Financial Literacy Month, observed in April, gives advisors the opportunity to reconnect with clients and ensure they’re well-positioned to meet their goals. The volatility that markets showed earlier this year is undoubtedly still raw in clients’ minds, and advisors should make sure their clients’ portfolios have adequate risk protection measures in place — which, in many cases, means implementing active strategies.
Already, 2018 is shaping up to be one of the more economically turbulent years in recent memory, and our always-on news cycle can make it nearly impossible for advisors to convince clients to stick with a coherent strategy. One day, the news feeds indicate the economy is strong; the next, the data shows growth is stalling. It seems when the Dow falls, interest in active management is piqued, but when it rises again, investors soon forget.
It’s up to advisors to make sure their clients’ portfolios are protected from bear market losses now — before it’s too late. Here are four truths advisors can tell clients during Financial Literacy Month to encourage them to embrace active strategies:
1. Investors can benefit from active strategies now — not just during a bear market correction.
It’s entirely possible that the market will continue to reach new highs in 2018, and that we won’t see a bear market correction until late 2018 or early 2019. But even though we’re in the midst of the second-longest bull market run in history — which just reached the nine-year milestone — the next bear market isn’t a matter of if, it’s a matter of when. Advisors should explain to clients who aren’t worried about an inevitable correction that market cycle research shows that bear market losses since 1950 were up to seven times more powerful than bull market gains.
What many investors don’t realize is that not only do active strategies provide risk mitigation during bear market cycles that passive products may not — active can also outperform passive in a bull market. According to the Morningstar Active/Passive Barometer, a semiannual report that measures the performance of U.S. active funds against their passive peers, 43% of active managers outperformed their passive counterparts in 2017. And despite above-average returns from the S&P 500, many active ETFs outperformed the index last year.
2. If the Fed raises rates too aggressively, they could plunge the U.S. into a recession.
In his first news conference as Federal Reserve chairman, Jerome Powell seemed to indicate that he plans to follow a similar playbook as his predecessor, Janet Yellen. Not only did the Fed raise rates last month, officials expect two or three more rate hikes this year and three in 2019, which would create a deliberately restrictive interest-rate policy.
Historically, when the Fed shifts policy from easing to tightening, it leads to a bear market correction and (yes, it’s possible) a recession. Increased corporate and consumer borrowing costs, which tend to slow down consumption and business spending, could be offset by the fiscal stimulus created by the new tax law — but it’s too soon to tell whether tax reform will cause the consumer spending, business investment and GDP growth that would justify rate hikes. Even the most seasoned investors can’t predict how this tug of war between fundamentals and Fed policy will play out, so they would be wise to protect their portfolios from potential risks created by the Fed.
3. Backlash against Facebook and other tech companies could impact the entire S&P 500.
It’s been a wild few weeks for Facebook. A series of revelations about how the social network violates users’ privacy caused the stock price to plunge 14% the first week these scandals emerged. Unfortunately for passive investors, it’s not just Facebook’s stock that suffers, but the entire index.
Many investors don’t realize that most passive ETFs are capitalization weighted, meaning the largest companies disproportionately impact returns, for better or worse. Last year, it was for the better, as Facebook and other FAANG stocks (Apple, Amazon, Netflix and Google) far outperformed the S&P 500. For example, the S&P 500 gained 19% in 2017, while Facebook’s stock jumped 53%.
This year might not be as rosy — and it’s not just Facebook that’s in trouble. According to a recent survey by Axios, favorability ratings for Facebook, Apple, Amazon and Google have plummeted in the last five months. Although Facebook’s favorability took the biggest tumble, dropping twice as much as the others, its struggles could erode trust in other tech companies and how they use consumers’ data.
With passive investing, returns can be symmetrical with the index. If the largest S&P 500 stocks decline, the entire index and those returns would thereby fall with them.
4. Crowded passive indexes have created a liquidity trap reminiscent of those preceding the 2000 and 2008 market crashes.
Last year, ETFs reached a record-breaking $4.5 trillion in assets under management — a trend that’s expected to continue in 2018. In the past, one of the indicators of a market top has been crowded trading. When investors’ outlook shifts from optimism to pessimism, selling off overpriced assets en masse creates a dangerous liquidity trap like the ones that caused the 2000 and 2008 market crashes. Investors got a preview of this in February, when speculation of more aggressive rate hikes from the Fed and fears of inflation caused a short-lived but dramatic market correction.
Institutional investors surveyed by Natixis Investment Managers earlier this year have a similar outlook. Fifty-nine percent believe passive investing has artificially suppressed volatility and distorted relative stock prices, while 63% feel asset inflows into passive investing have contributed to systemic valuation risk.
Whether it’s Facebook, the Fed or simply a bull market that’s run its course, a bear market correction seems far more likely within the next year, and investors are no doubt concerned about their portfolios’ ability to withstand it. This month, advisors should talk to clients about incorporating a mix of actively risk managed and passive strategies to mitigate losses during the next bear market cycle — which, whether it happens this year or is staved off until 2019, is inevitable.
Don Schreiber Jr. is the founder, CEO and co-portfolio manager at WBI Investments, which provides institutional and private client wealth management solutions.