The financial markets are expressing some euphoria over the prospect of a business-friendly environment in coming years, but several factors point to the possibility of higher volatility in 2017 and beyond—and that might spell trouble for investors who stick solely to a passive, index-oriented approach.
Even as expectations are riding high for overall economic growth and a boost to financial services and other sectors, thanks to the prospect of looser fiscal policy and fewer regulations restraining business operations, there is still uncertainty about how quickly—and even whether—such policies will get implemented.
“We’ve got a whole new administration with a soon-to-be president that has a very different view and style than we have seen. That can cause some upheaval in the financial marketplace,” says Noah Hamman, chief executive of AdvisorShares Investments LLC, a provider of actively managed exchange-traded funds.
“We’re going to see a lot of changes from regulatory rules to government policy to even tax policy that are going to have material changes on companies both domestically and internationally,” he says.
Investors shouldn’t forget that financial markets tend to price in news quickly—and reality has yet to set in. The markets “have basically priced in this very optimistic outlook for the economy as it relates to the price of equities,” says Josh Emanuel, chief investment officer of Wilshire Funds Management and portfolio manager of the AdvisorShares Wilshire Buyback ETF (TTFS). “There is still, in our opinion, a great deal of variability as to whether or not that’s going to play out as quickly as one would expect.”
Combine that uncertain future with rich valuations and what some say are optimistic earnings outlooks and you get a strong case that the investment environment will be choppier in 2017. That’s not to suggest investors should largely underweight equities, Emanuel says. But this type of environment makes a case for active management—experts who can pick apart the market, identify opportunities and risks and make strategic moves or even, at times, no move at all, as the situation warrants.
Certainly, passive index investing has performed well over the past five years and more, while active management suffered, with about 75% of large-cap equity managers underperforming their benchmark index. But that tide is likely to turn and when it does, investors may well seek managers who can navigate an uncertain future. “Ultimately, market-cap weighted indices are like price-momentum strategies,” Emanuel says. When all boats are rising, passive strategies fare well. Going forward, the story may not be so simple. “In the equity space, for example, there is reasonable dispersion in valuations between the most expensive and cheapest,” he says. “When you start to get valuations stretched like this for equities, there is an opportunity for active managers to step in.”
While changes are ahead, it’s also true that some strategies flourish over the long haul, almost irrespective of broader trends. AdvisorShares counts among those strategies the tactic of investing in companies that are buying back shares. Assuming investor demand remains consistent, a company that buys back shares is reducing shares outstanding; all else equal, that pushes the share price higher. In other words, buybacks are a clear way to create enterprise and shareholder value. Plus, buybacks may indicate that management considers the stock to be cheap. (There are situations to avoid, such as companies where management is taking on debt to buy back overpriced shares.)
Buybacks are enjoying a heady moment of late, with many prognosticators pointing to the possibility of a tax holiday for companies to repatriate cash back to the U.S.—the implication being that companies will use that cash to buy back their shares. While a tax holiday may indeed provide a short-term tailwind for the buyback strategy, the AdvisorShares Wilshire Buyback ETF (TTFS) has a longer-term focus. The Buyback ETF concentrates on the universe of large-cap companies that are increasingly buying back stock. On the whole, these companies enjoy cheaper market valuations. “There is a consistent risk premium, so to speak, that investors can earn by investing in companies that are buying back stock,” Emanuel says. “Trying to time that based on repatriation of cash or the market cycle is a very dangerous thing. We think buybacks are a good place to be consistently over time.”
Meanwhile, for those seeking a fixed-income solution, there are other risks to consider—chief among those is interest-rate risk. Floating-rate bank loans are one solution, in part because they offer “a relatively positive spread compared to a lot of other asset classes out there, with much less interest-rate risk,” says Bob Boyd, managing director of Pacific Asset Management and portfolio manager of the AdvisorShares Pacific Asset Enhanced Floating Rate ETF (FLRT).
Plus, floating-rate debt offers the protection of being senior secured. And the rate resets in almost all cases about every three months—a positive feature given the likelihood of higher interest rates in 2017.
AdvisorShares Investments LLC is a Bethesda, Md.-based provider of actively managed ETFs, currently offering 22 funds in a variety of investment types, including equity, income, multi-asset and commodity products.
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