What are the concerns you’re hearing these days from your clients? If you’re like most financial advisors, those concerns probably include one or more of the following:
1.“I’m nervous that the bull market in stocks is well into its seventh year without a major correction, and I’m concerned that a severe downturn is just around the corner. I’d like to avoid that, of course, but I can’t afford to miss the market gains if the bull market persists.”
2.“I’m annoyed that my portfolio, which is diversified according to your recommendations, has not been keeping pace with the broad equity market for several years now.”
3.“I need income from my portfolio, but I’m troubled by what I’m hearing about the prospects for fixed income investments in a rising interest rate environment.”
4.“I want a stable portfolio and I understand that that’s why you have me invested in so‐called alternatives, but I am very dissatisfied with their performance.”
You know that the first concern is a real problem, since you believe that equities represent the one truly essential component in virtually all your clients’ portfolios, and you agree that missing out on stock market appreciation may jeopardize the success of their financial plans. You share your clients’ apprehension about the inevitable severe downturn, but you’re not comfortable responding by timing the markets — that’s not a true and reliable skill, and you feel it would be imprudent to make market‐timing bets with your clients’ hard‐earned assets.
With respect to the second concern, you’re probably feeling some fatigue continually explaining the long term benefits of asset allocation and broad portfolio diversification to your clients. You still believe in those bedrock concepts, but you know that if we were to experience another market disruption on the scale of 2008‐2009, contagion across asset classes may again set in, and diversification will not protect your clients from harm.
The third concern, about fixed income investments, is a tough one. You know that the bond market is concluding a historic 30‐year bull market as interest rates have steadily declined over that period. As the Federal Reserve embarks on a new chapter in monetary policy, raising rates for the first time in a long time on December 16, 2015, the landscape will become more challenging for fixed income investments. You recognize that it is mathematically impossible for the fixed income asset class to repeat its performance of the last three decades over the next several years, and perhaps over the investment horizons of most of your clients. You can reach for higher yields, by moving into lower‐credit‐quality bonds for example, but you know that this will mean that your clients’ fixed income assets will start behaving more like equities, and that this will compromise their diversification benefit — a key reason you include fixed income assets in the first place. Because this is a phenomenon unique in the last 30 years, you recognize that this is a problem you and most of your colleagues in the profession have had no experience with in your careers.
Finally, you sympathize with the fourth concern because you are finding it increasingly difficult to identify alternative investments whose returns, and return prospects, haven’t descended into mediocrity.
So, what are you to do in an environment like this?
There has been increased activity recently in an investment approach that we’ve termed “risk‐managed investing” (RMI). By RMI we mean the attempt to imbed risk management directly within the equity investment itself. This equity risk management can take the form of volatility dampening and/or downside risk mitigation. RMI solutions have been coming to market with regularity. In our view, the best of these RMI offerings can explicitly and effectively deal with each of the concerns outlined above.
We’ll discuss how this can work in subsequent articles in this forum. We’ll address each of the concerns and the RMI response in detail. We’ll also cover RMI’s potential for dealing with classic investment and financial planning issues such as volatility drag and sequence risk. We’ll look into how large a cost you should tolerate for RMI. And we’ll examine RMI’s possible impact on alpha generation, portfolio construction and optimization, and performance benchmarking. For the more technically inclined, we’ll spend some time exploring the techniques used by these RMI solutions.
We look forward to a thorough, in‐depth, and interactive dialog with you.
Jerry Miccolis is the Chief Investment Officer at Giralda Funds, a participant in the ETF Strategist Channel.