As events unfold at breakneck speed on the national and international stages, uncertainty—and the volatility it inevitably breeds—seems to be the only enduring theme dominating the public conversation about investing. Volatility introduces the risk of loss and should invite caution, but it can also create opportunities for investors to purchase assets at compelling prices. Here are seven principles to help you and your clients maintain perspective.
1. Acknowledge that this is a time of flux, regardless of your political beliefs. Let's start with what's obvious and local: we are witnessing a seismic shift from a post-crisis ethos of intervention (think Dodd-Frank) to an administration that broadly favors deregulation. The swinging pendulum will touch industries beyond finance and ranging from healthcare to education to energy. Opinions differ on whether markets have priced in the right amount of optimism. From a more global perspective, an era of coordinated monetary easing has ended as the United States prepares for additional rate hikes. Meanwhile, in the United States and Europe, fiscal policy may be poised to loosen. ETFs are the most cost-effective way to express conviction that all will proceed smoothly and as expected. The possibility of a different outcome gives active managers a lot to chew on.
2. Understand the implications of following the herd. Have you heard your fill of offhand comments that ETFs represent the latest “bubble”? Rather than use the dreaded B-word, Seth Klarman—the “Oracle of Boston” and the only hedge fund manager heralded publicly by Warren Buffett—instead wields a powerful mathematical argument: when a lot of capital flows uniformly into (or out of) certain securities as a group, it “will tend to 'lock in' today's relative values” between those securities. Which is fine—until it becomes clear that some companies have been punished for merely not belonging to an index, while others have ridden the wave of index constituency to artificially high multiples. If this situation corrects itself and companies are priced more on their individual merits, well-managed active strategies stand to benefit.
3. Balance active and passive approaches. This is not to say that passive is passé. Active managers, and particularly funds of funds with double fee layers, start the performance race against lost cost indexing strategies with a significant net return disadvantage. Paradoxically, Buffett is both a staunch advocate for indexing and arguably the most successful active manager of all time. He reconciles these opposing views through the belief that there are a small number of investment managers capable of earning their fees—and then some—through superior performance. Klarman (whom Buffett believes to be among these select few managers) believes that the exodus of capital from active strategies will ultimately improve active managers' returns as fewer dollars chase a finite number of opportunities.
4. Revisit your definition of diversification. A portfolio of 500 companies will likely be less volatile over time than any of its individual constituents. However, in a downturn, each of those companies is likely to respond negatively to any of a number of events, like geopolitical conflict, a weaker-than-expected jobs report, or a larger-than-expected rate hike, to name a few. Moreover, an initial decline in an index could precipitate further declines as more and more ETF investors redeem in panic. Rather than think of diversification only as safety in numbers, it may be more prudent to approach it as a broadening of portfolios to include components that may respond differently to the same events. While many hedge funds, for example, have disappointed relative to indices in recent years, it is important to remember that they lost significantly less (on average) during the financial crisis and tended to recover these losses more quickly. This outperformance was due in part to their ability to “hedge” risk by reducing exposures quickly and by using short positions, derivatives and minimally correlated assets such as gold and U.S. Treasuries.