Commentaries

The Envestnet Edge, May/June 2015

When following the herd is risky, where is the safety?

Download the full PDF

Risk and safety. Safety and risk. In investing, as in life, balancing both is an ongoing challenge. We know intuitively that all of either one or the other rarely yields the results we want, but finding the right mix is easier said than done.

In today’s investing world, it appears that the search for safety is trumping risk. Although frequent commentary trumpets bubbles in riskier investments, that is not consistent with the hard data on money flows. The result of so much money chasing safety is quite the opposite of what we might want: so much money pouring into assets perceived as safe is actually making those assets riskier. Those riskier assets are attracting less money and fewer players, and as a result, may be safer than they appear. In short, today’s market presents a conundrum: there may be more risk in safety, and more safety in risk.

Risk in Safety

Risk is not only subjective. When investors hire a financial advisor, for instance, they are asked a series of questions, ranging from short-term needs to long-term goals, to determine where they fall on a risk spectrum. If the responses deem an investor “conservative,” the recommended asset allocation is heavily weighted towards bonds. And not just any bonds: only sovereign debt of countries such as the United States or Germany that are considered very safe, and highly rated corporate bonds, are recommended. Perhaps this “conservative” investor also will allocate funds into what are considered high-quality, large companies paying a dependable dividend. But for the most part, conservative, and hence safe, in the investing world has become synonymous with certain bonds and a very specific and small universe of stocks.

Historically, these “safe” bond investments had a low probability of default. They also carried a perception that their face value would fluctuate less, and exhibit lower volatility, than either equities in general, or riskier fixed income instruments such as high-yield (formerly known as junk bonds) and emerging market bonds.

The problem now is that funds are flooding into bonds, and especially into highly rated, low-yielding bonds. Instead of occupying one end of a nuanced spectrum, bonds are an ever-larger percentage of investment portfolios. In fact, a recent survey by Bank of America Merrill Lynch showed portfolios were underweight equities by as much as 19%, and thus had even greater concentration in bonds1.

Fund flow data is one of the best gauges of where investors actually are putting their money. Investor sentiment surveys can mislead, but money flows tell the true story of what is happening. And month after month, money has flowed out of U.S. equities and into bonds and bond funds. April of this year was a particularly stark contrast: more than $20 billion flowed out of U.S equities, and more than $10 billion went into bonds. The only category that did better was international equity, which has been buoyed by the quantitative easing and other measures recently instituted by the European Central Bank.

With money surging into assets viewed as safe, those assets, of course, have, become relatively more expensive, and thus the surge in bond prices and the drop in yields. It also helps explain the continued surge in worldwide real estate prices, an asset which may not be perceived as safe as bonds, but certainly seen as safer than stocks.

So much money concentrated in a relatively limited quadrant of the market cannot be a recipe for good things. The rush into safe assets may not end with a crisis, but it already has generated less optimal results in the form of very low yields and poor returns. Some banks have begun charging depositors for keeping money in savings and checking accounts, a sign that safety is creating costs.

Recent sharp moves in bond prices demonstrate just how risky safety can be. Yields on the supposedly staid and uber safe German bund dropped down and down and down to just about zero in April before shooting up nearly 70 basis points in the space of days. In bond land, that is about as volatile as it gets, and is hardly a sign of safety.

Safety in risk

If the massive concentration of assets on one end of the spectrum is creating potential risk, the substantial underinvestment on the other end may present significant opportunities. At the very least, the underinvestment in U.S. equities (and certain other types of bonds) may signal that there is less risk of investor panic and prolonged volatility.

Equities always have been on the riskier end of the investing spectrum. Advisors, who think in terms of risk buckets, as well as institutional and pension investors, all view equities as risky, because major loss is always a possibility. That scenario exists with bonds as well, but even if a borrower defaults, the risk of massive decline is rarely as great. That is why equities often are said to carry a “risk premium” compared to other investments.

Few investors approach equities with false equanimity, except in periods of exceptional euphoria (such as the 1990s, when stocks appeared only to move up). One thing that makes bond investing potentially riskier now than equity investing is that so many bond investors seem less sensitive to the potential for losses and volatility than equity investors. Being unprepared for risk is possibly the greatest one of all.

Other than international equities, stocks in general have seen investor flight, both retail and institutional. The recent surge of investments into international equities is impressive, but less so when juxtaposed with the past five years of their poor returns and tepid flows. U.S. equities have been among the world’s best performing assets over the past five years, and yet still carry the taint of risk. Although it has not stopped markets from rising, it certainly has stopped markets from going up the way they did from 1982 till 2000.

Suggesting that there may be more safety in risk does not mean that stocks and other “risky” instruments, such as emerging market debt, are free from the perils of sharp sell-offs and negative volatility. But it does mean that the space may be less prone to panic and systemic breaches, because investors are aware of the perils and the rewards, and are less likely to bolt at the first hint of trouble.

We all are part of herds, and today’s market herd mentality is to seek more safety and assume only dollops of risk. But the effect of such behavior is that too much money is being allocated to one corner of the market and not enough to others. It potentially can create a safety bubble, with some areas of the market called “risky” actually being far safer, in terms of dollars returned to investors over time.

If your portfolio is skewed toward supposed safety, therefore, consider that it may not be as safe as it seems. You cannot invest without risk, and the excessive pursuit of safety can be just as irrational as the exuberance in housing, equities, and derivatives that caused such tumult in the past fifteen years. Assessing risk tolerance is not the problem. The way we currently define safety and risk as synonyms for bonds and equities is the issue. It is one that we all should address now, rather than trying to do so if and when real volatility and turmoil once again rear their all-too-familiar heads.

Advisor Take-Away:
Historically, bonds were perceived as being relatively safe, and equities were considered risky. Portfolios were constructed accordingly to match investors’ risk tolerance. Actual money flows are challenging these traditional meanings of safety and risk; bonds may no longer be the safe asset they seem, as investors in German bunds were surprised to learn in April when rock-bottom yields were quickly followed by a 70 basis point rise. In contrast, equities, known for their risk of sharp sell-offs and high volatility, may be less prone to panic, since investors are aware of, and may be better equipped to withstand, both their perils and rewards. Pursuing safety in portfolios by overweighting bonds may be the greatest risk of all: being unprepared for a market turn. Investors, with the help of their advisors, may need to rethink their perceptions of safety and risk, and whether simple categories of bonds and equities are the best ways to define them.

1 Source: "BofA Merrill Lynch Fund Manager Survey Finds Investors Selectively Lowering Risk After Bond Sell-off", Bankofamerica.com, May 19, 2015.

The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this commentary is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results. Indices are unmanaged and their returns assume reinvestment of dividends and do not reflect any fees or expenses. It is not possible to invest directly in an index.

Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet | PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.

Neither Envestnet, Envestnet | PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.

© 2015 Envestnet, Inc. All rights reserved.

Featuring

Zachary Karabell
Head of Global Strategies, Envestnet, Inc., Consultant to Investment Committee*

Articles By This Author

Video: Taxes are certain, but don't obsess about tax reform Video: Time to stock up on growth or value? The Envestnet Edge, September 2017 Video: Time To Take A (Measured) Risk? The Envestnet Edge, July/August 2017 Video: Bitcoin: Buy Or Buyer Beware? The Envestnet Edge, June 2017 Video: FANG, FAAMG: Too Big a Bite of the Market? The Envestnet Edge, May 2017 Video: Invest "As If" The Envestnet Edge, April 2017 Video: What To Do In Quiet Markets The Envestnet Edge, March 2017 Video: Bull Or Bear: Should Investors Still Care? PMC Weekly Review - March 10, 2017 The Envestnet Edge, February 2017 Video: Separating markets from politics, is it really a "Trump rally"? The Envestnet Edge, January 2017 Video: Investing in Trump’s Economy? Proceed With Caution The Envestnet Edge, December 2016 Video: Have We Only Just Begun? The Envestnet Edge, November 2016 Video: Rotations, Reversals, Rising Rates: A Time to Reposition Post-Election, Will Markets and Portfolios Emerge Winners or Losers? Webinar Replay: Post-Election Winners and Losers The Envestnet Edge, October 2016 Video: In a 2-2-2 world, look for modest economic growth and expansion PMC Weekly Review - September 16, 2016 The Envestnet Edge, September 2016 Video: Diversification is working in 2016 (so far) The Envestnet Edge, July/August 2016 Video: Valuations: it's all relative Brexit: Plunging into the Unknown? The Envestnet Edge, June 2016 Video: Equity valuations and bond yields: reach no further PMC Weekly Review - June 17, 2016 The Envestnet Edge, May 2016 Video: Hitting singles: a measured approach for this investing season The Envestnet Edge, April 2016 Video: Investing with impact: increasingly a matter-of-fact Video: In this election cycle, will investors be winners or losers? The Envestnet Edge, March 2016 PMC Weekly Review - March 11, 2016 Video: In a low-growth world, less could be more The Envestnet Edge, February 2016 The Envestnet Edge, January 2016 Video: Markets are a mess, but don't jump to conclusions yet A Most Challenging Year Video: Interest Rates and Energy: The Highs and Lows of Year-End The Envestnet Edge, December 2015 The Envestnet Edge, November 2015 Video: We'll always have Paris The Envestnet Edge, October 2015 Video: Politics and the markets: déjà vu all over again? Video: China, Commodities, and Crisis: What's Next for Emerging Markets? The Envestnet Edge, September 2015 PMC Weekly Review - September 11, 2015 Is This The Big One (Financially Speaking)? Probably Not. The Envestnet Edge, August 2015 Video: In a "meh" market, look again at U.S. stocks The Envestnet Edge, July 2015 Video: Is this the Big One? What to do in a financial crisis Don't Worry About China Don’t Believe the Hype About Greece The Greek Catastrophe Is Finally Here (Unless It Isn’t) The Envestnet Edge, May/June 2015 Video: When Following the Herd is Risky, Where is the Safety? The Envestnet Edge, April 2015 Video: The End of Short-Termism is Long Overdue PMC Weekly Review - April 24, 2015 The Envestnet Edge, March 2015 Video: Keep Your Friends Close and Your Robo-Advisor Closer Video: The Return of the Comeback: Is 2015 the Year for International Stocks? The Envestnet Edge, February 2015 PMC Weekly Review - February 13, 2015 Why the Jobs Report Means Diddly Don’t Turn America Into Europe PMC Weekly Review - January 23, 2015 Video: Active and Passive: The Yin and Yang of Investing The Envestnet Edge, January 2015 PMC Weekly Review - January 9, 2015 Will Politics in 2015 Catch Up with the Economy? Video: Our Perspective on 2015: Maintain Yours The Envestnet Edge, December 2014 PMC Market Commentary: December 12, 2014 No, This Is NOT the '90s Economy Again PMC Market Commentary: November 14, 2014 Video: 2014 U.S. Midterms: A Win for Stocks? The Envestnet Edge, November 2014 Whose Economy Will It Be in 2016? PMC Market Commentary: October 17, 2014 Video: Special Video Commentary: Market Volatility and Fundamentals The Envestnet Edge, October 2014 Video: You Know What’s Not Sustainable? Ignoring the Opportunity in Impact Investing Don’t Panic! PMC Market Commentary: October 10, 2014 Greenberg’s Folly Naomi Klein Is Wrong PMC Market Commentary: September 26, 2014 Subprime Loans Are Back! Video: When it Comes to Interest Rates, Who Says What Comes Down Must Go Up? The Envestnet Edge, September 2014 PMC Market Commentary: September 12, 2014 Why Indie Bookstores Are on the Rise Again The Fed Is Not As Powerful As We Think PMC Market Commentary: August 22, 2014 Americans' Sour Mood on the Economy Doesn't Square with the Fact The Envestnet Edge, August 2014 Video: The World is in Crisis... the Markets are not PMC Market Commentary: August 8, 2014 PMC Market Commentary: July 25, 2014 Punitive Damages Video: Market Valuations and The Theory of Relativity The Envestnet Edge, July 2014 Don’t Kill the Export-Import Bank. Clone It. How India’s Economic Rise Could Bolster America’s Economy Video: Separating Risk from Reality PMC Market Commentary: June 27, 2014 No Sex Please, We're French PMC Market Commentary: June 13, 2014 The Envestnet Edge, June 2014 PMC Weekly Market Review, May 23, 2014 The Envestnet Edge, May 2014 Don't Bet on Rising Wages PMC Market Commentary: May 9, 2014 The Sharing Economy: Why Are So Many So Afraid? PMC Market Commentary: April 25, 2014 The Obsession with CEO Pay Won't Help the Middle Class PMC Market Commentary: April 11, 2014 Time to Face Reality: Our Unemployment Problems Are Structural PMC Market Commentary: March 28, 2014 In Defense of Relentless Optimism The "Made in China" Fallacy Forget GDP - Use Big Data