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Advisor Profile: Best of Both Worlds

Two advisors take different approaches in their portfolios to achieve the same goals: low risk and stability.

Kate Stalter, 03/07/2011

This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

From Stock-Picker to Passive Investor
Tom Posey was confident he was a good enough stock-picker to beat the market. So, when the Houston-based advisor opened his business in 2000, it followed that he chose actively managed mutual funds for his clients.

Before launching Posey Capital Management with his wife, Sarka, Posey had been an attorney and a chief financial officer in the oil industry. In the latter role, he had evaluated investments and acquisition opportunities, and he developed a knack for spotting prospects.

"I felt I could do pretty well as an active manager, and that's what I had in mind doing," he says.

Rather than choosing individual stocks, the fee-only advisor zeroed in on actively managed mutual funds to achieve more diversification for his clients. He was happy with the funds he chose, which included the Clipper Fund CFIMX and some from Dodge & Cox. These were funds with good track records and relatively low management fees. Posey was aware of research showing that indexed funds delivered better returns than actively managed funds. But he remained skeptical, convinced that he could beat the market by choosing the right actively managed instruments.

The Go-To Advisor
It's important to note that Posey's business doesn't center around money management as a stand-alone service. Instead, Posey emphasizes that his company offers comprehensive financial planning, which includes investing, among other services. He credits his background for shaping his approach. In addition to his earlier careers as attorney and CFO, he spent about 18 months at an advisory firm that specialized in insurance products.

"We do retirement cash-flow planning and complete risk management and asset protection," he says. For example, "even after a client has enough property and casualty insurance, we'll look at whether they should have legal vehicles to protect their assets beyond that."

Posey's firm also offers estate planning, charitable giving, and wealth transfer. Services include tax-loss harvesting, wherein a loss on paper can offset future taxable gains. Posey aims to be clients' go-to for all financial issues. If he doesn't have a staff expert in a specific legal or tax question, he refers clients to a network of trusted outside consultants.

Most clients are 55 or older, with at least $2 million in assets. The firm has about $90 million under management.

With his comprehensive management philosophy in mind, he began searching in 2002 for a low-risk investment for a client. He was seeking something that didn't use derivatives but delivered a good yield and held little interest-rate sensitivity.

"At that time, there were a bunch of ultra- short-term bond funds that had really high yields, but they were using all kinds of derivatives," he says. "And some of those, like Fidelity's Short-Term Bond Fund FSHBX and Schwab YieldPlus SWYSX, just got nailed after a couple of years."

He wanted something for his client with more stability and less volatility.

DFA Beckons
This search resulted in Posey shifting his approach toward a more passive investing style and away from actively managed funds. He found a one-year fixed-income fund from Dimensional Fund Advisors that fit his requirements perfectly. "It was just a plain-vanilla bond fund, and I thought it looked great," he says.

Having no inkling how DFA funds are distributed, Posey tried to buy the fund through Fidelity, the custodian for all his clients. Fidelity's website wouldn't allow him to make the purchase, so he called Fidelity to see what the problem was. He learned that he was not an approved DFA advisor and, therefore, was prohibited from buying the company's funds.

A representative from DFA told him that to become approved he'd have to attend a seminar in Santa Monica, Calif. At first, Posey was skeptical, but as he reviewed DFA's brochures, he grew more interested. He had gone into money management believing that he could beat the S&P 500 by choosing actively managed funds. But seeing the returns available to investors using DFA's indexing approach, he began to change his view.

He decided to attend the seminar to learn more, and he came away convinced that indexing could deliver better returns over time than actively managed funds.

Getting Clients on Board
But one problem concerned him: How would he convince clients of the wisdom of his conversion. After all, theoretically, a client could easily buy index funds without going through him. His solution? A thorough client-education presentation, emphasizing not just the idea of returns from specific investments, but also the spectrum of services Posey offered.

He says he keeps client communications straightforward and typically avoids conversations about Modern Portfolio Theory or the efficient-market hypothesis, saying that most clients are more interested in practicalities than theory.

"I don't promise returns," he says. "I do demonstrate why, with an indexed portfolio, whether it's DFA or Vanguard or someone else, they are very likely to beat an actively managed portfolio."

Posey's client presentation also shows how he will put together a portfolio specific to each client's situation as part of a comprehensive plan.

Once they understood it, clients didn't object to the indexed approach to mutual fund investing. It made sense to them, and as Posey had hoped, they gravitated toward the total package of his financial-management services.

Although he invests mainly with DFA and Vanguard, he's open to other fund families, when it's appropriate. On occasion, he'll put a client into an iShares ETF or a SPDR, but his asset allocation centers around indexed mutual funds.

If any of his clients want to carve out small sections of their portfolios to invest on their own, in aggressive growth stocks, for example, Posey doesn't discourage them.

"We have a couple of clients who enjoy doing that," he says. "But I do remind them that our mutual fund portfolio has beaten individual stock selection over time, and that's probably what will happen with them, too."PAGEBREAK

The Active/Passive Blender
For San Diego's Craig Hillegas, making sure his clients have a steady post-retirement cash flow means using a mix of passively and actively managed investments.

The tagline of his Hillegas Advisory Services, which he founded in 1993, is, "Integrating Life and Money." To accomplish that goal, Hillegas developed a methodology he calls "portfolio planning for lifetime income." It takes into account four areas of concern for his clients:

* Spending and income cushion and bear-market protection.
* Portfolio paychecks and income replacement.
* Broad diversification.
* Managing risk and opportunity investing.

Hillegas places a client's time horizon, goals and objectives, and tax variables at the center of his methodology. The process-and its attendant mix of investment strategies- germinated in the late 1990s and matured with the market's calamitous decline in the autumn of 2008. A prospective client approached Hillegas after suffering a seven-figure loss in the market free fall.

"He was just shell-shocked, asking, 'How could that have happened?' This newly retired client was an inspiration and ideal candidate for the lifetime income and portfolio-planning process," Hillegas says.

Indexing Has Its Place . . .
Hillegas' goal is to give clients a yield on their investments, steady cash flow, and a cushion in some less-risky vehicles. The idea is that even in another major market meltdown, clients' wealth will be protected, and they'll continue receiving regular paychecks from their portfolios to meet their everyday expenses. "So they know they can visit their grandkids or go play golf, because things are handled," he says.

Hillegas makes use of various instruments. Those include passively managed index funds, actively managed funds, and alternative investments such as natural-resources limited partnerships for accredited clients (those with $1 million or more in net assets).

"I employ very broad diversification, using a variety of assets that are going to zigzag differently from one another, with different correlations and risk/return profiles," he says.

Hillegas closely follows the latest portfolio- management research and makes an effort to find the best combination of investments that maximizes returns while offering downside protection. As part of that, he's open to using passively managed index funds and ETFs to gain exposure to specific asset classes.

"Indexing has its place, particularly in certain asset classes and in taxable portfolios, where Uncle Sam gets to share in returns. In those cases, the average active manager has a fairly high hurdle to overcome, especially with value-style equities," he says. "Perhaps the best illustration of the compatibility between passive and active investing is the simple fact that the index pioneers at Vanguard equally embrace active investing, having a comparable number of index and active funds."

. But an Active Manager Can Add Value
In other areas of the market, however, using an active manager makes sense, he says.

In the 1990s, having become familiar with asset-allocation research by Pennsylvania- based advisor Roger Gibson, Hillegas began seeking investments that offered downside protection when equity markets grew too frothy. His concern about that possibility grew in the late 1990s, as speculative technology stocks raced higher. He added convertible bonds to his overall mix, selecting that asset class for its balance of upside potential and downside protection. The Calamos Convertible Fund CICVX is among the funds he uses, along with the now-closed actively managed Vanguard Convertible Securities Fund VCVSX.

Another actively managed fund that Hillegas uses is Gateway GATEX, which falls under the umbrella of what he terms "reduced-risk growth." Gateway employs a strategy of selling S&P 500 index call options while buying index put options to cut downside exposure. The covered-call selling generates income for the fund. "If something really bad happens, they'll have out-of-the-money puts if things plummet, and that provides a bit of a floor," Hillegas says. "They have been very successful at smoothing out returns."

Hillegas uses other reduced-risk growth funds with similar active strategies, including Merger MERFX and Marketfield MFLDX.

Hillegas follows the work of Robert Arnott, founder of Research Associates. Arnott has spearheaded research into indexing based on fundamental criteria, rather than the traditional approach of weighting by market cap. Rather than constructing an index based simply on market capitalization, fundamental index factors include dividends, cash flow, sales, and book value. This methodology addresses the structural return drag caused by the systematic overweighting of overpriced stocks and underweighting of underpriced stocks in cap-weighted indexes. Arnott also manages PIMCO All Asset All Authority Fund PAUIX, which Hillegas uses. As its name suggests, the actively managed fund invests in a wide range of asset classes, including commodities, real estate, and global stocks and bonds. It achieves its goals by investing in other actively managed PIMCO funds.

For international exposure, Hillegas puts investors into the actively managed Matthews Asia Dividend Investor MAPIX and Matthews Asian Growth & Income Investor MACSX. He praises the depth of knowledge Matthews' specialist managers have about the region, and he's especially pleased with their track record of preserving capital in weak markets and delivering returns in better conditions. First Eagle Global SGENX and Mutual Global Discovery MDISX are two other global funds that he likes for their strong risk-adjusted return and downside protection.

A favorite area in which Hillegas uses both active and passive strategies is REITs, although as of December he had momentarily slashed his exposure in the category. With REITs, he favors a "core and explore" approach-using index funds as the core of a REIT portfolio and adding actively managed funds to flesh out other areas. For international exposure, Hillegas has used Cohen & Steers' global and international estate funds, among others. For the index funds at the REITs core, he works with Vanguard.

Focus on Objective
Rather than viewing his asset mix from a perspective of actively managed versus passively managed funds, Hillegas focuses on the objective he's hoping to achieve for his clients: a broad-based, multiasset-class, globally diversified portfolio. Within that broad strategy, he seeks the various options to deliver the best returns while also smoothing out downside volatility and protecting capital in a bear market.

In the end, Hillegas says, investing is not deciding between being active or passive; it's a matter of deciding how much risk to take on in a given market condition and which asset classes make most sense.

"If valuations are on the cheaper side, then you dial up risk and have more index exposure, 100% asset-class exposure with all the beta and all the upside, whether it's emerging markets or the U.S.," he says. "But another part of my managers' screen is about preserving principal. I need to know how they do in bear markets."

Kate Stalter is a columnist for RealMoney at TheStreet. com and editor-at-large for StockChartReader.com.

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