Individually Managed Market Cycle Investment Management Portfolios vs. ETFs and Mutual Funds as Investment Vehicles in Retirement Income Programs

The purpose of this paper is to describe the many differences between the Market Cycle Investment Management (MCIM) process and the investment process within Mutual Funds and Exchange Traded Funds (ETFs).
 

History:

The first Market Cycle Investment Management portfolios were developed in the early 1970s, at a time when there was still considerable interest in developing individual security portfolios for retirement income planning purposes, and years before there were Index Funds, Money Market Funds, IRAs, or 401(k)s.

Investment Management entities were mostly employed by wealthy individuals and major company Pension, Profit Sharing, and Savings Plans. Professionals compared their stock market portfolio performance with cyclical market movements --- recognizing and embracing the investment opportunities provided by predictably unpredictable market undulations.

Successful equity managers were those that did better than the market averages over the course of the stock market cycle... generally in terms of Peak to Peak and Peak to Trough measurements. Performance analysis in terms of months, quarters and years was rarely seen, because of the institutionalized "long term" nature of the investment process.

One would think that retirement income planning continues to require a long term focus.

Throughout the 70's and the early 80's, it was clear to investors that the primary purpose of equity investing was to realize profits and that corporate bonds, preferred stocks, and government securities were expected to produce secure income, regardless of their market value.

MCIM portfolios are designed and managed with a cyclical vision and they are all comprised of both growth purpose and income purpose securities; they are not designed for short term comparison with any market numbers. Short term performance evaluation of long term investment programs, particularly retirement income programs, appears to be an oxymoron.

Successful income portfolio managers were expected to produce safe and growing streams of income through both trading and compounding of interest. Quality and safety were the primary concerns of retirement income portfolios and they were never examined with either market value or equity based measuring devices.

When the income was needed for retirement, it was expected to be there... use of capital (i.e., invested principal) was not acceptable, except in annuities, when the investment portfolio was not large enough to produce enough retirement income. Pension plans often included annuity only retirement options for their employees, and there were no variable annuities until the 1980s.

Market prices of "Interest Rate Sensitive" securities were expected to vary inversely with anticipated interest rate movements; income produced from these securities was correctly expected to be stable, regardless of the also expected (and historically natural) fluctuations in market value.

Anything outside the normal realm of stocks and bonds, including: options, futures, IPOs, "Over The Counter" (i.e., NASDAQ) issues, penny stocks, commodities, most ADRs, currencies, emerging market securities, etc, were considered to be speculations. Of these, only a select few foreign company ADRs are included in MCIM portfolios.

Those were the days of "professional only" market influence. Today, markets are influenced by the same forces as they were then, plus the impact of millions of individuals, now heavily invested in all security varietals, both individual and derivative, and in all domestic and foreign markets.

Today's "real time" news and market information, coupled with instant gratification impatience, and a "sound bite" attention span have led to investment markets that encourage market volatility and day to day (if not minute to minute) investor hysteria. Cyclical, long term investing performance evaluation seems to have few friends in or on institutional Wall Street.

Today, Federal and State Government regulations have as much of an impact on markets as do economic conditions, and artificial (even social conscience) manipulation of interest rates has altered the natural relationship between borrowing costs and economic activity.

With the advent of Tax Deferred investment opportunities (IRAs, 401(k)s, etc.) and the growth of the number of potential investors, institutional Wall Street became extremely creative in providing new products for the new mass markets to use as investment vehicles.

Quasi-professional investment management became available to anyone who wanted it, and it wasn't long before there were more derivative securities than individual stocks listed on the major exchanges....

Corporate "Cash Balance" and Defined Contribution programs began to replace (the much more expensive for employers) defined benefit plans, largely because of the inappropriate methodology used to value pension plan income purpose assets. Once the Defined Contribution plans morphed into self-directed programs, the stage was set for speculative decision-making and "mob directed" volatility in the market place.

· NOTE H1: Market Cycle Investment Management programs are designed to take advantages of the market cycle by buying Investment Grade Value Stocks (IGVSI) when prices fall and taking profits when prices rise to target levels.

Self directed programs also set the stage for thousands of funds, ETFs, hedging vehicles, multi-level derivatives, swaps, and IPOs to flood the new investment shopping mall. Then, with a dash of Modern Portfolio Theory, the new formula "speculation x speculation = alternative investment" was created to the open mouthed shock of those with a more conservative, and more cyclical perspective.

Today, we even have an actively followed (and media reported) "Fear and Greed Index"... go figure. MCIM managers buy (IGVSI stocks only) when fear is rampant and take profits when others have become seriously too exuberant.

But, the important realities of investing haven't changed in spite of the new perceptions, products, and impatience that Wall Street has cultivated so well. Market, economic, and interest rate cycles still exist, are still predictably unpredictable, and still seem to be a much more rational framework for total portfolio performance measurement than simple calendar quarters and years.

One of the most significant changes in the past few decades has been in the severity of market corrections. There have been three major stock market meltdowns (35% to 50%) in the past twenty seven years... possibly more than in the entire previous history of the investment markets.

Interestingly, with crystal clear hindsight, it seems likely that a steadfast commitment to the conservative investment styles of the past would have outperformed everything that has been developed since... over any significant cyclical time frame.

· NOTE H2: MCIM portfolios are designed to be performance analyzed cyclically, with a minimum 30% allocation to income purpose securities, and not with an "equity only" ruler.

Risk Minimization:

Every investment text book examines the concept of "risk"... it is inescapable.

Risk comes in various shapes and sizes, none of which will be discussed in any depth here: Business Risk is about company viability; Credit Risk is about the ability to service debt; Market Risk is about price fluctuation.

· NOTE R1: Index Funds are designed to "track" the progress of a select group of securities... they will never move differently (in either direction) than the securities they follow. They do not attempt to "minimize" market risk.

Other forms of "risk" have been identified, the most "interesting" ones to retirement income programs being Regulatory Risk and Tax Risk... pretty clear where these originate. Some say

that the fastest growing industry (and job classification) in the US economy is Compliance; everyone knows that the US taxes its business enterprises (directly and indirectly) at the highest level on the planet...

Every page, every title, every subtitle, of every new regulation, tax, levy, requirement, minimum, maximum, whatever, increases the business and credit risks of the companies that all Americans own a piece of in their retirement income programs.

Most experienced investment professionals would probably agree that there are three basic "Risk Minimizers" that protect investors from business, credit, and market risk They would likely agree, as well, that all investment risk cannot be eliminated.

The "big three" risk minimizers, in both equity and income securities, are Quality, Diversification, and Income... the QDI. We will be looking at all three.

· NOTE R2: In addition to the QDI, Market Cycle Investment Management (MCIM) uses several other strategies, processes, and disciplines to limit investment risk: quality based selection universe requirements, market price based individual selection rules, income requirements, profit taking target disciplines, speculation restrictions, and hands-on, unrestricted, management.

Mutual Funds do a fine job of diversifying by security, but many are over-weighted in particular sectors or specialized in a single sector; ETFs have similar diversification issues, and the overriding principle with each is that the user (including non professional investors) will construct appropriately diversified portfolios using multiple funds and/or ETFs.

There is no way of determining the Quality of the individual securities inside either a Mutual Fund or an ETF without accessing publications like Morningstar and doing additional research to find the S & P rating information. Some of the "what's inside" may be other index or mutual funds.

Only Investment Grade Value Stocks, and a high quality selection of REITs (Real Estate Investment Trusts), MLPs (Master Limited Partnerships), ADRs (American Depository Receipts), and Equity CEFs (Closed End Funds) are included in MCIM portfolios.

· NOTE R3: Wall Street uses the term "Value Stock" for companies that analysts believe are undervalued based on their price relative to earnings prospects and other considerations. The price of the security is the prime determinant of "value". IGVSI stocks are companies rated in the highest quality categories by S & P Corporation that also pay dividends, are profitable, and are traded on the NYSE.

A growing stream of income is rarely a consideration of either Mutual Funds or ETFs and those with high equity allocations are generally compared only with stock market indices. Growing retirement income is generally not an issue.

Income only Mutual Funds may contain "high income" equities as well as bonds, preferred stocks, etc. Typically, they do not generate as much income as income CEFs and cannot add to positions, when prices fall, as readily as MCIM managers can using CEFs.

Upon retirement, ETF and Mutual Fund owners most often cash out their funds and transition into income production programs within IRAs or by purchasing annuity products. So, even a target retirement fund may be victimized by a low interest rate environment at the precise time the income is needed....

· NOTE R4: Annuity payments include both principal and interest; they are not designed to provide any residual estate for annuitants' heirs. MCIM portfolios are designed to payout income only, and to create an estate for investors' survivors.

MCIM portfolios are designed to be producing full retirement income when the investor chooses to retire. The current rate of return of the portfolio (if in an individual 401k environment) can easily be duplicated in a "rollover" IRA portfolio.
 

Quality Is Always Job #1:

Quality is a judgment measure of the economic viability of a company, its ability to pay the bills, service the debt, maintain market share, grow market value and profitability over time, and provide growing dividend distributions to its shareholders.

Both equities and income securities are evaluated and rated by various entities: Standard & Poor's and Moody's are the main bond, or debt, rating entities, and S & P is the premier common stock quality maven.

The higher the Quality of the securities in a portfolio, the less "business" risk is being assumed by the investor. MCIM portfolios are comprised exclusively of S & P investment grade, dividend paying companies, and ADRs with similarly solid fundamentals.

Equity Quality Selection Standards:

S & P has a letter rating system that has been in existence since at least the 1980's. Common stocks are ranked from a low of "D" (in reorganization) to A+ (highest). B+ is considered "average", and anything B+ or better is considered "investment Grade". S & P publishes changes, additions, and corrections monthly.

· NOTE R5: Neither Mutual Funds nor ETFs specify that they use only a specific level of S & P quality rated companies in their equity selection process, and it would be cumbersome for an investor to determine the quality rating of every security held by the fund.

Instead, mutual fund managers and ETF creators select equities based on capitalization levels, growth predictions, dividend growth measures, market share numbers, sectors, analyst opinions and market value performance guesstimates.

The MCIM equity selection "universe" contains only S & P, B+ or better rated companies. The companies must be profitable, dividend paying, institutionally held, and traded on the New York Stock Exchange. They also have to be priced above $10.00 per share. Less than 340 companies (mid-January 2014) meet these stringent selection requirements.

Additionally, a dozen or so foreign company equities (ADRs), a few REITs and equity CEFs, and some MLPs qualify for inclusion in the equity portion of portfolios. REITs, CEFs, and MLPs are derivative securities, meaning that their prices are "derived" form the prices of the professionally managed portfolios they contain.

· NOTE R6: Multi level derivatives are avoided in MCIM portfolios, since their actual content, payment history, and cyclical price performance is difficult to examine. MCIM portfolio content is available for examination by investors, in real time, simply by accessing their portfolio records on the Internet.

The Investment Grade Value Stock Index (IGVSI) tracks just the NYSE companies that qualify for inclusion in MCIM portfolios... no other index is nearly as quality specific. Interestingly, this index has outperformed the S & P 500 index in both Peak to Peak and Peak to Trough comparisons from June 2007 thru January 2014, and most likely since the S & P 500 ratings were created. So, theoretically at least, there is less risk and more reward with investment grade equities.  (See chart.)

ETFs and Mutual Funds make equity selection decisions that often result in the purchase of stocks at the highest price levels in market history; also, their selections may include companies that do not pay dividends, IPOs, and others that have no track record of profitability. Mutual Fund managers are restricted in their buying activities during extended market corrections.

In addition to an "S & P investment grade only, dividend paying, NYSE" selection universe,

MCIM managers absolutely never buy stocks at their highest ever levels, and avoid IPOs entirely. To even be considered for addition to a portfolio, an IGVSI equity must be down a minimum of 20% from its 52-week highest level. Positions are added to only when the current price is below the average position cost basis.

If, on a given day, nothing meets these requirements, nothing is purchased. These disciplined selection criteria are never altered or modified regardless of how much equity destined cash accumulates in the portfolio. MCIM independent investment managers are not pressured by owners, superiors, or customers to buy or to sell securities.

Bond Quality Selection Standards:

S & P and Moody's Investors' Services are the premier debt rating agencies. Each will post a letter designation (for example, AAA-, the highest, through D, defaulted issues). Anything rated BB or lower is considered to be speculative, but BB and B ratings are less likely to default under normal economic conditions than are debt issues with C's after their names.

An issue with no rating can be just as credit worthy as an AA security, but clearly, investors should research such issues more completely. The rating services are very expensive and rating itself is not compulsory...yet.

· NOTE R7: All income purpose security prices are sensitive to expectations about future interest rates. High quality fixed income securities almost always pay the same interest, regardless of their changing market values.

Mutual Funds and ETFs may contain any combination of funds, indices, and individual issues but their payouts to investors are typically less than comparably managed Closed End Income Fund (CEF) portfolios. This is true for various reasons, not the least of which is mutual fund managements' obsession with market value, yes, even with the market value of income purpose securities.

Mutual Fund managers create shorter term (duration), lower "coupon" portfolios to limit the amount of market value fluctuation during periods of higher interest rate expectations. They may have slightly less credit risk (risk of total loss of principal) than a portfolio of longer term, similarly rated, higher yielding securities, but they absolutely produce less income to reinvest.

Stable Value Funds are the best example of short term, ultra low risk income funds. They pay just a tad more than money market funds but they are not designed to be replacements for money market funds... they are not included in MCIM portfolios because, in times of crisis, managers may be restricted in their access to fund balances.

Retirement income portfolio participants, logically, should be more interested in "spending money" than in market value fluctuations.

· NOTE R8: The income asset allocation of MCIM portfolios is made up of 75 or more managed bond, preferred stock, and government security CEFs, and some real estate and oil royalty trusts... today's portfolios (mid January, 2014) are yielding in excess of 7%, net-net of all internal CEF expenses.

Income CEFs trade like equities on the NYSE and most pay monthly dividends. They can be purchased and sold throughout the trading day and, quite often, at a price below net asset value. Mutual Funds are never sold at less (or more) than their NAV, and cannot be "traded" intraday.

Income CEF prices fluctuate more than individual income securities for a number of reasons... a distinct benefit to MCIM investors. They have higher internal management fees than Mutual Funds comprised of the very same types of securities. But the much higher yields they produce for investors are net of all such expenses.

Income closed end funds have been in existence longer than ETFs and possibly longer than 401k and IRA tax deferred investment programs. MCIM portfolios contain only those CEFs with a history of stable dividend payments throughout the June 2007 through March 2009 financial crisis. Most have been around much longer.

(Note that very few MCIM CEFs reduced payments during the financial crisis and that a corresponding number actually raised their distribution levels. You can research this for yourself at CEF connect.com).

Most individual, professionally managed, CEFs contain more than 100 individual securities, with a very limited exposure to any of them (probably less than 2% per single issue). Each is constructed like the normal income mutual fund, with varying durations, appropriate geographical and industrial diversification, a mix of quality levels, etc.

· NOTE R9: One of the most appealing features of the "tradeable" income CEF is market price volatility. When they move down in price, MCIM mangers may buy more shares to reduce cost basis and increase both total portfolio income and individual yield on investment.

When they move up in price, the MCIM manager will take reasonable (one year's interest in advance) profits and reinvest the proceeds either to reduce the cost basis of other holdings or to establish new positions.

Neither Mutual Fund managers nor ETF designers actively "trade" their individual bond or other income positions in order to take profits, and are more likely to sell than to buy when prices fall. Both types are traded at, or very close to, their net asset values.

The average Income Mutual Fund typically pays significantly less than the average income CEF contained in MCIM portfolios. Most MCIM CEFs were paying above 6%, after all fund expenses, at the time of this writing, and were trading at significant discounts from their Net Asset Value.
 

Portfolio Management:

Hands on, disciplined, portfolio management is a risk minimizer in MCIM portfolios. When security prices strike reasonable profit-taking targets, the manager sells the security and looks for others that meet buying parameters. If there are none, equity allocated cash is held while income destined dollars are re-invested.

When security prices fall into pre-determined buying ranges, the MCIM manager will "shop" for portfolio additions at modestly lower prices still; and continue to keep the income allocation fully invested.

On the "buy" side, Mutual Fund managers probably do not operate in this manner; ETFs have no manager. It is more likely that new money is allocated across all portfolio holdings to maintain the current sector, security, and classification allocations, regardless of price.

Generally speaking, Mutual Fund managers have a lot of non-management issues. They must buy and sell securities (in most cases) as determined by an investment committee. Their performance is judged by how they fare in comparison to other managers within the same portfolio style niche, so they, and the investment committee (as paid employees), have an agenda that may be in some conflict with that of investors.

Regardless of what their experience tells them (and few managers have as much independent decision-making experience MCIM managers), if investors/speculators keep sending money into the fund, managers must continue to buy securities. Most funds are required by prospectus to stay roughly 95% invested. MCIM managers have no such restrictions.

Studies show that the cash flow in and out of Mutual Funds and ETFs was negative during the financial crisis, from 2007 through 2012... fund managers were selling. Not until the rally had run for nearly three years did the cash flow turn positive!

Then, throughout 2013, while equity prices surged to their highest levels in history, mutual fund managers had no choice but to buy securities as the cash flow scenario reversed itself... a "sell low, buy high" directive.

Similarly, when prices were falling like a stone during "the crash", "the dot.com bubble", and "the financial crisis" the managers hands were tied. When shareholders panic, mutual fund managers must sell. It's the unit holders that have the final managerial say in mutual funds.

In the unmanaged, passively observed ETFs, there is no manager to determine either that profits should be taken "off the table" or that there could be opportunities in lower prices.

· NOTE P1: In either ETFs or Mutual Funds, it's hard to imagine a scenario where buying decisions are made when market prices of either income or equity securities are falling for any extended period of time....

In MCIM portfolios, the manager is constantly taking target-profits during rallies, and reinvesting selectively only in "qualified" securities that are falling in price to target shopping levels... cash naturally accumulates during such times. This cash is used to reinvest during market downturns.

Investors stay more comfortable in MCIM portfolios throughout the market cycle precisely for these reasons.

·     NOTE P2: MCIM portfolios are designed for buying during sell offs and selling during rallies.

Participants have no need for portfolio adjustments to move in or out of equities; the manager has their back as a matter of standard practice.

When market prices are low or recovering, cash tends leaves mutual funds and ETFs; when prices rise to new high levels, investors can't buy them fast enough.... same story in 1987, same story in 1999, same story in 2007, same story in 2013.

Market Cycle Investment Management portfolios have a distinct advantage... when the going gets tough, MCIM goes shopping! MCIM managers are not controlled investment committees or by the individual investors who participate in their portfolios.

They sell at specific targets when prices go up, and buy at particular bargain levels when prices fall... the same high quality securities and income CEFs over, and over, and over again... operating within the structure of the market cycle, and loving it.

No true MCIM manager will ever lament a one day, 300+ point drop, in the Dow!

ETFs (passively managed) exist because most "investment managers" don't beat the market averages regularly... so why pay the costs of management? ETFs are cheaper than Mutual Funds, but in a falling market, won't panicky investors cause the same result as in Mutual Funds?

Mutual fund managers don't compete well with market benchmarks because they are removed from decision-making responsibility at the very moments when it is most necessary... their actions depend on the fear, or the greed, of the majority of their unit holders.

• NOTE P3: Regardless of the capitalization category, sector, global location, or market development parameters a Mutual Fund or ETF portfolio applies; they invariably are buying equities when prices are at All Time High (ATH) levels and selling them during market corrections. MCIM portfolio management disciplines prevent this from happening.

 

Logically, MCIM portfolio managers, should beat the market regularly over the course of the market cycle because of the disciplines included in the process. The clearest example of this is the market activity around the time of the dot-com bubble  (Issue Breadth Statistics  Around the Dot Com Bubble), when speculative dollars were sucked out of Investment Grade Value Stocks and thrown at every new issue being minted by Wall Street.

As the NASDAQ climbed, the NYSE faltered, and mutual fund managers bathed in the glory of the "no-quality-at-all.com" hysteria. When the bubble burst, the glory turned into blood as the NASDAQ crumbled (it still is below 2000 levels)... The MCIM program credo, logically, produced a different turn of the century experience:

• Investment Grade Value Stocks only = No NASDAQ, No Mutual Funds, No IPOs, No Problem.

In summary, neither Mutual Funds nor ETFs are managed entities when the markets have extensive movements in either direction. The latter (ETFs) were created because it was so well documented that the former were inadequate.

The latter (Mutual Funds) are inadequate because they are managed by the millions of individual fund owners, IRA self-directors, and 401(k) plan participants who invariably decide to throw money into the absolute heights of market rallies and to sell during market corrections.

Individual MCIM programs absolutely never have these issues...

Asset Allocation & Diversification:

Both Asset Allocation and Diversification are risk minimization/planning concepts or techniques; neither are "stand alone" investment strategies, and neither are sophisticated methods with which to "time" the markets.

Mutual Funds and ETFs may use the terms interchangeably, but in MCIM portfolios, asset allocation is the process of dividing the portfolio into two classes of securities: equity, or growth purpose, and income purpose.

The primary purpose of the equities is to produce growth in the form of "realized capital gains..." unrealized gains are given no respect at all by MCIM since they don't increase Working Capital or produce any additional income.

The primary purpose of the income securities is to produce income; fluctuations in price are normal, but fluctuations in the amount of income are comparatively rare. Because income Closed End Funds are used to populate the income purpose asset allocation "bucket', increases in market value are capitalized when the gain equals about one year's interest in advance.

Decreases in market value are not seen as problems, they are recognized as opportunities to reduce cost basis and increase yield on existing positions. Mutual Funds hold large positions in a large number of securities.... how likely do you think it is that they will be able to find more of (or want to increase exposure in) these already large holdings?

Also in MCIM portfolios, diversification regulates the amount of the portfolio that is invested in one security, one sector/industry, one economy, etc.

·     NOTE A1: MCIM asset allocation is based on total portfolio cost basis, not market value as with Mutual Funds and ETFs. Portfolios are always properly allocated as a function of each transaction. The equity "bucket" will hold minimal un-invested cash (called "smart cash") during corrections, and large amounts (mostly from profits and income) during rallies.

 

Asset Allocation General

Asset Allocation is the broader of these two essential activities: Diversification takes place among the securities purchased to fill up the two asset allocation "buckets." Asset Allocation involves the long term decision making designed to get a person from the position they are in now to the position they want to be in at some time in the future.

Most investors move through three investment portfolio "Life Cycles" in their journey toward retirement.

In MCIM, these three phases are called: Accumulation, Transition, and Retirement; the only "structural" difference is the asset allocation. The Accumulation phase can have up to a maximum of 70% invested mostly in Investment Grade Value Stocks; the Transition phase is a 50/50 balance between income and growth purpose securities.

The retirement phase has a 10% maximum equity element (including several equity CEFs), with the balance invested in a diversified portfolio of income Closed End Funds. This portfolio is also ideal for individuals just getting their program started and for those who wish to take on as little stock market risk as possible throughout their investment experience.

In retirement income portfolios, the overall (MCIM) objective is to have all of the (non safety net) income provided by the securities contained in the investment portfolio. To grow the income produced by a retirement income portfolio after retirement, roughly 30% of total portfolio "base Income" (i.e., dividends + interest) needs to be re-invested.

The amount of income produced by the portfolio, and the rate of income growth, is determined by the asset allocation formula and the means used to measure the assets in each allocation "bucket". The rate of income growth varies directly with the size of the income asset allocation.

All MCIM portfolios are designed to grow investment "base income" from the very start, regardless of the asset allocation, mainly because the process recognizes only two asset classes: Growth Purpose Securities (the equities) and Income Purpose Securities (bonds, government securities, preferred stocks, etc.).

Since Asset Allocations generally are in place for long periods of time, MCIM assures annual income growth by using security cost basis in portfolio position decision making. In a 60% Equity - 40% Income portfolio, all deposits and income are reinvested according to this formula.

As the portfolio working capital grows, so does the dollar amount invested for income, even in a falling interest rate market... this process is generally known as compounding.

· NOTE A2: In MCIM portfolios, both asset allocation and diversification are based on total portfolio cost basis (i.e., Working Capital). Since all positions produce income, total cost basis is always growing. Only net withdrawals, or net capital losses, can retard income growth. Market value of positions in the portfolio generally have no impact on the income they produce.

Both Mutual Funds and ETFs base their asset allocation decisions on market value, thus creating situations where excessive investment could be made in an asset class as a result of short term market conditions --- when looking at such portfolios using a "working capital" (cost basis) microscope.

·     NOTE A3: Both ETFs and Mutual Funds are available with unlimited asset allocation possibilities;

MCIM portfolios get the job done with three basic, semi-flexible, programs. All asset allocation numbers are "cost based" and individual security selection criteria are the same within each portfolio.

· Note A4: Every MCIM security produces income, and at least 30% are income purpose. Equities are mostly large and mid "cap" multinational IGVSI companies in many sectors. "Hot" sectors will not be well represented because profits will have been taken and reinvested in weaker sector companies of the same superior (IGVSI) quality.

MCIM Accumulation Phase Portfolio:   60% IGVSI Equities/40% Income CEFs

This asset allocation model is suitable for most investors until they feel they are within fifteen years of retirement. The asset allocation percentages are manager guidelines. The Income portion of the portfolio will always be fully invested at a level between 30% and 40%; the equity portion may approach 70% during long duration equity market corrections.

During market rallies, MCIM managers will generally be unable to find significant numbers of "buy" candidates (IGVSI stocks down 20% or more from their 52-week high). During such markets, managers have the flexibility to hold significant cash (money market fund) in the equity allocation "bucket" while keeping income positions at approximately 40% of the portfolio.

· NOTE A5: Money Market funds typically pay much more than they do while interest rates are being government controlled at historically low rates. When rates rise, these funds will become the best yielding "cash equivalent" vehicle.

· NOTE A6: Stable Value Funds are not "cash equivalents", being comprised of longer term paper than is found in Money Market funds. They pay around 1% now, and are a very safe/very low yield portion of the income-purpose asset allocation. They don't "fit" inside MCIM portfolios because of their low yield and potential market "crisis" liquidity issues.

The MCIM 60/40 portfolio could be labeled a "high quality, growth and income" portfolio, designed for use in the accumulation phase of a person's investment "Life Cycle". Unlike most mutual fund portfolios containing equities, this portfolio is likely to be fully invested during market corrections, but only in IGVSI (S & P's highest rated) companies. During rallies, profit-taking activities become more common, and a money market fund holds the cash ready for new opportunities.

· NOTE A7: The key difference between all MCIM portfolios and other growth/income portfolios is the plan to take profits when available, and to reinvest a minimum fixed % of the profit for income. The remaining cash is available for new buying opportunities all of the time, particularly when the market is falling

· NOTE A8: The MCIM 60/40, Accumulation Phase Portfolio is comparable to a Target Term Portfolio "2029" or higher; BUT the MCIM manager takes all targeted profits, grows income, and has cash available for corrections. Mutual Fund or ETF names that may correspond ONLY with the objective of the MCIM Accumulation Phase portfolio: Moderate Growth, Developed Market, Large Cap, Growth, Value, Mid Cap, REIT, Energy, Target Income or Retirement MCIM Transition Phase Portfolio - 50% IGVSI Equities/50% Income CEFs

The MCIM 50/50 asset allocation is most suitable for investors who are between fifteen and three (to five) years of retirement. Three years for larger portfolios ($400k or larger) and 5 years for smaller portfolios. The asset allocation limits are manager guidelines, but the income position will never fall below 50% of the portfolio "working capital" (i.e., cost basis).

Equity management is the same as in other MCIM portfolios, there is just a smaller exposure to the whims of the stock market and a higher, faster growing, "base income" level. Base income is the total of dividends and income received in the portfolio.

During market rallies, managers will generally be unable to find significant numbers of "buy" candidates, and will grow cash balances to be in a position to take advantage of opportunities that arise during the next market correction. The income allocation will be allowed to grow as high as 60% during extended stock market rallies.

·     NOTE A9: The MCIM 50/50, Transition Phase Portfolio, is comparable to a Target Term Portfolio

"2017 to 2029"; BUT the MCIM manager takes all targeted profits, grows income, and has cash available for corrections.

The MCIM 50/50 portfolio could be labeled a "high quality, balanced growth and income portfolio", designed for use in the transition phase of a person's investment "Life Cycle". It could also be suitable for any more risk averse investors who are not yet within five years of retirement.

Mutual Fund or ETF names that may correspond ONLY with the objective of the MCIM Transition Phase portfolio: Balanced, Developed Market, Large Cap, Growth, Value, Mid Cap, Moderate Growth, Conservative Growth, REIT, Energy, Target Income or Retirement Retirement Phase/Start-Up/Risk Averse Portfolio: 10% IGVSI Equities/90% Income CEFs.

The MCIM 10/90 asset allocation is suitable for three types of investors: those who are within three (to five) years of retirement, those who are just starting their retirement program, and those who would like to have the least amount of business and market risk in their retirement portfolio. Smaller portfolio (less than $300k) investors are likely to benefit from getting into retirement mode a year or two earlier than those with larger portfolios.

Equity management is slightly different in the Retirement Phase MCIM portfolio, because a smaller exposure to the stock market and a higher "base income" level are necessary. Equity content CEFs will be used to fill most of the "retirement phase" portfolio equity allocation, which will never be allowed to exceed 10 of "working capital" (cost basis).

During market rallies, cash should be expected to accumulate within the equity allocation of the portfolio; during corrections, equities and equity CEFs will be added. Standard profit taking rules apply in MCIM retirement phase portfolios, including the securities within the income "asset allocation bucket."

• NOTE A10: The MCIM 10/90, Retirement Phase/Start-Up/Risk Averse Portfolio is comparable to a Target Term Portfolio "Right Now to 2018"; BUT the MCIM manager takes targeted profits, grows income, and has cash available for corrections.

Mutual Fund or ETF names that may correspond ONLY with the objective of the MCIM Retirement/Start Up/Risk Averse portfolio: Total Bond, Long Term Bond, REIT, Energy, Target Income or Retirement.

 

MCIM "Life Cycle" Portfolio Summary

MCIM portfolios are managed based on the realities of the market cycle: markets are expected to move in both directions, and price volatility is the "normal" investment environment.

Investors should be able to anticipate what the MCIM manger will be doing in response to and in anticipation of market realities. In extended rallies, managers will be anticipating a correction by raising cash (taking profits) within the equity allocation. During corrections they will be purchasing equities in anticipation of the next rally.

Consequently, investors have no need to sell their MCIM portfolios during corrections as they often would be doing with Mutual Funds and ETFs... the MCIM process, in all three portfolio asset allocations, automatically raise and lower equity exposure systematically, cyclically.

• Note A11: No Mutual Fund or ETF includes only Investment Grade Value Stocks, specifies precise and disciplined buying prices and selling targets, and monitors both asset allocation and diversification using a "cost based" model.

 

Diversification: General

Diversification is one of the key "risk minimizers" used in Market Cycle Investment Management portfolios. Several types of diversification combine to the same extent in all MCIM portfolios, and all diversification decisions are based on percentages of cost basis or "working capital".

MCIM is the only investment discipline (to the knowledge of this writer) that uses the "Working Capital Model" in asset allocation and diversification decision making. All other management approaches, ETFs and Mutual Funds included, use market value. With a cost based approach, portfolio "balancing" is accomplished with every decision; year end, or periodic, "rebalancing" is never needed.... and the portfolio never moves "off plan."

Individual Position Size

Individual position size is kept well below 5% of total working capital, and all positions are initiated at a level of around 2%. Since positions are established only after a security has moved lower in price by at least 20%, it is likely (particularly in a weakening market) that the security will move even lower if the trend continues.

Positions are added to during the downward path, at a time and at the discretion of the manager. A decision to add new positions to the portfolio generally take precedence over an "averaging down" decision. Positions are never added to at higher prices than the average cost per share of the existing position. Income CEF, Equity CEF, MLP, REIT, and ADR positions are all dealt with in this manner.

Sector Representation

No effort is made to have representation in individual securities within every possible sector. MCIM portfolios will generally be sold out of "hot" sector positions (because of profit taking) and well represented in weaker sectors, as these will be where the lower priced opportunities will show up first.

Most business-type "sectors" will include Investment Grade Value Stocks, but the selection rules are based on price relative to 52-week high, and not just a "perceived" need to have additional sector representation. The MCIM process thrives on the natural "sector rotation" that most investment professionals are quite familiar with.

Equity CEFs, which are included in all MCIM portfolios to a certain extent, will likely retain positions in many sectors that the manager is not purchasing individually. Individual positions in a single sector are kept below 15% of the portfolio.

 

Geographic and Global Diversification

The majority of IGVSI equities are multinational companies with considerable presence in all markets at home and abroad. In addition, equity CEFs to a limited extent, and ADRs extensively, give MCIM portfolios appropriate worldwide coverage.

Additionally, income CEFs cover the world wide debt marketplace in the income allocation of MCIM portfolios.

 

Cash Balances

The MCIM process does not allow for a "cash or cash equivalents" asset allocation; all cash is held waiting for opportunities in the growth purpose allocation "bucket" (IGVSI stocks, REITS, MLPs, ADRs, equity CEFs). The income purpose "bucket" (Income CEFs, REITs, MLPs) is almost always fully invested.

Money market funds and or bank deposit funds are used as, cash equivalent, temporary holding areas while equity portfolio opportunities are screened for acceptability. Large positions are expected during market highs, and much smaller positions are likely during extended market corrections.

Stable Value Funds are very low yielding, very low risk securities; but they are not cash equivalents and there is a slight possibility that a "perfect storm" environment like the "financial crisis" could cause redemption difficulties or "holds" for the MCIM manager, precisely at the time when he needs liquidity...

During market corrections, MCIM portfolios require unfettered access to uninvested balances in order to repopulate the equity bucket of portfolios. The very low yield of Stable Value funds (less than 1% per year) does not justify any market risk at all. A rising interest rate environment (which could precipitate a stock market correction) would quickly bring money market rates higher with no chance of becoming illiquid.

· NOTE A12: Stable Value Funds are not used in MCIM portfolios because they are not cash equivalents and they could become illiquid during a financial crisis

Growing Retirement Income

Eventually, most investment programs become retirement income programs, particularly IRA and 401(k) rollover portfolios. It is likely that most retirees will be looking to their investment portfolios to provide the extra income they need to supplement any Social Security or pension benefits they have accrued.

Most learn rather quickly that: portfolio "market value" does not pay the bills and that a growing tax free income stream would have allowed them more flexibility in their retirement years. They also find out that Uncle Sam has no heart at all when it comes to the taxation of their nest eggs - -- including the "2nd time around" tax of Social Security benefits.

Over the past 30 years, market value supported retirement income programs have been devastated, on no less than three occasions, by major corrections in the equity markets... what's wrong with that statement?

The primary purpose of equity investments is growth, yet equity securities, equity indices, and other "growth purpose" investments are the dominant feature of most Mutual Fund or ETF based retirement programs.

· NOTE G1: Market Cycle Investment Management portfolios use both growth and income securities to grow income production annually, throughout all of the years leading up to retirement, and in many cases, during retirement itself.

This is accomplished by: using "cost based asset allocation", employing strict profit taking disciplines in both the equity and income security "buckets", and by only investing in securities of either type that pay some form of income. As investors move from the most aggressive MCIM asset allocation (up to 70% in equities during corrections) to the most conservative (0% in equities) portfolio, the income grows at ever faster levels.

· NOTE G2: In "dollars invested" terms, the income purpose portion of the investment portfolio grows every month, every quarter, every year.

The goal of the process is to have enough income available at retirement to allow for 30% or more of the income not to be needed for routine monthly expenses, thus allowing for future income growth.

 

Growing Income from Equity (Growth Purpose) Securities

In MCIM investment portfolios, at least 30% of the assets are "income purpose" assets; if they don't produce capital gains income, that is perfectly OK. The growth purpose portfolio allocation (the stock market investments) is also producing regular income in the form of dividends, albeit at a lower rate.

Using cost based asset allocation, some portion of every dollar of income is destined for income investing, and the compounding of income is done monthly, as the account manager determines which issues should be added to at lower prices, or which other issues should be added to the portfolio.

Two significant income enhancing events typically occur during stock market rallies: profit taking and money market interest contributions (admittedly very low as this is being written) from equity destined cash positions... theoretically, the larger the equity allocation, the larger the capital gain generated contribution to the income asset allocation during rallies.

· NOTE G3: In the MCIM equity allocation "bucket", profits taken during market rallies compound the growth rate of the income allocation bucket because a specific amount of every income dollar, regardless of source, is destined for income investing.

At the same time, also during rallies, the equity allocation begins to hold increasing cash balances as buying opportunities shrink with the rising market. If the next market correction (for example) is triggered by actual rising interest rates, cash balances in the equity allocation will produce higher money market rates AND all of it will be available to establish new IGVSI equity positions as prices fall from their highest prices ever.

· NOTE G4: MCIM equity investing is a "sell higher, for reasonable profits, buy lower" process. During rallies, cash is held in a liquid medium that can be used to take advantage of new opportunities without restriction.

Growing Income from Income Purpose Securities

All securities in MCIM portfolios produce some form of income and the dividend-alone contribution from growth purpose, equity securities (minimum 30%; maximum 90%) has a compounding quality unique to MCIM portfolios.

When combined with the (again, 30% to 90%) contribution from the income asset allocation, the compounding impact is clear. But, because all income purpose securities are owned in readily tradeable form, the income allocation bucket can and will (occasionally) produce capital gain income of its own.

The likelihood of capital gains from income CEFs, REITS, and MLPs depends on many factors, but a brief review of some individual issue income CEF charts at  CEFConnect.com shows just how frequently these securities fluctuate 10% or more in either direction without affecting the income they produce.

This "friendly" volatility allows the MCIM manager: to reap target profits ("one year's income in advance") occasionally and/or to add to positions at lower prices regularly. Both activities add significantly to overall portfolio income production.

· NOTE G5: Neither income security index ETFs nor income Mutual Funds appear to use income CEFs as regular income producers, possibly because of the very price volatility that MCIM portfolio managers find so appealing.

· NOTE G6: Income CEFs (CEFConnect.com) typically pay significantly more income than either Bond Index ETFs or Income Mutual Funds, and they were generally able to maintain their significant payout differential throughout the financial crisis.

Q & A

The author intends for this "White Paper" to prompt questions. Please submit questions via e-mail to sanserve@aol.com.

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NOTES BY SECTION

 

History:

NOTE H1: Market Cycle Investment Management programs are designed to take advantages of the market cycle by buying Investment Grade Value Stocks (IGVSI) when prices fall and taking profits when prices rise to target levels (page 2).

NOTE H2: MCIM portfolios are designed to be performance analyzed cyclically, with a minimum 30% allocation to income securities, and not with an equity only ruler (page 3).

Risk Minimization:

NOTE R1: Index Funds are designed to "track" the progress of a select group of securities... they will never move differently (in either direction) than the securities they follow. They do not attempt to "minimize" market risk (page  3).

NOTE R2: In addition to the QDI, Market Cycle Investment Management (MCIM) uses several other strategies, processes, and disciplines to limit investment risk: quality based selection universe requirements, market price based individual selection rules, income requirements, profit taking target disciplines, speculation restrictions, and hands-on, unrestricted, management (page 4).

NOTE R3: Wall Street uses the term "Value Stock" for companies that analysts believe are undervalued based on their price relative to earnings prospects and other considerations. The price of the security is the prime determinant of "value". IGVSI stocks are companies rated in the highest quality categories by S & P Corporation that also pay dividends, are profitable, and are traded on the NYSE (page 4).

NOTE R4: Annuity payments include both principal and interest; they are not designed to provide any residual estate for annuitants' heirs. MCIM portfolios are designed to payout income only, and to create an estate for investors' survivors (page 4).

NOTE R5: Neither Mutual Funds nor ETFs specify that they use only a specific level of S& P quality rated companies in their equity selection process, and it would be cumbersome for an investor to determine the quality rating of every security held by the fund (page 5).

NOTE R6: Multi level derivatives are avoided in MCIM portfolios, since their actual content, payment history, and cyclical price performance is difficult to examine. MCIM portfolio content is available for examination by investors, in real time, simply by accessing their portfolio records on the Internet (page 4).

NOTE R7: All income purpose security prices are sensitive to expectations about future interest rates. High quality fixed income securities almost always pay the same interest, regardless of their changing market values (page 6).

NOTE R8: The income asset allocation of MCIM portfolios is made up of 75 or more managed bond, preferred stock, and government security CEFs, and some real estate and oil royalty trusts... today's portfolios (mid January, 2014) are yielding in excess of 7%, net of all internal CEF expenses (page 6).

NOTE R9: An appealing feature of the "tradeable" income CEF is price volatility. When they move down in price, MCIM mangers may buy more shares to reduce cost basis and increase both total portfolio income and yield on investment (page 7).

 

Portfolio Management:

NOTE P1: In either ETFs or Mutual Funds, it's hard to imagine a scenario where buying decisions are made when market prices of either income or equity securities are falling for any extended period of time (page 8).

NOTE P2: MCIM portfolios are designed for buying during sell offs and selling during rallies. Participants have no need for portfolio adjustments to move in or out of equities the manager has their back as a matter of standard practice (page 8).

NOTE P3: Regardless of the capitalization category, sector, global location, or market development parameters a Mutual Fund or ETF portfolio applies; they invariably are buying equities when prices are at All Time High (ATH) levels and selling them during market corrections. MCIM portfolio management disciplines prevent this from happening (page 9).

 

Asset Allocation & Diversification:

NOTE  A1: MCIM asset allocation is based on total portfolio cost basis, not market value as with Mutual Funds and ETFs. Portfolios are always properly allocated as a function of each transaction. The equity "bucket" will hold minimal un-invested cash  (called "smart cash") during corrections, and large amounts (mostly from profits and income) during rallies (page 10).

NOTE A2: In MCIM portfolios, both asset allocation and diversification are based on total portfolio cost basis (i.e., Working Capital). Since all positions produce income, total cost basis is always growing. Only net withdrawals, or net capital losses, can retard income growth. Market value of positions in the portfolio generally have no impact on the income they produce (page 11).

NOTE A3: Both ETFs and Mutual Funds are available with unlimited asset allocation possibilities; MCIM portfolios get the job done with three basic, semi-flexible, programs. All asset allocation numbers are "cost based" and individual security selection criteria are the same within each portfolio (page 11).

NOTE A4: Every MCIM security produces income, and at least 30% are income purpose. Equities are mostly large and mid "cap" multinational IGVSI companies in many sectors. "Hot" sectors will not be well represented because profits will have been taken and reinvested in weaker sector companies of the same superior quality (page 11).

NOTE A5: Money Market funds typically pay much more than they have been while interest rates are being government controlled at historically low rates. When rates rise, these funds will become the best yielding "cash equivalent" vehicle (page 12).

NOTE A6: Stable Value Funds are not "cash equivalents", being comprised of longer term paper than is found in Money Market funds. They pay around 1% now, and are a very safe/very low yield portion of the income-purpose asset allocation. They don't "fit" inside MCIM portfolios because of their low yield, and potential market "crisis" liquidity issues (page 12).

NOTE A7: The key difference between all MCIM portfolios and other growth/income portfolios is the plan to take profits when available, and to reinvest a minimum fixed % of the profit for income. The remaining cash is available for new buying opportunities all of the time, particularly when the market is falling (page 12).

NOTE A8: The MCIM 60/40, Accumulation Phase Portfolio is comparable to Target Term Portfolios "2029" or higher; BUT the MCIM manager takes all targeted profits, grows income, and has cash available for corrections (page 12).

NOTE A9: The MCIM 50/50, Transition Phase Portfolio is comparable to a Target Term Portfolio "2017 to 2028"; BUT the MCIM manager takes all targeted profits, grows income, and has cash available for corrections (page 13).

NOTE A10: The MCIM 10/90, Retirement Phase/Start-Up/Risk Averse Portfolio is comparable to a Target Term Portfolio "Right Now to 2018"; BUT the MCIM manager takes all targeted profits, grows income, and has cash available for corrections (page 13).

NOTE A11:  No Mutual Fund or ETF includes only Investment Grade Value Stocks, specifies precise and disciplined buying prices and selling targets, and monitors both asset allocation and diversification using a "cost based" model (page 13).

NOTE A12: Stable Value Funds are not used in MCIM portfolios because they are not cash equivalents and they could become illiquid during a financial crisis (page 16).

 

Growing Retirement Income

NOTE G1: Market Cycle Investment Management portfolios use both growth purpose and income purpose securities to grow income production annually, throughout all of the years leading up to retirement, and in many cases, during retirement itself (page 16).

NOTE G2: In "dollars invested" terms, the income purpose portion of the investment portfolio grows every month, every quarter, every year (page 16).

NOTE G3: In the MCIM equity allocation "bucket", profits taken during market rallies compound the growth rate of the income allocation bucket because a specific amount of every income dollar, regardless of source, is destined for income investing (page 17).

NOTE G4: MCIM equity investing is a "sell higher, for reasonable profits, buy lower" process. During rallies, cash is held in a liquid medium that can be used to take advantage of new opportunities without restriction (page 17).

NOTE G5: Neither income security index ETFs nor income Mutual Funds appear to use income CEFs as regular income producers, possibly because of the very price volatility that MCIM portfolio managers find so appealing (page 17).

NOTE G6: Income CEFs (CEFConnect.com) typically pay significantly more income than either Bond Index ETFs or Income Mutual Funds, and they were generally able to maintain their significant payout differential throughout the financial crisis (page 17).

The author intends for this "White Paper" to prompt questions. Please submit questions via e-mail to sanserve@aol.com.