Absolute Return Investing

PivotPoint Advisors, LLC In a perfect world, your investment account would never go down and would grow every day at a solid steady pace. The only problem . . . we dont live in a perfect world. Instead we must either put many hours into figuring out the best investment approach that suits our investment objectives and risk profile and then spend countless hours trying to figure out how to make it work OR go to an investment advisor that we trust or a friend trusts and let them walk us through the process they feel will work best. This paper compares and contrasts different investment approaches. Our objective is to help you understand why we at PivotPoint Advisors have decided to manage money in the manner we do. We will begin by comparing Hedge funds with Mutual funds. The definition of a Hedge fund, according to Wikipedia: A private investment fund that participates in a range of assets and a variety of investment strategies intended to protect the fund's investors from downturns in the market while maximizing returns on market upswings. The definition of a Mutual fund: A mutual fund is a professionally managed type of collective investment that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities. Both Hedge funds and Mutual funds pool money to buy investments. Both have multiple investment strategies to choose from. As you can see in the definition of Hedge funds above, the investment strategies within a Hedge fund are designed to protect assets in market downturns without limiting returns during the market upturns. This approach is often called Absolute Return. Mutual funds dont subscribe to this approach. Many Mutual funds investment strategies are to select the best investments within their investment class. For instance a Large Cap Growth Mutual fund attempts to purchase the best Large Cap Growth stocks available in the market. If the Large Cap Growth classification lost 50% in the last period of time, the fund manager must still hold Large Cap Growth stocks. The only tool this Mutual fund manager has to protect the fund's investors from downturns is to select the Large Cap Growth stocks he feels will go down the least. This approach would commonly be called a Relative Return investment approach. The funds objective is to outperform relative to their asset class. Only the wealthy can invest in Hedge funds. Hedge funds are "Private Investment funds". This means they are not registered with the SEC and don't have to conform to the investment guidelines or practices imposed by the SEC. Since this is the case, only "Accredited Investors" can purchase them. Most accredited investors are wealthy individuals and organizations such as corporations, endowments and retirement plans. In order for an individual to be considered accredited, he must have a net worth (not including his home) of at least $1 Million dollars or have income greater than $200,000 per year consistently ($300,000 if married). This keeps the majority of the general public from using the investment strategies employed by the Hedge funds. The wall between Hedge funds and regular investors may get larger. The SEC is considering an additional requirement that the investor has $2.5 million in other investments. Manager compensation is dramatically different between the two approaches. The most common form of management fee in a Hedge fund is known as 2/20. This means the management company receives 2% of the assets they are managing plus 20% of the profits. Many Hedge fund managers have received over $10 million in annual compensation. The average A share mutual fund charges an up front load (waived for larger accounts) of typically 4 - 5% and annual charges of 1.4%. Jeffrey Vinik managed the multi-billion dollar Magellan fund for 4 years. After relatively mediocre returns there, he started managing a Hedge fund. He returned nearly 100% his first year and 50% per year each of the next 4 years. He then returned all the investor capital and had so much of his own capital he began a Hedge fund that only manages his own capital. He now owns multiple professional sports

franchises as well. Mutual funds are the most common form of investment for a majority of America. Over 75% of the folks who own Mutual funds within their retirement plan, own Mutual funds outside of their retirement plan. According to a 2007 study by the Investment Company Institute, 80% of these households bought their Mutual funds through either full service brokers or independent financial planners. Many of the brokers sell funds utilizing an asset allocation and diversification strategy. The theory is that since we don't know what is going to happen in the market next, lets have some of everything. In 1986, Brinson Hood and Beebower wrote an often misquoted report. This study is quoted as saying 94% of all returns are due to asset allocation and the other 6% is due to stock selection and timing the market. This isnt what the study actually says. This study compared portfolios managed by asset class vs portfolios managed by individual stock selection. Both approaches utilized allocation and diversification methods, they were simply looking for the best one. Wikipedia describes the results: The lesson of the study was that replacing active choices with simple asset classes worked just as well as, if not even better than, professional pension managers. Roger Ibbotson and Paul Kaplan did a study in 2000 to either confirm or deny the Brinson study. Their conclusion was put very succinctly: Most of a funds ups and downs are explained by the ups and downs of the overall market. Effectively the Brinson study simply concludes that 94% of an asset allocation portfolio moves with the market index it is designed to emulate. No comparison was made to Active Management (timing) as compared to asset allocation or Passive management. Brokers go on to say this study proves that all returns are due to time in the market rather than timing the market. The irony: The large investment firms of Wall Street sell their investment services through multiple channels. Accredited investors (the wealthy) have access to the firm's Hedge funds. The rest of America have access to the firm's Mutual funds through the firm's brokers. The brokers quote the above study and tell their client that asset allocation is the only way to invest wisely. At the same time, the firms wealthy clients are accessing the Hedge funds offered by the same firm. These Hedge funds are utilizing the very investment approaches the brokers say won't work. I will illustrate this with a real world example - JP Morgan Chase: This firm is the largest provider of Hedge Funds and fourth largest provider of Mutual funds in the Country. If you go to their website to read about their Hedge fund offering, you can see a broad description of their investment approach: "Capital preservation and risk management form the foundation of our investment process." "Portfolio construction and allocation decisions are guided by a process incorporating sophisticated quantitative models and qualitative judgment." Wikipedia describes quantitative models as "A type of information based on quantities or else quantifiable date (objective properties). Statistics are also known as quantitative analysis." Now if we define Qualitative Judgment: "<assessment, evaluation> Judgment or assessment based on personal views, experience or opinion rather than objectivity. Subjective analysis." This doesn't describe asset allocation or diversification. I will use an analogy to describe what it says to me. Qualitative judgment is like a pilot flying a jumbo jet. Most of the trip, the plane is flown by a quantitative system called Auto Pilot. The pilot is there to monitor and make adjustments to the quantitative system. Personally, I feel much more comfortable getting on a plane that has a pilot. If we go to the Mutual fund area of the same company, they describe their investment process an entirely different way. I've attached the 5 step process they recommend. Step 2 is to allocate and Step 3 calls for Diversification. If we want to see the fruit of their allocation and diversification method, we can simply look at their own investment managers equity curve. A good fund to look at might be the JP Morgan SmartRetirement fund 2025 (symbol JNSCX). This is a "fund of funds" which means an investment professional is choosing the proper funds for someone who is looking to retire in about 24 years from now. If you look at this approach vs. the S&P 500 you can see it doesn't reduce risk as compared to the market. From the high of the market in 2007 to the low in March 2009, both this fund of funds and the index lost approximately 50%. Neither have gotten back to their high yet, nearly 4 years later. Even the JPMorgan SmartRetirement 2010 fund lost nearly 40% in the last recession. See the chart below depicting these two funds vs. the S&P500. Step 5 of their process blows me away, I must quote the

whole thing Many people make the mistake of switching investments or completely abandoning their portfolio during normal market swings. In most cases, a better approach is to simply buy and hold the same sound investments over time. If your personal circumstances or the financial markets don't change dramatically, then neither should your fund mix. Consider meeting with a financial advisor at least once a year to review your portfolio. Together, you can decide if your current investments are still appropriate or if any adjustments are needed.

PivotPoint Advisors Approach We glean the best from both worlds. We utilize the absolute return approach from the Hedge funds. We dont like to have our accounts lose money, even if the market is losing. We dont like the steep fees the Hedge funds charge though. We also dont like to be exclusive to only the wealthy. Our fees start at 1.5% for individual accounts and only .75% for Defined Contribution plans. We havent set any account minimums yet. We use brokerage accounts (currently Fidelity and TD Ameritrade) that allow us to trade ETFs without any trading commissions. The ETFs themselves are very inexpensive while we own them. Our main S&P 500 ETF is less than of 1%. What is an ETF? An ETF (Exchange Traded Fund) is a market index that trades like a stock. Most people are used to Index Mutual Funds, such as the Vanguard S&P 500 Index Fund. Mutual Funds can only be bought or sold at the end of the day and quite often once you buy the fund, the fund company will charge you penalty fees if you need to get out right away. In most instances Mutual Fund index funds are much more expensive to own than an ETF. We choose to work with ETFs because they are very liquid, inexpensive and we dont have trading costs in most instances. This is what investing is all about.