This summer saw the S&P 500 rule headlines for enjoying the longest-running bull market in history. Yet, as per the old adage, what goes up inevitably comes down, and it is the job of advisers to manage clients’ portfolios accordingly – either directly or via the third-party investment services they use.
A crude assumption might be to expect a seismic shift towards active management, giving advisers the flexibility to avoid the painful decline of a pure passive approach that invariably follows the index down.
Advisers are also increasingly outsourcing to discretionary fund managers, with the potential advantage of speed in a downturn, as advisers would not have to seek permission from clients to rebalance investments, and could also benefit from investment expertise and greater research into how to position funds to mitigate the worst of a market crash (see chart below).
Tatton Investment Management chief executive Lothar Mentel notes one example earlier this year, where the firm took a view that they should reduce their US small and mid cap exposures, alongside certain emerging market positions. These funds fell 15 per cent since.
Compared to advisers either picking single strategy funds or constructing advisory models with discretionary permissions, he notes the DFM was able to make the change before the fall, rather than saying “let’s do it when we next meet” with the client.
Higgins Fairbairn Advisory chartered financial planner Gianpaolo Mantini notes that while index funds have become so popular following the financial crisis, the world has not seen any subsequent prolonged periods of down markets on which they can be judged.
He says whether the nadir of the global financial crisis in 2007/08 can be repeated in terms of how investment strategies stack up remains unknown. Passive funds may also be subject to forced sellers, driving a momentum trade that becomes something of a self-fulfilling prophecy. “I think it is more about the behaviour of the investors,” he says, downplaying the assumption that active funds shine brightest during down markets.
“It is not just about passive, but active funds, passive, structured products… There are multiple possibilities and we want to consider all the options in the armoury.
“This is our clients’ money and we need to look at their individual preference. If they favour a certain investment style, theme, or have another idea in mind, providing it is reasonable, then we can discuss that with them.”
Capital Asset Management chief executive Alan Smith says many market participants confuse volatility with permanent loss of capital. He points to a piece of JP Morgan research that notes the average intrayear market decline of the MSCI Asia Pacific ex-Japan is 20 per cent.
“They might be up 40 per cent one year and down 40 per cent the following, but with investment markets, such volatility is to be expected. It’s like saying it is going to rain one day. You might not know when, but if you are prepared, there is no need to worry,” he says.
“But permanent financial loss is different and, in order to protect yourself from that, you need to build a globally diversified, all-weather portfolio, which is based on facts and evidence.
“By adding in parts of the portfolio that protect on the downside – low-risk, defensive, non-correlated assets – it means that when the inevitable happens, that part of your portfolio that temporarily falls in value will be held up by the other assets that will probably rise in value, such as government bonds, or treasuries, for instance.”
He calls the idea active managers can anticipate when markets may start to fall a “fallacy”.
Based on data from tools such as Morningstar and S&P Indices Versus Active, Capital has created a series of “tolerance levels” and if any of their portfolios breach these thresholds there will be some proactive tweaking to ensure that their performance does not veer too far from their targets. But the default is an annual rebalance, because Smith sees trading too frequently as racking up frictional costs unnecessarily, especially when markets have tendencies to self-correct.
Meanwhile, Nexus IFA managing director Kerry Nelson says early preparation is key.
“We all understand the economic cycles, so would start to revisit our clients’ portfolios well in advance, as we go through the expansion phase of the economic journey. For example, in the midst of the highs we reviewed all our clients’ portfolios and started to de-risk them, taking a more conservative approach,” Nelson says.
Effectively rather than trying to time the market quite so accurately, by crystallising much of the upside, you might miss out on a bit more where there was further to run, but tempering that temptation to run the winners too long means you mitigate the risk of greed taking over and losing out altogether.
Rather than upping the ante in favour of active funds over passive, Nelson turns to cash for downside protection. “Many of our clients now have larger cash holdings and we have progressed this further over the months as we have felt additional pressure bubbling, which has taken additional time,” she says.
She also says where clients remain invested, their exposure to alternatives, for example, might be taken up in a bid to de-risk the overall portfolio. “This might bring in higher costs but will also mitigate risk and the intention is to smooth any major hiccups,” she adds.
Seven Investment Management, which runs its own model portfolios, sticks to the approach of long-term strategic asset allocation, with a tactical overlay.
Relationship manager and chartered wealth manager Henrietta Grimston says an anticipated downturn would not necessarily impact any blend of active versus passive holdings, rather they would be an important factor in the overall asset allocation, as dictated by the prevailing market conditions.
But she adds: “For shorter-term tactical positions, passive investments would generally be favoured due to ease of trading. Whilst passive investments have the edge when it comes to cost, we still support the inclusion of active management in our portfolios where managers have demonstrated a long-term track record of adding value over and above the costs.”
Wetherall’s director James Wetherall turns to Square Mile for his investment management, using cashflow modelling software to sense-check.
The key is not making sweeping changes in response to newsflow.
He says: “Typically we have about 60:40 in active to passive with an element of cash. We are able to trim the costs by using passives but we do not understand paying charges on government bond funds when we could hold cash instead.”
In terms of communication, education is critical. Smith says the counterintuitive nature of holding one’s nerve when things are falling is challenging, especially with his more sensitive clients.
He says: “In life, negative situations generally require a degree of action. With investments, it is the opposite, which is hard to believe when so much information is coming from elsewhere, and negative news stories are more interesting to read.
“With retail financial services, most have a long-term view. Even those in their 60s have a 30-year time horizon, or even longer because of intergenerational planning. Why are we worried about what markets are doing on a month-to-month basis?”