Markets always overshoot – and therein lies great opportunity for the smart investor. But the next bear market could see the tendency to overshoot become more extreme than ever, leaving investors in these smart beta strategies particularly hurt because their portfolios cannot adjust quickly enough.
Arguably, the domination of the Faang stocks makes this scenario more likely. The five Faang stocks combined have a market value of more than $2.8tn – more than the GDP of the UK and more than 10 per cent of the S&P 500. Moves in these stocks can cause more than ripples through the wider market.
We have not had much serious volatility since 2008, and algorithmic trading has only really taken root since then – so it has not been tested. In October – Red October, as it was known –we saw the S&P 500 lose 7 per cent in a month and the volatility continued through the rest of the year.
This may be just a small foretaste of what could happen in a bear market. It could also be a sign that normal market corrections are becoming more violent than we have become used to. This presents a serious challenge to the whole industry.
For us it means ensuring that the stocks we hold for clients represent fair value. A rising tide floats many boats, and there are now many stocks on valuations that are difficult to justify.
In a violent market correction everything will be hit, but one would expect robust, fairly valued firms to recover their valuations more quickly.
It also means looking at good but expensive stocks we do not hold and establishing clear target prices, so that if opportunities arise we are in a position to take advantage.
The adviser challenge
Many investors can hold quite substantial assets outside a self-invested personal pension or Isa wrapper that they are reluctant to sell because they will trigger a capital gains tax event. Advisers may wish to review these and, if there are concerns about the valuations, recommend a strategy for disposing of or reducing these holdings.
There is no guarantee that CGT rates will stay as low as they are, and that is another good reason to hold this review.
Key Points
- Passive strategies have taken off in the UK
- Normal market corrections are becoming more violent than we are used to
- Advisers should review stocks held outside wrappers
We believe all investment managers and advisers should discuss and evaluate the risks posed to their clients by automated strategies, whether client portfolios are invested in active or passive strategies or a blend.
This should include assessing whether clients are too reliant on strategies (like FTSE 100 trackers) that are overexposed to certain stocks and sectors and vulnerable to a particularly savage correction.
Consideration should be given as to whether portfolios are positioned to address the greater general volatility that the growth of automated trading strategies may bring.
