January 8, 2013 / 2:00 PM / in 5 years

YOUR PRACTICE: The case for a new way of controlling risk

Jan 8 (Reuters) - Advisers’ resolution this new year should be to rethink their investing strategies.

So says Mitchell Eichen, chief executive of Risk 3.0 Asset Management, who is among the strategists challenging the long-held investment tenet that says that diversification among stocks, bonds, real estate and other assets will balance the relationship between risk and return.

Eichen, whose firm manages $450 million in assets, argues that the flaws in so-called Modern Portfolio Theory were exposed during the 2007-2009 financial crisis with asset classes moving nearly in lockstep. Even so, advisers still cling to the theory’s tenets, he said.

As an alternative, Eichen, who has nearly 28 years experience in the financial service industry and also heads The MDE Group, a Morristown, New Jersey-based wealth management firm, created a strategy that he says is better at risk control.

The strategy pairs monthly trades of an exchange traded fund tied to the S&P 500 with put and call options. The combination protects the first 12 percent of loss on each of those monthly investments. In exchange for that protection, upside returns are typically capped to the high-single to low-double digits.

“This is an excellent tradeoff since we believe large, sustainable upside will not materialize in the current difficult financial environment,” the company said in a recent paper.

As of last November, the firm’s core strategy excluding fees was up 11.25 percent year to date - 3.1 percentage points below the S&P 500. Eichen said that his strategy had half the volatility of the S&P 500, making its risk-adjusted returns superior.

Of course, many take exception to Eichen’s attack on the Nobel Prize-winning Modern Portfolio Theory.

The theory has decades’ worth of data supporting it and has been validated by hundreds of peer-reviewed academic articles, says Dan Solin, senior vice president with Irvine, California-based Index Funds Advisors and author of several books that support the benefits of the investing philosophy.

He contends that in the economic crisis a portfolio diversified between stocks and high-quality bonds performed exactly as predicted by Modern Portfolio Theory, cushioning investors from steeper losses they would have seen if they were only in stocks.

Solin said he would like to see Eichen’s strategy put under peer-review, but even then he would remain skeptical until he saw a couple of decades’ of returns. Until then, Solin said, research shows that Modern Portfolio Theory is the “credible, responsible way to invest.”

Eichen, who said this kind of thinking is outmoded, spoke to Reuters about his strategy. Edited excerpts follow.

Q: Defend your statement that most advisers are not facing the realities of the current markets.

A: The adviser community grew up in an era of Modern Portfolio Theory, a relatively easy concept: you take a computer program, plug in different asset classes and it tells you for a given level of risk how to allocate assets.

Advisers understand that times are different - I don’t think that anyone is expecting that we’ll return to the ‘80s and ‘90s. But they’re still largely ignoring some structural change that this economy has undergone since the recent economic crisis.

This is not going to be another bear market followed by a 10-to-15 year rip-roaring bull run. Just like it took us 15 to 20 years to dig into this hole, it could take us that long or longer to dig out.

Q: Who are you to take on a classic investing theory like Modern Portfolio Theory?

A: Certainly (theory creator Harry) Markowitz was a gentleman of far greater intellect than I ever hope to be. That said, his work was done decades ago, based upon backward-looking data that supported his work up to that point. It doesn’t take into account that the structural framework of the global economy has changed.

Q: What exactly are advisers doing wrong?

A: People have to understand that diversification alone without other techniques will not protect client assets. Proponents of Modern Portfolio Theory will say over the long term it works - give it 5 or 10 years. But clients don’t have those time horizons any more. They’ll take losses, but they want to come back within a year.

Q: Your solution protects against downside risk at the cost of potentially giving up upside. Isn’t this a hard sell, particularly with the markets doing well lately?

A: If the adviser explains the strategy properly, the client will understand they had a 12 percent insurance policy under them the whole time. The way he paid for the policy was by selling away some upside. We’re not in the business of chasing market returns, we’re providing clients with peace of mind.

Q: What is your main message to advisers?

A: New times require new thinking, and I believe it’s important to build portfolios in today’s environment that provide consistency and predictability.

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