ETF Strategist Aims To Limit Losses

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V olatility may be the trader's friend, but it might not be yours. Volatility is risk come alive. It's the market's sudden up and down movements that make you lose so much sleep, you just want to sell and sit on cash. Most investment advisors tell clients to stay put during volatility because it's hard to time the market's tops or bottoms.

But it's also hard to do nothing when your portfolio feels like it's riding a roller coaster.

Over the past six weeks, the S&P 500 Index fell 11% at the end of August, recovered 6.5%, then fell an additional 5.4%. With the Federal Reserve threatening to raise interest rates while deflation moves around the globe, many anticipate a lot more volatility.

ETF strategist Herb Morgan, founder and CEO of Efficient Market Advisors, uses tactical shifts to limit downside volatility in his portfolios. Efficient Market Advisors is based in San Diego and has $630 million under management. The firm uses only ETFs in its portfolios, which are audited by an independent company.

In Morningstar's second-quarter rankings of ETF managed portfolios, Efficient Market's 20-year-plus Moderate portfolio posted a five-year average annual return of 13.5%, making it the best U.S. stock portfolio.

The firm's 20-year-plus Aggressive and 20-year-plus Conservative portfolios took second and fourth place, respectively. Efficient Market also captured the top three places in Morningstar's U.S. fixed income category. In the U.S. balanced category, the firm has nine of the top 16 portfolios.

Examine The Drawdowns

Morgan said that investors need to compare the drawdown, or decline, of their portfolio to the benchmark index. Then compare how quickly the portfolio recovers to break even.

The experience of Efficient Market's 20-year-plus Moderate portfolio during the fiscal crisis of 2007-09 provides investors with a good example of what to expect. The portfolio peaked in June 2007. It then experienced a 21-month drawdown, losing 44.2% of its value. Over nearly the same period, the S&P 500 fell 58%.

The portfolio took just another 21 months to recover all of its losses, while the stock market index took more than five years to break even. The firm's shorter-term Moderate portfolios fell even less and recovered even quicker.

"We deem it a success if you decline significantly less than the benchmark and recover far more quickly, so that over time it outperforms the benchmark," Morgan said.

In the second half of 2011, the portfolio took another tumble, falling about 17%. In less than a year, it had again recovered enough to break even.

Morgan is an old-school investment advisor. His portfolios have low turnover, and he puts no specific time period on how long it should take a portfolio to recover.

He avoids algorithms and technical analysis, and uses a traditional fundamental economic analysis to look for value-oriented sectors.

All his portfolios hold the same 15 ETFs, but the weightings are adjusted to accommodate risk tolerance. The 15 ETFs hold about 3,500 underlying securities, making the portfolios as diverse as any institutional investment plan .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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