the peak price.

The end of the decline-tracking occurs when there is at least a 2% or greater increase from the closing price low. Once at least a 2% or greater bounce has occurred from the low, then the time-monitoring of price to see if it can pierce through the last peak is next. If the previous peak is pierced, time-monitoring continues until the new future peak has been attained. Once attained (there must be at least a 2% fall from the peak), the opposite occurs—the monitoring of decay.

Next, I run an average of the peak-to-trough price declines and the average number of days elapsed. This average starts from the beginning of the established cadence. There is latency, however. I use a two-outlier rule to label an emerging cadence that is strengthening while the established cadence is decaying. During this transition, allocations are changing to a more defensive posture. Once the established cadence has ceased and the emerging cadence becomes the established, then the outlier events are pulled into the new established cadence measurements.

In the table, you will notice a consistency of rather shallow and quick dips between 2/19/13 and 9/18/14 in the S&P 500. However, on 10/15/14, a decline of 7.40% occurred and created a price outlier. Also, the number of days elapsed was uncharacteristic to the previous

peak-to-trough periods. This preceded the first big outlier during the 12/5-12/16/14 period when the Index experienced another decline, then was out of synch of the previous longer recovery peri-ods. This outlier was followed by a confirmation outlier between 12/29/14 and 1/6/15 when the S&P 500 fell 4%+ and within five days increased at least 2%, but could not pierce the last peak. Outlier 3 again supported outlier 1 and 2.

In order for a longer positive trend type of cadence to emerge, we must continue to have elongation of recovery on the bounces from the troughs producing higher highs, while having a succession of higher lows during the decay periods. Right now there is a new outlier to the possibly short-lived choppy cadence we saw in December 2014 through January 2015. We shall see …

Proactive Advisor Magazine presents weekly commentary provided by well-known market analysts, financial authors, investment newsletter publishers, and economists. The opinions expressed each week represent their personal perspectives and not necessarily those of the magazine.

Source: Investment Portfolio Solutions

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proactiveadvisormagazine.com | March 12, 201512

HOW I SEE IT

There can be no assurance that any investment product will achieve its investment objective(s). There are risks associated with investing, including the entire loss of principal invested. Investing involves market risk. The investment return and principal value of any investment product will fluctuate with changes in market conditions. Guggenheim Investments represents the investment management businesses of Gug-genheim Partners, LLC. Securities offered through Guggenheim Funds Distributors, LLC. Guggenheim Funds Distributors, LLC is affiliated with Guggenheim Partners, LLC. x0515 #12526

Uncover the True Cost of Trading Mutual Funds and ETFs

The reflexive perception that ETFs cost less, simply based on their low expense ratios, and are more cost-effective than mutual funds, is not entirely true. In addition to an expense ratio, there are additional considerations that should be considered when making an informed choice between ETFs and funds— including spreads and commissions. This informative white paper from Rydex Funds provides an in-depth look at the cost of ownership of no-transaction-fee (NTF) mutual funds and ETFs—with a focus on active investing strategies.

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A Comparison of ETFs and Mutual Funds—The True Cost of Investing

continued from pg. 11

With ETFs, the share cost is known at the time the order is executed; however, other costs come into play. The price of a particular ETF is based on supply and demand. The ETF could trade at a premium or a discount to its under-lying NAV depending on market conditions. Bid/ask spreads also influence the price of an ETF. This is the difference between the price a buyer is willing to pay (bid) for a security and the seller’s offering (ask) price. Bid/ask spreads can vary considerably based on market vola-tility, the underlying stocks that make up the ETF, liquidity, the issuing company and other factors. One effect of the bid/ask spread is that a buyer may pay more than the value of the individual stocks that make up the ETF. These unknowns make “best execution” practices for trading ETFs essential.

The issue of end-of-day pricing and volatil-ity into the market close is an important one, as many fund managers find the “one price a day” nature of mutual funds more conducive to consistent strategy and trading execution—and “cleaner” for backtesting strategies—than intraday-traded ETFs.

Regardless of supporting factors and costs, ETFs are transforming the active manager’s trading arsenal. As managed equity ETFs pro-liferate, reflecting the investor’s desire to have a manager actively selecting investments he or she

believes are best-of-class, active managers may find less reason to actively trade mutual funds to manage market risk and target opportunities.

Then again, one certainty in life is uncer-tainty. The giants of the mutual fund industry, Vanguard, Fidelity and others, have moved to develop their own ETF products, inherently recognizing that each product has suitability depending on a manager’s or investor’s needs and strategies. So the answer to the ETF vs. mutual fund debate is an inconclusive “draw”—an unexciting but sensible response of “it all depends.”

ETFs vs. mutual funds

Linda Ferentchak is the president of Financial Communications Associates Inc.  Ms. Ferentchak has worked in financial industry communications since 1979 and has an extensive background in investment and money manage-ment philosophies and strategies.

What is the answer to the ETF vs. mutual fund debate? “It all depends.”

13March 12, 2015 | proactiveadvisormagazine.com

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Copyright 2015© Dynamic Performance Publishing Inc. All rights reserved. Reproduction of printed form, whole or in part, without permission is prohibited.

EditorDavid Wismer

Associate EditorElizabeth Whitley

Contributing WritersLinda Ferentchak

Ian NaismithDavid Wismer

Graphic DesignerTravis Bramble

Contributing PhotographerMike Morgan

March 12, 2015Volume 5 | Issue 10

Proactive Advisor Magazine is dedicated to promoting and educating on active investment management. Distribution reaches a wide audience of financial professionals who advise clients on investments and portfolio management. Each issue features an experienced investment advisor who offers insights on active money management, client service, and investment approaches. Additionally, Proactive Advisor Magazine offers an up-close look at a topic with current relevance to the field of active management.

The opinions and forecasts expressed herein are those of the author and may not actually come to pass. Any opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. The analysis and information in this edition and on our website is for informational purposes only. No part of the material presented in this edition or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any portfolio constitutes a solicitation to purchase or sell securities or any investment program.

Community involvement promotes business growth

Megan L. Avery, ChFC®

Lutherville, MD

Questar Asset ManagementLegacy Consulting LLC

Securities offered through Questar Capital Corporation (QCC), Member FINRA, SIPC. Advisory Services offered through Questar Asset Management (QAM), a Registered Investment Advisor. Legacy Consulting LLC is independent of QCC and QAM.

“lunch and learn” events at our office where clients will come in to learn about a new in-vestment product or to discuss an issue rel-evant to retirement or tax planning needs.

I think the inclusion of all of these types of activities improves our visibility in the community and contributes to the positive word-of-mouth that has helped our practice grow and thrive.

market my practice in a number of ways. I am a very high-energy person with a lot of personal and professional interests that all work together to help in developing

new clients. But my number-one principle is to do right by a client, and that will pay off in many rewarding ways.

We deliver a number of services to clients in what I call the “three-pronged approach” to retirement planning, estate planning, and life planning. This covers a lot of territory, including services I either provide directly, such as tax services, or refer out, such as estate legal planning, real estate services, or elder care. When you add up the individuals who work directly for me or are continuing partners, there is quite a significant network of cross-referrals being generated that can benefit everyone.

I also think it is important in our busi-ness to continue one’s education and to share that perspective with clients and prospects. Each year I attend a number of educational events, and in turn, speak at local financial informational events or seminars. I have also appeared in the local media as a guest on several financial radio talk shows. All of this helps me grow in articulating my beliefs and in providing exposure for our firm.

I also have very specific client events that may include potential prospects. Last year on our firm’s 16-year anniversary, we held a ballroom dancing gala attended by over 200 people. It was awesome and ev-eryone loved the event. We frequently hold

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TIPS & TOOLS