If Volatility's Back, Are You Ready? -- WSJ

03/05/18 02:47 AM EST

The recent market tumult is a warning sign for investors to prepare for more sharp moves ahead

By Michael A. Pollock 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (March 5, 2018).

As stocks have rebounded from a scary early February slide, the up and down may be foreshadowing a new, more-volatile period for markets.

Is your fund portfolio ready?

Advisers say there is no reason to abandon a long-term investing strategy because of a bout of turbulence like early February's, when stocks dropped 10% in 10 trading days. But they also say it's a good time for investors to review how their strategy performed. The process can shed light on how a portfolio might behave in an even deeper downturn -- and help investors conquer their fears of volatility by providing a clearer picture of what to expect, says Glenn Wiggle, managing partner of Palm Beach Gardens, Fla.-based Peak Brokerage Services.

"Understanding how a mix of assets will perform can make investors feel more comfortable about staying the course," he says.

Here is a look at how the recent market tumult affected funds -- including those tied directly to volatility -- and what investors can do to prepare for more sharp moves ahead.

Put the plunge in perspective

Volatility is a normal part of investing that can be triggered by any number of events, so investors shouldn't be surprised when it occurs, advisers say. In the week ended Feb. 9, renewed worries about inflation and rising interest rates ended more than a year of relatively steady equity gains. On two separate days, the Dow Jones Industrial Average plunged more than 1,000 points. While these were record point moves, the declines in percentage terms weren't historic, at 4.6% and 4.1%, respectively. The Dow, S&P 500 and Nasdaq Composite all ended the week down more than 5%.

The tumult affected different types of funds to different degrees, with investments designed to bet against volatility faring especially badly.

As stocks fell, a key gauge of market stress -- the Cboe Volatility Index, or VIX -- soared, sparking big losses for fund investors who had been betting on continued calm. Nomura Holdings Inc. and Credit Suisse Group AG closed exchange-traded notes that moved inversely to the VIX after they shed more than 80% of their value; an actively managed fund that also had bet against volatility, LJM Preservation & Growth (LJMAX), suffered a similarly sharp loss; and another VIX-tied exchange-traded fund fell 88% but survived. (More on the fund tumult.)

But selling was so widespread that many conservative funds also were affected. T. Rowe Price Dividend Growth (PRDGX) and ClearBridge Appreciation (SHAPX), which own shares of financially solid companies, were down about 5% that week, according to Morningstar Direct, which tracks fund performance. Morningstar gives both high marks for their long-term performances. "In market panics, everything goes down," says John Lynch, chief investment strategist for LPL Financial.

The way for investors to weather this kind of environment is to keep an eye on the long term, advisers say. "Investors who stay diversified, rebalance on a regular basis and stick with a plan, and understand their downside are a lot better off in this kind of market," Mr. Wiggle says.

That includes regularly monitoring portfolios to ensure stock positions haven't become too concentrated or grown into a much larger portion of total holdings than what investors have targeted. (Advisers often suggest that if an equity allocation moves more than 5 percentage points above an investor's long-term target, it is time to trim it back.)

Take stock of surprises

Periods of market volatility can rattle the nerves, but they also provide investors with an opportunity to examine how the specific funds they own performed under pressure.

Funds that hold stocks trading at lofty valuations or that focus on narrow market slices typically are more volatile, so it shouldn't be a mystery if they tanked in February. Figuring out why an actively managed fund didn't perform as expected based on its name, style or market focus, however, requires closer scrutiny.

Aiming to beat peers as markets rallied, a manager may have bought some hot stocks that aren't in a fund's benchmark index. A way to gauge a fund's degree of relative risk is to compare how it did on down days against its benchmark, which may not be the S&P, says Chris Zaccarelli, chief investment officer of Independent Advisor Alliance in Charlotte, N.C. If the fund significantly underperformed its own benchmark, that could signal that its manager is running a riskier portfolio than an investor may be comfortable with, he says.

Understand the downside of downside protection

Low-volatility funds may seem appealing now, but may not help a portfolio's performance if stocks continue to rally this year.

Funds such as PowerShares S&P 500 Low Volatility ETF (SPLV) and iShares Edge MSCI Min Vol USA (USMV), which hold the least-volatile stocks in the S&P 500, did help some investors in the market melee.

According to CFRA, a New York-based financial data provider, the PowerShares ETF shed 4.6% in the week ended Feb. 9, while USMV was down 4.7%. But in return for that cushion, investors had to give up greater gains in previous months because such strategies usually lag behind during market rallies. Last year, for example, SPLV was up 17% and USMV gained 19%, versus a nearly 22% gain in the S&P 500 index.

While some investors may have a good reason for buying a low-volatility fund after a market correction, doing so could make it harder for them to make up lost ground.

Short-term attempts to outperform the broad market won't beat a well-designed buy-and-hold strategy over time, says Len Hayduchok, chief executive of Dedicated Financial Services, in Hamilton, N.J. "If you don't understand that you could lose a significant amount in a short period, you shouldn't be in the stock market," he says.

Prepare to bargain shop

Many investment pros believe the equity rally could continue for a while, fueled by the recent U.S. tax cuts and strong global growth. As such, it could make sense to shop for bargains during another pullback.

With the Federal Reserve on track to raise interest rates this year, investors should avoid rate-sensitive sectors such as telecoms and utilities, advisers say. Materials and some commodity stocks typically outperform late in market cycles, says Jay Batcha, founder and chief investment officer at Michigan-based Optimal Capital. But, he adds, investors should wait to buy at lower valuations, which might result from another broad market pullback.

Among popular ETFs in that sector are iShares Global Materials ETF (MXI), Materials Select Sector SPDR (XLB) and Vanguard Materials ETF (VAW).

A prudent approach would be to put money into the market periodically, perhaps on the first of each month or quarterly, says Mr. Lynch of LPL. Known as dollar-cost averaging, this strategy reduces the risk that an investor will buy into a fund at a bad time, such as right before a big correction. That said, if the market were to fall by another 10%, investors might want to consider moving ahead then with the next scheduled reinvestment, he says.

Leave it to the pros

Investors who aren't experienced in decisions about individual ETFs or allocations might consider buying an actively managed fund that owns both stocks and bonds. Called "allocation" or "multiasset" funds, they buy stocks when valuations are attractive and put more into bonds when stocks get pricier.

CFRA gives high ratings to Fidelity Puritan (FPURX), which recently had about two-thirds of its assets invested in stocks, and Oppenheimer Capital Income Fund (OCIYX), which had a much more conservative 34% in stocks. In the week ended Feb. 9, the Fidelity fund shed about 3.7%, while the Oppenheimer fund was down about 2%.

Bonds probably won't perform as well in a period of rising rates. But they still can play an important role, says Todd Rosenbluth, CFRA's director of ETF and mutual-fund research, generating a stream of income and reducing overall portfolio risk.

Mr. Pollock is a writer in Ridgewood, N.J. He can be reached at reports@wsj.com.


(END) Dow Jones Newswires

March 05, 2018 02:47 ET (07:47 GMT)

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