Advisers tested by spike in market volatility

Financial advisers are confronting the possibility that nearly six years of a generally rising stock market has given way to a climate far less forgiving of complacency.
Six days of rollercoaster trading after Oct. 8 almost completely erased the S&P 500 index’s gains for the year (which, as of last month, were close to 9%) as weak estimates of global economic activity pointed to a naggingly slow recovery from a recession that began in 2008 and still haunts financial markets. Another dose of worry and uncertainty was added as public health officials fought an Ebola outbreak.
But nothing is set in stone. By Friday, trading in the top U.S. stocks turned cheery, with major benchmarks gaining about 2% by midday in New York. For the week, however, investors were still looking at net losses on most market gauges.
“It’s been a wild week,” said Joe Quinlan, managing director and chief market strategist for U.S. Trust, Bank of America Private Wealth Management. “But complacency can be a vice as well. Volatility is kind of a wake-up call for investors.”
The sudden bout of volatility is testing the resolve of professional investors from financial advisers to mutual fund managers to brokers.
“If the rest of 2014 brings us up to even average, we’ve got a bunch of volatile days to come,” wrote Daniel P. Wiener, CEO of money manager Adviser Investments, in a note to clients this week. “Deal with it!”
Paul Schatz, president of Heritage Capital, said the “vast majority” of damage to stock prices is over for now.
“From here, there are two scenarios I am working with,” he said in an e-mail. “One, stocks see all-time highs from here and two, stocks rally, roll over to marginal new lows and then head to all-time highs in the first quarter.”
(Related: AQR’s Asness says market volatility is a good reason to diversify)
Many investment strategists and advisers have spent the past few years encouraging wary clients to remain invested in unusually calm markets while at the same time wrestling with whether and how to use alternative strategies to reduce their clients’ exposure to a widely predicted decline in stock and bond returns.
“Everybody’s trying to get better returns with lower risk,” said James Osborne, a financial planner at Bason Asset Management. “In ’08, ’09, we got this springboard effect, where practically every asset class fell in tandem.”
He added: “People are still carrying scars from that time period.”
Most financial advisers continue to counsel clients to stay invested.
David Edwards, president of Heron Financial Group, e-mailed a note to clients Wednesday, when the blue-chip Dow Jones Industrial Average dropped 400 points before recovering to finish the session off 173, letting them know he was staying invested in the stock market.
“We don’t fear the stock market, which goes haywire far more often than people remember,” he wrote. “We fear our clients ordering us to do something stupid, like liquidate their portfolios.”
He also told clients with cash on the sidelines to think about investing it now and offered to speak with anyone who had questions or concerns.
Other advisers took to social media to call for calm.
Marc Freedman, president of Freedman Financial Inc., tweeted: “Those who have a financial plan know market volatility represents a mere slice in their overall plan,” adding the hashtag #stayrational.
The question remains: How should financial advisers and brokers deal with the assumption that the run-up in stocks must come to an end, particularly as central bank stimulus in the U.S. slows and investors face the possibility that rising interest rates will hurt bond returns?
One answer is to adopt alternative asset classes and investment strategies associated with hedge funds into the portfolios of retail clients.
Until this week, that discussion had occurred against a backdrop of market calm. The Chicago Board Options Exchange’s volatility index, a proxy for implied equity volatility known as the VIX, is averaging 14.32 this year, below the 20.25 it averaged over the prior 23 years, according to Mr. Wiener.
But on Wednesday, when Mr. Edwards was e-mailing his clients, the VIX spiked to 31.06, a new 52-week high.
Now, the debate is anything but academic.
In a note, Lisa Shalett, the head of investment and portfolio strategies at Morgan Stanley Wealth Management, said the volatility “raised the question of how anxious clients can protect their portfolios,” given concerns about economic growth, the spread of the Ebola virus and the perceived threat of terrorist attacks from a group in the Middle East known as the Islamic State.
“These ‘known unknowns,’ while impossible to quantify in a market model, still pose serious portfolio management challenges,” she said. “The need for portfolio protection is increasing.”
But the options are few, Ms. Shalett said. Market-timing risks missing future gains, returns on cash are “virtually nonexistent” and gold can be hobbled by the rising relative value of the U.S. dollar, as well as interest rates. She said long-term U.S. Treasury debt also seems expensive and can be hurt by rising interest rates.
“Increasingly, we are looking to global macro and managed futures funds as sources of portfolio protection,” she said. “Although these strategies have been undistinguished during the past five years due to the market’s lack of volatility and upward bias, we see the current backdrop creating opportunities and dispersion that active managers can exploit.”
But Mr. Osborne disagreed.
“Everybody’s been looking for a silver bullet since the beginning of time,” he said. “It’s a hard truth that earning equity returns comes with volatility, and as long as there’s someone looking for a solution that doesn’t include volatility there will be someone selling a product that claims to be able to do it.”
Liz Skinner contributed to this story.