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Thinking “Smarter” in the New Environment

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Thinking "Smarter" in the New Environment

Managing risk is vital—in every area of life. Managing that risk before a crisis hits is even more critical.

A home fire can wipe out what is probably the largest investment of your lifetime, reducing that value to nothing but a pile of ashes. But installing a smoke detector not only protects your home and your cherished belongings, but also saves lives. (The US National Fire Protection Association estimates that nearly two-thirds of deaths from home fires occur in properties without working smoke detectors.) Even the best smoke detector in the world won’t help you after the fire breaks out.

As an advisor, you know the same is true for your clients’ investment portfolios. A well-diversified strategy has the potential to help manage market volatility. That’s the very reason more and more advisors are turning to smart-beta ETFs heading into 2017. A fire may be headed our way, and the time to manage risk is now.

Don’t get me wrong: I’m not predicting a market crash. But I do see some potential danger down the road. Why? Q4 2016 created a perfect storm of risk for many—if not all—of your clients. By the end of 2016, every major index posted year-over-year gains, some reaching all-time highs. The Dow recorded its best performance since 2013, gaining almost 13.5% from its 2015 closing value. The large-cap S&P 500 proved less volatile during the year, yet closed 2016 up almost 11.0%. The Russell 2000 came in as the year’s biggest gainer, soaring almost 20.0% over last year’s closing value. Numbers like these certainly have your clients smiling, and many of them won’t want to change a thing. After all, why fix something when it’s not broken? But as an advisor, you’ve seen the writing on the wall, and you know this is precisely the time when risk management is needed the most. My suggestion: make it your #1 goal to find ways for your clients to stay invested, but at a lower risk. Assume volatility is a given over the next 12 months,

That doesn’t mean you need to start from scratch, but it does mean you need to make some important adjustments to your core portfolio. In this environment, pure index funds aren’t the answer, primarily because while these funds provide one level of diversification due to the sheer number of securities they hold, they don’t necessarily hold the right combination of those securities to maximize risk adjusted returns. In some asset classes, active mutual funds also falter, simply because they haven’t exceeded the performance of the major indices enough to overcome their fees and the negative tax impact of turnover. Traditional ETFs have their merits—enough to make them one of the most popular investment vehicles on the market. But while older ETFs do deliver lower costs, most are based on legacy indices, which aren’t necessarily the most effective way to access various asset classes. 

So what’s the answer?

Smart-beta ETFs (aka “ETF 2.0”). More sophisticated than the earlier generation of ETFs, smart-beta ETFs are based on a level of academic and investment process rigor that has taken passive investing to a whole new level. Today there are nearly 3,000 ETFs on the market, and they’re growing faster than ever, yet ETF 2.0 has only just begun.

But even with that fast and furious growth, until recently, one important piece of the puzzle has been missing among that vast library of options—especially for advisors seeking to lower risk in today’s potentially volatile market. That missing piece? A broad array of high quality fixed income tools. A relative newcomer to the ETF market, fixed-income ETFs were introduced just over a decade ago. And while they only hold about $445 billion in assets in the U.S.—a small fraction of the $2.5 trillion+ in ETFs as a whole—fixed-income ETFs are one of the fastest growing asset classes in the ETF market. While advisors have liked them because they provide easier, cheaper, more liquid access to bonds, the legacy fixed income ETFs have a variety of structural flaws which can be solved by adopting “smarter” fixed income exposures which are only now becoming available.  These new fixed income ETFs retain the traditional benefits of ETFs such as liquidity and low cost, however provide exposure to the asset class in ways that have the potential improve the outcome that advisors seek for their clients.

Even if you’re a wild optimist, you’ve seen the writing on the wall.  During the first week of 2017 the NASDAQ hit four days of record highs in a row—something that hasn’t happened since 1999, right before the tech bubble collapsed. The Dow has been pressing up against the 20,000 mark for over a month, and the gains have been more bullish than anyone would have dreamed just six months ago. That means that, despite rising interest rates, fixed income is still a vital piece of any portfolio as we head into 2017.

Ultimately, your goal is to make more over the long term by losing less in the short term. Fixed income has always served as a tool for diversification, managing volatility, and yield, but in today’s environment, it can be a tricky challenge for advisors. A well-designed fixed income ETF can help by offering the diversification of fixed income, along with the lower costs and deep academic research that put the “smart” in smart beta. Just remember: managing risk of any kind only works if you put those smoke detectors in place before the fire hits!

IndexIQ’s IQ Enhanced Core Bond U.S. ETF (AGGE) and the IQ Enhanced Core Plus Bond U.S. ETF (AGGP), both track smart beta-style indexes using a momentum approach to fixed-income markets. Click here to learn more. 

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