We’re providing financial advisors with talking points and solutions to address concerns your clients might have with opportunity and volatility in the U.S. equity market.

Wayne Badorf: Given high valuations and volatility in U.S. equities, we’re providing financial advisors with talking points and solutions to help clients address what matters most, not only growing but also preserving wealth. I’m Wayne Badorf, and this is The Essential Practice podcast.

We’ve spent the last two episodes taking a deeper dive into our thought leadership narratives—focusing on “Risks worth worrying about” in the fixed-income markets. And over the course of the next two episodes we’ll focus on “Managing for the ‘what ifs’” in the equity markets in an effort to keep your clients focused on their financial goal.

Joining us is Jeff Doinoff, equity strategist with Wells Fargo Asset Management. He’s chief author of the “Managing for the ‘what ifs’” presentation. Jeff, welcome.

Jeff Doinoff: Thank you, Wayne; good to be here.

Wayne: Well let’s get right to it, Jeff. Given the high absolute recent U.S. equity returns which has led to higher valuations, the long duration of this bull market, and increased volatility—one way we address it in this presentation is suggesting to the investor to “Pick your spots domestically.” What’s the thinking behind that?

Jeff: Well, it’s our perspective that stock prices are likely to diverge more than they have in recent years, Wayne. So, if investors are concerned about positioning his or her portfolio, given the recent double-digit returns, higher valuations, and recent volatility in the U.S. stock market, we’re suggesting that this environment may actually create opportunities for active managers to add excess return.

Wayne: Well Jeff, I appreciate that. But let’s unpack that a bit for us.

Jeff: Wayne, our assertion is quite simple. The future often does not look like the past in terms of what drives investment returns. The returns recently experienced and stock correlations had been well above average and induced by the unprecedented accommodative Fed policies.

More recently, however, we’ve actually have seen some decline in correlations on the back of the Fed’s unwinding. And we experienced earlier in the year an increase in volatility that can occur quite quickly. This, we believe, in turn creates an environment that offers the opportunity for active managers who adhere to a disciplined process to improve upon stock selection and be able to generate excess returns.

Therefore, we are still constructive domestically, but we believe you need to pick your spots, which may mean looking different than what has worked in the past.

Wayne: Okay, let’s back up that assertion. What’s the proof that active management adds value in cycles like we’re in?

Jeff: Sure Wayne. The data we provide is actually quite clear. There has been a strong reversal among the universe of active managers, in that a greater percent of the managers are now outperforming their respective style benchmarks versus the much lower levels that we experienced during the prior few years. This period clearly coincides during the time of correlations declining. And again on the back of this unpreceded extended QE policy, effectively a one-way rising market lifted all boats, and the opportunity for stock selection to be effective was significantly diminished.

Wayne: So does this hold true for preparing for the next cycle?

Jeff: Of course, there is no guarantee. But if the more recent numbers are any indication, the environment looks promising. And let me clarify, when I suggest the environment looks promising, what I mean is a better set up for active management.

As we also depict in the presentation, Wayne, often it’s times of disruptive events, uncertainty, and crisis that active managers often get the opportunity and do in fact add excess return as volatility increases and correlations decrease. It is much more difficult to add excess return during periods of calm waters, narrow markets, or policy-induced periods.

Wayne: Okay, let’s switch the conversation over to addressing clients’ concerns over market volatility. And in the presentation we address it by suggesting clients “Consider dampening equity risk.” Now how does that help the investor who’s wondering if a correction is on the horizon and wants to know how to manage risk while maintaining equity exposure?

Jeff: Sure Wayne, well again we got a little taste of this early in the year, but the waters, particularly in the U.S. have been quite calm. But preparation is the key, and there are 3 basic ideas here. Number one, employing active managers who can limit exposure to stocks they consider overvalued or otherwise high risk. Number two, pursue lower-risk downside strategies within traditional equity categories. And the third is allocating to alternative and other investments that exhibit lower volatility and lower correlations to the broad U.S. stock market.

Wayne: Out of those three ideas, two tie back to the active management conversation we just had, while the other points to the use alternative approaches can have in client portfolios. Can you expand upon those a bit?

Jeff: Sure, the active manger is buying because of what they believe to be the attractiveness of the underlying equity. So we can think about it in terms of both price and value, not simply price, because it is in a certain index or at a certain weight. Therefore, active management can eliminate or reduce investments deemed to be less attractive. And by definition, an index cannot.

A subset of this idea is to pursue dividend-related strategies. We know how important dividends are to the component of a total return, but they also may provide less volatile returns and downside protection during periods of uncertainty.

Beyond the dividends component, it can also simply be a portfolio that because of its process lends itself to downside protection.

And lastly, it can be a portfolio specifically managed to minimize volatility. So, that covers the ideas that fall under the more traditional equity product categories.

The third, as you mentioned, is an alternative portfolio that depending on the makeup will likely still have equity exposure, but often a much lower exposure or perhaps even a neutral exposure. Therefore, these portfolios also often don’t look like an index.

So in summary, Wayne, whether it’s through dividends, lower volatility, lower downside capture, or in alternative portfolios, the key tenet is the same: That is attempting to win by not losing.

Wayne: Yeah. You know, so many investors believe that they have to capture 100% of the upside to outperform, when in fact that’s just not the case.

Jeff: at’s right, Wayne. And we provide examples of this, as well, in the presentation. It’sIt’s belief that when the portfolio is protective enough on the downside, because of how the compounding of returns work, that you need nowhere near 100% of the upside to either outperform, or the very least, generate a similar return with less volatility—creating a smoother ride for advisors’ clients. Hence the key tenet belief of attempting to win by not losing.

Wayne: Well Jeff, as you were sharing that, I was just picturing driving down a road that’s bumpy and how many times, when it’s bumpy, you can’t wait to get out of the car because you can’t stand the bumps.

And why it reminded me of that is, to the extent that the advisor can manage the volatility in the portfolio will much more likely keep the investor engaged in that plan toward their goal.

Before we wrap this conversation, Jeff, we’d certainly welcome a parting thought.

Jeff: Sure, Wayne. Our perspective is that we believe incremental portfolio repositioning is the key to not only growing but preserving wealth. If we wait until the evidence is clear, the opportunity to proactively make the change and protect wealth may simply no longer be available.

Wayne: Jeff, let’s continue this conversation in part two—“Managing for the ‘what ifs’ in equities: Consider exploring internationally.” Until then, Jeff, thanks.

Jeff: Thanks for having me, Wayne.

Wayne: I’llI’llt to remind our audience that access to these thought leadership presentations are just a call or email away to your regional partners—we’re all here to help. Until next time, I’m I’mne Badorf. And thank you for listening to The Essential Practice podcast.

 

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