Wealth Management Philosophy

Fundamentally, we are long-term investors looking for value in equity and debt markets throughout the world.  Over the years, we have built a flexible world-class wealth management platform designed to generate superior, risk-adjusted, after-tax returns in a cost-effective manner.  

Employing true open architecture, we apply objective analysis to source, evaluate, and select “best in class” investments, wherever they are to be found.  We manage over $100 million in assets for a discerning clientele consisting of high net worth individuals, family estates, non-profits, and small to medium size retirement plans around the United States.

PFA is strictly a fee-only wealth management firm.  We are completely independent of any product provider, custodian and/or financial company.  Our revenues are derived solely from fully-disclosed professional fees paid to us by our valued clients.  And speaking of fees, you will find that the total cost of our wealth management services are among the most competitive anywhere.  We are committed to ensuring our value far outweighs our cost.  By design, our offices are informal and functional – not opulent.  Each member of our team is an expert in their respective area.  Our clients benefit from our intentionally lean structure which allows us to deliver world-class wealth management services for a fraction of what other firms charge.

As a SEC registered investment advisor, PFA acts as a fiduciary for each client.  We do not sell any products and we do not accept any commissions.  We provide a written oath to each client pledging to always put their interests first in all of our dealings.  In other words, we manage your wealth as carefully as we manage our own.

Our Core Principles and Beliefs

Our Asset Allocation Discipline

Assessing Your Personal Risk Tolerance

Our Investment Selection Process

Implementation of Your Investment Plan

Our Core Principles and Beliefs

 Below are some of the core principles underlying our approach:

•          Markets work. Capital markets do a good job of fairly pricing all available information and investor expectations about publicly traded securities.  Markets are usually efficient.

•          Market timing doesn’t work.  An overwhelming body of evidence indicates that consistently making accurate near-term forecasts of a market’s direction is a loser’s game.  Just one or two ill-timed decisions can undermine all advantages of a well-designed investment strategy.  We coach clients to tolerate short-term volatility so that they reap the rewards of a well-designed long-term strategy.

•          Diversification is crucial.  Global asset allocation reduces the risks of individual securities.  We diversify investment portfolios by equity market capitalization (large and small), investment style (growth and value), geography (domestic and international), and optimal correlation among asset classes (equities, fixed-income, real-estate, commodities, etc.)  An effectively diversified global strategy captures the compensated risk dimensions of the markets in an extremely reliable fashion.

•          Risk and return are related.  The compensation for taking on increased levels of risk is the potential to earn greater returns.  There are no “free lunches”.

•          Portfolio structure explains performance.  Numerous academic studies show that the asset classes that comprise a portfolio and the risk levels of those asset classes are responsible for a vast majority of the variability of portfolio returns.

•          Costs Matter.  As much as Wall Street likes to obscure costs, wise investors know that costs matter.  PFA believes in transparency – especially as it relates to costs.  The fact is that the more you pay in commissions, mutual fund expenses, trading costs, bid/ask spreads, and fees, the less you accumulate over time.  That simple mathematical truth is irrefutable.  PFA keeps your costs low by designing, implementing and maintaining portfolios of institutional asset class funds, index funds, exchange-traded funds (ETFs) and other low-cost investment vehicles.  This strategy is ideal for knowledgeable investors who know the importance of low costs in realizing strong long-term results.

•          Taxes Matter.  Taxes are one of the most insidious portfolio costs.  Minimizing taxes is critical to building long-term real wealth.  With our team of CPAs, Attorneys, and Certified Financial Planners, we are expert in mitigating the tax consequences of wealth management.  We exercise great care in the appropriate placement of investments within taxable and tax-sheltered accounts and continually monitor portfolios for opportunities to minimize tax, including the determination of when and how assets are bought and sold.

•          Disciplined investment policy.  Because portfolio structure is the key determinant of results, the principal challenge for investors is to develop an asset allocation policy that aligns their risk preferences with their financial goals.  A successful policy is one that can be adhered to, without undue anxiety, through both good and bad markets.

•          Coordinated Wealth Management.  An investment strategy does not reside in a vacuum.  It exists as a component of the client’s overall financial life.  Accordingly, an effective investment strategy will be integrated with an overall financial plan that addresses not only investments, but also taxes, cash flow, risk management, estate planning, asset protection, and charitable planning.

Our Asset Allocation Discipline

Our asset allocation process is the result of significant academic research combined with many years of “in the trenches” portfolio management for hundreds of real clients.  Our asset allocation decisions assume a minimum three-year time frame. Three years is long enough to give us confidence that underlying investment fundamentals, rather than short-term market sentiment, will drive returns. However, we continually test the overall portfolio risk over one year periods of time.

There are three primary steps to our asset allocation discipline:

1. First we establish a neutral allocation for each portfolio type.
2. Next, we shift our asset allocation away from neutral only when there are “fat-pitch” opportunities.  This occurs when one asset class is extremely undervalued or overvalued relative to competing asset classes.
3. Finally, we use scenario analysis to test the portfolios’ exposure to downside risks.

The following discussion describes each step we take as we build investment portfolios. We call these our GPS (“greatest probability of success”) Portfolios.                

Neutral Allocations

What is a neutral allocation?  It reflects a logical allocation for a prudent long-term investor.  It is based on our evaluation of historical long-term risk/return relationships of various asset classes and reasonable expectations going forward.  It is the starting point for our asset allocation process.

What is the purpose of the neutral allocation?

1. The neutral allocation is the asset allocation that we implement when our conviction about any specific asset class is not high enough to justify deviating from neutral.  It gives us a sensible long-term allocation based on sound capital market research.
2. It gives us a frame-of-reference against which to measure decisions.  For example, if we like REITs, we must decide what they will replace in the portfolio and how far from neutral we will stray. This permanent frame-of-reference helps us consistently apply our methodology and avoid decision errors.
3. Finally, neutral allocations give us benchmarks against which to measure progress.

How did we choose the neutral allocations?  We identified risk tolerances - defined as maximum declines over 12 months.  By examining numerous iterations of asset class mixes over various long-term historical periods, we came up with neutral allocations that:

1. Have very high statistical probabilities of not violating the stated risk tolerance of each portfolio.  (Though the probabilities are in the high 90% range, they are not 100% — there is no guarantee that the risk tolerance will not be violated going forward.)
2. Are diversified enough to provide a smoothing of performance.
3. Have delivered, over the average 10-year period, a higher return than a simple S&P 500/bond mix - with less variability.
4. Make common sense going forward.

Neutral allocations for each portfolio type are summarized in the following table:

            *We seek to limit the downside risk of our Equity portfolios to no greater than the total global stock market.

How have the neutral allocations performed historically? The table below depicts the historical performance for our neutral allocations based on the returns of the representative indexes. We’ve included the S&P 500 return for a comparison to the Equity portfolio. Note that the more diversified Equity portfolio outperforms the S&P 500 over the average 10-year period. While there is no guarantee this will continue in the future, our research covers a long and varied timeframe.

The following table is based on rolling returns starting with each calendar quarter beginning in October 1968 and running through December 2007.  October 1968 is the earliest month we had reliable data for each of the asset classes that comprise the neutral allocations.

Please note that at times we invest in asset classes that are not included in our neutral allocations because the neutral allocations are merely starting points.  Each investor's portfolio is individually designed. 

Straying from Neutral Allocations

Our decisions to invest differently from neutral emphasize swinging only at “fat pitches”.

What is a fat pitch?  Financial markets are quite efficient – most assets are priced fairly (based on all publicly available information) most of the time. This means that most of the time it is difficult to “out-smart” the market.  Occasionally however, the market does offer investors exceptional opportunities.  Capturing a portion of the return from these opportunities over a market cycle can generate strong investment results.  Despite all the information at investors’ fingertips, irrational greed and fear occasionally drive the market for financial assets.  It isn’t the norm, but it happens.  For example, we saw both extremes in 1998 (greed) and then again in 2000/2001 (fear).  Some of the fat pitches we have pursued include: (a) buying opportunities in long-term bonds in late 1994; (b) underweighting technology in early 2000; and (c) buying opportunities in REITs and value stocks in mid 2000.

How much trading activity does this generate?  Our strategy typically generates very low turnover.  Too many investors believe that investment success requires lots of activity. This is wrong.  Our discipline allows us to “swing” only when the odds are heavily in our favor because an asset class is not pricing rationally—a fairly rare occurrence.  This may mean little activity in some years.  Importantly, by patiently waiting for the truly compelling opportunities, we minimize mistakes by not swinging at bad pitches.  We take action only when the markets are clearly acting irrationally.  When they are rational, we won’t try to make something out of nothing.  However, this requires discipline and focus to have the patience to wait for the real opportunities.  It also takes intestinal fortitude to act when the real opportunities arise.

How do we determine a fat pitch?  First, we believe it is critical to apply a consistent and disciplined investment methodology.  We define a fat pitch as an extreme undervaluation (or overvaluation) relative to alternative asset classes.  For example, when we compare equity assets (foreign stocks, small-caps, REITs) we do so relative to the S&P 500.  We might ask ourselves:  is this alternate asset class extremely undervalued versus the S&P 500?  Please note that experience tells us that the fat pitches we pursue will often be the result of a bear market or a severe correction.  The extreme under-valuations we seek are often caused by fear-based selling during volatile economic environments.

When there is a fat pitch, how much will we buy or sell?  The more aggressive the portfolio, the wider our discretion to stray from neutral.  We are biased toward capital preservation in our more conservative portfolios and maximizing return in our more aggressive portfolios.  See the table below.

 Isn’t this akin to market timing?  No.  We expect our discipline to lead us to overweight early (before a bottom) and get us back to our neutral allocations early (before a top).  However, we have no expectations for “stop-on-a-dime” market timing.  In fact, we are not aware of anyone who has successfully executed a market timing strategy over any reasonably long period of time.

Scenario Analysis

We use scenario analysis to assess the risk exposure of each portfolio. We consider different scenarios that could trigger a stock market decline. We then assess the downside exposure to the overall portfolios in each scenario.  This process may lead us to become more or less defensive.

Assessing Your Personal Risk Tolerance

Investors must consider many factors in determining how much risk they can tolerate.  First, from an emotional standpoint, can they endure a worst case decline?  At what percentage decline do they become so uncomfortable that they abandon their investment strategy?  This is a personal and somewhat subjective matter.  Second, investors need to determine if they can still reach their investment and retirement goals in a worst case scenario.  If necessary, will they be able to adjust retirement plans and budgets to maintain the sanctity of their investment policy?

A few more general rules for determining an overall equity/fixed allocation are noteworthy.  Study the above tables carefully and assume these are very optimistic numbers.  Avoid extreme allocations unless your circumstances allow it.  Handle lump sums conservatively.  Imagine how it would feel to watch your equity holdings decline "x"% and stay down for "y" years.  Try to ascertain your personal sense of your maximum decline tolerance.  No table or questionnaire can tell you what your risk tolerance should be; it is a highly individual matter.  The correct investment mix for you is the one that will provide you with the highest probability of achieving your financial goals and still allow you to sleep at night.

Our Investment Selection Process

After we have determined which asset classes offer value, we then turn to investment and/or fund selection. Choosing the right managers is important. Even within a single asset class, performance can vary widely.  Our first level of fund analysis focuses on the manager’s record and expenses. We are looking for long records of consistent performance, low expenses, and strong tax-efficiency.  However, as we all know, past performance is no guarantee of future returns.

That’s why we spend a great deal of time trying to understand managers’ investment philosophies, getting to know the dynamics of the portfolio management team, and determining how successful managers have added value.  We also assess managers’ personal characteristics against those that our many years of experience have shown contribute to investment success.  Manager selection (like asset allocation) is a combination of art and science.  Performance is a screening mechanism, but there’s more to choosing investment managers than hot records.

Often, we use institutional mutual funds not available to the general public.  Because of this, our fund expenses are typically two-thirds less than those of the average portfolio of retail funds.  Of course, we pass these savings directly onto our clients.  We also select managers who are specialists in their asset class or style.  We regularly perform extensive screenings of all managers according to the same fiduciary standards used by the world’s largest pension and endowment funds.  Of course, when necessary or beneficial, we do not hesitate to change investments in a portfolio in order to keep your plan on track.

Written investment policy statement.  At PFA, we work with each client to develop a written Investment Policy Statement (IPS) that describes why they are investing and defines how their funds will be invested to achieve their articulated goals.  Our team leads you through a personalized process to determine your goals and your individual risk profile. The culmination of this process is a written, personalized Investment Policy Statement that provides guidance for your investment planning.  Academic research, as well as our experience, has shown that investors who take the time to develop an IPS are far more likely to stick with prudent investment discipline in times of euphoric market returns (when greed causes people to ignore risk) as well as during times of apparent bleak economic circumstances (when fear drives people into damaging short-term decision making).

Implementation of Your Investment Strategy

When you are ready to become a PFA client, we handle all the details to help you open the necessary brokerage accounts.  We normally use TD Ameritrade as custodian of the assets we manage.  Your accounts are titled in your name, not ours.  You retain all ownership and control of the accounts.  You simply grant us permission to manage your accounts on your behalf.

Discretionary Money Management

Who has control of your money?  You do.  We are only your investment advisors.  After all, it's your money, not ours.  You will get a statement from your custodian every month.  You will also receive a trade confirmation anytime a trade is placed in your account.  In addition to the very low cost structure of our institutional investment platform, PFA pays all trading costs and ticket charges for our clients.  This provides yet another benefit of being a PFA client.  Not being “nickel and dimed” for commissions and ticket charges results in another direct cost savings for our clients.

We Can't Touch Your Money

All funds are held in a custodial account with a major financial institution in your name or as you direct.  We never actually touch your money – we merely manage it on your behalf.  You do not send us money, stock certificates or other securities. You move your funds from their present location to your new brokerage account. Of course, we can and will help with all of the administrative details to make it hassle-free for you.  In many cases transfers are done electronically.

You Give Us Certain Revocable Permissions

When you become a client, you will grant us the following permissions regarding your accounts:

• We will receive a copy of your statements.
• We will submit our advisory billings to the brokerage firm, who will pay it from your account.  We deduct one simple all-inclusive advisory fee each quarter from all managed accounts.
• We will have discretion to trade your account. This means we can buy and sell securities in your account.  However, we only buy and sell according to our agreed upon written Investment Policy Statement.  We do not receive any compensation whatsoever from trading activities.  Accordingly, you can rest assured that we trade only when it is in your best interest.
• We will buy and sell to accomplish the following:
• To implement your initial portfolio design.
• To manage your portfolio. For example, you may have a certain percentage in a specific position. Due to changes in the markets, you may wind up having a higher amount in a certain position than the design calls for.  When that happens, we may sell a portion of that position and buy an under-weighted position in order to maintain the integrity of your portfolio design.
• To replace one of the investments when our research tells us the current investment no longer serves you optimally.  Of course, you are encouraged to call anytime you have a question.
• Because of a change in your financial situation which requires an overall portfolio design modification.

CONCLUSION

We hope this paper has helped you understand our investment management process.  Our discipline means taking action only when the odds of success are very high.  Fundamentally, we are long-term investors looking for value in the equity and debt markets throughout the world.  We execute our strategy using best in class investment vehicles.  We determine “best” using a whole host of quantitative and qualitative criteria.  Risk control is also critical.  We manage risk through diversification and ongoing scenario analysis that tests for downside risk.  Portfolio management is a dynamic process, calling for constant attention and adjustment at the margin to enhance returns as well as to control risk.  Please remember that all investing involves risk and that past performance cannot guarantee future performance. 

Respectfully,

 The Puckett Financial Advisors Research Team

©2010 Puckett Financial Advisors, LLC. All rights reserved.