It's easy to get lulled by the gentle and seemingly unstoppable ride higher that investors have been enjoying with almost all their funds. But it can't last forever.
Greg Davis, the new chief investment officer at investing giant Vanguard, isn't predicting when the next downturn for stocks will happen, but he says investors need to be ready for it given how expensive the market has become. So if swelling stock prices mean they make up a much bigger part of your portfolio than before, and you wouldn't be able to stomach a 10 percent drop without panicking, consider paring back on them.
The largest mutual fund by assets, Vanguard's Total Stock Market Index fund, has already returned 11.4 percent so far in 2017, for example. That's close to its best performance for any of the past three full years.
In his role, Davis oversees more than $3.8 trillion in assets, including the stock index funds that made Vanguard famous and bond funds run by managers looking to beat the market. That's close to the size of Germany's economy. Davis is no stranger at Vanguard. He previously oversaw its bond investments.
Davis recently talked about his outlook for markets and fund investing. Answers have been edited for clarity and length.
Q: Nearly every investment is going up, from stocks in the U.S. to bonds from emerging markets to stocks in Europe. Is it worrisome that everything is doing so well at the same time?
A: I don't see that as worrisome, those things being in sync. The bigger concern is that valuations have gotten a bit stretched, on the equity side as well as the fixed-income side. That's a bigger concern to me than all these things moving in tandem. Much of that can be attributed to the very loose monetary policy from central banks around the world. That's put a very strong bid across these markets.
So it's not a surprise, but there is a need for caution and a need for customers to be comfortable with the amount of risk in their portfolios. It's something they should be looking at. You can never predict when a downturn will come, but it will eventually come, and investors need to make sure they're not too far ahead of their skis.
Q: Conventional wisdom says that the U.S. stock market is more overvalued than in Europe and other countries. Do you agree?
A: If you look at Europe, those markets look a bit more attractive than the U.S. market. The way we would talk to investors is: You want to be diversified around the globe. You want to have the diversification so that if there is a downturn in the market, you don't do inappropriate things at inappropriate times.
Q: "Inappropriate things" means selling low whenever stocks take their next tumble?
Q: And when you're telling people to "stay diversified," that sounds like shorthand for making sure you have enough bonds in your portfolio to ease the sting of any downturn for stocks. Can bonds still be that stabilizer if yields are so low?
A: If you go back and look at the worst months for the equity markets, high-quality bonds provided a strong ballast to an investor's portfolio. If you're in one of those environments where U.S. stocks go down 6 percent, you typically have high-quality bonds showing slightly positive returns.
It's an asset class that's not expected to go down, even in a low-rate environment. After the "Brexit" vote, even when yields (on European bonds) were negative, high-quality bonds still held up even as equities sold off. Bonds have historically done their job, even when they're yielding low amounts or even negative yields.
Q: Investors seem to be throwing in the towel on funds run by stock pickers, and they're choosing index funds instead. Do you think index funds will continue to be the overwhelming favorite for where investors put their new dollars?
A: Our view is that investors are clearly voting that paying high costs in an environment where returns are expected to be muted are the best option for them, and we're seeing them move to lower-cost funds. If you have a higher cost structure, it's harder for you to outperform your market. And if you do, you have to take on substantially more risk to achieve those returns.
Any manager in our complex is low-cost by nature. We've seen significant inflows into our active funds as well.
Q: Do you think the industry could ever get to a point where someone offers a fund with zero fees, to be a loss leader and bring in customers for their other funds?
A: You already have people doing loss-leader strategies now. You have companies adding new funds that are clones of existing funds that are at a lower price to try to be a loss leader. The reality is you have to look at the entire complex and ask if it's enduring.
The industry broadly is still too-high cost, across the board. There's still opportunity for many prices to go down.