Slow Down, Look Both Ways
Income and Diversification can be Key to Managing Volatility


January 2012

Investing in a time of economic and market uncertainty is like approaching a semi-controlled intersection with the traffic signal flashing yellow.

"You slow down, but you don't stop," says Peter Jacobs, senior product manager for mutual funds at Northern Trust. "It's a time to be cautious, but there are strategies to help investors keep moving toward their financial goals without taking unnecessary risks, even in a highly volatile environment."

You might think of those strategies as front and side airbags. Certainly, there are problems coming at investors from West and East, plus others closer to home.

The eurozone has not resolved its credit or sovereign debt issues, the turbocharged Chinese economy has hit a few speed bumps, and the recovery in the United States is distressingly slow.

Yet none of those problems are necessarily insurmountable.

Most experts expect the European Monetary Union to survive because the alternative, a breakup, would be far worse.

Similarly, the United States is widely projected to avoid another recession. In fact, there are encouraging signs that economic growth is actually accelerating.

And Chinese inflation is finally reduced to levels that could allow authorities to reverse their monetary tightening campaign, perhaps setting the stage for a resumption of China's exceptionally fast economic growth later this year.

So if the investment road map doesn't exactly resemble the German Autobahn, it might not have to look like the Hollywood Freeway at rush hour, either.

Here are three options to navigate volatile markets in uncertain economic times:

  • Seek more current income with ultrashort funds
  • Invest in dividend-paying stocks as a defensive equity strategy
  • Manage risk by diversifying across multiple asset classes with a fund of funds

Stay in the right-hand lane
Once upon a time, investors seeking relief from risk might never have merged into traffic, choosing instead to remain parked in cash equivalents. During the difficult equity markets of the early 1980s, for example, money market fund yields often were in double digits.

Not so, this time.

When the Federal Reserve slashed benchmark rates to near zero in December 2008, cash yields went south as well — which is where they'll remain if the Fed follows through on its pledge to keep money virtually free until late 2014.

So one strategy to help manage portfolio volatility, while still having the potential to generate income, would be to invest in products that mature later than cash equivalents but sooner than most bonds.

As skinny as money market fund yields have become, however, Jacobs says that old-fashioned cash still has an important role to play for most households.

"There is still no substitute for cash as a vehicle for keeping money that might be needed in the near future completely out of harm's way," he says.

Once those liquidity requirements are met, however, investors might consider mutual funds that have the potential to pay more current income with only modest additional risk.

"There is a middle ground between sitting completely in cash and taking big bets on interest rates or credit quality," Jacobs says.

That middle ground is occupied by ultra-short fixed income funds, which extend the average maturity of their holdings in an effort to capture the yields that usually accompany somewhat longer dated debt securities.

No one's going to get rich in an ultrashort fund — and there is the possibility of a loss of principal as well — but investors might pick up a measure of additional yield, which in today's super-low-rate environment can make a difference.

"The weighted average maturity of a money market fund is limited to 60 days, with a 13-month boundary for individual securities" says Carol Sullivan, who oversees two ultra-short Northern Funds. "Our ultra-short funds have weighted average maturities of roughly one year and can hold securities with maturities up to three years, giving us the opportunity to boost the net yield."

Like Jacobs, Sullivan cautions that ultrashort funds are not a substitute for cash because the dollar-in, dollar-out feature of money market funds does not apply.

"Unlike money market funds, the net asset value of an ultra-short fund is not fixed at $1 a share, so there is some day-to-day movement," she says. Still, Sullivan says it usually would take a significant jump in market interest rates over a brief period to offset the potential yield advantage from ultra-short funds, especially over a full market cycle.

In part, that's because ultra-short funds can hold floating rate debt along with fixed rate bonds, whose yields are designed to increase as interest rates rise. That keeps the price of those securities relatively stable while they strive to provide investors with more income.

"Ultra-short funds are designed for conservative investors who have met their liquidity needs and who can accept a modest amount of additional interest rate and credit risk in return for a potentially better yield," she says.

Topping off the tank
Another strategy for managing a portfolio in volatile markets is to invest a portion in dividend-paying stocks. That's because dividend income could function as a mild buffer during periods of market stress.

Of course, dividends are not a magic bullet against volatility. Dividend-paying stocks also go down during market sluffs, though generally not by as much.

"A company can't pay dividends with promises or potential," says Jacobs. "A cash payout to shareholders is real money, which could make the stock more valuable."

Dividends can be an important part of a stock's performance. During the 12 months through November 2011, shares of S&P 500 companies that paid a dividend generated an average total return of 8.28% versus an average of 0.96% for non-payers.1

According to Ned Davis Research, from 1930 through mid-2010, 46% of the total return of the S&P 500 came from dividends. But if those payouts were reinvested in additional shares, the dividend portion rises to a stunning 95.8% of total return.

"Those are very powerful numbers and argue strongly for holding stocks that pay a solid and secure dividend," says Jacobs.

This is good news, since cash-rich corporations are returning more money to shareholders through dividends. Through the first 11 months of last year, S&P 500 companies increased dividends by a whopping $37.2 billion, with 309 stocks paying higher dividends and only five stocks lowering or suspending them.2

The impact of rising dividends and falling bond yields also may have shifted the relative appeal of equity versus fixed-income investments. In December, the dividend yield on the S&P 500 was 120% of the yield on 10-year U.S. Treasuries; since 1962, that figure averaged just 43%.3

Still, there can be too much of a good thing. Jacobs cautions against "chasing yield" by loading up on stocks whose dividends are too far above the market average, which is currently around 2%.

"A 3% or 4% dividend could be fine," he says. "Those might be companies in less volatile, lower-growth industries like consumer staples and utilities."

But stocks yielding close to double digits, while perhaps a tempting target for income-starved investors, should be a red flag. Jacobs contends that an unusually high dividend yield could reflect problems that have caused a stock to collapse — or doubts about whether the dividend can be maintained.

Either way, stay away.

"Professional investment management can help make those calls," Jacobs says.

Expand your itinerary
Since there's usually a bull market somewhere, a third approach to managing a portfolio during volatile times is to invest in a multitude of asset classes from around the world, some of which occasionally move in opposite directions.

Those asset classes could include domestic and international stocks, bonds, commodities, precious metals, real estate, currencies and cash, plus sub-sectors within those groups.

"It's all about managing risk through broad diversification," says Jacobs, who stresses that diversification does not guarantee a profit or protect against a loss.

Still, diversification could help to minimize volatility since asset classes don't always move in lock step. "If they're combined in optimal ways," Jacobs says, "overall volatility potentially could be reduced."

One vehicle for expanding a portfolio's diversification is a so-called fund of funds. These investments typically employ multiple portfolio managers, each of whom focuses on their specific area of expertise.

Fund of funds are a way for investors to achieve broad-based exposure to multiple asset classes through experienced professional managers who otherwise would be available only to deep-pocketed institutional investors.

Another benefit to a fund of funds is that weightings of the various portfolio components are tweaked based on market conditions. If the global economic outlook was favorable, a fund of funds might boost exposure to emerging market stocks. Conversely, its allocation to lower risk assets like U.S. government bonds could be raised if the world economy seemed headed for trouble.

"Flexibility can be an important tool in managing risk," says Jacobs.

Hopeful sign
Besides being a signal to slow down without stopping, that flashing yellow light at the uncontrolled intersection might mean something else as well.

The color yellow is the universal symbol of hope and optimism. As the new year begins, it's not a stretch to see global economic uncertainty in a different light.

"Volatility has kept stock prices and valuations down," says Jacobs. "For long term investors, that could be good because it may provide attractive entry points."

In the meantime, the three strategies noted above could help investors position their portfolios for better times while dampening near-term market turbulence.

Besides earning a negative inflation-adjusted yield, Jacobs notes another problem with idling too long in the all-cash parking lot.

"No one is going to ring a bell when it's time to get back into the markets," he says. "You've just got to be there."

But take it slow along the way.

Three Roads Less Travelled

The Impact of Stock Dividends on Total Return

Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.

Equity Risk: Equity securities (stocks) are more volatile and carry more risk than other forms of investments, including investments in high-grade fixed income securities. The net asset value per share of this Fund will fluctuate as the value of the securities in the portfolio changes.

High Yield Risk: Although a high yield fund's yield may be higher than that of fixed income funds that purchase higher rated securities, the potentially higher yield is a function of the greater risk that a high yield fund's share price will decline.

Interest Rate Risk: Increases in prevailing interest rates will cause fixed income securities, including convertible securities, held by the Fund to decline in value.

Asset Allocation Risk: An asset allocation strategy does not guarantee any specific result or profit nor protect against a loss.

International Risk: International investing involves increased risk and volatility.

1 Standard & Poors
2 Standard & Poors
3 Standard & Poors

 
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