According to The Wall Street Journal (subscription required), the CBOE Volatility Index (VIX) (often referred to as the “fear gauge”) “peaked at 24.64 on [Oct. 14] — a level last seen in July 2012 — marking an 80% increase since the start of the year and a 50% increase this month alone. Since hitting its 52-week low of just under 10.28 in July, it has more than doubled to well above its 20-year average of around 20.”
There are numerous reasons for the rising VIX, including China’s slowing growth, stretched equity valuations in the developed markets and a growing sense that the U.S. economy may not be able to reach “escape velocity” soon enough to overcome the impact of its loose monetary policies. The increase in the fear index is also rooted in a rash of geopolitical events in West Africa (Ebola), the Middle East (endless quagmire), Ukraine (power grab) and Hong Kong (demand for more autonomy). Simply put, we are witnessing a confluence of a whole lot of bad news, which is putting downward pressure on risky assets, coming at a time when the markets are at an all-time high and many investors are waiting for the other shoe to drop.
As the equities market continues to gyrate, with big up days followed by big down days, and with only 32% of fund managers expecting the economy to improve over the next six months, many target-date providers are increasing their equity exposure. Consequently, many DC investors — who are having their equity exposure ramped up — will be experiencing even greater volatility as they are affected by these increased equity allocations in TDFs. There is little doubt that DC investors require a significant amount of equity exposure in order to have good outcomes; however, volatility will increase significantly as equity allocations are increased.
Though the view is that most participants tend to stay the course — especially if they are not active traders and have committed to a long-term asset allocation program — it seems unwise to assume that participants experiencing significant volatility will not have their faith in the stock market shaken and thus contribute less or not at all.
In a study by the Center for Retirement Research at Boston College, “401(k) Participant Behavior in a Volatile Economy,” the authors concluded that, as a result of the Great Recession, participation dropped off slightly, while contribution amounts and contribution rates declined dramatically. This suggests that economic forces outweigh inertia in participation decisions, the report noted.
It is also the case that Millennials are increasingly losing faith in the stock market, as reported by Money magazine this past summer. “Unfortunately, after growing up in the Great Recession, Millennials would rather put their money in a sock drawer than on Wall Street,” the author noted.
The Money article points to a 2014 Wells Fargo survey of roughly 1,500 adults between 22 and 32 years of age in which “52% stated they were ‘not very’ or ‘not at all’ confident in the stock market as a place to invest for retirement.” It looks like the age group that will be seeing the highest levels of equity exposure is rapidly losing faith in stocks as an investment vehicle to save for retirement.
There seems to be little doubt that volatility is an important issue and that plan sponsors and advisors should be considering ways to reduce it. However, the standard means of reduction — adding a smattering of alternatives with low correlations to U.S. equities — may simply not be enough to move the needle.
Regarding the use of alternatives and other focused asset classes to reduce volatility, Theodore Enders (senior portfolio strategist at Goldman Sachs Asset Management) and Bruce Emken (a member of the Goldman Sachs alternatives sales team) recently presented some interesting perspectives on the use of alternatives in asset allocation strategies. InvestmentNews reported on the presentation.
The Goldman team, presenting at a recent Investment Management Consultants Association (IMCA) conference, characterized much of what is being done with alternatives today as “dabbling versus diversifying.” They suggested that in addition to a more extensive use of alternatives, “strategic satellites” such as “emerging market stocks, international small cap stocks, public real estate, commodities, leveraged loans, and global high-yield bonds” play a large role in the construction of asset allocation programs.
To drive their point home, the Goldman presenters compared two illustrations:
- A traditional 70/30 stock/bond portfolio in which “stocks represent 99% of the portfolio’s 12% expected annual volatility”
- A more “diversified model”, allocated as follows: “40% equity, 45% from strategic satellites, 12% from alternatives, and 3% from bonds” with an “expected annual volatility of 8.8%”
The diversified model, while representing a significant reduction in volatility over a traditional 70/30-split allocation, creates certain challenges when implemented in a self-directed DC plan:
- This type of asset allocation alchemy needs to be performed within a self-contained funding option such as a target-date or target-risk fund. There are ways that this type of management — the extensive use of strategic satellites and alternatives — can be executed in a managed account. However, it is limited if the underlying funds must also be offered as standalone investments.
- If this somewhat novel approach to asset allocation is to be implemented either in a TDF or a managed account structure, it would be wise to document the rationale for adopting such a strategy.
- Given the high standard imposed on plan fiduciaries, any non-traditional approach to asset allocation ought to be carefully examined in more areas than simply its impact on volatility. Back-testing alone cannot be relied upon to illuminate certain risk factors. For instance, the behavior of emerging markets (no doubt a major “strategic satellite”) over the next 20 years will be highly divergent from how these markets behaved over the last 20 years. There is also the need to stress test these portfolios under various economic scenarios.
Conclusion
Ever-increasing market volatility is a dominant feature of a highly interconnected global economy. This volatility seems to have no rhyme or reason to many investors. As a result, many of these investors are growing increasingly skeptical of the stock market, with Millennials especially expressing distrust of the market (many of whom feel the market behaves in a highly capricious manner, e.g., the tech crash, the Great Recession and now, “what’s next?”).
Given that all the major economies are interconnected, why not take advantage of areas of growth while reducing volatility at the same time? This is particularly attractive if extensive diversification is married with a dynamic allocation process that takes into account market valuations.
The challenge of implementing an asset allocation strategy utilizing such a large number of alternatives and long-only asset classes that tend to have high risk premiums and lower correlation to the core asset classes is that most of these options would not be appropriate as standalone investment options. Hence the appeal of utilizing fund structures in implementing this type of strategy.
Efforts on the part of plan sponsors and their advisors grappling with the issue of volatility and its impact on participant investing, is time well spent. Volatility is not only here to stay, but will most likely just continue to increase.
