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What the Reemergence of Equity Funds Means for You

After having been shunned for years by investors, equity mutual funds are finally back en vogue.

For the most recent 18-month period, the funds have captured $287.9 billion in assets, according to fund tracker Lipper and FinancialPlanning.com. The trend is a reversal from the 2008-2012 period, when the funds saw annual average net outflows of approximately $86 billion as investors remained fearful of equities following the Great Recession.

Investors’ acceptance of equity funds is a positive development as most individuals will need to pursue long-term capital appreciation to reach their savings goals. But, the trend is also creating challenges for financial advisors.

Understanding the mindset of investors who have been embracing equity funds isn’t clear cut. Some investors have watched the breakneck gains of equities over the past few years and now feel like they need to make up for lost ground. At the same time, the memory of sizable market losses following the subprime mortgage crisis is strong in the minds of many investors who understandably want to protect against future corrections.

With that in mind, advisors have two clear cut challenges resulting from investors’ renewed interest in equities. One challenge is to build risk-managed portfolios that address clients’ concerns over market volatility while managing investor expectations of future market returns.

The second challenge is incorporating capabilities for building risk-managed portfolios of mutual funds into their marketing strategies. That is, advisors need to articulate how their skill in building attractive equity portfolios can help manage risk.

When building portfolios of mutual funds, advisors should focus on time-tested practices for managing risk. For example, they should evaluate the risk-adjusted returns of funds to assess the skills of portfolio managers and to ensure that shareholders aren’t taking excessive risk relative to returns. Advisors should also strive to combine funds and asset classes that have low performance correlations. So, funds should have an attractive risk profile on a stand-alone basis and by combining funds, the resulting portfolio volatility should decrease. When diversifying assets across equities, bonds, and foreign securities, advisors should also evaluate if alternative investments, such as mutual funds that hedge risk with options, may also reduce portfolio volatility.

Building diversified portfolios, however, is only the first step, as advisors need to illustrate the value of their fund selection and asset management services.

Perhaps the best way to do that is to show the impact of using different but similar mutual funds on a portfolio's volatility.

For example, advisors may want to illustrate the impact of a market correction on model portfolios that may have similar asset allocations but funds with different risk and return profiles. By showing the widely varying results, advisors can demonstrate their capabilities for researching investment products to manage risk.

When making the presentations, advisors should show the impact of volatility in dollar terms based on the size of a client’s portfolio. The idea is that clients will understand the scope of a market decline if expressed in dollar terms rather than in percentages.

In addition, the method of presenting portfolio risk will show that an advisor’s research is highly customized for individual investors, which will convey to prospects and clients that the advisor isn’t using a cookie cutter approach to asset management.

Advisors should also be able to show graphics that illustrate the efficient frontier of different model portfolios. The goal is to create clear and compelling presentations that are easy for clients to understand.

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