Defensive Investing Can Net Bigger Returns

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BOSTON (TheStreet) -- "Buy-and-hold" investing no longer works, says Howard Present, chief executive officer of Massachusetts-based F-Squared Investments.

"The incentives, the business model and the intent of the industry has shifted further and further away from the real needs of investors," he says. "It is one of the few industries where clients just sort of accept the metric of success that is provided to them, as opposed to service providers really focusing in on what succeeds for them."

F-Squared, which has $550 million in funds under management, positions its portfolios defensively. But being defensive doesn't necessarily translate into smaller returns. In the three years through 2009, the company's AlphaSector Premium Index returned 14.3%, compared with a loss of 5.6% for the S&P 500, the U.S. benchmark. For the 12 months ending March 31, the stock market rallied 50% while F-Squared's portfolios gained 38%.

"Managers get fired for lagging their benchmark by 12 percentage points in a one-year period," Present says. "But we never had a single client complain."

Present's core strategy is investing in the nine sectors of the S&P 500 exclusively using exchange traded funds.

Among the ETFs that correspond directly to sectors are: Consumer Discretionary Select Sector SPDR Fund, Consumer Staples Select Sector SPDR Fund, Energy Select Sector SPDR Fund, Financial Select Sector SPDR Fund, Health Care Select Sector SPDR Fund, Industrial Select Sector SPDR Fund, Materials Select Sector SPDR Fund, Technology Select Sector SPDR Fund and Utilities Select Sector SPDR Fund.

Each week, every sector is scrutinized. Among the factors considered are historical prices and volatility.

"In some ways, this is a little bit of a throwback strategy. Back in the 1960s and '70s, when a broker saw flood waters coming, they went to high ground, moving to cash. It really wasn't debated," Present says. "Today, especially in the mutual fund world, most managers are precluded from providing that sort of protection by the prospectus. It is not how smart they are, or what their intent is -- they are actually prevented from doing it." 

"Rather than trying to time the overall S&P, which is just this big hodgepodge of conflicting data and information, we go sector by sector," Present says. "We ask a simple question, 'Looking forward, does that sector have a higher probability of making money for a client or losing money?' If it turns out there is a higher probability of losing money, we sell the sector entirely."

Initially, all nine sectors are equal weighted and there is no cash position. As one is dropped, the portfolio is adjusted proportionally. Currently, F-Squared's investments are in five sectors, having dropped health care, technology, energy and financials. An even more conservative approach kicks in when the portfolio drops to four sectors. At that point, a cash position, using the SPDR Barclays Capital 1-3 moth T-Bill ETF, is weighted in.

"In September, 2008, we only had the consumer-staples sector left, and we were at 75% cash," Present says of the time that marked the beginning of the stock-market crash. "The following month, we turned off all nine sectors and were 100% in cash. We stayed in that exact spot until the first week of April 2009."

He stresses that quarantining poorly performing sectors is crucial. The average spread between the best- and worst-performing sector averages about 37 percentage points. In the 12 months ending in July 2008, the spread was almost twice as wide.

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