Helping clients understand why they aren't beating the S&P 500

Big stock market gains can often mean big headaches for financial advisers when it comes to explaining to clients why their portfolio didn’t keep pace with the S&P 500 Index, which gained 30% last year.

Aside from the obvious answer that most clients are not 100% allocated to a single broad market equity index, savvy financial advisers are using this time of year to reintroduce clients to the benefits and realities of diversification and individual risk-tolerance levels.

“When markets have big years people always want to know why they’re not 100% in the S&P, and the answer is if your risk tolerance doesn’t correlate to the S&P using that as a benchmark is a fool’s errand,” said Paul Schatz, president of Heritage Capital.

Mr. Schatz said no matter how well you try and educate and prepare clients, big market gains will usually draw questions and comparisons.

In most instances, his standard response is to compare the S&P’s 38.5% drop in 2008 to the 16% drop of his main portfolio strategy.

“If you want to assume the risk and reward of the S&P, let’s not forget that twice in the past nine years it experienced peak-to-trough declines of more than 50%,” he said, citing the 50% drop between 2000 and 2002, and the 58% drop between 2007 and 2009.

“Most of the time we don’t meet or beat the S&P 500 Index simply because we don’t take on the volatility risk to make that happen,” said Tim Holsworth, president of AHP Financial Services.

“It’s almost always about the level of volatility the client said they could handle,” he added. “It’s all about clearly defining volatility limits and setting realistic expectations.”

The risk-reward conversation is not a new one for most financial advisers, but that doesn’t mean they aren’t regularly revisiting it with clients, particularly after a year like 2019 when diversification beyond anything but U.S. stocks dragged down portfolio performance.

In the most basic example of a portfolio including 60% in iShares Core S&P 500 ETF (IVV) and 40% in iShares Core US Aggregate Bond ETF (AGG), the return would have been 22% last year.

If you go beyond the plain vanilla to include areas like international equities the trailing performance gets even worse.

“Investors would have been better off focusing solely on U.S stocks last year, but historically that’s not the case,” said Todd Rosenbluth, director of mutual fund and ETF research at CFRA.

“It’s easy in hindsight to wish you had only been in equities, but the bull market will come to an end at some point and investors will be pleased they are more diversified when that time comes,” he added.

Factor-based strategies

Of course, if you really want to feel bad about the way a diversified portfolio performed last year, take a gander at some of the factor-based strategies that concentrate on specific slices on the high-performing S&P 500.

Indexed factor strategies focused on minimum volatility, share buybacks, quality, and high beta all returned between 32.4% and 34.4% last year.

But looking in the rearview mirror is virtually useless when it comes to investing, according to Aye Soe, global head of product management at S&P Dow Jones Indices.

“I’m not a believer in factor timing because we never know what factor is going to outperform,” she said. “My message is, even though you think you know what you will get, be diversified and have exposure to all these factors because you don’t know which will do better.”

Dennis Nolte, vice president at Seacoast Investment Services, is a firm believer that most investors think their individual tolerance for market volatility is higher than it is, which is why he embraces a simpletruth.

“If your clients are properly diversified, you're always going to be apologizing for something,” he said. “But at this point, no one seems to be concerned they didn't make 30% last year; they're glad to have taken less risk and received less of a return, since most folks still seem to believe something bad is going to happen.”