How to handle return-hungry clients’ portfolios during upticks in volatility

Happy New Year to all — and equity markets greeted us with the worst opening weeks we’ve ever seen. We encountered another correction, and clients are growing nervous, as they usually do. They’re all asking, “Is it going to get worse? Where are the markets going? Down? Up?”

Every honest asset manager and adviser has to admit, we do not know.

Global equity markets are too big, too unwieldy and in some cases too opaque. We can crunch the numbers all day long — and we do — but we are likely to find rationale in the data that could support every position. Markets constructed by human beings have psychological, often irrational aspects.

Are we in a bubble, even? That’s the hard part. History shows that no one ever sees a bubble when they’re in it; only after it bursts does it become clear.

Markets do not always go up, and yet some investors focus almost entirely on the potential upside. They can suddenly grow nervous when markets turn. Very nervous. We have seen too much of it recently. In such an environment, clients can become like greedy chickens, trying frantically to fatten up on whatever feed (or risk) they can find as markets march steadily upward — but scared to death and ready to bolt for safety at the first signs of market decline.

Our goal should always be to help investors stay in the markets for the long term, through good and bad. The most important service we can render in tumultuous times is to help investors refrain from selling out at the worst possible time, usually when the market hits bottom. When they do, the damage can be substantial. Worse, they may never want — or be able — to get back in again.

(More: Alternative growth strategies for a fearful, low-growth world)

Investors are best served by portfolios positioned to meet their objectives, regardless of market moves. Helping them understand that is a challenge every adviser faces.

Without being too pedantic, choppy and declining markets require an increased focus on alpha and beta, confusing as the words can be. Many think alpha is a catchall for gains, but it is more accurately summarized as the excess return resulting from active management decisions, above what could be made on indexed products.

Beta is a measure of market volatility, or systemic risk, compared to the market as a whole. A beta of 1.0 means that price movements will be in line with the overall market. (Many index ETFs strive for this, although some are moving away from market-cap-weighted indexes to improve diversification.)

A beta greater than 1.0 means that returns should be more volatile than the overall market — rising more when markets go up, falling more when markets decline. The opposite is true for betas under 1.0.

Think of beta as a dial advisers can turn for clients. When equity markets are flying, advisers can turn the dial up, further to the right, above 1.0, to take advantage of the upside opportunities. In mixed markets, it may make sense to leave it on 1.0, or tweak it a bit to either side.

We may now be entering low-beta territory, when advisers should be ready to turn the dial down, perhaps significantly. These can be hard conversations to have with clients. Everyone wants to be a greedy chicken, but the question we should be asking is, “How much can you afford to lose?”

For those who say “not much,” the best posture is defensive: downside risk management.

(Related read: Return of volatility means the good, bad and ugly will be revealed)

This is where alpha and beta come in. Say an investor is older, with a solid portfolio, but feels as if she still needs more growth to ensure a comfortable retirement. A smart adviser may counsel her to turn her beta dial back to 0.7 or 0.6 to provide risk management against declining markets. At the same time, some asset managers can achieve alpha, even in tough conditions. If investors can take advantage of that alpha, their portfolios can be appropriately managed and continue to grow.

Put another way, say an investor wants to limit downside capture goals to 70% or even 50%. How much better off would they be with a product that still strove for 80% upside capture?

These are the solutions investors need: dialing down the beta while capturing some alpha. They can smooth the inevitable peaks and valleys, akin perhaps to our grandparents’ utility stocks.

Many excellent lower-beta products are on the market, with more on the way. Examples include managed volatility equity strategies (typically offering downside captures of 50-70%, with upside captures of 60-80%) and market neutral strategies (typically beta 0 in a long/short portfolio, resulting in pure alpha from the asset manager’s best ideas). They can enhance true diversification by seeking to avoid the concentration risks inherent in market-cap-weighted index funds.

These products can encompass multiple asset classes and incorporate the full range of equities, fixed income and alternatives. Most are traditional open-end funds but some are packaged as ETFs.

All are partially, if not wholly, actively managed. That’s the point: Anyone can ride a seemingly perpetually rising market up, but as the financial crisis of 2008 showed, it takes skill, experience, a sharp eye and a steady hand to make the right adjustments when markets implode.

We must look out for the greedy chickens among our clients. Dialing the beta dial down can go a long way — while keeping an eye out for alpha. Solutions are available that can help keep clients invested for the long term, allaying their real fears that their money — and dreams — may disappear.

Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.