Capital Appreciation Or Preservation?

You’ve seen the headlines in recent months: Northern Trust projected five years of “tepid” returns last summer; Wall Street Journal’s Jason Zweig pointed out the “cold, hard truth” of an era of low stock returns ahead last spring; and more recently, the Royal Bank of Scotland dramatically made news with its call to clients to sell everything.

The message investors are getting with increasing emphasis is that the U.S. equity returns bonanza we saw after the financial crisis—for about six years straight—is over. So what now?

We asked a few ETF strategists whether investors should focus on capital preservation rather than capital appreciation in the current market environment. Here’s what they had to say:

Gary Stringer, president/chief investment officer, Stringer Asset Management, Memphis, Tennessee:

We think that in the current environment, capital preservation should be more of a focus than capital appreciation. As a manager who combines a strategic, longer-term outlook with a more tactical, near-term approach, we believe in diligently managing risks in real time. This helps to potentially smooth the ride for our investors.

Mixed signals from the indicators we track leave us more leery regarding the U.S. economy and global financial markets over the near term. In fact, we expect the current U.S. business cycle to come to an end over the next 12-18 months. As a result, our portfolios are cautiously positioned regarding equity and credit risk.

While the U.S. jobs market continues to look healthy, the credit markets suggest caution. The yield curve has flattened, investment-grade credit spreads have widened, and market-based inflation expectations have decreased. Combined, these indicators suggest lackluster economic growth ahead.

Previously when these indicators suggested caution, such as in 2011-2012, we were in an environment where the Fed was supportive through its quantitative easing programs. Now the Fed is pivoting to tighten monetary support through raising short-term interest rates. We think that the Fed tightening monetary policy increases the risk of slowing economic growth further, exacerbating head winds to revenue growth and earnings for U.S. corporations.

The globally economic repercussions of these trends are more complicated, but at least as impactful. Therefore, we have reduced our global equity exposure with a tilt toward defensive equity sectors, investment-grade bonds, and cash. These areas can protect principle in the near term and may allow us to have dry powder to use for future opportunities.

Michael McClary, chief investment officer, ValMark Advisers, Akron, Ohio:

For highly tactical investment strategies focused on short-term market timing, I think the capital preservation versus capital appreciation question is a very viable one right now.

We’re encountering numerous head winds to growth in the U.S. economy, and equity valuations are such they may not provide a significant cushion for stock prices. The global economy is facing head winds as well.

However, we would caution investors to be careful not to become a speculator in the heat of the moment. For our portfolios that manage risk by systematically increasing or decreasing exposure to stocks over time, we use a highly sophisticated strategy that is not predicated on emotion or short-term human speculation.

For typical investors, and even institutions, I often break the investment decision down to "playing ball" or "not playing ball." If they decide they don't want to play ball, then cashlike investments is the place to be. If they do want to play ball in the long term, we believe it’s difficult to try and time the market, and it might be risky not to be invested.

If investors are going to play ball, what’s the best way to do it? That’s where I would say a globally diversified portfolio is relatively well-positioned for the long-term investor. I wouldn’t want to put all of my chips on U.S. stocks right now, given valuation levels, the value of the U.S. dollar and economic momentum. I wouldn't want to put all of my bond money in the aggregate bond index, given interest rate expectations.

Wesley Gray, CEO/CIO, Alpha Architect, Broomall, Pennsylvania:

As a general rule, making decisions during chaotic periods is generally a bad idea. Instead, it’s best to follow a program developed during a calm time that was put in place when emotions weren't as high.

When it comes to capital preservation, there are two things one should have been doing all along:

1. Holding a globally diversified portfolio (with diversification reducing portfolio volatility); and/or
2. Applying basic long-term trend-following risk management rules, which manages the risk of very large drawdowns

I don't think the current market environment—or any market environment—implies a need for additional activity or changes. Just because our gut screams “do something!” doesn’t mean we should follow this urge. When in doubt, do nothing. Diversification benefits are straightforward and should be exploited by investors, but 2008 highlighted that diversification isn't a silver bullet.

Trend following is more controversial—and doesn't work all the time—but here is a 200-year backtest highlighting the historical evidence for how trend following can be an effective drawdown management tool.

Andrew Gogerty, vice president, investment strategies, Newfound Research, Boston:

I think people need to be conscious of capital preservation in all environments.

In a sideways market where capital appreciation is nonexistent, income may be the only source of capital growth, which is where having a plan to invest in both traditional and alternative income asset classes can have a great benefit.

Contact Cinthia Murphy at [email protected].