Several years of strong returns in equities have led to a high appetite for risk that may ultimately hurt investors who don’t rebalance to suit appropriate asset-allocation parameters, according to experts from Malvern, Penn.-based Vanguard Group who spoke at the 2017 Vanguard Investment Symposium in Toronto on Tuesday.
“There is an important role for advisors to play in behavioural coaching, not just in bear markets but in bull markets,” said Fran Kinniry, global head of portfolio construction for U.S.-based Vanguard Group. “History shows that a balanced, diversified portfolio has fared well. When we do have a bear market, the portfolios in the best position will be those that have been selling equities and rebalancing during this bull market.”
Kinniry acknowledged that after several years of bullish performance, it’s easy for investors to get complacent and hard for advisors to convince them to sell off equities and switch to fixed-income, in which forecast returns going forward are in the 1.5% range annually.
However, he says that past market crashes such as those of 2000 and 2008 have shown that the best non-correlated asset has been bonds — and they offer a better potential offset to stock market losses than other asset classes, such as commodities, real estate securities or emerging-markets stocks.
“We don’t know when there will be a bear market, but when it happens I worry that it won’t end well,” Kinniry said. “Bonds can offer protection, although it won’t be with the same amplification of the past.”
With interest rates at low levels and the possibility of U.S. and Canadian central banks implementing further hikes, bond investments could offer merely stabilization to portfolios rather than juicy returns, he explained.
Kinniry suggested advisors could prove their value to clients by finding other ways to improve portfolio returns, such as seeking low-cost investments and allocating assets in a tax-efficient manner.
Vanguard’s research shows that optimal asset allocation between taxable and tax-advantaged accounts such as RRSPs, TFSAs and RRIFs can add up to 42 basis points to overall average annual returns for clients.
The highest value added by advisors is in the area of behavioural coaching — such as helping clients stay the course with their financial plan and asset allocations — and this can add as much as 150 basis points to a portfolio’s annual performance, according to Vanguard’s research.
Vanguard’s newly appointed chief investment officer, Gregory Davis, called for “muted” returns going forward in both equity and fixed-income markets. He said the failure of the Trump administration to implement reforms in the area of health care, and the likelihood that a new health care regime and other promises such as major infrastructure spending and tax reform will not happen in 2017, has dampened optimism in the U.S.
At the same time investors are trying to come to grips with expectations of interest rate hikes.
In the low rate environment, investors in fixed-income have been chasing higher-yield fixed income assets, increasing their allocations to corporate bonds, emerging-markets bonds and high-yield bonds. This has resulted in a narrowing of the spread between these higher-risk alternatives and higher-rated securities, such as U.S. and Canada government bonds, Davis said.
“Investors should be cautious about getting into high-yield fixed-income at this time,” Davis said.
Corporate bonds would be vulnerable to an economic downturn if the U.S. goes too far with interest rate increases and triggers a recession, he said. With the narrow advantage on yields relative to treasury bonds, the risk in these securities has risen.
On the equities side, he warned that valuation metrics such as price/earnings ratios are high.
“Optimism has held so far in equity markets, but they are now looking a bit overvalued,” he said. “Markets are at rich levels, and that has key implications for what investors should expect during the next few years.”