Content provided by Grant Engelbart, CFA, CAIA, CLS Portfolio Manager

Volatility is at its lowest levels in decades, consumers are feeling confident, unemployment continues to fall, and markets continue to grind higher. This type of environment can be great for investors, but it can also be dangerous. The lull can create complacency and encourage excessive risk taking or vice versa.

A prime example of this is the recent filing of a 4x leveraged ETF. Yes, you read that correctly, an ETF that delivers 4x the return of the S&P 500 on a daily basis (key). Not only are investors becoming complacent, they could potentially have a tool to feed into that complacency and blow themselves up. There was also a filing for a 4x inverse version for the fearful to use (and ultimately lose.) Luckily, these approvals are on hold for the time being, but bears watching.

As coaches in the investing game, we have to keep investors in check. Of course, telling them not to use leverage is a great first step, but there are other cures. Knowing how much risk we are taking and measuring that risk is the hallmark of what we do at CLS. It can be tempting to think “what if I was a higher (or lower) Risk Budget,” but that can prove dangerous. It is up to us and our advisors to keep investors in check. Think about it: Even if we were crazy enough to use the aforementioned 4x ETF, a 100 Risk Budget investor could only own 25% in their portfolio, and the rest would have to sit in cash (assuming a Risk Budget of 400, which is likely too low).

Second, stay diversified. Yawn, right? We preach it constantly. But guess what? Since the beginning of 1999 (inception of the index), the MSCI Emerging Markets index has outperformed the S&P 500 by 230%! And ironically if you used a 3x or 4x S&P 500 ETF that return gap actually widens substantially, as evident in the chart below. It seems wild that the long-term return of a 4x product could be so low, but during this time there were 13 days of returns lower than -5%.  Multiply those by four, and you have a bear market in one day, 13 times over.

The market can stay at these levels of low volatility and grind higher for months, if not years. Take advantage of that appropriately by ensuring your Risk Budget is in line with your long-term goals. Keep an understanding that volatility is part of investing; we’ve just been spoiled lately. There is a cure for complacency, and even lunacy: Risk Budgeting and good old-fashioned diversification.

2582-CLS-5/18/2017