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Equity market action since the late summer of 2015 has unsettled many investors. In August, investors experienced a 12% intra-month decline in the S&P 500 index followed by an 11% intra-month decline in January 2016. While volatility over this period has been elevated compared to 2012-2014, it is actually “normal” in a historical context. Exhibit 1 plots S&P 500 annual returns since 1980 (bars) and overlays the largest intra-year declines (dots) in each of those years. Note that in many years when the S&P 500 experienced significant downside volatility, it was still able to deliver a positive return for the year.
If history is any guide, the elevated volatility seen recently is likely to persist - and we could even see worse ahead - but investors should not be overly alarmed by that prospect. Instead, they should be prepared. In this article, we consider one of the most effective strategies for managing market volatility - diversification - and explore a new tool to help investors diversify, strategic beta ETFs.
Source: Standard & Poor's, FactSet, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Intra-year declines refers to the largest market drops from a peak to trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2015. Data are as of December 31, 2015.
A diversified portfolio is arguably one of the best antidotes to market volatility and also a sound long-term investment approach. Most investors, and certainly most financial advisors, understand the virtues of diversification, but many fail to implement the strategy effectively. One reason for the gap between insight and action may be the growing prevalence of market capitalization-based (market cap) index products. These products, which include household names like the S&P 500 and Russell 1000, are ready-made stock portfolios in which each stock is represented in the portfolio in proportion to its market capitalization (price x number of shares outstanding). Many investors use market cap funds or ETFs as part of a core equity allocation, believing that they provide well-diversified market exposure, along with other benefits such as lower costs and improved tax efficiency.
Some perceived benefits of market cap products are real, but sufficient diversification is unfortunately not one of them, and misperceptions can prove costly to investors. Because market cap products are constructed based on a company’s market capitalization, the higher a stock’s price, the more representation it gets in the portfolio (all else being equal). This has important implications: By definition, market cap products give greater weight to more expensive and potentially over-valued stocks. Further, they are prone to risk concentrations as speculative market bubbles form and market cap products must buy ever-higher priced shares.
For example, consider that in the lead up to the 2008 financial crisis, financial services stocks comprised as much as 28% of assets in the FTSE Developed World index, a widely tracked market cap index. That asset concentration may already sound uncomfortably high, but when the high volatility of those stocks is considered, the end result was that more than 44% of the index’s risk was concentrated in financial services. This is hardly a rare phenomenon: in fact it is a recurring feature of market cap products, seen in episodes ranging from the tech crash of the early 2000s to the Asian financial crisis of the late 1990s.
Unlike market cap products, strategic beta (also known as smart beta) - whether in traditional fund formats or ETFs – does not select and weight stocks based simply on market value. Indeed, this is their key differentiating feature. Strategic beta may select stocks based on other attributes (e.g., valuation, size, profitability) and/or weight stocks according to factors such as volatility. In recent years, a range of strategic beta ETFs have come to market aiming to improve diversification by combining multiple factors and/or weighting stocks based on volatility. These ETFs can offer a particularly attractive value proposition for long-term investors seeking a more stable core equity allocation by seeking to reduce downside market volatility while attempting to preserve upside returns (Exhibit 2). This can help deliver smoother investment returns, which can in turn encourage investors to stay on course with their long-term investment plans, supporting stronger long-run returns.
The performance quoted is past performance and does not guarantee future results. Investment return and prinicpal value will fluctuate so an investor's shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be higher or lower than performance here. For performance current to the most recent month-end call 1-844-4JPM-ETF. Shares are bought and sold at market price (not NAV) and are not individually redeemed from the fund. Brokerage commissions will reduce returns.
Just as importantly, these strategic beta ETFs can help mitigate the risk concentrations inherent in market cap products, while retaining the convenience, low cost, and tax advantages often associated with traditional market cap ETFs. The combination of these features may help more investors and their advisors stay focused on the long term the next time the market swoons.
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