With equity volatility on the horizon, what's an investor to do? Reduce risk or ride that wave?


Man has to choose the right path

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As the wise, old sage Yogi Berra once said, “When you come to the fork in the road, take it!”

That simple advice doesn’t apply for today’s investor, because the market offers several fork-in-the-road options for risk-minded individuals.

As the economy strengthens and the U.S. equity market hovers at near-record levels, investors are faced with a conundrum: Should they take some equity risk off the table to avoid a (potential) pullback? Or should they stay fully invested and ride the (possible) wave?

It has never been easy to answer these questions with certainty, and now is no exception. But today investors may be better equipped with new tools to help them navigate these challenging questions and invest wisely.

It is well known by now that bonds are not quite the risk refuge they had been the last 30 years or so. As the Federal Reserve continues to raise rates, bond prices may fall in the coming months and years. Hardly the kind of derisking investors may be seeking.

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And if riding that wave seems like the best way forward, here’s another note of caution: A large part of the U.S. equity market’s gains over the last several years has been concentrated in only a handful of names.

The likes of Facebook, Amazon, Netflix and Google (Alphabet) — the FAANG stocks — have powered many portfolios’ returns. I’ve observed that as these relatively few stocks have grown in size, they have become an ever-larger proportion of passive strategies. With these companies trading at or near record highs, there is little room to be wrong. High-flying stocks such as these tend to get pummeled amid any signs of slowdown.

I believe that heightened equity volatility may be on the horizon.

So what’s an investor to do?

Let’s start with the bad news. There are no easy answers here. Most investors can make a case for several ways forward. Stay invested in equities; seek to reduce risk; generally avoid bonds. But what investment strategies can potentially reconcile these seemingly conflicted views?

The good news is that investors have access to a newer breed of investment strategies that were designed with these risks in mind. Available in exchange-traded fund packaging, which offers lower cost and tax-efficient exposure to equities relative to traditional active mutual funds, investors have access to strategies that may allow them to invest with more confidence in this environment.

Consider the broadening category of single- and multifactor investment strategies. Ranging from the tactical to long-term strategic, these strategies may warrant investigation.

Certain single-factor ETFs, such as low-volatility strategies, seek to deliver exposure to equities with historically lower risk. The thinking behind them goes like this: Investing in stocks whose prices have been historically less volatile may deliver a smoother ride during times of market instability. While this may be an effective strategy in certain environments, some of the ETFs may also introduce other risks, such as sector concentrations or valuation risks that can occur as a by-product of a single-factor focus. Look for options that take these risks into account.

As the labels suggests, multifactor strategies seek exposure to more than one factor and may include value, quality, momentum, size and low volatility.

“Investors should be encouraged by the range of available investment strategies that comprehensively evaluate risks and make sensible choices in pursuit of capital growth.”

So what is the thinking behind these strategies? Certain factors perform better in different markets, and diversification across multiple factors may smooth the ride. Not all of these strategies are alike. Some comprehensively manage other risks, such as sector and country diversification. Still others may seek to reduce volatility, offering another potential line of defense in the equity portfolio.

While there certainly is no such thing as a free lunch, investors should be encouraged by the range of available investment strategies that comprehensively evaluate risks and make sensible choices in pursuit of capital growth. It’s these kinds of multifactor strategies that can help investors navigate a lifetime of forked-road investment conundrums.

With a long-term investment horizon, staying invested is the most important thing. Seeking ETFs that manage some of the risks may give you the confidence to do so.

— By Bill Hoyt, head of research/portfolio management at Hartford Funds

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