Tech sector rules Q3 • pg. 7

Brokerage options for 401(k)s • pg. 3

November 20, 2014 | Volume 4 | Issue 9

First magazine focused on active investment management

Robert Kinnun pg. 8

Asset growth & protection

Highly correlated markets increase risk • pg. 4

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Active money managers will effec-tively watch over their portfolios every day and take up defensive positions if the market turns. For a pilot who might be away from home base for many days, or on a series of long flights, that is a pretty attractive proposition.

I stress that this can be an easy process, as they can use the brokerage option available in many 401(k)s that allows professionals to manage their money. And for the die-hard investors and traders, I also always point out there is no reason they cannot also fund a small account to run their own trad-ing programs—one concession goes a long way.”

big part of my prac-tice is helping to bring

third-party active investment manage-ment to 401(k) plans. My profession-al network includes people associated with the airline industry and the mili-tary, and I have found a very receptive audience there.

Pilots are intelligent people who have mastered a challenging and highly technical skill, and they naturally think they can bring the same talents to in-vesting. Many are knowledgeable, but frankly, their investment success rate is usually not any better than average.

Like many others, they generally took a big hit to their portfolios during the crash of 2008-09. They know they could benefit from some professional assistance and a new way of looking at investments. They know they would only want someone who is ‘instrument-rated’ to fly their planes, and the same thing applies to investments.

I spread the word among the pilot community about how they can employ actively managed strategies in their 401(k) plans. When I talk with them, they see that there’s a process through active money management that can provide them with a more dis-ciplined approach—which is especial-ly important as they plan for a secure retirement.

Brokerage options: an “instrument-rated” approach to 401(k) plans

Mike JonesVirginia Beach, VA

ProEquities, Inc.Patriot Strategic Investments

A“

Mike Jones is an Investment Advisory Representative with Patriot Strategic Investments in Virginia Beach, Virginia. Advisory services offered through Investment Advisors, a division of ProEquities, Inc., a Registered Investment Advisor. Securities offered through ProEquities, Inc., a Registered Broker-Dealer, Member, FINRA & SIPC. Patriot Strategic Investments is independent of ProEquities, Inc.

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Proactive Advisor MagazineCopyright 2014 © Dynamic Performance Publishing, Inc. All rights reserved. Reproduction of printed form, whole or in part, without permission is prohibited.

EditorDavid Wismer

Associate EditorElizabeth Whitley

Contributing WritersLinda Ferentchak

David Wismer

Graphic DesignerTravis Bramble

Contributing PhotographerBrad Ziegler

November 20, 2014Volume 4 | Issue 9

Proactive Advisor Magazine is dedicated to promoting and educating on active investment management. Distribution reaches a wide audience of financial professionals who advise clients on investments and portfolio management. Each issue features an experienced investment advisor who offers insights on active money management, client service, and investment approaches. Additionally, Proactive Advisor Magazine offers an up-close look at a topic with current relevance to the field of active management.

The opinions and forecasts expressed herein are those of the author and may not actually come to pass. Any opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. The analysis and information in this edition and on our website is for informational purposes only. No part of the material presented in this edition or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any portfolio constitutes a solicitation to purchase or sell securities or any investment program.

November 20, 2014 | proactiveadvisormagazine.com 3

TIPS & TOOLS

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GROWTH ACTIVE MANAGEMENT

of passive index investingincreases the need for

By Linda Ferentchak

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John Bogle has said it for years. Warren Buffett joined the chorus in his 2013 Berkshire Hathaway shareholder letter regarding his estate, “My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.” For the average investor, the popular financial advice is that the best investment is a passive index fund allocation.

The prevalence of that advice is changing the nature of the financial markets. It doesn’t matter how much the phrase “Past performance is not indicative of future returns” appears, financial advice tends to be a backward-looking profession. Unable to see the future, one looks to the past for trends and future expectations.

What the past does not tell us is how to deal with a structurally changed financial market in which an estimated 20% of the U.S. market is on autopilot—invested in index funds—while a majority of actively managed mutual funds are benchmarked to indexes, with some 33% in-dexed to the S&P 500, according to Investment Company Institute data.

The use of third-party asset managers by financial advisors has grown dramatically over the past decade, particularly those managers using active, risk-managed strategies. A recent industry study, in fact, estimated an AUM growth rate of over 25% for TAMPs in 2012 and 2013. Paradoxically, passive index funds have increased their share of total investment assets at the same time, furthering the risks associated with more highly correlated markets.

Source: 2014 Investment Company Fact Book

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

9.510.2

10.9 11.4 11.7 11.5 11.6 11.813.4

14.114.9

16.417.3

18.4

As of year-end 2013, 372 index funds managed total net assets of $1.7 trillion … Mutual funds indexed to the S&P 500 managed 33% of all assets invested in index mutual funds. The share of assets invested in index equity mutual funds relative to all equity mutual funds’ assets moved up to 18.4% in 2013.

Index equity mutual funds’ sharePercentage of equity mutual funds’ total net assets, 2000 -13

proactiveadvisormagazine.com | November 20, 20144

Exchange Traded Funds (ETFs), which are primarily index-based, took over the lead in index investing in 2014. At the end of 2013, ETFs accounted for $1.67 trillion in assets with 26% in large-cap funds. By September 2014, ETF assets had surpassed $1.9 trillion.*

In 2013, the market capitalization of the U.S. stock market exceeded $17.7 trillion, roughly half of the world’s $36.5 trillion total equity valuation. U.S. index mutual and exchange traded funds held $3.4 trillion. Assuming 15% of all index fund assets are in-vested in bond and hybrid funds, it leaves $2.9 trillion in equities, with 20% of the total U.S. market equity effectively on “autopilot.”

Why does this matter? In their study of the impact of indexing on the U.S. equity markets, Dr. James X. Xiong, CFA, senior research consultant with Morningstar Investment Management, and Rodney N. Sullivan, CFA, editor of the Financial Analysts Journal, conclude, “Our results suggest the fragility of

the U.S. equity market has risen over recent decades.”** From their findings:

Stocks are no longer selected for a portfolio based on expectations of outperformance, or at least

respectable returns. Their inclusion in an index drives demand and has been shown to add a premium to their valuation.

Changes to an index fund are often made at excessive values. New additions to the S&P 500

have documented price increases of up to 40% prior to inclusion. Once included in the index, funds have no choice but to purchase the stock regardless of price.

Correlation between stocks held in the indexes increases, reducing the value of diversification. As new

money flows into index funds, demand for

all stocks in the index increases, driving price increases.

In capitalization-weighted indexes, higher capitalization stocks may mask the underperformance of

other positions.

Index derivatives were major contributors to the stock market decline of October 19, 1987, and

the “flash crash” of May 6, 2010, setting up feedback loops that accelerated selling pres-sures, while the concentration of technology stocks among the indexes played a major role in the market’s 2000-2002 decline.

For the active manager, “feedback loop selling” is a major concern. In 1987, index in-vesting was just beginning to make an impact. Since 2010, indexed assets have increased by more than 30%. In the 1987 and 2010

444

88 87

143

203

42

211

146

64

247

Large-cap Mid-cap Small-cap Other Domesticsectorequity

Global International CommoditiesEmergingmarkets

Bond andhybrid

Broad-based domestic equity Global/International equity

ETF total net assetsBillions of dollars, year-end 2013

1.

2.

3.

4.5.

1.

2.

3.

4.5.

1.

2.

3.

4.5.

1.

2.

3.

4.5.

1.

2.

3.

4.5.

Source: 2014 Investment Company Fact Book

* “Rising Stocks, $15B Inflow Push US ETF Assets To Record, But Growth Lags 2013,” Barron’s, September 2, 2014.

** “How Passive Investing Increases Market Vulnerability”, James X. Xiong, CFA, senior research consultant, Morningstar Investment Management

and Rodney N. Sullivan, CFA, editor of the Financial Analysts Journal. August 20, 2011.

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November 20, 2014 | proactiveadvisormagazine.com 5

75%

70%

65%

60%

55%

50%

45%

40%

35%

30%

50%

60%

51%

45%

52%50%

53%50%

57%54%

60%

49%

61% 63% 62%

57%

64%

50%

66%63%

71%

67%

Teleco

m

Utilities

Energy

Materia

ls

Cons. Stap

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Cons. Disc

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Finan

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Industrial

s

Health Care

Tech

nology

EarningsRevenues

Technology sector tops Q3 earnings season

arnings season for Q3 2014 is winding down and the results

were generally better than expectations. The earnings beat rate (percentage of

companies that reported EPS stronger than consensus estimate) of 62.1% was the highest quarterly result of the year so far and roughly equivalent to levels seen throughout most of 2013.

The revenue beat rate of 57.2%, according to Bespoke Investment Group, was below the average for the current bull market (59.4%) and the average for all years since 1998 (61%). Still, it was higher than many quarterly figures seen over the past two years.

There is little doubt that the technology sector led all groups in powering the positive earnings season results. As can be seen in the chart, technology companies on average performed better than all other industry groups on both earnings and revenue beat rates at 71% and 67%, respectively. Energy companies were near the bottom—not surprising given the recent global retrenchment in oil prices.

The technology sector has also helped to fuel the powerful and fast rebound from the market lows seen in mid-October.

E

Source: Bespoke Investment Group

Technology stocks rank a close third among all of the sectors in performance from October 15 through November 14, up 10.8%. In fact, the two individual stocks with the greatest contribution to S&P 500 Q4 gains have been Apple (AAPL) and Microsoft (MSFT). Apple alone has accounted for more than 10% of the S&P 500’s rally this quarter and, with a 19.6% weighting in the S&P, the technology sector has been a big driver of gains. On the

flip side, there have been some notable tech decliners, led by IBM’s poor performance.

Overall for Q3, FactSet is reporting the blended earnings growth for the entire S&P 500 at 7.9%. The slowing of global growth outside of the U.S. appears to have had a notable impact. The earnings growth rate is 9.0% for U.S.-centric companies, versus 6.5% for companies with greater than 50% of sales outside the U.S.

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Smart money is already hedging against inflationJust because inflation is still a mere blip on the economic radar screen is no reason to ignore the potential threat to investment portfolios.

What advisors are talking about—volatility near the topMarket volatility was the third most popular conversation advisors initiated with their clients last month.

Riding out the storm: active risk management in actionNAAIM (National Association of Active Investment Managers) publishes its proprietary exposure each week, showing how active managers are reacting to the current market environment.

% OF COMPANIES BEATING EARNINGS & REVENUE ESTIMATES BY SECTOR

7November 20, 2014 | proactiveadvisormagazine.com

TOPPING THE CHARTS

L NKS WEEK

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By David WismerPhotography by Brad Ziegler

Asset growth & protection

Whether a high-net-worth client is focused on charitable giving or leaving a family legacy, moving assets into active strategies makes sense.

Robert Kinnun

What HNW clients want

8 proactiveadvisormagazine.com | November 20, 2014

Proactive Advisor Magazine: Rob, how do you differentiate your practice?

Robert Kinnun: I am based in Midland, Michigan, a relatively affluent area of Michigan. It is a great city, with a healthy business com-munity and a commitment to the arts, civic responsibility, and charitable outreach. I have focused my advisory work on higher-net-worth clients with some complex planning and estate needs. Most of my referrals come through at-torneys and CPAs, as they know I can handle the most challenging and complicated planning issues.

What are some specific issues facing this type of client?

The obvious ones are managing wealth across generations, handling planning for chari-table donations and foundations, and providing for smart business transitions. But the needs of high-net-worth clients are really no different than those of any other client: protect and grow assets.

time that many elements of MPT just do not go far enough or account for changes in the en-vironment—there are so many factors and new investment choices to consider today. MPT is fine in theory, but in practicality is not always able to handle all the variables, risk issues, and the potential emotional behaviors of clients.

How did your thinking evolve?

It has been a process over the years, always looking to optimize portfolio diversification and performance while having a strong measure of risk management. I now utilize third-party active money managers who can go several steps beyond the first few generations of portfolio optimization. They have the ability to be very responsive to market conditions—to go to 100% cash for example, or to add or remove asset classes, or to use leverage, or to employ various hedging techniques.

Some would argue that going to cash is a very conservative action. I would argue just the opposite—it is a very aggressive and active move that is predicated on a technically based model indicating that the investment environment has changed significantly. That to me is active

management, not passive. It goes way beyond just adjusting some allocation percentages or rebalancing the portfolio. This requires clearly communicating to clients what they might expect under different market conditions—what actions their portfolios might take based on bearish or bullish conditions.

How do you educate clients around actively managed investment strategies?

It is an interesting paradigm. I am using some of the most sophisticated quantitative strategies out there for clients, but I still start the process with an old-fashioned yellow pad and pencil. I want to truly understand who the client is first, what is most important to them in life, and their family circumstances. There is plenty of time to drill down into the specifics of their financial lives, but the entire process becomes much easier and more valuable by first making that personal connection.

Each family has different situations; there is no cookie-cutter approach. That said, active investment management, with its focus on managing risk first, can work for virtually all of my clients. I have one widowed female

continue on pg. 10

Robert KinnunMidland, Michigan

Broker-dealer: Madison Avenue Securities, Inc.

Experience: 25 years in advisory services

Estimated AUM: $180M

Licenses: 6, 63, 65, 27 Supervisory

Member: Financial Services Institute

Charitable involvement: HopeWell Ranch, Weidman, MI Global Compassion, Inc., Midland, MI Music & More, Midland, MI

Avid coin collector

“Third-party managers give me the ability to accommodate my clientsno matter their life circumstances or outlook on risk.”

We need to make sure that programs are in place to manage the unfortunate events of life such as disability, death, and divorce, being mindful of tax implications. And we need to make sure clients are well informed about their financial state of health and fully understand the objectives and strategies that we have agreed upon. I have always believed in client education and full disclosure of everything I do on behalf of clients.

As it relates to protecting and growing assets, what is your broad investment philosophy?

Pretty early on, even before the popularity of Modern Portfolio Theory (MPT), I was in the camp of strong diversification for an investment portfolio. But I have learned over

November 20, 2014 | proactiveadvisormagazine.com 9

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client, for example, who is holding a substantial amount of physical gold. She is very wary of the stock market. I am not necessarily going to rec-ommend that she sell her gold, but for her other assets, active management can provide a way for her to enhance her returns while providing some reassurance that defensive strategies will be in place for the next big market downturn. Though it has been a long process educating her on risk concepts, she is slowly introducing some conservative active strategies into her portfolio.

I have another client family on the opposite side of the spectrum. They have very ambitious charitable giving objectives over the long term. They are perfectly suited to be under the active money management umbrella, but with a more aggressive, growth-oriented risk profile than the first example.

That is one of the real benefits of the third-party managers I use—having the ability

to accommodate my clients no matter their life circumstances or outlook on risk. These strate-gies are a component of a broader financial plan that has to cover a variety of objectives, but it can be a very important component. I have a growing percentage of client assets moving into active strategies.

The key to everything I do for clients is the education process. Clients have to understand exactly what we are doing in terms that are understandable from a non-professional’s point of view. They need to understand what the risks are, what the benefits are, and where the trade-offs lie. I always explain the parameters of worst-case scenarios and how they might be managed.

With virtually all of my high-net-worth clients wanting and needing both asset growth and asset protection, active investment manage-ment is a very logical part of the solution.

continued from pg. 9

Robert Kinnun is a registered representative of and offers securities through Madison Avenue Securities, Inc. (“MAS”), member FINRA & SIPC, a registered investment advisor.

10 proactiveadvisormagazine.com | November 20, 2014

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scenarios, an outside shock to the market sent stock prices down, triggering futures selling by portfolio insurers, which were purchased by stock index arbitrageurs, who then sold the rel-atively overvalued stocks, pushing prices down further. Add in panic selling of index funds by investors of all sizes and the potential decline worsens.

There is an important difference between owning a stock or mutual fund purchased for sound fundamentals and owning an index fund. Where an investor might have confi-dence in the ability of the individual company or investment manager to weather a downturn and continue to prosper, the index fund is more of an unknown. The investor does not have

extensive knowledge of all of the stocks that make up an index, limiting that confidence in its prospects for recovery.

Despite the often-repeated message to in-vestors to buy and hold, there is little evidence from past market declines that they will do so. The damage to portfolios from market de-clines over the last 14 years has further eroded

investor confidence, which has left the markets vulnerable to rapid and deep episodes of selling. While there may be valid reasons to own index funds as part of a diversified, actively managed portfolio, there can be no doubt their growth has changed some basic structural facets of the overall financial markets.

The risk management provided by active management may be the saving grace for many advisors and their clients when the next major market decline comes. And come it will. Because there is another new factor to consider that makes active management even more critical: a substantial portion of the equity market is now on autopilot.

4.5.

A substantial portion of the equity market is now on autopilot.

11November 20, 2014 | proactiveadvisormagazine.com