Last year’s abysmal market performance, across nearly all asset classes, may be heralding a new era of lower, less predictable returns. After six years of solid stock market profits (S&P returns of over 17 percent annualized from 2009-2014), the completion of the Fed’s unconventional monetary policy called quantitative easing (QE) did little to support already fully valued asset prices. Enormous debt growth, especially among emerging markets, and the demise of the commodities super cycle have generated a degree of angst among investors and speculators not seen since the Great Recession. The important work of helping clients to remain disciplined and engaged throughout corrections cannot be overestimated. Behavioral coaching—along with a bit of guile—can go a long way toward saving clients from themselves.
What does 2015’s performance mean for future investment returns? Has unconventional monetary policy pushed asset prices above sustainable levels? Could the Fed’s QE unwind pressure asset prices for the next several years as early 2016 may be indicating? Lastly and perhaps most importantly, is there a worldwide credit/commodity recession unfolding? And if so, what does it mean for the U.S. economy and future stock returns?
Now that the unwind phase of QE is at hand, deflationary pressures may well reassert themselves. No one really knows. The process whereby QE purchased securities mature, known as tapering, may diminish market liquidity and offset the Fed’s extensive easing efforts of the past several years. With few recent data points to draw from, deflation is poorly understood by most advisory practitioners. What’s more, the Fed’s recent focus on eliminating the threat, may have served to postpone deflationary pressures, making identification all the more difficult.
Growing market volatility and a newly emergent “risk off” mentality initially in energy and highly leveraged financials is spreading to other vulnerable markets. The slightest earnings disappointment or adverse narrative is now grounds for a thrashing from disappointed traders and short sellers.
Portfolio Management Best Practices
One of the more important, yet vexing, issues for most advisors revolves around appropriately defining and managing the risks specific to each individual client. Spending time to understand client risk tolerance including time horizon, age and income needs is essential. Risk varies by client circumstance and market environment, so it can be a moving target. To some, diminishing risk means avoiding significant portfolio price declines (asset value volatility) while to others it’s about having sufficient lifetime income (sustainable withdrawals). Developing and maintaining the appropriate risk tolerance framework during a correction (or bear market) is a conundrum requiring time, effort and an ongoing commitment to client communication.
Arriving at a suitable asset allocation and retaining that mix throughout a correction is the most important determinant of long-term performance. Discipline and consistency within a portfolio is essential. Regrettably, a client’s commitment to necessary risk assets can disappear rapidly during market corrections. Once an allocation is in place, maintaining a long-term focus throughout the correction will help limit short-term distractions and behavioral blunders.
Fortunately, there are several proven practices that may improve returns during tumultuous market corrections. When markets grind lower, volatility tends to elevate and liquidity suffers. Trying market conditions increase the temptation to sell all assets without differentiating between better and lesser quality. During these “risk-off” time frames, discipline and adherence to proven practices can add significant value and perhaps, more importantly, save clients from themselves. Human nature is a wonderful thing…but not in fast markets.
Core-satellite is a well-established approach to portfolio construction offering enormous potential benefit to taxable investors. Core investments are focused on less active, lower cost managers who emphasize competitive “market-like” pre-tax returns with the potential for improved after-tax performance. Satellite strategies typically offer unique return generating, if not diversifying, investment exposures.
Through the use of separately managed accounts (SMAs) advisors can support the more advantageous treatment of each individual security in the portfolio. Unlike mutual funds or ETFs, SMAs are made up of independently tradeable securities reported on as a whole. Through a core-satellite approach and the use of SMAs, investment advisors are able to collaborate with core asset managers to create a more client focused solution offering the potential for significantly improved after-tax returns. After-tax returns may be further enhanced through active tax-loss harvesting. During prolonged corrections, where stock prices fall below their original portfolio purchase prices (or basis), tax loss harvesting opportunities may abound and can be used to offset future realized gains across the portfolio. This strategy can be a great way of adding value to client portfolios when few other prospects avail themselves.
Active trading, under-diversifying, or even momentum investing (buying winners while selling losers–the root cause of many bubbles) are all examples of poor investor judgement driven by behavioral biases and speculation. Creating a buy and hold portfolio supports the avoidance of these behaviors–especially market timing. In a recently published study by Yahoo Finance, missing the best five days over a 20-year time period reduced annualized equity returns by 24 percent. Missing the 20 best days slashed returns by an astounding 67 percent.
Balanced portfolios, those with allocations to both bonds and stocks, have proven to provide better risk-adjusted returns than all stock portfolios. Even during periods of low fixed income market yields, as is now the case, bonds have a fraction of the volatility of stocks and tend to rise in price when stocks are stressed. Investors often underestimate the value of high quality fixed income investments as market buffers—especially during stock market corrections.
We recommend that retirees emphasize large cap stock portfolios to further insulate themselves from market declines. Large caps typically outperform riskier small caps in bear markets. Additionally, over an entire market cycle, large caps offer a better risk adjusted return based upon the widely accepted Sharpe Ratio. Purchasing stocks that offer above average growth in dividends is yet another way investors may help protect themselves (albeit partially) from the grips of a correction or bear market. Historically, an astonishing half of equity returns have come from dividends. In addition to providing retirees with extra cash flow, many higher dividend paying stocks are also high quality large caps.
Active core stock portfolio management can offer significant benefits unavailable from passive strategies during market corrections. Active managers can often identify fully priced equity markets and intervene by defensively adjusting their portfolios (either through lowering the beta, raising residual cash or equity sector realignment) as valuations warrant. Proactive management that avoids a portion of the correction’s decline, unlike a fully invested benchmark portfolio, can be enough to help investors remain engaged and may be an important value-add opportunity.
While not specifically portfolio management techniques, many of the higher value-add, tax-aware techniques can add significant value during market corrections as well. Location management, the thoughtful assignment of assets based upon their tax implications is one of the more valuable tax planning considerations an investment advisor can provide. Tax-loss harvesting (described earlier), can add extraordinary value during a market correction. Likewise, establishing and adhering to an annual realized gain budget will support the building of losses (to be used against eventual realized gains) while improving after-tax results and avoiding unpleasant year-end tax surprises.
Rebalancing in taxable accounts, unlike those in deferral, should be done in moderation as a means of retaining overall portfolio alignment rather than as a quarterly ritual that often generates taxable gains. While over/under weightings should be corrected over time, minor allocation drift should not be considered a problem. Realignment can occur as a way of managing portfolio risk or when sector strategy changes are necessary. Thoughtful rebalancing with realized gain budget limitations in mind should be a central tenant of asset management best practices.
In challenging markets quality manager selection and due diligence becomes even more important and should be done with great care. We recommend hiring proven experts and taking time to gain insight into their respective disciplines. Within core, long term performance/value-add should always be the primary focus. Once hired, even if early performance proves sub-optimal, managers should be given an extended period to prove themselves as this will avoid wholesale liquidations and the tax problems that can result.
Market Corrections Necessitate Asset Management Best Practices
Stock market corrections are healthy. They perform an important function as a counterweight to unsustainable rallies, poor investment decisions and by piercing market bubbles. Once high or unsustainable valuations are brought back into line, market expansion can begin anew. As corrections run their inevitable course it is essential that investment advisors remain realistic yet constructive on the markets. Assuming each client’s risk tolerance remains acceptable and appropriate, a commitment to the strategy allocation should remain.
The 2016 Legg Mason Global Investment Survey of investors found that respondents would capitulate (or liquidate their core equity holdings) after a 23 percent market decline. Investor psychology, especially during market corrections, is clearly of critical importance. Similarly, a 2014 Vanguard study “Putting Value on your value: Quantifying Vanguard Advisor’s Alpha,” found the single largest contribution to “Advisor’s Alpha” was behavioral coaching which could add up to 150 basis points annually (or around half the overall value-add potential accorded to advisors by their study).
What does the poor market performance of 2015 and early 2016 and the ongoing unwind of QE hold for future investment returns? What does the worldwide credit/commodity recession mean for the U.S. economy and future stock returns? Only time will tell but eight years into the bull market we can anticipate a continued narrowing of stock market leadership and a slowdown in corporate earnings growth. Pressure on earnings growth along with growing market volatility will continue to frustrate investors and may ultimately lead to heightened anxiety, occasional panic attacks and the especially harmful behavioral psychology gaffes.
Within this more challenging environment, the use of large-cap stocks in a buy and hold portfolio may soften the market setbacks and the emotional client reaction that can result. According to Vanguard, cost effective portfolio implementation (minimizing management fees, trading costs and taxes) can add up to 45 basis points per year. Maintaining a long term, balanced portfolio with a thoughtfully designed asset allocation should lower volatility and ease investor anxiety. Avoiding the siren call of market timing during corrections is essential. Rebalancing only when necessary in taxable accounts is the best tax-aware strategy and can add value over and above the 35 basis points Vanguard assigns it.
Challenging markets require improved lines of client communication. Better communication (more of it, more often) should lead to a shared understanding of market fundamentals and help advisors to anticipate changes in a client’s tolerance for risk. Exercising proper manager selection and due diligence, with an emphasis on less active, more defensive managers and avoidance of passive index-like strategies (or market beta) can support improved client confidence and patience. Helping clients remain calm and stay the course during protracted market declines is one of the most important value-adds an advisor can provide. Discipline, behavioral coaching and a modicum of guile will prove useful in overcoming the episodic emotional over-reaction investors are prone to during market corrections.
Steve Riley, CFA, CFP, and Rick Furmanski, CFA, CFP, are tax-aware portfolio managers at Clearview Wealth Solutions.