A Quantum of Solace

The U.S. stock market has experienced a nearly uninterrupted advance each year for the past six years. The strength of the rally has been notable for its duration, the near absence of volatility and the length of time between corrections.

The advance in the S&P 500 took root in traditional fundamental factors, such as earnings growth and a sustained (although subpar) economic expansion, but it also took considerable support from an unusually accommodative monetary policy environment at a time when the market had become exceptionally cheap. These tailwinds have begun to fade with earnings growth slowing, the economic expansion aging and monetary policy poised to turn less accommodative. In addition, as we wrote in “Assessing the Value of Valuations” last month (Market Perspectives, October 2015), current stretched valuations would anyway indicate more limited upside for U.S. stocks.

With the Federal Reserve (Fed) signaling its intention to normalize monetary policy, investors will not only have to adjust to more modest returns from U.S. stocks, they may also have to brace for heightened volatility as the “Yellen put option” fades. The same could be said for U.S. fixed income given the low level of interest rates.

Assuming investors don’t want to sacrifice their objectives by accepting lower returns, they will have to accept potentially greater risk. One avenue for boosting returns is to tilt portfolios toward specific tactical sector, geographic and factor opportunities and away from the perceived risks. For example, we suggest building exposure to cheaper developed markets where monetary policy is unambiguously expansionary and valuations are more forgiving, such as in Europe and Japan. Such tilts are effectively trying to get the best exposures to systematic/market risk, or beta.

However, with returns likely to moderate, volatility set to rise, and some financial markets looking on the expensive side of fair value, we think investors would benefit from looking to idiosyncratic risk and security selection, or alpha, using an active manager to source some of their returns. Low volatility and strong returns benefited beta during the early years of the recovery, as can be seen in the sustained underperformance of active managers relative to their benchmarks since then. But with the bull market and economic expansion more mature, blending alpha exposures—whether through actively-managed exchange traded funds (ETFs), multi-asset managers, long/short managers or traditional active equity managers—with beta vehicles will become increasingly important for meeting return objectives and controlling risk.

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