Almost every fund manager newsletter and commentary in recent months has discussed the low level of volatility as represented by the VIX index, and what it does or does not mean.
“Complacency” is a word used in many commentaries. Investors are ignoring a boxful of geopolitical risks, as well as the uncertainties that accompany the ending of quantitative easing. Not only that but most developed equity and bond markets are expensive on almost any measure and none are cheap.
Yet the fund managers reporting on this complacency almost all come to the same conclusion: the economic outlook is so positive it is worth maintaining overweight positions in equities.
There are structural reasons why fund managers are optimists. A fund group gathers assets based on good relative performance, so it will not mind if a fund tanks – so long as it has previously gathered enough assets based on superior performance relative to its peers.
And fund groups’ earnings (and directly or indirectly, the remuneration of individual managers) are based on assets under management. The result: rarer than hen’s teeth is the fund manager who suggests you sell.
But financial advisers do not share the same incentives as fund managers and should not be driven by their logic. For most clients, preservation of capital is more important than the returns they get. That ought to drive every aspect of the investment process in advice firms but mostly does not.
Instead, many advisers boast how much money they have made for clients during bull markets but fall silent and hide under stones in bear markets. They unwittingly follow JM Keynes’ maxim that it is better for a professional investor to fail in company than alone.
Asset Allocation 101 taught us diversification is the best protector of capital, but those books were written before global QE. With interest rates near zero and equities fully priced, it is easy to see that a sharp simultaneous decline in bond and equity prices is possible. How to protect client portfolios against that eventuality ought to be investment advisers’ top priority.
Every week sees another attempt to square the risk-return circle. Funds investing in structured products are the latest new kid on the block, following targeted return, emerging market debt and infrastructure plays, and, for those who want it all in one box, multi-coloured multi-asset funds.
Advisers can use these and other building blocks to create more resilient portfolios. That is all very well but, when the blue chips are down, the key issue is what percentage of a client’s portfolio is invested in equities (I would also say developed market bonds) since, in a crisis, all equities are likely, as usual, to correlate to one.
Look through all those new-style funds to the underlying asset allocation of the portfolio. The simplest and most effective way of reducing risk is reducing equity (and developed market bond) exposure.
I have heard advisers say they cannot increase allocations to cash because clients would object to paying an annual fee on a cash holding that generates no return. But cash is an investment asset precisely because only cash is guaranteed not to correlate with the others.
If valuations keep rising, cash will become the only sensible remaining refuge for risk-averse investors. It might be a good idea if clients understood that.
Chris Gilchrist is director of Fiveways Financial Planning