Volatility: Ignore The Noise And Remain Invested For The Long Term

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Includes: AAPL, AMZN, CL, DVY, F, GLD, GM, GOOG, GOOGL, IAU, INTC, JNJ, MSFT, NVDA, ORCL, PFE, PG, SPHD, SPY, UNH, VDC, VHT, VIG, VNQ, VNQI, VOX, VPU, VTI, XSHD
by: Craig Blanchfield, CFA
Summary

Volatility has increased significantly in recent months and may not subside anytime soon.

The headlines and risks driving uncertainty are difficult to trade, giving long-term investors an advantage in this environment.

By adopting different portfolio strategies, one can remain invested during the ups and downs without sacrificing (too much) sleep.

Ignore the noise, avoid short-term emotional decisions, and focus on what you can control over the long term.

(Photo Source)

The ongoing stock market volatility has many investors concerned about the future. With so much uncertainty around trade with China, future Fed policy, concerns around global economic growth, Brexit, and ongoing investigations into the Trump administration, it seems like markets are whipsawed daily by the headlines.

But are these headlines tradeable? Should you try to trade around the non-stop barrage of “news”?

As a professional investor and advisor to ultra-high net worth clients, my answer to both of the above questions is an emphatic "No!" Investors are best served by focusing on the long term, a period I define as a bare minimum of 3-5 years, but ideally a length of time measured in decades.

The objective of the strategies described below is to keep investors fully invested, while avoiding market timing.

Reduce Your Beta

A simple way to remain invested during volatile periods while dampening the fluctuations of the value of your portfolio is to reduce the beta of your stock exposure. This can be accomplished using both individual stocks as well as mutual funds and ETFs. The beta of your portfolio describes not only the directional correlation between your portfolio and the broad market but also the magnitude of those moves. In other words, a stock with a beta of 1.5 with respect to the S&P 500 is expected to not only move up and down with the market but is also expected to make 50% larger moves than the market on a percentage basis, up and down. Therefore, in a volatile market, it may make sense to reduce beta in order to remain invested, helping to avoid the pitfalls of market timing.

For individual stocks, using like names is often possible. For example, in the semiconductor space, Nvidia (NVDA) has a beta of about 1.9, implying that a 1% move in the S&P 500 would result in a nearly 2% move in the stock. While their businesses are different in many ways, retaining exposure to semiconductors could be accomplished through replacing Nvidia with Intel (INTC), which has a beta of about 0.7. Of course, investors should review the fundamentals of any individual company prior to making an investment. In this case, semiconductors have had difficulty due to slowing growth in China that has resulted in earnings below analyst expectations. Other examples include Colgate-Palmolive (CL) with beta 0.8 and P&G (PG) with beta 0.4, Microsoft (MSFT) and Oracle (ORCL) with betas of 1.2 and 1.0, respectively, and General Motors (GM) and Ford (F) at 1.3 and 1.0, respectively.

For those using ETFs, a similar outcome can be achieved using a variety of different funds. For example, those with diversified exposure to U.S. large-cap stocks through the SPDR S&P 500 (SPY) or Vanguard Total Stock Market ETF (VTI), both large-cap blend funds, could reduce beta by shifting toward more value and/or dividend-paying funds that have lower betas. The effect of shifting toward these funds is even more pronounced for investors invested in growth-oriented funds. For value or dividend-focused funds within domestic stocks, the Vanguard Dividend Appreciation ETF (VIG) or the iShares Select Dividend ETF (DVY) might make sense. VIG currently yields and has beta of 2.1% and 0.9, respectively. The iShares fund, while more expensive at 39 bps, has a higher yield of 3.5% and has a lower beta of 0.8 with respect to the S&P 500.

Sector Rotation

During periods of late cycle volatility, like the one we’re experiencing now, pundits in the media will often discuss sector rotation. If done properly, this is a viable strategy for investors to remain fully invested while reducing portfolio volatility. Like the strategies described above, sector rotation will also likely result in a lower average beta of an equity portfolio.

For example, investors may be interested in reducing their technology exposure. Positions in Apple (AAPL), Amazon (AMZN), or Alphabet (GOOGL) have partially rebounded from December lows, potentially creating an opportunity to capture the bounce while rotating into more defensive positions. The chart below shows the performance of the three companies since Amazon’s peak at the beginning of September.

For investors worried about volatility, slowing economic growth, and looking for potentially contrarian strategies, utilities, communication services, consumer staples, and even some healthcare have become increasingly attractive. While I don’t advocate making tactical moves, it is better to tweak your portfolio my making the volatility more palatable than trying to time entry and exit points by oscillating between a fully invested portfolio and cash.

To gain efficient access to specific sectors, I suggest using low-cost, transparent, and liquid sector ETFs like those managed by Vanguard. Similar funds from other managers are also available, but for illustration, I am focusing on Vanguard. The Vanguard Utilities ETF (VPU) is broadly diversified within the sector with about 71 holdings, generating a current yield of about 3.3% with an expense ratio of 10 basis points. Similarly, Vanguard has ETFs covering the communication services (VOX) and consumer staples (VDC) sectors, both with expense ratios of 10 basis points. The Vanguard Health Care ETF (VHT) is also an attractive option at 10 basis points, but investors would be well-served to understand the underlying holdings. The fund has about 9% of value held in Johnson & Johnson (JNJ), as well as 6% positions each in Pfizer (PFE) and UnitedHealth Group (UNH).

Trimming your exposure to technology and other high beta sectors, and rotating into more conservative, value-oriented, and lower-beta sectors will keep you fully invested, while allowing you to sleep at night as the daily fluctuations will be much easier to stomach.

Broaden Your Horizons

Broadly diversified portfolios help investors remain fully invested during times of turmoil by reducing daily swings in portfolio value, ideally protecting the downside, while also capturing most of the upside. This is accomplished by investing across assets with low correlations to broad equity indexes as well as with each other. Beyond just stocks and bonds, investors should consider adding other asset classes, including commodities and real estate to their portfolios.

Within commodities, I suggest adding a position in gold. Gold is different from other commodities, as its price moves more on macroeconomic factors such as interest rates and exchange rates, and less on supply and demand dynamics. This allows investors to use gold as a hedge against several risks. Specifically, it serves as a hedge against inflation (although the correlation is moderate, the beta is high), geopolitical uncertainty, a weakening dollar, and to some extent, falling interest rates. Gold is easily owned directly and cheaply through ETFs. The most popular by trading volume gold bullion ETF is the iShares Gold Trust ETF (IAU). Those holding the SPDR Gold Trust ETF (GLD) would be well-served to switch from GLD to IAU to save on expenses, as IAU charges 25 basis points compared to 40 for GLD.

For public equity investors, real estate is best owned through real estate investment trusts (REITs) that offer diversified exposure to real estate across property types and geography, while generating higher yields due to their tax-advantaged status. The caveat to owning real estate in this environment is the uncertainty around monetary policy. While rising interest rates can eat into total returns for REITs, falling rates are generally viewed as a tailwind (assuming stable employment and occupancy). REITs are also able to mitigate the impact of rising rates to some extent through escalating rents of the underlying assets. Furthermore, the asset class has been resilient over time and has performed well for long-term investors. In the event of a severe and protracted economic contraction, however, REITs may be unable to perform well as vacancy rates in commercial buildings climb with unemployment.

To gain exposure to U.S. real estate, the Vanguard Real Estate ETF (VNQ) holds a portfolio of about 190 names, costs 12 basis points, and has a trailing 12-month yield of about 4.2%. For those interested in real estate outside the U.S., Vanguard offers its Global ex-U.S. Real Estate ETF (VNQI). The fund is invested across numerous countries, with significant exposure to Western Europe, Japan, and other developed and emerging markets. The fund has a trailing 12-month yield of 4.2% and an expense ratio of 14 basis points.

Pay Me Now, Pay Me Later

During volatile periods, shifting more of your total return to current income becomes more attractive. It reduces your portfolio’s dependence on price appreciation, which, in these periods, is volatile and captures more value creation through dividend income and return of capital distributions. The key caveat for this strategy is the potential impact of rising interest rates. With rising rates, large coupon or dividend payments are discounted at a higher rate, which can have a meaningful impact on principal value. In other words, although investors receive a higher current income, rising rates can reduce the principal value of their investment by more than this amount. Fortunately, there are ways of navigating this environment to capture greater value, regardless of the movement of rates.

Tweaking your stock exposure to favor more value-oriented, dividend-paying stocks can help keep you fully invested, while reducing overall portfolio volatility. To accomplish this, investors can look to the Invesco S&P 500 High Dividend Low Volatility Portfolio ETF (SPHD) that boasts a current yield of about 4.1% and a beta of 0.8. The fund invests in about 50 holdings, tilts toward value, and is relatively inexpensive at 30 basis points. It pays its dividend monthly. A choice in the small-cap space is the Invesco S&P SmallCap High Dividend Low Volatility Portfolio (XSHD) that tracks the 60 highest dividend-paying stocks in the S&P SmallCap 600 Index which also have the lowest observed volatility over the trailing 12 months. Like the large-cap fund, the expense ratio is 30 basis points and dividends are paid monthly. The current yield is just below 5%.

Final Thoughts

The ideas I described above can be interpreted as being tactical, given the suggestions to trim some positions in favor of others. But instead of making tactical moves, the idea is to maintain a fully invested portfolio in an effort to avoid timing the market or making decisions based on emotion rather than evidence. The drivers of recent performance and volatility, including trade tensions with China, uncertainty around monetary policy, and concerns about global growth, among others, are likely to persist for the foreseeable future, and investors should respond accordingly.

Using the above strategies should be looked at within the broader context of the global financial markets and sized appropriately. These suggestions are intended to be incremental moves that tilt the complexion of portfolio assets in a way that makes the ongoing volatility more palatable. Any overweight or underweight position to an asset class, sector, or equity style needs to be considered carefully to understand its impact on long-term total returns. I look forward to your feedback and answering your questions in the comment section below.

Disclaimer

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Mosaic Advisors ("Mosaic"), including the author, or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level, be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Mosaic or the author. Mosaic is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the Mosaic's current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.

Disclosure: I am/we are long AAPL, AMZN, GOOGL, INTC, PG, MSFT, ORCL, F, SPY, VTI, VIG, JNJ, PFE, UNH, GLD, IAU, VNQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.