Advisors must convince their clients they can profit from market volatility

By Reynaldo Marquez | January 18 2008 02:47PM

In times of high stock market volatility, financial advisors must convince investors they can benefit from this situation in order to avoid losing them as clients when the next financial crisis strikes, experts say.

There are three key steps advisors may follow to achieve this. First, advisors must sell their clients on the idea of keeping their eyes on their investment time horizon, because the likelihood of negative returns in long run is lower than that of a short term investment strategy.

Second, advisors should actively manage their clients’ portfolios to outperform a given benchmark index. And third, they should also rely on proper asset diversification in order to offset the impact of low or negative returns on their clients’ holdings.

When applied properly, this strategy should provide investors with a solid sense of confidence and should help them stay at the top of the financial investing game during down market times.

This is the overall message conveyed by the speakers that took part in a conference on how advisors should guide their clients through a volatile stock market at the 2007 Insurance and Investments Convention on October 25 in Montreal.

Extend time horizon

Clients must be reminded that market volatility, such as that triggered by the U.S. mortgage market, which caused $1.5 billion to flow out of the Canadian mutual fund industry last August, is neither a friend nor a foe. Historically speaking, the market has always recovered from adversity and has risen over the long-term,suggested Nevin Markwart. Mr. Markwart is originally from Regina and was a professional hockey player who played for several years with the Boston Bruins. Now a Chartered Financial Analyst, he is the managing director of Canadian investments for Boston-based Pyramis Global Advisors, a unit of Fidelity Investments.

He emphasized that "The key for financial advisors is that when the negative returns come, which they will, they don’t cause your client to become risk averse and leave the game." If investors leave the game with negative returns, chances are they will be gone for good, he warned advisors in the audience during his presentation.

Mr. Markwart said that some people have the impression that market volatility is on the increase, whereas others think that it is decreasing. Neither of these is right. "In fact, it (volatility) has been a constant market trend through time," he said. "Sure it has peaks and valleys, but clearly when you get into times of financial, political or economic stress, volatility tends to go up."

"But market volatility also tends to be short lived. And then it tends to come back to a lower level. What I call a middle level over time," he added.

As proof, the average return of the S&P/TSX composite index has been positive throughout time, Mr. Markwart points out. The average return for that index from December 1965 to December 2006 was 11.8%, TSX data shows.

Therefore, advisors must make their clients realize that in order to get the average return, they must be willing to make the negative returns that over time have accompanied positive returns, he explained.

But convincing investors about the virtues of time horizon is the hardest thing to do because they tend to become very panicky the moment they start suffering heavy capital losses, Mr. Markwart warned.

Active management

Active management, also called active investing, is another way of getting investors to stay in the game in times of high market volatility, said Bruno Guiot, head of U.S. liability driven investments and structured products for AXA Investment Managers, during his presentation.

Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming a benchmark index, Mr. Guiot explained. Ideally, the manager exploits market inefficiencies by purchasing securities that are undervalued, and or short selling securities that are overvalued.

"Depending on the goals of the specific investment portfolio or mutual fund, active management may also strive to achieve a goal of less volatility or risk than the benchmark index instead of, or in addition to, greater long-term return," he said.

So especially in times of high volatility, advisors should find themselves a competent portfolio manager who will be capable of generating greater returns than the benchmark. "That way, if your clients’ portfolios generate a higher return than expected when the market is down, you will increase their likelihood of remaining in the market," Mr. Guiot said.

Back to basics

Although volatility may be depicted as undesirable, Mr. Guiot reminded the audience that a down market reinforces the case of wider portfolio diversification. Combining a variety of investments, such as stocks, bonds, and hedge funds that are not likely to move in the same given direction helps to offset the risk associated with any single one of them. Diversification can be achieved through asset allocation, industry or sector or geographic region, Mr. Guiot said in his presentation.

But advisors must be careful to perform appropriate diversification, said Scott Mackenzie, president and CEO of Morningstar Canada. And in order to do so, they must first find out what are the underlying assets that comprise the funds they sell to their clients.

"Some advisors may say they allocate 10% of their clients’ money to monetary funds, 40% to Canadian equity and 30% to U.S. equity, and so on."

"But how exactly do they know they are actually accomplishing just that without knowing what the underlying assets in those funds are?" he asked.

While many large institutions may tell advisors that they sold them a 100% Canadian equity fund, this is often not the case, Mr. Mackenzie warned. He said that in fact there could be up to 20% to 30% of U.S. stocks in such a fund. "So here you are busy supposedly doing an asset allocation while you are nowhere near the asset allocation you want to achieve," he said.

Mr. Mackenzie says if advisors are to understand the risk a given mutual fund represents, they need to know what its underlying assets are. This could help them avoid being invested in another subprime-like bust where some Canadian equity mutual funds were exposed to third-party asset backed commercial paper.

He noted that over the past three to four years, some mutual fund companies have become increasingly reticent to disclose what is inside their mutual funds. "But advisors have more power than they think. If they see a fund company that goes out of its way not to divulge what is in their funds, simply don’t buy it."