October 2024 Monthly Commentary

Challenges in Portfolio Construction · A Time for Alternatives? · Invest at All-Time Highs? 

Portfolio Advice, Talking Points, and Useful Resources

• Despite the current challenges in portfolio construction, maintaining discipline and diversification is crucial — portfolios should continue to perform as expected.
• Given the challenges facing traditional asset classes, alternatives may play a valuable role in enhancing portfolio performance, particularly in the current environment.
• Is it a good idea to invest when markets are at all-time highs? Surprisingly, yes! Historically, the market tends to outperform in the year ahead, as momentum is often in its favor.
   

This commentary is being written weeks before the presidential election, and by the time it’s published, the landscape may look quite different. However, some things remain constant. Constructing well-built investment portfolios that align with investors' goals and perform as expected is as critical as ever. Today’s environment presents unique challenges for portfolio construction, influenced by both market dynamics and broader economic factors.

One of the key challenges is the current state of conventional asset classes like stocks and bonds. In this commentary, we’ll explore the topic of investing in the stock market at all-time highs (the insights may surprise you), and we’ll also discuss why alternative investments deserve consideration for well-diversified portfolios.

As we write each month, we believe that long-term investors are best served by staying invested, staying diversified, and staying disciplined. This month’s commentary includes sections that delve into each of these principles. We hope you find this analysis valuable. 

Stay Disciplined: Current Challenges in Portfolio Construction

By Rusty Vanneman, CFA, CMT, BFA, Chief Investment Strategist

In October, Orion Wealth Management hosted a two-day Elite Advisor conference in Savannah, Georgia. The event provided a platform to discuss Orion’s strategy, offer insights on the upcoming election, share best practices for growth, and explore investor behavior trends. The conference also featured roundtable discussions addressing the portfolio construction challenges financial advisors face today, given unique market conditions and the aging demographics of both advisors and clients.

The Impact of Wealth Transfer on Portfolio Construction

Demographic shifts are a key focus for advisors, especially with an estimated $90 trillion in assets expected to transfer over the coming decades to younger generations, including Gen X (born 1965-1980) and Millennials (born 1981-1996).

Source: Board of Governors of the Federal Reserve System.

This wealth transfer raises important questions:

• How are advisors preparing for this transition? What strategies are they using to help Baby Boomers transfer wealth efficiently to younger heirs?
• Balancing risk tolerances: How are advisors managing different risk profiles across generations, such as Baby Boomers focusing on retirement income, while Millennials seek growth and impact investments?
• Customization for younger clients: As Millennials and Gen Z investors demand greater customization and alignment with personal values, how are advisors tailoring portfolios to meet these expectations?
   

Aging Advisors and Succession Planning

Another challenge discussed was the aging advisor population. In the next 10 years, nearly 100,000 advisors — managing almost $12 trillion in assets — are expected to retire, representing about one-third of all advisors.

This raises further questions:

• Succession planning: How are advisors planning transitions to ensure continuity in portfolio construction for long-term clients?
• Generational differences in portfolio strategy: Are younger advisors approaching portfolio construction differently compared to their senior counterparts? What strategies are being used to maintain client relationships during transitions?

Navigating Unique Market Conditions

The group discussed various market challenges and their impact on portfolio construction:

• High market valuations: Some participants noted that the stock market is near or at historically high valuations, with market concentration in a few large names driving a lot of the gains.
• Fixed income challenges: Despite rising interest rates, core fixed income still offers lower yields than historical averages and is not providing the same level of diversification in equity-dominated portfolios. Additionally, market volatility has increased, causing the traditional 60/40 stock-bond portfolio to experience twice the volatility seen just a few years ago.
• Increased interest in alternatives: With fixed income struggling to diversify portfolios, more advisors are incorporating alternatives to enhance returns and manage risk. Some of this demand is driven by illiquid alternatives, while others aim to diversify away from traditional stocks and bonds.

Key portfolio construction questions raised included:

• How are advisors building fixed income portfolios to manage today’s lower yields and higher correlations with equities?
• How are non-core fixed income asset classes and alternatives being used? What challenges do they pose?
• Are advisors using tactical strategies to navigate market volatility?
• How are global uncertainties, such as political and economic risks, influencing asset allocation?

Behavioral Finance and Portfolio Construction

Behavioral finance (BeFi) also played a prominent role in discussions. BeFi benefits both clients and advisors, with compelling statistics supporting its value:

• Investors who work with advisors accumulate nearly three times the terminal wealth of those who invest independently, thanks in large part to the behavioral guidance advisors provide.
• Beyond financial outcomes, behavioral advice improves overall well-being — clients experience less stress, better communication, and even improved life satisfaction.
• Advisors who implement specific BeFi tools see significant business benefits, including twice the new client growth and three times the asset flows from existing clients compared to those who do not.

Key behavioral finance questions explored included:

• How is behavioral finance shaping portfolio construction?
• How are advisors using BeFi strategies to improve client outcomes and satisfaction?

Key Takeaways from the Roundtable Discussions

While the roundtable discussions provided many insights, a common theme emerged: “It depends.” While a common thread in discussions was keeping portfolios as simple as possible, portfolio construction must always be tailored to each client’s unique goals, risk tolerance, and personal circumstances.

However, several recurring ideas stood out:

• Discipline is key: portfolios must behave as expected. 
• Diversification remains critical to managing risk and enhancing long-term returns.
• Customization and personalization of portfolios continue to grow in importance, offering benefits such as tax efficiency, better risk management, and alignment with client values.
• Behavioral finance tools are helping clients better understand their own risk tolerance and make more informed decisions.

At Orion Wealth Management, we are committed to supporting advisors with portfolio construction solutions. Whether working with high-net-worth clients, offering OCIO services, or helping advisors develop personalized portfolios, our team provides tailored guidance. For more information or assistance on portfolio construction, or really anything on the markets or investment strategies, please reach out to our Investment Strategy team at OPSResearch@orion.com.

Stay Diversified: Alternatives – An Ace in the Hole During Election Years?

By Nick Codola, CFA, CAIA, Sr. Portfolio Manager

With the presidential election less than a month away, and the two candidates running head-to-head in the polls, there is certainly a lot of uncertainty in the markets. That is best visualized by the S&P 500’s option market and its volatility surface:

Source: Data on the S&P 500 Volatility Surface of the Option Market as of 10.14.24.

The key takeaway? As illustrated in the red section of the graph, investors are paying a premium to secure protection for the next 3-6 weeks. While options can be an effective way to hedge against a market downturn, another viable approach is through alternative liquid strategies.

Put options, which many investors are currently purchasing, yield profit only if a specific outcome occurs — the S&P 500 declines. Should the market rise or even remain stable after the election, the value of those options would diminish. In contrast, alternative strategies offer protection through diversification. Their return drivers are uncorrelated or have low correlation with equity markets, allowing them to potentially reduce portfolio volatility and enhance resilience across various market conditions.

Drawing on monthly returns dating back to 1989, the table below presents the average monthly performance of various funds, highlighting that Q4 tends to be a strong quarter for equities, fixed income, and liquid alternatives. Event-driven strategies, which capitalize on corporate actions such as regulatory changes, merger arbitrage, and bankruptcies, typically perform exceptionally well during this period. In fact, December has historically been the best month for these strategies.

This trend is not surprising — companies, and especially their leadership, aim to start the new year with a clean slate by resolving any outstanding business. If a merger, bankruptcy proceeding, or similar event is still pending as the fourth quarter progresses, management often strives to conclude it by year-end, avoiding the burden of unfinished business at the start of the new year. Leaving such issues unresolved could also complicate earnings calls, comparisons, and other reporting matters. In essence, the mantra of ‘New Year, New Me’ also extends to companies.

Source: Morningstar. Monthly Data from 1989 – September 2024. ‘US Fund’ constitutes an equal weight average contribution of all the funds within Morningstar’s defined category that has data at that time. So, US Fund Event Driven Monthly Returns constitutes the average monthly performance of all US Event Driven funds.  

But how does this relate to elections? Alternative strategies can help diversify a portfolio's return drivers and offer protection during periods of uncertainty. A multi-strategy fund, which provides exposure to various alternative strategies wrapped up into a single investment, can act as a versatile "Swiss Army knife" in a portfolio, helping to reduce volatility and smooth out returns. While allocating to a specific alternative strategy may increase both risk and potential returns, each strategy carries its own distinct set of risks. For event-driven strategies, the primary risks are that a deal may collapse or, even if completed, the process might take longer than expected, rendering the trade unprofitable.

Traditionally, fixed income has served as a reliable hedge against equities during downturns. However, in a low-yield environment characterized by heightened fixed income volatility, bonds have become less effective diversifiers — consider 2022 as a case in point. Even though yields are now significantly higher than at any time in the past decade, volatility remains elevated; the 10-year Treasury yield, for example, rose nearly 50 basis points over the past month.

Against this backdrop, alternatives may offer valuable diversification and protection. Examining return data from every U.S. presidential election over the past thirty years, multi-strategy and event-driven funds have not posted a single negative one-year return. Here, "one-year return" is defined as the performance from October of the election year through September of the following year, for instance, October 1992 to September 1993.

Source: Morningstar Direct as of 10.14.24. Data from October to September of every election year since 1992.

Fixed income has struggled in recent election cycles, with bonds averaging a return of -0.83% over the last three elections. Looking beyond just returns during the one-year period surrounding an election, alternative strategies have delivered strong risk-adjusted returns:

Source: Morningstar Direct as of 10.14.24. Data from October to following September of every election year since 1992.

If one focuses on just the data from this century, i.e. from 2000 to present, the data maybe even more compelling:

Source: Morningstar Direct as of 10.14.24. Data from October to following September of every election year since 2000.

While the risk metrics for event-driven strategies remain relatively stable, returns from other asset classes tend to drop by 30-40%, all while maintaining similar levels of volatility. Although future returns and election outcomes are inherently unpredictable, alternatives, especially event-driven strategies — have consistently served as effective hedges against market uncertainty during election years. This is because their return drivers are largely independent of election results. Additionally, as we enter a historically strong seasonal period for these strategies, there is even more incentive to consider adding them to a portfolio.

Stay Invested: Investing at All-Time Highs

By Ben Vaske, BFA, Sr. Investment Strategist

Intuitively, most investors believe that investing in the stock market at all-time highs seems misguided and a precursor to sub-par returns. After all, investing at new highs means paying a price that nobody has paid before. Thus far in 2024 (as of 10/11/2024), the S&P 500 has reached an all-time high 45 times, tied for the 10th most record prices since 1929, and we still have over two months to go! Again, most would assume that investing at these levels would result in lower average returns. However, our research suggests that despite this seemingly inopportune timing, average returns after investing at new highs are higher than a simple dollar-cost-average investment cadence over time.

Source: Charlie Billelo, Creative Planning. As of 10/14/2024.

To illustrate this point, the chart below from the JPMorgan Guide to the Markets examines the performance of investing in the market at new highs, compared to investing on any random day. The results show that the market tends to outperform over the 1-, 3-, and 5-year periods following a new high. The reason? Positive price momentum. In the short term, momentum tends to persist, driving continued market gains.

Source: FactSet, J.P. Morgan Private Bank. Data is as of August 27, 2020.

This data challenges the common perception that investing at all-time highs leads to suboptimal returns. In fact, market highs often reflect strong underlying fundamentals — such as corporate earnings growth, favorable economic conditions, or technological advancements. Additionally, all-time highs can be a signal of sustained momentum in the market, not necessarily an indicator of an impending downturn.

It's crucial to remember that over time, the market has a natural upward trajectory. Historically, the S&P 500 rises about three-quarters of the time on an annual basis. Waiting for a pullback to invest may seem prudent, but missing out on the long-term compounding effects of staying invested can significantly hinder portfolio growth. To further illustrate this point, here are the returns of investing in cash at the year’s all-time stock price highs, a measly return of just 1.3%.

Source: OPS Quarterly Reference Guide. As of 12/31/2023.

Moreover, one of the core principles of successful investing is avoiding the temptation to time the market. Trying to predict short-term market movements or waiting for an ideal entry point rarely works in investors' favor. Instead, staying disciplined, keeping a long-term perspective, and focusing on a well-diversified strategy has proven to be a more reliable path to achieving financial goals.

Finally, while volatility and corrections are inevitable parts of the market cycle, they are typically followed by recoveries. History shows that pullbacks following all-time highs often prove to be buying opportunities rather than signals to exit the market. Investors who stay the course are often rewarded for their patience and discipline.

Investing at all-time highs should not be feared. The data indicates that over time, these investments can outperform conventional strategies. With a long-term mindset, a diversified portfolio, and a disciplined approach, investors can feel confident in navigating markets — even at record levels.

Thank You for Letting Us Serve You

Thank you for your time and trust. If you have any questions or feedback, please let us know. As always:

Stay invested, stay diversified, and stay disciplined.

Invest well and be well,

Rusty Vanneman, CFA, CMT, BFA
Chief Investment Strategist