If the world of investing feels like it’s become more confusing lately, you’re not imagining things. Market swings, also known as volatility, have indeed been very dramatic. Volatility has increased approximately 43% from a year ago, based upon the Volatility Index (VIX) as of Feb. 25.
While all this doom and gloom can seem daunting, we believe investors can best seek to reduce volatility and capture opportunities in their portfolios by keeping it simple and focusing on two key things:
Now, you might ask, how can you be both broadly diversified AND selective with your investment choices? You may find what fits the bill is a strategy that seeks to leverage both the active and passive worlds of money management.
We’re talking about being “actively passive.” In other words, choosing passive exchange traded funds (ETFs) in an active manner can help you potentially reduce risk and create value. And with more than 1,500 ETFs available in the U.S. at the end of January, according to Markit, there are many ways you can use them in your portfolio.
Don’t sit on the sidelines
The one thing you probably shouldn’t do when markets get choppy is cash out. As Russ Koesterich and Heather Pelant have discussed at length, cash is not a long-term strategy. Selling low and sitting on the sidelines until the market steadies itself means you’re more likely to buy high and miss growth opportunities to boot.
For example, if you had invested $10,000 in US stocks, as represented by the S&P 500 index during all 5,036 trading days of the last 20 years1, you would have returned 8.19%, and the value of your investment would have been $48,250, according to Index Fund Advisors. However, if you had missed the five days with the biggest gains, you would have returned just 5.99%, for about $32,000 total value.
You may prefer to manage your portfolio by doing your own research and picking specific stocks and bonds. But you don’t have to miss out on market returns in the meantime. With ETFs, you can stay actively invested and capture the ups with the downs.
Diversify your core
When investing for the long term, ETFs are a low-cost way to build and diversify the core of your portfolio. With just a few funds, you can get a broad representation of companies and sectors from around the world. You can select ETFs that focus on just stocks, or bonds, or both. Some multi-asset, sometimes called all-in-one, funds are specially designed to aim for the level of risk you are willing to take while seeking to achieve your financial goals.
And these diversified ETFs can be significantly cheaper to own than similar active funds, according to Morningstar data through the end of last year, potentially saving you thousands of dollars over 10 or more years.
By using ETFs as the foundation of your portfolio, you can then try to be more tactical by selecting other types of investments that reflect your market views.
Another thing to note about ETFs is that they can also be an easy way for investors to target asset classes, geographic regions or industry sectors that look attractive over the near- or medium-term. And there may be some good deals out there. It’s easy to see in the below chart the difference a year can make: Take a look at the current valuation of assets versus a year ago.
So what does this mean in practice? This is where selectivity comes in. You can use ETFs to boost your exposure to regions with attractive valuations and to sectors that are poised to do well in the current economic cycle.
You can also combine selectivity and diversification with smart beta ETFs. These funds focus on certain factors that have historically been shown to drive investment returns, such as quality, size, momentum and minimum volatility.
In today’s volatile market, picking winners is exceptionally challenging, but ETFs can help you navigate the ups and downs.