[This article appears in our September 2020 issue of ETF Report.]
The economy is in tatters, a pandemic is ravaging the globe, there’s social unrest over systemic racism, political uncertainty is elevated with an election coming up, tensions with China are heightened, yet the stock market is back near record levels after suffering the fastest, sharpest sell-off in history.
It’s no wonder clients and financial advisors are trying to figure out what’s going on.
With so much peril circulating, advisors have both short-term and long-term worries, says JD Gardner, founder of Aptus Capital Advisors, which works with financial advisors and has three risk-based ETFs. In the short term, advisors are trying to navigate and position portfolios in a volatile environment; for longer time horizons, they’re thinking about risks such as longevity.
Many advisors mention to him that they can’t see any reason to own bonds right now, and that’s a problem, since many advisors are building traditional allocations where a significant part of the portfolio is invested in some sort of fixed income.
“If you’re owning an asset class where the math moving forward doesn’t look pretty, then that’s going to be a significant drag on returns going forward,” Gardner said. “That’s obviously a major contributor to the increase in longevity risk.”
In this environment, advisors say they’re using different strategies to mitigate higher risk while still delivering returns to clients. Some are hedging equity positions, some are temporarily cutting back on equity exposure, some are keeping fixed income duration short. All are trying to understand a situation that makes little sense.
Worried About Equities
Glen Smith, managing partner of Glen D. Smith and Associates, notes that he’s concerned about how expensive technology stocks have become versus other sectors of the market. He uses the iShares Core S&P U.S. Growth ETF (IUSG), which, at the beginning of the third quarter, was up 13%. Meanwhile, another fund he uses, the iShares Core S&P U.S. Value ETF (IUSV), was down 13%.
“The chasm between the two is huge,” Smith observed. “I’m a little nervous about the growth stocks.”
Because of the valuation rise in growth stocks, he’s trimming positions from holdings in IUSG and investing in value names such as IUSV.
Eric Bond, wealth advisor and president of Bond Wealth Management, is worried that the market’s quick rebound after such a devastating fall means people still want to take on too much risk. “I think we would have a much healthier stock market if it would have stayed low,” he noted. “If we went down for a little bit, we would have felt that pain.”
In that vein, Craig Kirsner, president of Stuart Estate Planning Wealth Advisors, says with the Federal Reserve injecting so much stimulus, he’s nervous the market is back in bubble territory as mania takes over, and that it’s due for another break. He points out that the broader stock market is again being led by a few technology names, while areas like small caps aren’t participating in the rally.
“This is not typically a good sign for a healthy overall economy,” he said.
Safe bonds such as U.S. Treasuries were spared the wrath of the market drop, but other parts—such as municipal bonds, bank loans and high yield—were pummeled in the first quarter.
“I think people had a bit of a rude awakening in the first quarter when some of their passive, fixed income exposure that had a lot of credit in it sold off just as much as equities,” said Nancy Davis, portfolio manager of the Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL), who notes that some of the fixed income ETFs were short volatility, which also got hammered when volatility spiked during the market plunge.
Although the Fed stabilized the debt markets by slashing rates and buying bonds, that means yields of around 0.6% for the key 10-year U.S. Treasury note are barely outpacing inflation. That’s worrisome for advisors, who may try to reach for yield, Aptus’ Gardner says. With rock-bottom Treasury yields and the S&P dividend around 2%, “if you buy anything with a stated yield of 5-7%, you’re taking on far more risk than you probably think you are,” he noted.
There are no fail-safe solutions for now, just ways to lessen the blow if markets turn south again, sources say. Hedged equity strategies are becoming popular; that is, using ETFs that have some market exposure, but offset that by put-buying.
Andrew Mies, chief investment officer of 6 Meridian—which put its market strategies in ETF form—suggested that municipal bonds still play an important role for their clients, but points out that even high quality, longer-dated municipal bonds are paying around 2%.
To recoup some of that lost yield in traditional fixed income, his firm employs high quality, risk-averse dividend-paying stocks, but Mies admits that approach still comes with risk, noting that even dividend payers fall with the broader market, because the beta of those stocks is similar. Hedging equities with put options helps mitigate some risk.
Smith is also concerned about low interest rates. Although he doesn’t believe rates will go up anytime soon, he’s being very careful to not be locked into long-term government bonds. For bond strategies, Smith’s staying with shorter-term corporate bond ETFs, such as the iShares 0-5 Year Investment Grade Corporate Bond ETF (SLQD).
Although the fund is a little more volatile than the broader market, it doesn’t hold much low quality credit, and being shorter duration, there’s less interest rate risk. That can mean lower yields, but he sees it as a safe haven holding.
Smith sees some opportunities in banks, which are down because low rates squeeze their margins, but he says the weakness may be overdone relative to the broader market. Smith has been buying the iShares U.S. Financials ETF (IYF), which was down around 17% at the start of the third quarter. “We think banks are really cheap,” he noted.
Bond says one result of the current market turmoil is that some people are rethinking the goal of their money, and with that reflection, he’s seen more curiosity about environmental, social and governance (ESG) funds. There’s a greater interest in not only seeking returns, but investing in companies that are doing good from a standpoint of the environment, diversity and corporate governance.
He says he’s using some of BlackRock’s ESG ETFs such as the iShares ESG MSCI U.S.A. ETF (ESGU) for clients.
Kirsner is taking a conservative approach. Because he believes the stock market is too frothy, he’s cut back on some of his equity positions, swapping them for more defensive positions, at least for the short term. Kirsner says his firm bought several of Schwab’s short-term and intermediate-term Treasury bond ETFs, including the Schwab Intermediate-Term U.S. Treasury ETF (SCHR). He points out that this fund did well in the downturn, and says this move suits his clientele well, as they are mostly between ages 65 and 85 and retired millionaires with a moderately conservative bent.
He notes that most of his portfolios are usually no more than about 45% in stocks anyway.