The U.S. economy is into its ninth year of growth—the third longest expansion in the post-war era. The result: stock prices are higher than ever, your portfolio has grown rapidly, and investors are basking in post-recession bliss. Smart advisors, however, know that while this shift is a welcome reversal from extreme lows and emotional angst of the financial crisis, the current market expansion presents its own challenges. The name of the game heading into 2018 is applying careful investment strategies that seek to leverage today’s market exuberance while also mitigating risk.
Here are four strategies to help navigate this expansion to grow, preserve, and protect your portfolios—and keep your clients smiling:
It’s clear that the U.S. has entered the later stages of the business cycle. And though analysts have been warning of a downturn for years based on past trends, it seems history is decidedly not repeating itself at the moment. In fact, there are many reasons to believe the growth we’re seeing today will continue for some time. Growth has topped 3% in Q2 and Q3, and Q4 seems on track to meet—or even beat—that mark. At the same time, indicators point to a very low probability of a U.S. recession.
Sources: Thomson Reuters Datastream, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis, 9/30/17. Last observable data point, September 2017. Smoothed recession probabilities for the U.S. are obtained from a dynamic-factor Markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales.
That’s all good news, but it’s important to look closely at the big picture. Financial market valuations are elevated. Credit conditions look increasingly suspect. And firms in the U.S. and abroad face an increasingly difficult environment for growth. Given this outlook, consider implementing a more tailored investment approach. Begin to take profits where appropriate. Take steps to manage risk exposure in high-yield. Implement a more flexible investment approach across asset classes. And lastly, seek alternative solutions to further diversify your holdings.
The performance of large-cap U.S equities has been the key fuel for today’s stock market highs, but in the face of elevated valuations, the struggle for continued growth for these larger companies very is real. That’s precisely why now may be the time to look for opportunities outside of U.S. large-cap stocks. The first place to look is to U.S. small-cap stocks. Not only have small-caps historically benefitted when the U.S. economy has shown signs of increasing strength, but they have also historically performed better than large-cap stocks during periods of rising interest rates—making them an asset class worth considering.
Source: Morningstar, 9/30/17. U.S. Large Caps are represented by the S&P 500 Index. U.S. Small Caps are represented by the Russell 2000 Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
Also consider adding non-U.S. equities to your mix. At the moment, developed and emerging economies abroad are more reasonably valued and are also earlier in the economic cycle than the U.S.—offering more upside potential. Differences in monetary policy, earnings growth, and price momentum may also help to boost international investments, making them an important diversification tool for your portfolio.
Related: Going Global With a Hedge
When an asset class is difficult to replicate, inefficient, or both, an active investment strategy can make sense. Fundamental changes in the financial industry and the current regulatory environment are driving a greater focus toward lower-cost, more tax-efficient products. For advisors, this means that many of your clients are pushing for lower-cost beta exposure. Unfortunately, that push can come at the expense of actively managed investment solutions that have the potential to add unique value.
While the desire to minimize expenses is understandable, it’s important to note that both active and passive strategies have a place in a diversified portfolio. Use the following to help your clients understand the importance of complementing passive strategies with active strategies.
Sources: Morningstar, New York Life Investments, 12/31/16. Each asset class listed is represented by its respective Morningstar category. Past performance is no guarantee of future results, which will vary.
As the chart illustrates, a higher percentage of active managers has outperformed their respective benchmarks in certain asset classes, including municipal bonds, intermediate- and short-term bonds, and international equities. For this reason, it may be wise to use a portion of the portfolio’s fee budget to hire active managers where they have the ability to outperform.
One way to seek that active/passive mix is to invest in a Smart Beta ETF. Smart Beta is designed specifically to sit right at the intersection between active and passive management. These strategies tend to keep fees lower than active managers, while offering the possibility of competitive risk-adjusted returns.
Source: Ignites Distribution Research. Report: The Opportunity in Smart-Beta ETFs, August 2016.
Smart Beta ETFs offer the flexibility to target specific factors to create an ideal portfolio based on a given asset allocation. Whether your goal is to increase the number of value stocks in your portfolio, manage risk in your core portfolio, or tilt a portfolio toward low volatility, a Smart Beta ETF can be used to help you achieve an asset allocation that supports beneficial returns with lower risk.