To Calm Client Fears About International Stocks, Speak Their Language

To Calm Client Fears About International Stocks, Speak Their Language

Written by Guest Writer: Chris Shuba, Founder of Helios Quantitative Research

Market volatility is normal. And though we can’t predict the future, volatility in the coming years is a safe bet. Clients look to you, their advisor, to build investment portfolios that can help them navigate through unstable times.

Clients tend to invest in what they are familiar with. They recognize U.S.-based indices like the Dow, the Russell, Nasdaq and the S&P 500, and build their portfolios with them. Currently, U.S. investors have nearly 75% of their investments in U.S.-based assets¹. Diversification, such as exposure to international markets, is a key component to a stronger portfolio and can help protect clients against volatility. As their advisor, you can provide simple recommendations based on multi-factor data to help bridge this “international” gap in your clients’ portfolios.

If you’re not familiar with the concept of multi-factor investing, it’s quite simple. Specific investment factors— value, quality, momentum, low volatility, and size—can be used to select assets that tilt a portfolio in one direction with the goal of boosting returns. For example, a portfolio that focuses on “value” seeks to identify stocks that demonstrate a favorable price-to-earnings ratio. A focus on “quality” looks at equity return, leverage ratio, and earnings variability, while a momentum-based strategy weighs heavily on stocks that have been outperforming the market for a given period and are expected to continue in the foreseeable future. Each factor-based strategy provides specific benefits depending on the market environment at the time.

The powerful thing about introducing multi-factor investing in a client discussion is that it gives you the opportunity to compare apples to apples, making it much easier for your clients to understand not only why international equities are a valuable diversification tool, but also how multiple components in a portfolio work together to help ensure sustainable returns over the long term, even in the face of unprecedented volatility. You can start by introducing the concepts of value, quality, and momentum—all factors that are easy to explain, and that most every investor can grasp quickly. Discuss how a diversified portfolio can help create a more consistent return structure, and then use real-world data and market information to create a simple model that illustrates the 12-month implied volatility for international equities compared to something every client is familiar with: domestic large caps within the S&P 500. What the numbers show is that volatility tracks quite consistently across the two asset classes.

Source: Helios Quantitative Research


Next, discuss how the risk associated with the two asset classes is also similar, and by overweighting international equities within a U.S.-equities-based portfolio, risk is reduced because, quite simply, the client doesn’t have all eggs in one basket. At the same time, the implied volatility chart can be used to talk through how this diversification can help smooth volatility over time.

Telling this simple story can do wonders at calming client nerves, setting their expectations not only about the value of international equities and why they serve as an important diversification tool even when they are underperforming, but also about the need to protect against continued volatility within the U.S. equities space. While the value potential for U.S. equities seems high, there’s no way to predict how long that value will last. By leveraging a cost-effective, multi-factor ETF that focuses on high quality, high value international equities, your clients can effectively “dip their toes in the water” using a tool that is specifically designed to reduce the impact of volatility on their portfolio.

¹Source: Openfolio

Opinions and statements of market trends that are based on current market conditions constitute our judgment and are subject to change without notice. These views described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Past performance is no guarantee of future results. Investment returns and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. ETF shares are bought and sold throughout the day on an exchange at market price (not NAV) through a brokerage account, and are not individually redeemed from the fund. Shares may only be redeemed directly from a fund by Authorized Participants, in very large creation/redemption units. For all products, brokerage commissions will reduce returns.

J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.
 
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Sizing up Strategic Beta

Sizing up Strategic Beta

Interest in strategic beta ETFs is rising. A few simple guidelines can help investors pick from among the often-bewildering number of options.


The number of strategic beta ETFs has grown at 20% a year, consistently in good markets and bad, since the year 2000.[2] With good reason: Strategic beta ETFs offer a more thoughtful passive option than cap-weighted indexes—and they can do so with a more transparent process and lower fees than actively managed funds.

Bright future, dim past    


All well and good, but how should investors assess any particular strategic beta ETF? Close to 40% of these funds have been in operation for less than three years[2]. This lack of an established track record can make it hard to validate their claims. ETF sponsors may try to make up for that shortcoming with back testing, running simulations of holdings they might have had against actual past market performance, but that has its limitations:

Back testing doesn’t always account for fees, liquidity or transaction costs.

Back tests are “selection biased”—that is, back testers have a tendency (conscious or not) to engineer positive outcomes. Live outcomes are therefore likely to be inferior.

Too great a focus on recent history can lead to “driving in the rearview mirror.” While an index or ETF may solve the problems of yesterday well, an investor’s focus should instead be on solving the potential problems of tomorrow.

Three steps to an informed judgment


Because the indexes tracked by strategic beta ETFs are by design somewhat exotic, effective assessment of them calls for some digging:

  1. Investors first have to understand who the index designer and asset manager are (they may not be the same people). They should have a clearly expressed investment philosophy and the expertise to enact it in practice.
  2. The properties of the portfolio should reflect the investment philosophy. Not only does the transparency of ETFs allows examination of the holdings to ensure that this is the case, it also measures such as active share relative to a cap-weighted benchmark or turnover can indicate whether an ETF is performing as designed.
  3. Performance can also be used to confirm that an index is doing its job. While short-term results shouldn’t be given too much sway, the index designer should be able to explain when and why an index will perform and when it might not.
     

One key aspect of performance shared with traditional passive management is tracking error. Like earlier cap-weighted index tracking funds, strategic beta ETFs should have minimal tracking error to their own indexes. Beware, though, the tracking error to the benchmark can be large and dynamic, it is by this differentiation that strategic beta adds value.

Made to measure


Strategic beta does not defy analysis, despite its novelty. Indeed, it has a lasting advantage over standard active manager due diligence. Strategic beta, after all, is rules-based. What an investor sees in straightforward, well thought-out index composition rules is what the investor will get. In that sense, strategic beta is relatively immune to the personnel changes, style drift and index hugging that can challenge actively managed mutual funds.

Learn more about ETF due diligence here.

DISCLOSURES

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be a recommendation for any specific investment product, strategy, plan feature or other purpose. Any examples used are generic, hypothetical and for illustration purposes only. Prior to making any investment or financial decisions, an investor should seek individualized advice from a personal financial, legal, tax and other professional advisors that take into account all of the particular facts and circumstances of an investor’s own situation.

Opinions and statements of market trends that are based on current market conditions constitute our judgment and are subject to change without notice. These views described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Past performance is no guarantee of future results. Investment returns and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. ETF shares are bought and sold throughout the day on an exchange at market price (not NAV) through a brokerage account, and are not individually redeemed from the fund. Shares may only be redeemed directly from a fund by Authorized Participants, in very large creation/redemption units. For all products, brokerage commissions will reduce returns.

J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. J.P. Morgan Exchange-Traded Funds are distributed by SEI Investments Distribution Co, One Freedom Valley Dr., Oaks, PA 19456, which is not affiliated with JPMorgan Chase & Co. or any of its affiliates.

For additional disclosure 

For a longer discussion, please see our recent publication Strategic Beta’s due diligence dilemma (J.P. Morgan, April 2017).

[1] Morningstar.

[2] Morningstar.
J.P. Morgan Asset Management
Empowering Better Decisions
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See how ETFs differ from other investment vehicles, learn how to evaluate them, and discover how ETFs can be used effectively to achieve a diversity of investment strategies. ... Click for full bio