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Smart ways to manage global volatility

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Even as advisors currently find themselves in a low-volatility investing environment in the U.S. – a stark contrast to intense market turbulence of 2008 – they aren't convinced that such calmness will go on forever.

Over the last four decades, trading volatility in the U.S. has increased. Between 1973 and 1982, there were 99 days when the S&P 500 saw swings of 2% or more. Recently that number has more than doubled, with 224 such days in the period from 2003 to 2012. (See the chart below.)

What’s next, some advisors predict, is an increase in volatility in the U.S. followed by an uptick in global volatility.

“It’s fair to say that global markets are following a similar path to U.S. markets,” says Joe Nelesen, director and head of the institutional product management and consulting team for iShares.

In general, Nelesen recommends that advisors help clients keep exposure to equities – including international stocks – but with an eye on managing downside risk.

"We have encountered clients who had no exposure to emerging markets because of perceived risk in those markets,” says Nelesen. “Through the use of minimum volatility funds, those clients were able to begin incorporating emerging markets as an asset allocation, without excessively adding to risk.”

Minimum volatility funds, which invest in securities that exhibit lower volatility characteristics than the broader market, typically have lower risk and lower beta compared to the market, Nelesen says, so they may trail slightly in total return when volatility is low and returns are high.

But research shows that over a longer horizon, these minimum volatility strategies can outperform; the MSCI EM Minimum Volatility index has an annualized return of 11.3% since 2009, compared to 5.3% for the standard MSCI EM index.

In a highly volatile year, minimum volatility strategies can help investors who are worried about risk; in 2011 the MSCI ACWI (all-country-world) Minimum Volatility Index returned 5.3% while the standard cap-weighted MSCI ACWI had a negative return of (-7.4%).

Beyond this category of funds, Nelesen provides the following considerations for advisors working with clients to address global volatility.

1. Talk about it. When it comes to risk, advisors must really listen to clients and also make sure they understand the tradeoffs. A low-volatility strategy won’t do as well in terms of total return in a short-term bull market, but it will probably get 70% to 80% of return compared to market-cap weighted indexes with less risk, analysts say.

2. Understand your client’s unique risk profile. How are clients dealing with risk today? Are they ignoring an asset class entirely? Are they using dividend stocks? Or are they trying to time the market?

“Trying to time market volatility by going to cash instead of equity is very difficult; many times entry and exit points in the market are badly timed,” Nelesen says, adding that some clients made bad allocation moves in 2008 and 2011 based on misreading the markets.

According to Nelesen, some clients may be avoiding international equities out of concern over higher risk due to correlation in those markets. International dividend strategies, for instance, are often thought of as lower-risk, but may sometimes bring high concentrations to certain sectors or countries. With dividend strategies, the manager may want securities that offer dividends but in doing so inadvertently concentrates too much in utilities and financial-sectors a client may or may want to be in, Nelesen explains.

3. Aim for a global footprint. Advisors must understand how much diversification clients would like. If investors are ignoring international stocks entirely, they are probably also giving up some return.

“International (non-U.S.) stocks can help diversify and add growth to an equity portfolio,” Nelesen says. Over the past 15 years, international equities (developed and emerging) have generated 60 basis points more in annualized return each year versus the S&P 500, based on the MSCI ACWI ex-US index, since July 1999.

4. Reduce unnecessary fees. Some international-focused mutual funds, for example, carry not only higher expense ratios than ETFs, but also early withdrawal fees and can only be purchased or sold once per day, says Nelesen.

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