The Big Picture

The Big Picture

Investing by Jean Gruss | Editor/Lee-Collier

Jerry Pearson, Florida chief investment officer at Fifth Third Bank Investment Advisors, considers the broad economic themes before making his investment picks. It might make you think differently about your portfolio.

If the recent stock market swings have you worried that this kind of volatility is only going to get worse, it might pay to listen to Jerry Pearson's soothing words.

Pearson, a slim triathlete who manages nearly $1 billion for about 500 wealthy clients of Fifth Third Bank's Florida operations, says globalization has actually resulted in less U.S. stock-market volatility because other countries such as Brazil and China have joined the world economy, spreading risk more globally.

Globalization is one of the major themes upon which Pearson bases his investing strategy as the chief investment officer for the bank's money management business in Florida.

These kinds of broad themes will determine where investors can make money. "We want to get the big picture right," says Pearson, who is based in Naples.

Besides globalization, other broad long-term themes include a forecast of lower interest rates and moderate inflation, which is an ideal environment for stocks. But Pearson uses these themes to invest in other kinds of assets too, such as bonds and commodities.

There's a lot riding on his success. With rising costs of deposits and increasing competition to make loans, banks are putting more emphasis on providing services such as money management that generate steady non-interest income.

"We'd like to grow assets under management by 20% to 30% a year," Pearson says. Annual management fees range from 0.5% to 1.5% of assets, depending on the size of the account. "I'm very focused on growing assets under management," he says.

Controlling risk

Pearson sees his primary responsibility to clients as ensuring that they've controlled their portfolios for risk. He does that by allocating investors' money to assets that don't perform in synch, in accordance with the widely held belief that the majority of returns of a portfolio are due to asset allocation decisions.

For example, Pearson will look to the recent past and see that the performance of utilities, energy and natural resources doesn't move in tandem with the Standard & Poor's 500-stock index, a broad measure of large-company stocks. In a portfolio designed for capital appreciation, Pearson balances stock holdings with a 5% dose each of gold and commodities in order to diversify some of the risk of owning stocks.

The best way to diversify into assets such as gold and commodities is to buy exchange-traded funds (ETFs), he says. ETFs are baskets of securities that mimic an index and can easily be bought and sold on an exchange. Their relatively low management fees make them appealing to investors who want to own a particular slice of the market.

Pearson has even started placing some of his clients' money into an ETF that invests in private equity funds. The PowerShares Listed Private Equity (symbol: PSP) ETF, charges 0.70% annual management fee, a lot less than private equity managers charge. But because of the risks that private equity managers take, he won't allocate any more than 2% to 3% of an aggressive investor's portfolio in that type of investment.

Pearson doesn't pick investments because he thinks they'll outperform the broad market. "I'm not looking for sector calls," he says. "I want diversification."

One of the biggest challenges Pearson faces when diversifying a client's assets is that investors often have an overwhelming position in one stock, perhaps because they inherited it or acquired it by working for a single employer for many years. "It's a heartstring issue," Pearson says.

In Southwest Florida, Pearson says he's seen lots of clients with large investments in General Electric, Johnson & Johnson and Procter & Gamble. But as good as these companies are, Pearson says investors reduce their portfolio's risk by holding one stock to no more than about 5% of their total portfolio.

What's more, investors with big positions in a single stock often have a very low basis, which means they'll have a big tax bill if they sell. The solution is to sell over a period of years and manage taxes so that as many of the gains can be offset with losses. "An investment person is not worth their salt if they can't take a loss," Pearson says.

Pearson helps investors overcome these issues by illustrating his own strategy. Formerly with Northern Trust, Pearson says his portfolio at one time had more than 50% invested in that company's stock. It took him six years to sell and now he doesn't own any. "You need to practice what you preach," he says.

Personalized risk

More aggressive clients want Pearson to beat the market returns, of course. But because he doesn't have a model portfolio and tailors each customer's holdings to their risk preferences, Pearson doesn't publish a track record. He lets his clients determine a benchmark such as the S&P 500 and lets them measure his performance against it.

To do that, Pearson favors stocks over bonds. Fifth Third has a "buy" list of about 150 stocks from which Pearson can choose. The list includes mostly large-company stocks, though the bank doesn't disclose them.

Based on his forecast of lower interest rates and volatility, Pearson is a fan of small-company stocks. But allocation to small-capitalization stocks depends on a client's tolerance for risk because small stocks' performance tracks that of large stocks more closely than most people think. ETFs such as the iShares Russell 2000 Index fund (symbol IWM) are a good low-cost way of investing in small-company stocks.

In light of increased globalization, Pearson has boosted his clients' allocation to international stocks to as much as 25% of a portfolio, up from as little as 5% five years ago.

However, Pearson cautions that exposure to overseas markets doesn't necessarily mean investors have a diversified portfolio. In recent years, U.S. and overseas markets have moved more in tandem than in the past. Investors need only witness February's global stock-market decline sparked by investors in China to realize that. "The world is truly flat," Pearson says.

Still, Pearson will invest about a quarter of an aggressive investor's international exposure in stocks of emerging markets, such as Brazil, China and Russia. Just like gold and commodities, Pearson prefers to use ETFs to invest in emerging markets.

However, he cautions that investors who expect the sector's 30% annualized returns over the last four years are likely to be disappointed. "That will not hold," he says.

Managing for income

Portfolios that are geared to generate income have a greater allocation to bonds. For high-income investors with large taxable accounts, that means investing in tax-free municipal bonds. For those in lower tax brackets or those who have tax-deferred accounts such as IRAs, Pearson will invest in U.S. Treasuries, agencies such as Fannie Mae and Freddie Mac and high-quality corporate bonds.

Pearson prefers to ladder bond maturities out to 10 or 12 years, paying particular attention to when these bonds pay interest so that the income stream is smooth. That's despite the unusual fact that yields for longer-term bonds have not been much higher than short-term bonds in recent years.

Pearson says it's prudent to invest in longer-term bonds because his outlook for interest rates is that they'll decline over time. He says it's important for bond investors to protect themselves against what's called reinvestment risk - that is, investors won't be compensated as much as they are now when their bonds mature and they have to reinvest in new bonds.

Still, Pearson recommends income investors allocate between 10% and 25% of their money to Treasury Inflation Protected Securities (TIPS) in case his inflation forecast doesn't pan out. "We're not always right," Pearson acknowledges.

That's important because inflation is a bond investor's biggest threat, eroding the value of principal and interest. TIPS are U.S. government bonds and their interest payments are tied to inflation. TIPS investors benefit over traditional government bonds if inflation spikes.

REVIEW SUMMARY

Industry. Money management

Trend. Most of your portfolio's return is determined by asset allocation.

Advice. Identify broad economic trends before determining your portfolio's asset allocation.

Portfolio Case Study

Jerry Pearson, Florida chief investment officer for Fifth Third Bank Investment Advisors, tailors each investor's portfolio according to his own situation.

As you might expect working in Florida, Pearson advises wealthy investors with substantial real estate investments. Consider a recent case in which a Florida investor with large real estate holdings who recently asked Pearson for advice. Pearson outlined the risks this investor faces and the recommendations for his portfolio.

Risk: A downturn in commercial real estate. A downturn in commercial real estate may result in decreasing property valuations and rental activity.

Recommendation: No exposure to real estate investment trusts, homebuilders or other real estate related assets.

Risk: Reduction in global liquidity. The sharp upswing in real estate investments can be partially attributed to a sharp increase in global liquidity.

Recommendation: No exposure to emerging markets, such as Brazil, China or Russia.

Risk: Weakening dollar. If the dollar begins to decline, U.S. dollar-denominated assets become less attractive for global investors.

Recommendation: Invest more in international stocks and bonds.

Risk: Geopolitical risk. Gold is money and can be used as a hedge against geopolitical uncertainty and rising energy prices.

Recommendation: Invest more in gold, U.S. Treasury bonds and government agency securities.

Risk: Dramatic economic slowdown. A dramatic domestic or regional economic slowdown will hurt your real estate investments.

Recommendation: Buy U.S. Treasury bonds with long durations. Duration is the calculation that measures how many years it will take an investor to recover the cost of the bond considering all future principal and interest payments.