This past autumn, market participants faced a myriad of threats like a swift market decline, Ebola and instability in the energy market—all with different potential outcomes that posed many challenges to advisors on how to best counsel their clients. The hyperbole generated in the media can have detrimental effects on clients’ well-being when their emotions are stoked to the point of inducing panic sales.
Fast declines like the almost 8% drop endured by the S&P 500 in October invariably have no long-term significance, but can have long-term consequences when investors throw in the towel. Despite the possibility that markets are confronting more of these scares, investors may still not be learning how to cope with them.
With ETFs, advisors have tools at their disposal to help manage clients’ volatility exposure, which in turn should help clients better manage their emotions. Although the market action of this fall will soon be forgotten, now is the time for advisors to take the time to learn about different ways to reduce portfolio volatility, remind clients that markets do go down and spell out a plan of action for whenever the next serious decline occurs.
The terms most commonly used to describe these particular ETFs are liquid alternatives (or liquid alts) and diversifiers. Such terminology covers many strategies including selling short, tactical allocation (which can reduce or increase equity exposure), hedge fund replication, managed futures and some form of options overlay. All of these strategies seek to deliver the same general result of having a low correlation to equities.
Most financial professionals are likely aware of the statistic that domestic equities have an up year 70% to 75% of the time. This creates context for the role of liquid alternatives in a portfolio where the goal is volatility management. If equities move higher most of the time then too much exposure to funds that are designed to behave differently will become a drag on returns. Portfolio protection becomes less “important” and that performance drag caused by diversifiers in an up market becomes a source of frustration and impatience for clients. This may have been a contributing factor when CalPERS announced it was divesting its hedge fund exposure—although that came after years of “underperformance” from the HFRI Index when compared to domestic equities.