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Toward the end of an eventful 2016, we sat down with Chuck Gray, CFP, a partner with SignatureFD, LLC, director of its SignatureLAW initiative and a member of PIMCO’s RIA Advisory Board, to discuss drivers of change in financial services, particularly how technology is affecting advisory practices. We also delved into the issue of active and passive management and the role alternatives might play in a portfolio.
Chuck Gray: I’m actually really optimistic about the innovative tools that have been developed and our ability as professionals to refine processes and make better decisions. I remember when spreadsheets changed my life. There’s been a lot of evolution and innovation due to technology over 30 years. We can’t stop innovating. And just as people, our behavioral biases are what create risk and return opportunity, for both individuals and professionals. We want shortcuts, we want cheaper solutions, we want simplicity. We seek perfection.
I often use this analogy with clients: If you wanted to climb Mt. Everest, you could train and buy the tools, take a course and get very specific instructions about how to overcome each section of that mountain. Or you could hire a team of Sherpas. The Sherpa’s identity and purpose is all about how to navigate that mountain. The weather is constantly changing. But they wake up every morning thinking about how to climb Mt. Everest and how to get up and down it safely. When the stakes are high, you want a Sherpa. You don’t want to try to figure it out yourself.
CG: Increasingly, at our firm, we’ve focused on creating a culture that tries to empower people to use their wealth to live a great life. I started working with attorneys more than 20 years ago. One of the things I figured out is that an attorney builds equity completely differently than a corporate executive or a business owner.
We recognize that our clients’ wealth is broader than their financial resources. It’s their time and talent and also their influence. The thing that is different about us is that we have created what we call “Client Initiatives.” Basically, they’re designed for specific groups of people – women, attorneys, executives, business owners, professionals. By focusing on the unique challenges and opportunities of a particular group and its complexities, we are able to deliver a very detailed plan for those folks. Within our firm, we try to build collaboration. For example, we have a close community of attorney client groups. We try to learn from each other.
CG: Yes, constantly. There are lots of examples of the ways these groups have changed and how that has affected their financial planning. Take executives: Back in the '90s, they were all being paid with incentive stock options. As corporations converted the way they compensated their executives, executives had to adjust their financial planning. We saw a paradigm shift. Things like that are constantly presented. The way attorneys manage and grow their law firms has changed dramatically. To be successful, you have to be very proactive and change as your clients and their needs change.
As a financial firm grows, you can get more specialized and focus on that unique thing that you’re awesome at. We harness technology to collaborate with each other. And each role has different tools to help us do our jobs. We are big adopters of technology and work to be more efficient and productive. I think the successful firms embrace it as a tool to help people make better decisions.
CG: I look at active and passive strategies in terms of alpha and beta. We use both active and passive strategies in our portfolios. That’s not new for us; we’ve done that for a long time. The relationship is highly cyclical. You’ve had passive outperforming for many years. And many in the RIA community adopted passive back in the 1990s. There was a long period of outperformance that came to an abrupt end in 2000. We look at the impact of taxes and costs. But I think passive and factor-based tilts or smart beta strategies are here to stay. Of course, long periods of passive outperformance tend to create the next environment when active has more opportunities. So, they kind of feed upon each other.
Historically, there have certainly been times when passive made more sense. Coming out of the financial crisis, passive strategies had more of a low-quality factor. Companies that were being priced like they were going out of business appreciated very rapidly. So that was a very efficient way to capture mispricing.
CG: Are you asking whether we take the added expense of an active strategy into account in our overall decision-making? Yes, we do. And now you’re seeing a big push into smart beta and factor tilts. It’s not cheap indexing, but it doesn’t have full-blown active expense ratios; it’s somewhere in the middle. You’re making it very portable where advisors can express their views with smart beta products. I think there’s a huge push to identify new factors and create more efficient and better diversified portfolios, for sure.
Correlations are at 10-year lows right now, and there tends to be reversion to the mean on these cycles. You’ve really got to get detailed about what style or area of the market you’re talking about. But I think certainly there seems to be fertile opportunities for active management in certain parts of the market. We’ve seen a lot of volatility in the fixed income market here with the election. And higher volatility tends to be an environment in which active management excels. We’ve had very low volatility for several years. That can be an environment where active struggles. So now it looks like there may be an opportunity for a regime change. So I would think active – depending on what part of the market you’re talking about – might have a better opportunity set.
CG: We’ve used alternatives, but I think they have the potential to be confusing for investors. Stocks, bonds, real estate, commodities – those are all asset classes. But alternatives are strategies, not an asset class. And they can be very broad. They include both public and private investments. It’s really all about correlations. There’s a great deal of optionality in those strategies that’s very difficult to model in your portfolio construction process, because a fund might be positioned completely differently this year than last year. Equity risk is the dominant factor in most risky asset portfolios.
I’ve said for a while that we’ve got a low carry offer from bonds. Historically, we’re looking at a 32-year bond bull market. Bonds may be less efficient diversifiers. So alts are trying to fill that role to be an efficient diversifier and help manage volatility.
Take hedge funds. That’s a strategy whose golden age was 1998 – 2005. I would argue that a lot of the performance was on the back of leverage and the growth of securitization. Post the financial crisis, that leverage is not available. And a lot of the alpha that occurred in the private illiquid space can’t be done with a liquid, public 40-Act fund. So the persistency of the alpha is constantly self-depleting. And if a certain theme or factor is working, it can quickly become a crowded trade.
It’s a very competitive space, and we’re constantly doing due diligence. We have a very small set of funds that we believe have the potential to offer consistent benefit.
CG: We are constantly making adjustments to our models. In the near term, there seems to be a bit of a reflation trade. If you look at sentiment, no one seems to be very worried about inflation. We could see a surprise in growth and a reflation trade. The markets don’t yet appear to be pricing that in.
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A Word About Risk: All investments are subject to risk and may lose value. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. Smart beta refers to a benchmark designed to deliver a better risk and return trade-off than conventional market cap weighted indexes per PIMCO style.
Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. Beta is a measure of price sensitivity to market movements. Market beta is 1. Correlation is a statistical measure of how two securities move in relation to each other. Carry is the rate of interest earned by holding the respective securities.
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