Over the past weeks, we’ve received a number of calls and messages from clients about the sudden decline in the stock market caused by the Covid-19 pandemic.
It’s normal to feel anxious in such uncertain times. After all, the stock market descended into a bear market very quickly and all markets continue to experience strong fluctuations. Even highly experienced investors have found this to be an extraordinarily challenging period.
Here are some of the questions I’ve been fielding recently from clients and my answers.
Question: Can my equity funds go to zero?
Answer: Equity portfolios held by PWL clients are composed of more than 8,000 different companies operating around the world. All the companies in the stock market would have to go bankrupt for the funds to go to zero. Some businesses will go under given the current environment, but the vast majority will not.
You may ask: If you know some companies are going to go bankrupt, why not just hold the good ones? Because no one knows ahead of time which companies will perform well and which ones will fail—especially in a global crisis. Not even Warren Buffett!
You may recall that in 2008, Buffett invested billions in General Electric stock. By 2018, GE was performing so poorly it was dropped from the Dow Jones Industrial Average, after having been a member of the index since its inception in 1896.
Holding all companies in the market ensures you won’t suffer a permanent loss of capital, which could be the case if you were invested in individual stocks. Markets have always recovered over time.
Question: Could this be like the Great Depression or Japan’s 20-year stagnation?
Answer: The Great Depression was exacerbated by poor policy responses from the recently formed U.S. Federal Reserve and from the U.S. government of the day. The Fed actually increased interest rates while the U.S. government, led by Herbert Hoover, increased taxes and reduced expenditures following the stock market crash of 1929.
A similar story happened in Japan, where policies designed to deal with an economic decline turned out to be too little, too late in an economy beset by deflation. Japan was also faced with the compounding problems of a relatively older population and little immigration to provide economic vitality.
In this crisis, central banks and governments around the world have learned the lessons of the Great Depression, the Japanese experience and the financial crisis of 2008-09. Central banks were very quick to announce policies to ensure markets remain liquid and banks remain stable. At the same time, governments have introduced exceptional stimulus packages to enhance the traditional “automatic stabilizers” of the economy, like employment insurance, and created new measures like wage subsidies and large tax deferrals.
Question: Are my investments liquid? Can they be easily sold?
Answer: Definitely. The exchange traded funds (ETFs) and mutual funds we use in client portfolios are all very liquid and can be converted into cash within the standard two-day settlement period.
We use only the largest, most well-known ETFs that trade in large volumes on stock exchanges every day. Their prices closely reflect the value of the underlying stocks that make up the fund (the net asset value or NAV), typically ranging within 0.1% above or below that value.
In the last three weeks, however, bond markets came under significant pressure, with a marked decrease in the volume of bonds traded. This has caused some concern over the behavior of bond mutual funds and ETFs. We have spent numerous hours on the phone with our fund providers (Vanguard, BMO and Dimensional in particular) to understand this phenomenon.
In the short term, the Bank of Canada and the U.S. Federal Reserve have stepped in to buy bonds and provide liquidity to the bond markets. This has relieved the pressure on the bond market and on these funds and their behaviour has normalized somewhat. Raymond Kerzérho, Director of Research at PWL, recently wrote a good piece explaining the issue. Dave Nadig, Director of Research at ETF Trends, also wrote an in-depth piece for those wishing to dive deeper.
The takeaways from these articles are that bond ETFs and mutual funds use different methods to calculate their net asset values, which can lead to short term divergences. Holding a combination of bond ETFs and mutual funds in your portfolio gives us the flexibility to use the most appropriate tool to take advantage of the divergence depending on if we need to buy or sell bonds.
In addition to ETFs, we only use mutual funds issued by Dimensional Fund Advisors. As with all mutual fund, the underlying basket of stocks or bonds is valued at the end of each trading day and fund purchases and sales occur at that value.
We have studied Dimensional’s trading and redemption practices closely. They have some of the best trading practices in the world as measured by third-party trade-auditing companies. Their portfolio construction is such that they have flexibility that very few other managers do in their approach to the market. Their bond funds also keep a significant reserve of high-quality and very liquid government bonds to meet redemption requests as needed.
Question: When should I rebalance my portfolio?
Answer: No one knows when this market rollercoaster will end, and we certainly can’t predict when the markets will hit bottom. We will only know this in hindsight. Was the decline on March 23 the bottom? Or was the subsequent rally a so-called dead-cat bounce before another downturn? We can only guess since all information known today has already been priced into the markets.
Thankfully, the exact timing of rebalancing decisions doesn’t actually have that great an impact on the long-term outcome as explained in this article. What matters is that you do it! You can rest assured rebalancing is a key part of our work in managing portfolios. While we have not started to rebalance portfolios at large yet, we will begin to do so carefully in due course.
This is not an easy time. We are all nervous about how this virus is spreading and how long the mitigation and isolation measures will need to last. We are all looking forward to things getting back to normal but must remain vigilant and not let up on physical distancing too soon.
If you have any questions or concerns, please do not hesitate to reach out to us.