Following lacklustre returns in the Canadian stock market in 2017, financial advisors are concerned that higher levels of market volatility, interest rate hikes and possible asset bubbles threaten investment returns for 2018, finds a survey by Natixis Investment Managers. This environment can also lead investors to make costly mistakes—and managing the emotional reactions of clients could be advisors’ greatest challenge this year, notes the firm.

In fact, 94% of advisors say that preventing clients from making investment decisions based on their feelings is important to their success, according to the survey. In addition, 34% report that their clients reacted emotionally to recent market movements; 43% believe investors are prepared for a market downturn.

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Financial advisors also have their work cut out as they navigate through the market’s choppy waters. As survey respondents strive to grow assets under management by an average of 14% over the next 12 months, they see several potential roadblocks.

  • Threats to investment performance: Advisors see rising volatility as the biggest potential threat to the markets—73% say it would negatively affect overall investment performance. Trailing perils are asset bubbles (63%), geopolitical events (57%) unwinding of quantitative easing (57%), interest rate increases (56%), the low yield environment (55%), regulation (43%) and currency fluctuations (41%).
  • Impact of short-term rate increase: Advisors say an increase in central bank short-term interest rates is expected to adversely affect the housing market (75%), credit market (71%), bond volatility (68%), overall market volatility (65%) consumer spending (62%) and economic growth (53%).
  • Portfolio risks: Advisors’ top risk concerns are interest rate hikes (51%), asset price volatility spikes (45%) and low yields (38%).
  • Concerns about bubbles: Advisors believe there are asset bubbles in the real estate market (49%), the tech sector (23%), the stock market (23%) and bond market (22%). They show the most concern for cryptocurrencies. After those currencies experienced a considerable run up in 2017, 69% of respondents see them as a potential bubble that could burst in 2018.

“Advisors have an important role to play in all markets, helping investors to be aware of the harm emotionally driven investing can cause and assisting them in dispassionately examining their goals, risk tolerance and timeframe,” says Abe Goenka, CEO of Natixis Investment Managers Canada, in a release. “Our research shows they are increasingly turning to active managers for the tools and flexibility to diversify their clients’ portfolios and reduce risk.”

Active management

According to the survey, advisors are turning to active managers and deploying alternative investments to manage new and numerous risks facing their clients.

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In fact, 86% say the risks in the market add up to an environment that favours active management. These professionals demonstrate a clear preference for actively managed investments and continue to allocate the majority of assets to these strategies.

Advisors who responded to Natixis’ 2016 survey reported that 68% of the assets they manage were allocated to active strategies and 32% to passive. They projected that within three years they would moderate their active allocations to 62% and increase passive allocations to 38%. Instead, allocations to active have increased in the past two years. Respondents in this year’s survey now say they have 72% of assets allocated to active management.

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Greater sentiment toward active management could generate a further shift to active strategies, which have become essential in recent years as advisors seek opportunities to generate alpha. Advisors say that passive strategies, in contrast, are used mainly for their lower fees (56%). Notably, 75% of advisors believe individual investors are unaware of the risks of passive investing, and the same number has a false sense of security about this type of investing.

Alternatives regaining momentum

Financial advisors also believe it’s important to invest in alternatives to obtain benefits, such as moderating volatility, producing alpha and generating stable income. Survey results show that 66% recommend alternative investments to clients today. Their strategies include real estate/REITS (35%), infrastructure (33%), real assets (29%), commodities (19%), hedge fund strategies (17%) and private equity (15%). Further, 47% give an alternative strategy more than three years to prove itself.

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Among those who recommend alternative investments, advisors see a number of liquid alternative strategies playing distinct roles in their portfolios.

  • Diversification: Advisors most commonly cite global tactical asset allocation (40%) and multi alternatives (37%) as best for diversification.
  • Fixed-income replacement: Top choices for providing a source of stable income include option writing (34%) and real estate (17%).
  • Volatility management: Advisors cite market-neutral (48%) and long-short equity (24%) as best suited to manage volatility risk.
  • Enhanced returns: One-quarter (25%) cite global tactical asset allocation as their top choice for enhancing returns. They also see long-short equity (20%) as useful in meeting this objective.
  • Inflation hedge: Advisors view real estate (18%) as best for inflation hedging strategies.
  • Reduced risk: Top choices for risk mitigation include long-short equity (25%), long-short credit (21%) and market neutral (18%).

Clients need practical education

Investors need to know themselves and the markets to make sound decisions, especially during growing volatility. Yet, just 53% of advisors believe investors understand the risks of the current market environment, and an even smaller number (43%) believe that investors are prepared for a market downturn. Further, 81% say the extended period of higher markets has made investors complacent about risk, and 82% say risk awareness often comes too late, with investors not recognizing risk until bad outcomes have occurred.

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According to the survey, other than giving investment advice, financial advisors describe their role with clients as:

  • guiding clients through emotional decisions (86%);
  • providing ongoing financial education (71%);
  • helping navigating life events (70%);
  • providing guidance on identifying and achieving life goals (65%); and
  • helping mediate family financial affairs (42%).

“To be successful, advisors will need to be in close communication with their clients, and their advice will need to come from both the right side and the left side of the brain,” says David Goodsell, executive director of Natixis Investment Managers’ Center for Investor Insight, in the release.

About the survey: Conducted in March 2018, the survey included 2,775 financial professionals, with $113.7 billion in assets, in 16 countries and territories in Asia, Europe, Latin America, the U.K. and the Americas. In Canada, CoreData surveyed 150 financial professionals.