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Taking Advantage of Equity Market Volatility

Equity markets have declined sharply over the past few days, in response to escalating US-China trade tensions. Rather than attempt to analyze President Trump's tweets or the Chinese Politburo's decisions, it may be more helpful to review the strategies that MFA employs to mitigate equity volatility when it inevitably occurs.

To be clear, equity investors will experience volatility. Volatility is the price that equity investors pay for long-term outperformance, relative to less volatile assets like cash and fixed-income. Of course, there are strategies to dampen volatility, but most of them involve dampening returns as well. Oftentimes, the best way to reduce volatility is to simply reduce equity exposure. However, we do employ two strategies that aim to reduce equity risk while preserving returns. They include:

  • Utilizing vehicles that combine multiple sources of return. For instance, it is possible to invest in a fixed-income portfolio and overlay it with swaps to obtain equity exposure, which means that for every dollar invested, investors can have both $1 of equity exposure and $1 of fixed-income exposure. Why is this beneficial? Fixed-income tends to do very well when equity markets experience sharp selloffs. Thus, fixed-income performance can offset equity performance.

  • For accounts larger than $250,000, we can buy the individual stocks in an index rather than buying an index fund, which allows for more tax-loss harvesting. For instance, investors who bought an S&P 500 index fund in 2016 cannot harvest losses today (because even the though the market has declined from recent highs, it is still above where it was three years ago) and the post-tax return will be the same or lower than the pre-tax returns. However, investors who own the underlying stocks can take advantage of days like today to harvest losses. Whether markets are up (like 2017) or down (like 2018), there are nearly always opportunities to harvest losses and generate post-tax returns that exceed pre-tax returns.

Again, equity investors will experience volatility and even the above strategies will decline in value when markets sell off  (like today). It is important to remember that days like today occur relatively frequently and to be prepared to capitalize upon them when they do occur. Please do not hesitate to reach out with any questions whatsoever.