Episode 21 – Investing Opportunities in Chaotic Markets

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Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode is investing opportunities in volatile markets. I’m Josh Zumbrun. I’m the External Director of Communications here at Mercer Advisors, and today, I’m joined by Will Rockett, our Sr. Director of Investment Strategy. Will, thanks so much for being here.

Hey, Josh, thanks for having me.

So obviously, the market is in a little bit of turmoil right now with the S&P 500 recently entered that correction territory, down 10% from its peak earlier this year. So obviously, a lot of people are seeing these headlines, thinking about what’s going on here. Will, tell us a little bit about some of the more sophisticated ways to look at market volatility that institutional investors care about.

Sure, absolutely. We’ve certainly seen a bit of a rise in volatility recently. And most investors, I think, who have their CNBC or Bloomberg television screens on behind them, will just see different market indices going down, going down more volatile during the day.

What institutional investors tend to focus on is something called the VIX. And the VIX is an index that measures market expectations on volatility over the next 30 days. And it’s based on S&P 500 options. And basically, the way to think about it is the higher this VIX index, the greater market uncertainty lays ahead.

And so we’ve had a period here where it’s been a little bit elevated for the past month or so?

Yeah, it’s certainly been higher and looks certainly higher than it was in 2023-2024. So it’s been trending up. And it certainly influences how markets are thinking going forward and how things are priced.

Compared to what we’ve seen over the past few years in terms of volatility?

I mean, a lot of changes this year, right, Josh?

It goes without saying that the last 90 days or so have had a number of events that are driving markets, whether those are economic data, whether those are different rhetoric coming out of Washington D.C., from overseas, geopolitical events, so lots of changes. Markets don’t always like changes.

And we have an administration change. We have policy changes. They’re abrupt.

There’s positioning on tariffs that are coming and going. We don’t really know what exactly is going to happen. There’s plenty of very well thought out theories, but we don’t know. So markets like more certainty than what they’re getting. And the VIX is a good way to measure how markets are feeling about the uncertainty out there. And this VIX index is showing us they are feeling uncertain about what’s to come.

Now, we want to get into how we invest in these kinds of moments, what strategies are there for people to even take advantage of volatility a little bit. But before we do that, let’s look at some of these past episodes where we’ve seen the market go down, where we’ve seen volatility spike up like this.

Obviously, this happens in big moments, global financial crisis. Volatility is through the roof right. The start of the pandemic, volatility is through the roof. But let’s talk about some of these other moments that have occurred where we’ve seen spikes of volatility that maybe didn’t lead to that broader economic crisis.

Sure. I think that’s a good point. We tend to focus on the big ones. And I remember what felt like a big one when I was starting my career on Wall Street was the long-term capital management crisis in 1998. And a lot of smart people at that firm who had made some very big bets from an economical analysis perspective, they believed were very likely to succeed, and they did not.

And with the amount of leverage they had and the amount of investments, they had big decreases in value for LTCM, which caused the market really needing to support with different banks coming in with various funding and support, financial support for the markets to keep them afloat. Then in 2011, the Eurozone debt crisis is a good one. If you remember, Josh, the flash crash, I think that was in 2015.

That was the day that the market just suddenly went down 1,000 points, and nobody knew really even knew why at the time.

And it causes a bit of fear and uncertainty when something like that happens at such a magnitude. What is actually happening?

And you mentioned the pandemic, obviously, that was a very large and more sudden change. But remember, in ’22, after all the stimulus, we saw interest rates going up. Fed was hiking. Was the fed moving too fast?

We also had Silicon Valley Bank and banking crisis. So the VIX went up then as well. But for the remainder at the end of ’22, and then absolutely for ’23, ’24, hasn’t been high relative to historical norms. So it’s coming up significantly in the last month. And it’s something to pay attention to.

It’s something to pay attention to, but I think about those episodes you mentioned and a lot of them, if you were in the market day-to-day, they were a big deal. But if you were taking a longer view, 1998, now we look at that and we say, oh, what a great time to be invested in stocks the late ’90s were.

We look at the 2010s, the mid-2010s, and we say what a great ball market to be invested in. And so you look back on these episodes and you say, oh, for the long-term investor, I shouldn’t have been necessarily too spooked by this. What do you see as the key lessons from these episodes?

Yeah, you bring up some good points that I think many of us, in hindsight, look back and say, well, I wish I bought the market in March of 2009, or I wish I didn’t use Bitcoin to buy a pizza back in 2008. But hindsight is something we don’t have the benefit of in the moment.

And we’ve spoken, Josh, in the past about how to protect portfolios from changing market conditions, and for the unpredictable, which is why the VIX goes up, something that’s unforeseen, something that the market believes more unforeseen events might happen in the future, we can guess as to what those changes might be, but no one can do that with any certainty. So we like to think about things from a diversification perspective. Diversify across asset classes.

A lot of individuals, investors have done very well from their investment in the S&P 500, US growth, US tech stocks over the past 15 years. Remember what’s been the case really from 2010 to 2022? Interest rates were anemic. It was incredibly cheap to borrow money and to finance companies and to grow. And that’s not the case anymore.

2022 interest rates rose. Mortgage rates are up. Cost of lending is up.

So these are things we’re looking forward markets might look a little bit different. And having that diversification across asset classes, not just investing in companies because they are the biggest. Looking at stocks that we think will do well because of how they’re positioned, how profitable they are, what their PE looks like, and where they’re located. Are they not in the US?

Are they looking at different currency than the dollar? Emerging markets, international, fixed income. Correlation of Treasury bonds with the S&P 500 is roughly zero. So this is a bold risk to your portfolio.

So whether it’s looking across one of our most popular strategies in our multifactor portfolios, or again, we’re investing in different factors, like momentum, profitability, value, those are guiding investment decisions besides just how big the stock’s market cap is. Josh, the S&P was down about 9-10% from its peak, but in international, international is international is up I think over 10% this year.

The Bloomberg US bond AG index was up about 2% this year. So we’re seeing investors’ portfolios that have this diversification obviously do better and also being rebalanced as US equity markets are going down. So being able to perhaps take advantage of some of this volatility, buying in and rebalancing as prices adjust.

The diversification is really the first line of defense here. Like, yes, the S&P 500 is down, but if you had a diversified portfolio, right now the S&P 500 is doing worse than most of those components. And so if you have all the components, you’re actually in a better place than just looking at the headline market might make you think.

It’s been a challenging era I think looking back to be diversified, because there have been so many investors who haven’t been. They’ve been very overweight tech, very overweight, large cap growth. And they’ve done well. And I think what the last month or two shows us is that there can be unforeseen events. There is volatility in the market that can rise. And over time, diversification and matching your investment allocation with your financial plan, rebalancing is a great way to play defense to some of this volatility. And hopefully, Josh, we can talk a little bit more about offense too.

Right. This is how you position a portfolio for whatever might come. Broad diversification is what the best strategy we think for whatever might come. But when you have a moment like this, where there’s a lot of volatility, what are some of the strategies that are out there in terms of playing offense? What can investors do to take advantage of this a little bit?

So let’s think about how opportunistically we could take advantage of volatility. So what is volatility? Volatility is standard deviation, for those of you who remember your statistics class from high school or college.

It is the amount of variance around the mean. So how are things moving relative to the average? And the more things move, prices go up, prices go down, there’s a way to go on offense and actually create value.

And tax loss harvesting is not something that’s new and is a concept which is investing in strategies that methodically sell investments that have gone down in value, and then replace them with an investment that has similar characteristics. So by doing that, you’re tracking an index. Maybe you’re tracking the S&P 500. You’re tracking the Russell 1,000.

You don’t own all those 500 or 1,000 stocks, but you own a large portion of them. And as stocks go down, you would sell a stock, take that loss, replace that stock immediately with something that’s very similar to it.

So by the end of the year, you’re tracking the performance of that index, the S&P or the Russell 1,000, plus or minus some tracking error because you don’t own all the stocks. But you’ve also got these capital losses that you can use outside of your portfolio. There’s a value to those losses to offset gains, to take distributions from portfolios. There’s a benefit there.

So the way it works is you can imagine hypothetically a year where the market starts and finishes the year at exactly the same level. Maybe it started at 5,000 and it ends at 5,000. And so if you just held that index the entire time, you’d be flat. But the insight here is that there were moments where the market was down and moments where it was up in that period.

And if you had sold in the moment it was down, you could record a little bit of a loss. So suddenly, you get to the end of the year, your investment hasn’t gone anywhere, but now you have a loss that you can use when it comes time to do your taxes and you can say, hey, I lost $10,000 on this investment I sold. You can offset a little bit of a capital gains obligation that way. That’s the simple version of the strategy.

That’s it. People always hear loss and they associate that negatively. These losses can be good, these tax losses. And these capital losses that help you recognize better net capital gains at the end of the year.

But remember, you’re tracking the performance of that index. So the index goes up. Index goes down. You’ll track that performance plus or minus some tracking error, since you don’t own all the securities. And I think investors get comfortable with that tracking error because of the benefit of those capital losses.

Now, we also talked in a previous podcast, it was episode 17, exploring the long short strategy, if you want to go check it out, we talked about a more sophisticated strategy to take advantage of volatility. Will, kindly remind people how this can work, especially for someone who has a really large, concentrated position in a particular stock.

Sure. Long-short, think about it, Josh, very similar to what we just talked about. It’s tax loss harvesting. But it’s tax loss harvesting with stocks that you are long and stocks that you are short. So you’re not reliant on the market going down to have to take losses. If you’re also short stocks, when the market goes up, stocks go up, you can cover those shorts, take a loss and then replace that short position with another one.

And by doing that, you’re able to take advantage of the volatility market going down, market going up, leads to greater tax losses at the end of the year. In addition, these strategies will use a little bit of leverage. So adding that leverage to the long-short strategy amplifies the opportunity set that you are able to generate these tax losses.

And at the end of the day, think about it like this. You have $1,000 invested in the market. You add something called a long-short extension. So maybe you add another $300 in long positions and another $300 in short positions. So you’re not taking additional market risk because the long and short extensions cancel each other out.

But now, you’ve magnified your ability to take losses. So at the end of the year, while someone who’s in a long only tax loss harvesting product might have received X in terms of capital losses, maybe you’ve received 2x or 3x. So it’s a really interesting way to take advantage of market volatility.

And I think — Josh, you and I have talked about this. It’s almost like tax alpha, investing in tax alpha. And we really think this is almost an investable asset class, going on offense. And it allows for this compounding of short-term capital losses through this trading year over year.

You can use them in one year. You can put them almost in your short-term capital loss bank.

And if you have something in the future that you are planning to sell, a house, a business, if you’re banking these losses, and when you take that gain in the future, you can offset it. And we talked in December in that podcast, number 17, about how to use this strategy to take a concentrated stock position with a lot of embedded gains and create a diversified portfolio from that concentrated position, and have the transition from one to the other be tax neutral. It all comes down to this ability to generate losses through both long and short positions, and adding a little bit of leverage to the equation.

I mean, this is a fairly sophisticated strategy, but it’s actually something we see all the time, is we see people who maybe they were paid in company stock over an extended period, or maybe they made a big investment 30 years ago, or inherited a large investment. And there’s this huge capital gain that they would have to pay if they go to sell it. The point of these strategies is they’re a little bit sophisticated, but they help someone potentially diversify that asset without taking huge tax hits along the way.

If you’ve been paid in your company’s stock for 20 years, you can potentially have just an absolutely huge capital gain bill. You’re going to really lose out on a lot of what you’ve earned if you don’t think carefully about the taxes. What we always say is that the only returns that matter are the returns you get to keep.

On that point, Josh, so at Mercer, we have all of these internal teams that work with clients on plans. And you and I have spoken with individuals who work in our financial planning group or our tax group, or our estate group. And my financial planning colleagues love being able to project out the growth of wealth over time of someone’s portfolio and the needed cash flows going out and expenses in the future by not having as much tax expense today.

So they love the strategy like this for that reason. And then for me, and for our group, we really like it because we don’t like the volatility profile of someone being too much in one stock in their portfolio. Even though the company could be great, could be a solid foundation, idiosyncratic risks occur or are around, and things can happen that we don’t expect.

So the ability to transition out of some of these positions with really large embedded gains in a tax neutral way, allows our clients a little bit more ease in selling some of these positions without having to incur that tax bill. We want those portfolios to get better and more diversified. If you had all that cash to invest today, Josh, would you invest — of your $100,000 investment, which you put $90,000 in one stock, or $50,000 in one stock, but you wouldn’t, right?

You wouldn’t start out that way.

Yeah. And maybe you stay that way because you don’t want to incur the taxes to transition. And this is what this strategy helps with.

And these moments of volatility we’re in now, are actually like, they’re like grease for that strategy. They make it run a little more smoothly. Now obviously, this is pretty technical for a lot of people. But the volatility that we’re seeing right now, it also has a pretty big impact on options contracts. Will, what are some of the situations where you might want to think about whether or not there’s a strategy with options contracts that you can take advantage of in a moment like this?

Sure. So the first situation we just talked about, markets trade up, markets trade down, volatility tax loss harvesting opportunity, for this one, Josh, volatility, or standard deviation, is actually part of the equation on how an options contract is priced. So the higher amount of volatility, the higher amount of the price of that options contract.

It reminds me of 15 plus years ago when I was an analyst at a hedge fund. And one of the asset classes we looked at was convertible bonds. And when the volatility of the underlying stock for this convertible bond was higher, most of the time, that convertible bonds price would increase.

And that all has to do with the option to be able to convert a bond to stock, or many other options where you’re able to buy a stock or sell a stock at a certain price point. That volatility really drives pricing. And Josh, it goes back to your finance class at your college. Where did you go to school again?

Georgetown.

So you’re at Georgetown, it’s junior or senior year, and you’re taking your finance class. And I’m sure you went through the Black-Schole options pricing equation. So this is the equation, higher vol means higher option contract prices. And strategies that you can leverage with options contracts, maybe covered call writing.

You have the stock. You could sell call positions, earn income from those call positions, as you do so, there’s option color strategy where you have a stock position and perhaps you want to protect the price or the value of that stock within a certain range. So you would buy a put option at a strike price below the current market value, and sell a call option at a strike price above the current market value.

The premiums of those two can sometimes cancel each other out, or even be a little bit in the money for you. And as a result, you protect that. But the prices of those options contracts will increase through this volatility. It’s really interesting to think through that as well.

Obviously, these are technical situations. So what are the situations where I, as an investor, should say, hey, I should be thinking about this. I need to talk to somebody who really specializes in this to understand whether or not I should take advantage.

So you mentioned one of them right there. It’s somebody who has some holding, a stock that’s done very well, and they want to protect themselves against that asset going into decline. What are some other situations where I, as an investor, should reach out to my advisor, to my investing team and say, hey, is there something I should be taking advantage of right now?

Yeah. I think we talked about two. So protecting the value of a stock position through a collar, an income strategy, a covered call writing strategy would be too. And then I think reaching out to an advisor, Josh, makes a lot of sense because we go back to taxes.

Say, for the covered call writing strategy, that income you generate is taxed at ordinary income. So those of you with high tax brackets will pay significant taxes on the income you receive from selling call options. What we like to do at Mercer is look at things more holistically, a 360 approach to investing in your portfolio.

So pairing different strategies together can work phenomenally. So what if you had a covered call writing strategy and you’re generating income from existing equity positions? And then in addition to that, you invested some cash into a long-short portfolio and generate some short-term capital losses.

So now, you have market exposure. You can even choose the beta of the investment in the long short strategy. You could have zero beta, or half a beta, or one beta. And for those of you who forget what beta is, it’s how much risk am I taking in the market. You can choose your risk profile and still generate those capital losses, which could offset the gains on that income you’re getting from selling covered calls.

So we love combining stuff, thinking about things from a 360-degree perspective. And that’s where I think not looking at a product in a vacuum, think about it as a solution for your portfolio, and a 360 analysis of how all of this could work together and really maximize what you can do, investing in the market, investing in tax alpha.

So let me try to sum this up really. So our first line of defense as investors is having this broadly diversified portfolio. If you are all-in on the S&P 500, let alone if you were all in on a few of these high flying tech stocks, it’s been a tough couple of weeks. But if you were diversified, you’ve been feeling much better this period. So that’s the first line of defense.

The second strategy for people to think about is what we said about tax loss harvesting. There are things you can do to position yourself so that if the market’s going up and down a lot, you can help mitigate capital gains taxes. So if you’ve got a trickle or a stream of capital gains every year, like this is available for a really wide range of investors to take advantage of a little bit.

And then the third set of strategies, they’re more complicated. But for people that have huge concentrated positions, there’s an opportunity here to get out of that concentrated position with less of a tax consequence. And then for people that are in really sophisticated situations, there’s actually a lot of really interesting strategies that you can take advantage of.

So Will, I think this is a really helpful overview for people to think about OK, what bucket of that am I in. Do I just want to have the diversification? Do I want to be thinking about — do I need to be talking about putting tax loss harvesting in my portfolio? Or do I have one of these situations where I could really use a very sophisticated strategy to make my portfolio better without a big tax?

Three buckets that are really helpful to think about. Will, thank you so much for being with us here today for this conversation.

Thanks, Josh. It’s great to be here.

If you’re already a Mercer Advisors client and are interested in learning more about any of this, don’t hesitate to reach out to your advisor. If you’re not a client but you’re interested, check out our website, merceradvisors.com. Set up that introductory phone call. That’s how it begins. Thank you so much for being here with us today. This has been Market Perspectives.

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