Discretionary Portfolio Management with 44° North

Introduction

While our advisors are free to work with you on different strategies that you are comfortable with, we have developed a process that many of our current clients use and you may want to consider. Our portfolio management process addresses many investors’ concerns, particularly in the area of helping to manage downside risk. The last twelve years has been a struggle for financial markets. From December 31, 1999 through December 31, 2009, the S&P 500 had a total aggregate return of -24%1! This has left investors with great concerns about their financial service firm’s ability to preserve client assets in volatile markets.

The “efficient frontier” model of portfolio management has widely been adopted by many firms over the last 30 years as a way to try to prudently invest clients’ assets. This model tries to diversify assets into different classes that have historically had low correlation2. Unfortunately, we believe that model of investing does not have a process for selling assets to limit losses as the markets decline. This deficiency was not obvious, nor seemingly necessary, until this past decade of downturn. In addition, due to globalization and increased efficiency of news dissemination, the markets3 have become highly correlated (markets moving together). As an example, in the mid 1990’s the movement among U.S. stocks compared to the movement of foreign stocks was approximately 40% correlated4. Now, 15 years later, they are currently over 85% correlated5 (meaning they move together 85% of the time). Additionally, in times of stress and illiquidity in the markets like we experienced in 2008, other asset classes which have traditionally moved opposite to stocks, fell in value along with stocks. We believe efficient frontier models are ill equipped to deal with these types of crises, again because there is no point where a “sell” recommendation is implemented. Our portfolio management process aims to help investors’ manage these concerns, particularly in the area of managing downside risk.

Of particular note, you should be aware that our program is fee-based. This means you pay an agreed upon annual fee based on your assets under management with us. There are no commissions for transactions within this portfolio management account, so our interests are aligned with yours in that we want to grow your portfolio. We manage portfolios on a discretionary basis. This means we do not have to call you prior to making adjustments to your account, whether to simply rebalance, eliminate an asset class, take profits in a holding, sell because we have hit a stop-loss, or make an emergency adjustment to raise cash in a time of market panic. We feel this is in your best interests because no matter the size of your account, or your availability to respond to our call when we feel there is a need to change, your portfolio will be adjusted when we feel it is appropriate.

Portfolio Construction

As is typical at the beginning of any relationship, we gauge overall income needs and financial goals to establish the parameters for your portfolio’s level of risk. This helps us set aside a certain piece of your

assets which will be placed in historically lower volatility, income-oriented investments. This more conservative piece is still actively managed to find the best yields possible within certain constraints and varying economic conditions, but we want to be relatively certain that these assets would be considered by most investors to be low risk. Beyond this segment, the remaining assets are placed into our more actively managed segment for growth. We may include the following asset classes in your portfolio:

  • U.S. and Foreign stocks, including Emerging Markets
  • Commodity oriented equity investments (gold, oil, grains, base metals, etc.)
  • Real Estate Investment Trusts (REITS), both U.S. and Foreign
  • Both U.S. and Foreign government and corporate bonds
  • Currency oriented equity investments
  • Cash, short term instruments (money market funds)

How we choose portfolio components…

We are not “married to the market”. We have found that many strategies employed today are based on the “efficient frontier” models, which maintain positions in stocks or other volatile assets no matter what direction they are going, or how bad the economy. Our process does not do that. We employ technical analysis in the management of our portfolios, in addition to the fundamental research that many advisors use. We believe this allows us to approach which assets to include in a non-emotional way. Our process for choosing asset classes is based on relative strength (comparing the change in price of the aggregate asset class over the last year to a market index, such as the S&P 500). Measuring relative strength allows us to compare the previously listed assets against each other to determine which has the best price momentum. We then compare each to cash – because even if we include the best performing assets relative to one another, if all of them are losing value, so will your portfolio. We seek to confirm that the major classes we choose to include are trending in a positive direction. We typically include the strongest three major asset classes for diversification, and then dig into each, to its sub-asset class components, in search of the best ranking relative strength investments.

Risk Management

We set downside protection levels on the various investments and asset classes in your portfolio in an effort to protect your positions, moving the stop price up as the price increases. Using gold as a hypothetical example, if we initiated a position in gold at $850/oz. because it had better relative strength than many of our other asset class choices, our stop loss might be $780/oz. As gold moves up in price, it likely will not do so in a straight line. Typically, any asset will appreciate to a point, and then naturally give back some of the appreciation, while still maintaining a general uptrend. The points at which it bottoms during a pull-back, and then heads higher become natural support points. Our downward protection levels move up to the support points as the asset progresses, so that we can help to lock in gains if the asset reverses the uptrend. At the same time, we are evaluating gold’s relative strength to the other asset classes we’ve included in your portfolio. Even if the price is trending higher, if it is under performing other options, we will eliminate it to move to the best performing assets, according to relative strength. We use this downward protection level process for each asset class we include in a portfolio, be it stocks, bonds, commodities, REITs, or currencies.

What about Taxes?

In our opinion, our process lends itself well to qualified accounts (IRA’s, etc.) because there are no tax consequences in making portfolio changes. We are sensitive to capital gains in taxable accounts. We tend to increase the size of our core positions, and use smaller strategic allocations which generate higher turnover. We look to rebalance strategically as certain positions reach the long-term gain holding periods. Our stop-loss process remains the same however. When using bonds for the less aggressive component of a portfolio, generally we use municipal bonds for taxable accounts when they make sense. We seek to manage risk in bonds by looking at the duration and average maturity of the portfolios. Additionally, when facing the potential of a rising interest rate environment, and when bonds tend to be subject to loss of value, we may consider managers who have the ability to hedge their interest rate risk.

Summary

44° North uses a proactive and dynamic process in managing your assets. We look to find growth opportunities with greater relative strength than the overall S&P 500 market while the trends are positive. When the trends turn negative, our process for setting stop-losses is well defined, and the breadth of investment asset classes that we can access (as listed previously) gives us ample opportunity to position portfolios for potential growth opportunities even when the overall stock market is not trending in a positive direction.

1 Source: S&P 500 Index 10-year annualized return January 1, 1926 through December 31, 2009
2 Correlation- the degree to which different investments move in the same direction at the same time.
3 S&P 500 index, MSCI index, EAFE- foreign developed countries index, and the MSCI emerging markets index.
4 Source: FactSet; June 30, 2007.
5 Source: JP Morgan “Guide to the Markets” 1 Q, 2010

Fee based services offered through Commonwealth’s Preferred Portfolio Service (PPS) Program.  Commonwealth does not offer tax or legal advice.

Diversification does not ensure against loss.
There is no guarantee that these strategies will succeed. This information is intended to illustrate products and services available. The strategies do not necessarily represent the experience of other clients, nor do they indicate future performance. Investment results may vary. The investmentstrategies presented are not appropriate for every investor. Individual clients should review with their Financial Advisors the terms and conditions and risks involved with specific products or services. Past performance is no guarantee of future results.
Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

There may be additional risk associated with international investing, including foreign, economic, political, monetary and/or legal factors, changing currency exchange rates, foreign taxes, and differences in financial and accounting standards. These risks may be magnified in emerging markets. International investing may not be for everyone.

REITs are subject to special risk considerations similar to those associated with the direct ownership of real estate. Real estate valuations may be subject to factors such as changing general and local economic, financial, competitive, and environmental conditions. REITs may not be suitable for every investor. Dividend income from REITs will generally not be treated as qualified dividend income and therefore will not be eligible for reduced rates of taxation.

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.

Foreign Currencies (Foreign Exchange -“FX”) are volatile and involve inherent risks including foreign economic, political, monetary and/or legal factors, changing currency exchange rates, foreign taxes, and differences in financial and accounting and regulatory standards. These risks may be magnified in emerging markets. International investing may not be for everyone.

Past performance is no guarantee of future results.

The information contained in this communication is based on generally available information and, although obtained from sources believed to be reliable, its accuracy and completeness is not guaranteed. The authors of this brochure are not research analysts and the information in this communication is not intended to constitute “research” as the term is defined by applicable regulations.