How to Have Thriving Clients in the Next Market Correction

By iSectors Chief Investment Officer, Chuck Self on December 22, 2017

2017’s fabulous equity market performance has led to increased expectations for future returns by many advisors’ clients. As you know, broad market valuations are historically high and the flattening U.S. Treasury yield curve could be portending a slowdown in future economic growth.

As the chart below indicates, over the last 37 years, the average intra-year decline in the S&P 500 has been 14% while 11% represents the median decline.

Although advisors create wonderful client financial plans, including asset allocations, based on long-term averages, declines of greater than 10% can cause clients fear and consternation.  The worst that can happen is for a client to call (or text) while deep in the decline instructing the advisor to sell everything and go into cash. Since we have had a significant rise in stock prices and expectations for future returns have risen, there is a greater probability that this behavior will take place in the next decline.

On this note, we specify a plan to combat this behavior.  Most importantly, clients must have allocations to strategies that will decrease market exposures when necessary.  Although portfolios with maximum exposure to equities given risk tolerances are optimal over the long-term, the probability of client making “sell-all” calls increases with this strategy.  One of the most important value propositions advisors can make is that they will keep clients always invested.  Cash is, historically, a terrible asset class in which to invest and presents negative after-tax real returns to taxable investors.  This is especially true during the financial repression we are currently experiencing.

An advisor can keep such clients fully invested in equities in two ways.

Clients can be less-than fully invested in equities based on their risk profile.  Advisors will often do this to keep clients from selling in moderate market declines.  By taking this tack, clients are accepting less return than available if they were fully invested.

Alternatively, clients can invest in strategies that vary exposure to equities based on expected levels of risk and return.  These strategies use 21^st century statistical and computational methods to create expectations that outperform intuitive or qualitative assessments of the environment.  Also, these tools are significantly more rigorous than mere trend following, which studies show do not work well in the equity market. (See “Equity Trend Following Strategies are Shams.”)

How does an advisor find strategies that fit these requirements? 

One, the strategy must utilize many factors to compute the expectations.  When an individual factor falters, it is important to have other factors to step in and increase explanatory power.  Two, a truly diversified portfolio must be created.  The individual securities’ returns should, at worst, be moderately correlated or, better yet, uncorrelated to each other.  Three, the model should focus on reducing downside risk instead of outperforming an index.  For the most part, clients can accept some underperformance if the absolute returns are quite positive.  They will not be happy if returns are significantly negative even if the results bested a benchmark (as many advisors experienced in 2007 – 2009.)

Our research indicates that an optimal mix of dynamic and strategic equity allocations of 50% each is appropriate. 

This gives the client strong equity exposure in positive environments (even if the dynamic portion is not fully invested in equities) while providing significant protection during corrections or bear markets.

iSectors® Post-MPT Growth Experience in Negative Market Quarters

Below is presented the 18 rolling three-month periods of the Standard & Poor’s 500 Index Total Return’s negative returns and the corresponding iSectors Post-MPT Growth Allocation’s performance for time frames after the 2007 – 2009 bear market (the bear market comparisons would be too easy for Post-MPT Growth; it outperformed the S&P 500 by almost 21 percentage points in 2008.)  For comparability, all returns are gross of fees.

Although no strategy will perfectly outperform the benchmark, Post-MPT Growth was superior to the S&P 500 in eleven of the eighteen periods for an average difference of 3.18% and a median difference of 1.07%.  In fact, Post-MPT Growth had positive returns in 39% of these timeframes when the S&P 500 was negative!

How did Post-MPT Growth exhibit such stellar returns? 

Again, the quantitative model behind the strategy uses over a dozen inputs to create allocations that minimizes expected downside risk.  Also, Post-MPT Growth can own non-index sectors such as US Treasury bonds, gold stocks and real estate investment trusts.  For instance:

• In mid-year 2010, Post-MPT Growth allocated only to Treasury bonds, gold stocks and utilities (a low risk sector.) Therefore, the portfolio was not exposed to the 16% decline that took place in the broad market that year
• Although the strategy had a low allocation to utilities and no exposure to Treasury bonds in early 2011, it correctly raised the weightings to both sectors by mid-year such that they composed 80% of the portfolio by June protecting portfolio returns during the 2011 correction
• Although there were over-weights in Treasury bonds and utilities at times during 2012, large allocations to healthcare and technology helped the portfolio returns significantly during that correction
• During the late 2015 to early 2016 correction, Post-MPT Growth had healthy Treasury bond and utilities weightings but became significantly over-weighted to financial stocks that had been oversold and eventually recovered

If you are a financial advisor looking to learn more on how to protect client assets in market declines, please contact Scott Jones at 800-869-5184 or [email protected].  Alternatively, you may wish to register on our website www.isectors.com to review information on the Post-MPT Allocations. It should be noted that we are in the midst of a complete website remodel. Our all new responsive website will be up and running in January 2018.

Individual investors can contact Scott Jones for a referral to a recommended iSectors advisor that can help you determine the best iSectors asset allocation for their portfolios.

The iSectors Post-MPT Growth Allocation is also available as an exchange-traded fund (ETF). For more information, visit https://isectors.com/isectors-etfs/.