By Shefali Anand
The May 6 "flash crash" in the stock market spurred a big change in the instruments financial planner Michael Maloon uses in client portfolios: He has largely sworn off exchange-traded funds and returned to using traditional mutual funds instead.
The reason, he says, is liquidity risk. Sometimes, when there is a lack of buyers and sellers, the price of an ETF can diverge sharply from the value of its underlying investments. That's what happened on May 6, when some ETFs lost almost all of their value briefly. The Dow Jones Industrial Average, by comparison, fell 9.2% at one point during the trading session.
"When something deviates 99% from what it's supposed to do, I don't care if it's even for five minutes," says Mr. Maloon, who is based in San Ramon, Calif. "ETFs, in my book, have completely flunked the test."
One of Mr. Maloon's clients lost more than 20% of his stake in one ETF because of a stop-loss order requiring the fund to be sold if it fell below a certain price. And the day "could have been far worse," says Mr. Maloon. If the ETFs hadn't regained their value before the market closed, clients who logged into their accounts that evening would have seen massive losses in their portfolios and possibly panicked, he says.
Securities and Exchange Commission Chairwoman Mary Schapiro called May 6 "a market failure" in a recent speech, and a spokeswoman for the fund trade group Investment Company Institute says that "the SEC has several initiatives under way to strengthen the markets for the benefit of all investors, including ETF investors."
Still, worried about the possibility of a recurrence, Mr. Maloon has been selling clients' ETFs and buying index mutual funds instead. He still holds some ETFs in taxable brokerage accounts because selling them would result in capital gains.
While some of Mr. Maloon's partners continue to hold ETFs, he says net buying throughout his firm has stopped. "Definitely, everybody has got the message that it's not as straightforward as it appeared," he says.
In this column, we feature model portfolios from prominent financial advisers. Mr. Maloon, age 47, started as a stockbroker in 1988 and co-founded his current firm, California Financial Advisors, in 1998. The firm manages $750 million. Mr. Maloon has taught financial planning at Golden Gate University in San Francisco.
Here Mr. Maloon shares a model portfolio commonly used for his clients in retirement who are mortgage-free. The portfolio's weighted average cost is 0.51%. It returned 8.5% for the 12 months ended Aug. 31 and 2.12% annualized over the three years through that date, Mr. Maloon says.
U.S. STOCKS: The portfolio has a 30% allocation to U.S. stocks, including both index and actively managed funds. Mr. Maloon allocates 9% to Vanguard 500 Index /zigman2/quotes/209016161/realtime VFINX +1.06% for exposure to large-company stocks. He also allocates 9% to T. Rowe Price Capital Appreciation /zigman2/quotes/204825222/realtime PRWCX +0.79% , which he considers a "defensive" equity fund. "It better lose less in a down market, because that's really why I hired it," says Mr. Maloon. So far, he says, the fund has met his expectations.
There is a 6% allocation each to medium-size and small firms, through Dreyfus Midcap Index /zigman2/quotes/207179114/realtime PESPX +1.19% and DFA U.S. Small Cap Value /zigman2/quotes/201690238/realtime DFSVX +0.87% .
FOREIGN STOCKS: Over the last decade, Mr. Maloon has increased the allocation to foreign stocks to reflect the global nature of markets and economies.
Of the total 16% allocation, half goes to First Eagle Overseas /zigman2/quotes/209014684/realtime SGOVX +0.35% , which Mr. Maloon has used for two decades. "My biggest problem with First Eagle is [its] expense ratio. It's very high" at 1.2%, says Mr. Maloon. Still, he believes it's worth it. The other half of the foreign allocation goes to Dodge & Cox International Stock /zigman2/quotes/207409772/realtime DODFX +0.45% . Both funds, Mr. Maloon says, have beaten their broad benchmark index over long periods.
While these funds buy a few stocks of companies in developing countries, Mr. Maloon doesn't use a dedicated emerging-markets fund, as he thinks that is too risky for his retired clients.
"It's hard enough to explain that portfolios are getting hurt because of Bank of America and Wells Fargo," he says. "I don't want to get into [explaining] it's because of some takeover problem in Zimbabwe."
BONDS: Half of the portfolio is in bonds, which serve as the "defensive barrier," he says. At times when stocks are falling, such as in 2008 and early 2009, Mr. Maloon directs clients' attention to their bond allocation to show that it is enough to allow them to get through a 15-year stock-market downturn. This helps keep clients from panicking.
The bond allocation is primarily in two Pimco funds—20% in Pimco Total Return /zigman2/quotes/210424051/realtime PTTAX +0.56% , which buys various types of bonds, including government and corporate bonds, and 15% in Pimco Low Duration /zigman2/quotes/200986696/realtime PTLAX +0.21% , which has two-thirds of its portfolio in bonds that mature in less than three years.
The remaining 15% is invested in Vanguard Short-Term Investment-Grade /zigman2/quotes/200545654/realtime VFSTX +0.40% .
In taxable accounts, Mr. Maloon uses a national and a California municipal fund, which buy bonds of short and intermediate term. However, he allocates some money to Pimco Total Return as well, for diversification.
COMMODITIES: Mr. Maloon allocates 4% of the portfolio to Pimco CommodityRealReturn Strategy /zigman2/quotes/202542418/realtime PCRAX +0.83% , which aims to provide the return of a commodity index while also buying some inflation-protected securities. He believes that the global demand for commodities is headed upward. Commodities also act as "a good diversifier," he says.
Ms. Anand is a personal-finance columnist for The Wall Street Journal, based in New Delhi. Email: email@example.com.