As market volatility continues into the second half of 2020, can investors find clarity?
It’s been a marathon of a year—and we’ve barely crossed the halfway point. Against the backdrop of a pandemic that has disrupted economies and capital markets, businesses across the globe—including Parametric—have been forced to rethink their strategies to keep moving forward.
As we move into the second half of 2020, we find ourselves working with clients to identify the key factors that may help investors create a clearer vision for the road ahead. Let’s look at some of the issues that are top of mind for Parametric in the foreseeable future.
Municipal liquidity management
The Fed has repeatedly broadened the MLF’s scope to provide an adequate backstop for the municipal market. Unfortunately, states and localities continue facing lockdowns and economic hardships amid growth in confirmed cases of COVID-19. There are talks of Congress providing additional funding sources through—for example—a second CARES Act, but the size and scope of relief remains uncertain. While a return to March’s conditions is unlikely, the ongoing potential for widespread volatility and dislocation gives investors reason to be cautious when managing liquidity.
Protection through diversification
At face value, hedging against the current market seems like a good idea—until you consider that premium protection for hedging is expensive, the value of long-term returns can be jeopardized by hedging, and timing the market amid volatility is difficult. Assuming the market doesn’t sustain its current rate of growth, any of these factors could render hedging a liability for investors.
Diversification offers a more practical approach to investing in today’s volatile climate. Customizations such as focusing on defensive market sectors or reducing equity exposure can help investors manage their risks more effectively. Portfolios rich in geographic diversification through a mix of US, international, and emerging market stocks can also reduce the impact COVID-19 has on investments.
Fallen interest rates and dividend pressure
Despite a stream of disparaging dividend headlines, large, stable dividend payers have sustained and grown payouts while smaller, weaker firms in hard-hit industries have struggled. Aggregate dividends announced by S&P 500® firms to be paid in the year ahead remain nearly as large as the past year. Unlike during the global financial crisis, credit markets are open, and liquidity flows freely. Between unprecedented intervention from the Fed and fears of the economic fallout from a COVID-19 resurgence, bond yields remain stubbornly low, capping the reward for traditional, high-quality fixed income investments. Equity income exposures offer elevated cash flows and the prospect of long-term growth relative to traditional fixed income investments.
Mutual fund gain distributions
In an effort to reduce the burden of COVID-19 on taxpayers, the federal government extended the income tax filing deadline to July 15. The extension offered relief to many taxpayers, but it may prove to be a setback for investors paying capital gains taxes on mutual funds. Investors are generally at the mercy of fund managers when buying mutual funds, which can lead to investors inheriting a fund’s cost basis when paying capital gains. Larger shareholders with more influence can drive the buying and selling decisions of mutual funds, and redemptions can often trigger those capital gains.
This outcome has become more pronounced as of late, with capital gains distributions in the equity market rising over the past decade to hit $318 billion in 2019. Amid market volatility, we can expect to see an increase in liquidity outflows in the second half of the year. When combined with the high amounts of unrealized gains, these outflows could mean large capital gains distributions in 2020.
We suggest replacing or combining mutual fund holdings with tax-efficient custom SMAs that seek to offset gains and lower investors’ tax bills. In times of volatility, it becomes increasingly difficult to time and size distributions, but there are options for mitigating and eliminating exposure to distributions and their ensuing taxes.
Diversity and transparency through shareholder engagement
In light of recent events that continue to highlight racial inequality in America, increasing diversity is a priority in boardrooms across the nation. We’re starting to see more women being appointed to boards (however, we still have a long way to go before parity), but much more progress needs to be made for racial and ethnic minorities. This leads us to ask: Do we have the data we need to assess progress on diversity and inclusion at all levels of seniority in the corporate world?
We checked in with Gwen Le Berre, Parametric's director of responsible investing, and her research indicates that data on demographic characteristics like race isn’t as robust as it is for gender. Gwen suggests leveraging shareholder engagement to make the biggest impact on companies. Having conversations with key decision makers nudges companies to create better disclosures, which are necessary for measuring progress and keeping companies accountable. Gwen’s team is working to increase public disclosure of EEO-1 data, which is a new shareholder engagement initiative for New York’s comptroller. Increasing representation of minorities in boardrooms is about social justice, but it’s also about better corporate governance. It’s important for boards to reflect on their own composition, and having diversity of thought can lead to better-informed decisions.
The bottom line
The uncertainty of 2020 has taught us the importance of adaptability. Investors and advisors who embrace flexibility and transparency may be best positioned to navigate whatever comes our way in the second half of 2020.