For long-term investors, it is a mistake to make too much out of a three-month window of market performance; longer stretches are what really matter because that is your holding period, too.

But the third quarter was not just any old three-month period. After stocks posted a nearly unbroken string of robust returns since early 2009, the most recently ended quarter provided a glimpse into how various security types would behave in a less sanguine environment for global economic growth. The S&P 500 lost 6.5% during the quarter, its worst showing since 2011, and the MSCI EAFE Index shed more than 10% of its value. Emerging-markets equity indexes lost between 17% and 18%.

Of course, the next market swoon is likely to be a little different from this one; the U.S. market, rather than emerging markets, could lead the way down. But in many respects, the recent sell-off had some predictable elements that can be instructive for investors aiming to find balance and manage the risks in their portfolios. Here are some takeaways:

1) High-quality bonds are decent ballast, but do not expect miracles
Previous data have indicated that high-quality bonds are equity investors’ best diversifier, and that relationship held up during the third-quarter sell-off. The long-term government-bond category led the way with a 4.3% return during the third quarter, as investors bid up long-term bonds when the Fed decided to stave off an interest-rate increase. The short- and intermediate-term government categories delivered lower average returns of 0.3% and 0.9%, respectively.

Of course, most investors do not limit themselves to government bonds but instead hold intermediate-term bond funds that own government bonds as well as corporate and mortgage-backed securities; such funds also remained in positive territory, with average returns of 0.3%. The Barclays U.S. Aggregate Bond Index, which is heavier on government bonds than the typical intermediate-term fund, outperformed with a 1.2% return.

In a tough market, positive returns are nothing to sneeze at, but those numbers illustrate that bonds will not fully compensate for equities’ losses; only funds that took substantial duration risk were able to do so. Such funds are apt to be volatile (and hard to hang on to) given the prospective headwind of rising rates. Nor will duration risk definitely be rewarded in future market sell-offs, particularly if rising interest rates are the catalyst for the equity-market sell-off.

It is also worth noting that some bonds and bond funds will not offset equity losses at all; they will actually go down right along with stocks. For example, lower-quality bonds were less effective as ballast during the stock sell-off. Given that worries over economic growth precipitated stocks’ decline, it is not surprising that high-yield bonds fared especially poorly, shedding 4.5% on average; funds that had invested heavily in the hard-hit energy sector faced a double whammy. The bank-loan and multisector-bond categories also lost ground, albeit to a lesser extent. Non-traditional-bond funds sold like hotcakes a few years ago, touted as a way to dodge rising rates. But because most such funds take credit risk in lieu of interest-rate risk, the group’s third-quarter performance was undistinguished.

2) Alternatives’ returns were intriguing, but they are still not a must-own
Alternatives were generally disappointing during the 2008 financial crisis, though many such categories were quite small at that time. Given the proliferation of funds in several of these groups, the most recent stock market downturn provided a more useful, albeit short, window into alts’ behavior during difficult markets. As with the 2008 downturn, the bear-market category was the only group to deliver a truly impressive gain during the third quarter.

Most of the other alts categories managed small gains or muted losses relative to pure equity funds during the third quarter, a result that is in line with expectations. Many alternatives categories, such as long-short, provide exposure to equity-market performance, so it is unfair to expect them to deliver completely uncorrelated returns.

The managed-futures category, an investment type that is neither correlated with the equity market nor sensitive to interest-rate changes, managed a small gain during the third quarter. To date, many alternatives have delivered a risk/reward profile that is in line with a balanced portfolio but with higher costs.

3) Risk-averse investors should emphasize high-quality equities
The equity-market rally that has prevailed since 2009 has been frequently described as a low-quality rally, with highly leveraged, high-growth companies leading the way. Higher-quality companies, while posting strong gains in absolute terms, have lagged.

That relationship was turned on its head during the market downturn. Conservative, quality-oriented funds managed much smaller losses than their counterparts. Such funds also fared relatively well during the financial crisis. And in contrast with investment types that shine in one bear market but perhaps not another, there are persistent fundamental reasons that high-quality companies should hold up better than lower-quality ones in uncertain times.

That is not to say that well-balanced portfolios should not include both types of companies. Lower-quality companies frequently outperform at the outset of an economic recovery, for example, because they are frequently growing more rapidly than the mature, wide-moat dividend-payers that typically fall under the high-quality umbrella. But investors who are concerned with downside protection, either because they are retired or simply risk-averse, can reduce the volatility in their portfolios by tilting toward high-quality companies, either individual wide-moat stocks or funds that emphasize high-quality firms.

4) Sell-offs can open up long-dormant tax-saving opportunities
In an upward-trending market, tax-conscious investors do not have all that many ways to reduce the drag of taxes on their investment results; the best they can do is take maximum advantage of tax-sheltered savings vehicles and practice savvy asset allocation.
But a downward-trending market can open up tax-saving opportunities that were not there before, and those opportunities can be a saving grace in a tough market. Tax-loss selling is one such opportunity. Investors employing the specific-share-identification method for cost-basis accounting might be able to sell higher-priced lots of stocks or funds in their portfolios at a loss; stockpiling losses might help fund investors, in particular, offset impending capital gains distributions from actively managed funds. Investors may also be able to cherry-pick losing positions in unloved sectors such as energy or commodities.

A weak market also makes Roth IRA conversions more attractive than they otherwise would be, as lower investment balances lower the tax bill due upon conversion. For investors who have converted IRA assets in the past, when their balances were higher, undoing the conversion via recharacterization can make sense.


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