The wild stock market gyrations this year have shocked investors who had been lulled into complacency during a largely uninterrupted rally over the previous decade. Suddenly, the word ‘volatility’ is dominating stock market discussions, and investors are being warned that it could continue into the foreseeable future. What seems to be lost on many investors is that volatility is not new – it is the norm, as it has been for more than 100 years. This is, however, a shock for many investors, especially those who favor passive investments like exchange-traded funds. Those passive investors – and it is a huge group – are learning that their index funds can decline 4% in a day or 10% in a week, just like the stock market. This creates some challenges, and some opportunities for a growing number of investors. Is Multi-Asset Class Investing for them?
It’s a New (Real) World for Passive Investors
The market has always rewarded patience and discipline for investors who exercise it. The problem is that the average investor does not have much tolerance for volatility as evidenced by the massive fund outflows following major corrections such as experienced in January 2016, and the more recent one in February 2018. To make matters worse, average investors do not return to the market until it is well into its recovery, which effectively locks in their losses. That is a key reason most individual investors significantly underperform the stock market..
The surge of inflows into passive investments has occurred just in the last five years – a period during which the average annual return of the Standard & Poor’s 500 Index exceeded 19%. The big draw for passively managed funds is ow fees, which is an advantage if there is no need for active management. That is the primary reason why robo-advisors have also proliferated during the same period. Using algorithms to formulate a custom asset allocation of low-cost index funds or ETFs, obviates the need for human advisors.
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What’s Next for Passive Investor?
Most passive investors have not experienced a down market or a rising interest rate environment, much less the persistent volatility that typically accompanies both. For that matter, neither have robo-advisors. However, one thing they should count on is the next time the stock market falls 40% so too will their index funds.
While the recent environment of low volatility and upward trend has been ideal for passively managed investments, the return to normal volatility in an aging bull market is likely to increase their risk exposure beyond what many investors can tolerate. For strict passive investors, the only way to minimize the risk of the inevitable market downturn is to try to pick the right time to move their money out of the market and, as history has clearly shown, investors are lousy market timers.
Higher Risk-Adjust Returns with Multi-Asset Class Investing
Decades ago, it was shown that by combining volatile asset classes with dissimilar return patterns that asset managers could n generate a higher risk-adjusted return with significantly less volatility than a typical weighted average fund containing the same asset classes. Multi-asset class investing recognizes the futility of trying to predict which asset classes will outperform at any given time. By combining multiple asset classes with low or negative correlations, investors are likely to achieve a higher portfolio return and a significant reduction of risk.
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Covering the Downside Requires Active Management
What matters most to investors is protecting their portfolios in a downturn. If risk or volatility is their concern then having agility and taking proactive steps to preserve capital until the markets begin to recover makes sense. Doing better than the market in down turns is one way to ensure positive long-term performances. The increasing risks of the market underscores the need for an adaptive, real-world, regime-based approach that takes into account financial cycle and macroeconomic risk.