Volatility's Bite Returns: What Now?

Keeping an eye on the VIX Index is imperative for both advisors and investors, some managers point out. For example, one reasonable scenario is there is "a general decline in volatility back to a less than 10 VIX within the next quarter that is sustained till the end of the year," Jaffarian says.

"We expect a return to normal historical levels during 2018," Alfred Eskandar, co-founder of Salt Financial explained. "Investors can bet on the VIX hitting 20, and not returning to 10 this year."

Several factors likely will come together to normalize volatility, with a frequency of greater than 1% daily moves, says Frost's Thompson. These factors include Fed interest rate hikes, the lagging effect from the changing shape of the yield curve, the quantitative tightening regime, peak profits, corporate taxes now incorporated into earnings, higher expectations, the new risks brought on by trade policy, and investors who expect capital spending to raise productivity.

However, "[If] capital spending increases pipeline inflation pressures in the supply chain, this could add to inflationary pressure, adding to the risk the Fed 'kills' the cycle," Thompson said. One adage is particularly relevant today:

Cycles do not die of old age, they are killed off by the Fed — or some shock like the bursting of a bubble (as in 2000 and 2007) or some external shock, he adds.

As higher volatility is predicted to be the norm for the year ahead, how will it be different from 2017? The speed at which information is shared and processed by market participants is, of course, on the rise.

"This is a positive because it gets hashed out more quickly," said Brandon Moss, director of XY Investment Solutions. "Our biggest concern is the emotional connection people have to 1,000-point drops, which causes them to make much more susceptible rash decisions." He sees valuation being replaced by momentum and the fear of missing out (or FOMO), "which gets away from real intrinsic valuations. Very reminiscent of the tech bubble."

Gibbs agrees: "Given the reliance on systematic trading platforms, periods of sharp volatility are a high probability for a long time. However, we do not feel every period of weakness will be exacerbated by systematic trading to the degree seen during the January to February pullback." Instead, he sees pullbacks of 3-5% being the norm for the near term.

Playing Defense With continued higher volatility expected, different portfolio strategies will be needed to take advantage of market moves or protect investments from cannibalization of gains. Definitely, "long-term investors should not sell solely because of volatility," says Morningstar's McNeela. "Often the best thing to do is to do nothing, and that's typically the case with volatile markets."

That said, he believes defensive positions should be taken by underweighting U.S. stocks, U.S. government bonds and cash. "We also think value-oriented sectors in foreign developed and emerging markets are relatively attractive compared to U.S. stocks," the portfolio manager explained.

Its longer-term view of "entrenched growth" and "stuckflation" means Northern Trust Asset Management sees a "con-structive backdrop for risk assets," according to Darek Wojnar, head of funds and managed account solutions.

"During the recent market correction, we asked ourselves if that narrative still held. Because we thought it did, we maintained our overweight [stance] to risk assets — global equity, high yield and real assets such as real estate — and in some cases, used the market weakness to get underinvested portfolios to target allocations," Wojnar explained.

Crowell agrees. "It is quite possible — and in fact probable — that the strong market gains of the past nine years have caused meaningful deviations from target allocations levels. Investors should rebalance to their targets on a regular basis to ensure compliance with their plan," he said. "Don't forget, diversification is critical."

Diversification and sticking to long-term plans are the most prevalent advice passed on by advisors, portfolio managers and investment strategists. "Don't panic and stick to your plan," said LPL's Lynch.

"Despite rising rates, in the big picture we think bonds can still play their traditional role as diversifiers. Keep near to slightly above benchmark risk but look for traditional 'higher vol' sectors — such as small caps, emerging markets — to provide excess risk-adjusted returns."

"For true diversification, we lean on our risk-control assets — including cash, inflation-linked fixed income and investment grade fixed income," said Northern Trust's Wojnar.

Also, dividend-growth strategies "tend to perform well in the latter half of economic cycles," according to USAA's Toohey.

Frost's Thompson suggests investors examine higher quality floating-rate debt to hedge rates and credit risk. He also believes investors should look at strategies with a lower correlation to the conventional balanced (60/40) set up and equities that grow "relatively independent of the cycle." Finally, "consider positioning your fixed-income duration shorter," adds Tooney.

The view of 361 Capitals' Stanton is that investors should be "dialing back equity risk, increasing cash to be put to work at better valuations in the future and embracing strategies that can truncate losses (for example, long/short equity) or derive returns that are uncorrelated to equities, like managed futures," he says. Although Thompson agrees with the idea that investors should consider increasing their holdings of alternative investments, he prefers hedged or private debt rather than private equity.

Probabilities' Childrey says his new portfolio mix is 50/30/20, with the 20% being alternatives. "This new mix is intending to mitigate potential Fed moves that drive bonds lower," he said. "With the broad range of liquid alternative investments available to retail investors today, the idea merits consideration due to the risk/reward characteristics of such a strategy observed over a long term."

Tactics are as important as strategies, investment managers insist. Lynch suggests using tax loss harvesting to rotate to preferred asset classes. "Dips may provide opportunities to add modestly to risk, but that's a more challenging route," he said. For his part, Morningstar's McNeela cautions against "a 'buying the dips' strategy that doesn't carefully consider valuation."

Yet buying dips strategically is smart, note some advisors. According to Gibbs, "As pullbacks occur, investors should take advantage of the weakness to make tactical decisions within the confines of each client's long-term investment plan."

Other experts suggest dollar cost averaging, which McMillan says "remains useful in a volatile market." Crowell goes along with this view: "Use market volatility as an opportunity to dollar cost average for new cash or even rebalancing."

Many advisors welcome the volatility. "Volatility can be the investors' friend," Vollaro said.

Salt Financial's Eksandar sees its upside for advisors, who "must harness its power to drive returns instead of shunting it aside as something to fear and use rebalancing to enforce discipline." He recommends combining highly volatility assets with "staid" ones to create acceptable variances in portfolios and to provide a future cushion. "Taking risks should pay off," Eksandar explained.

Not Their First Rodeo Many advisors and investment professionals have been through this type of volatility before, such as during the 2006-2007 stock run up, says XY's Moss. "After such a large run-up, many clients became what we would call 'overfunded' based on their goal set and had some good options. Either take on loftier goals or reduce allocations and take some volatility out of their portfolios," he explained.

Commonwealth's McMillan compares today's volatility to that of 1999. "When clients start to reach for risk and fear missing out more than anything else, they usually learn that is a mistaken attitude," he said. Investors tend to ask about relative value — specifically the relationship between corporate credit and equity volatility — too late in the cycle, according to Matt Rowe, managing partner and chief investment officer of Headwater Solutions.

"This was particularly so in 2008, which saw an unprecedented spike in volatility — of over eight standard deviations [in the VIX] — and a collapse in the corporate credit market," he said. "The current likelihood of repricing in corporate credit and equity is high, based on historical measures and [expectations regarding the market] landscape going forward."

The financial crisis taught many a lesson, says D.A. Davidson's Crowell. "The sharp market correction which accompanied the Great Recession is quite instructive," he said, adding that some long-term clients couldn't ride out the market storms.

"Some even questioned whether their financial plan was relevant and should be believed, as this type of black swan event was perceived to be completely new and untested…," Crowell explained. "Some never reentered the markets as they just didn't trust the recovery."

Market battle experience has its benefits, Jaffarian points out, as those without it seemed very shaken by the Feb. 5 explosion of volatility. "They could not fathom how fast and meaningfully equities were correcting," he said. "For the vast majority of investment professionals who have worked through at least one, if not several far more severe and long corrections (2008, 2001 and 1987), the week of Feb. 5 felt perhaps more like a return to normality than a severe earth-shaking event."

Toohey recalls the Brexit vote of June 2016 and the associated bout of volatility, which he saw as an "opportunity to focus on fundamentals and valuation and to stick to the investment process."

MacDonald also has a long-term perspective. "The market was recently at an all-time high," he explained.

"What that means to us is that for every recession we have ever had — every depression, world war, Watergate scandal, or energy crisis — we have survived it and gone on to new highs. 100% of time," the portfolio manager said. "The only thing that can derail a long-term investment plan is to abandon it when times look tough. Stick with an intelligent wealth-management plan, and turn off CNBC."

Ginger Szala is executive managing editor of Investment Advisor and the former editor-in-chief of Futures Magazine Group.