As I write in my latest Investment Directions monthly market outlook, the global equity market faces a number of risks. However, the risks I worry about most are those that aren’t completely reflected in relevant asset prices. In other words, if these scenarios occur, investors aren’t being compensated for any resulting violent market reaction. Here’s a look at four such risks.

The risk of a US slowdown – Not discounted in US valuations. While US valuations currently look reasonable, they’re predicated on a US economy growing at around 2% to 2.5%. The risk of slower growth is not priced into the market. If US economic data continues to disappoint, and we get a growth hiccup in the second or third quarter, then we’re likely to see some US market weakness.

The risk of a crisis in the Middle East – Not fully discounted in oil prices. Oil is currently trading a little higher than I would expect given the current supply situation and inventory levels. This suggests that a bit of risk premium is built into oil prices. However, prices aren’t high enough to discount potential large events related to a Middle East crisis. As a result, in a scenario such as an Iranian production shutdown, oil prices would likely spike.

The risk of a eurozone crisis flare-up – Not fully discounted in eurozone valuations. Many people are worried about a European banking crisis or the euro dissolving, so eurozone stock prices already reflect a fair amount of risk. But prices in the region still could be cheaper.

The risk of an unknown exogenous shock – The market seems too complacent. This is perhaps the scariest risk. There’s very little you can do to actually prepare for such exogenous shocks because they’re impossible to predict. There’s always the chance that North Korea is going to do something unpredictable. There’s always the chance that we’re going to see another tragedy like Boston.

Sometimes terrible things happen, and it’s not exactly clear when they’re going to happen. So you just have to think: Is the market priced for perfection? Is there some cushion in prices if an exogenous event occurs out of the blue? How complacent, or how nervous, are investors?

One measure for this is the VIX or CBOE Volatility Index (otherwise known as the fear gauge). The index tracks the implied volatility in S&P 500 options. Low levels suggest that investors are feeling sufficiently confident that they’re not paying much of a premium to buy insurance – in the form of put options – on the market. In other words, they don’t believe that markets will move much up or down, meaning there’s not likely to be a lot of bad news. On the other hand, when the VIX is high, investors are paying a bigger premium and they’re nervous.

The index is currently at 14, well below both the long-term average of around 20 and the average seen between 2008 and 2012. Even with global markets’ drop, investors still appear complacent, and I believe a modest exogenous shock may lead to an outsized correction.

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

Not only is inflation low, but the latest numbers show it’s actually falling. And as I write in my commentary this week, inflation is unlikely to become a problem in the United States for at least another 12 to 18 months. Why? There are a number of headwinds keeping US prices low in the near term.

These include ongoing anemic wage growth and continued tepid bank lending, both of which I wrote about in a post on inflation earlier this year. Plus, while the US economy is expanding, recent economic reports suggest growth has softened this quarter. One other factor has also been helping to keep prices down: Greater US energy production. The surge in domestic natural gas and oil drilling has led to lower, more stable energy prices.

So what are the implications for investors of a continuing low inflation environment? Here are four.

1. Stick with stocks. With inflation low and falling, the Federal Reserve can afford to ere on the side of too much stimulus. This means that the Fed is unlikely to quickly remove monetary accommodation. This is probably good news for stocks, which I believe can continue to move higher over the next six to 12 months.
2. Still hold high yield. Continued Fed stimulus is also potential good news for high yield, at least in the near term. As I recently noted, for yield hungry investors, there are few alternatives to this asset class in today’s record low rate environment. One way to access high yield is the iShares High Yield Corporate Bond Fund (HYG).
3. Maintain an allocation to gold, but consider keeping it small. Low inflation is likely bad news for gold. As inflation drops, investors are less focused on inflation hedges like gold. In addition, lower inflation and stable nominal rates mean that real interest rates are rising, which could hurt gold.
4. A bond market meltdown isn’t imminent. Low inflation confirms my 2013 outlook for interest rates. While I expect rates to rise this year, with the US economy slowly normalizing and the Fed likely to take its foot off the accelerator very gradually, rates should rise slowly.

The bottom line: One silver lining of today’s slow growth environment is that inflation is unlikely to be a problem before 2015.

The author is long HYG

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Gold and other precious metal prices may be highly volatile. The production and sale of precious metals by governments, central banks or other larger holders can be affected by various economic, financial, social and political factors, which may be unpredictable and may have a significant impact on the supply and prices of precious metals.

It’s a great question, and one we like to revisit every so often since it’s not the most intuitive process.  If you’re wondering whether these new Apple bonds will end up in your fixed income ETF, you first need to look at the index your ETF tracks.  Bond indexes have rules that determine which securities should be included, things like maturity range, credit rating and issue size  (these rules can usually be found on the index provider’s website and the ETF’s prospectus).  And since the bond market is constantly in flux, with new issues entering the market all the time, most bond indexes rebalance on a monthly basis – typically on the last day of the month.  During the rebalance, the provider applies their specific rules to the overall market and all the securities that qualify are included in the index.  This is one of the nice things about most bond indexes – the constituent selection process is rules-driven, which gives investors a clear understanding of what is included in an index and why.

In the case of the Apple bonds, the issues that came to market were large and high quality, ensuring that they would be included in most of the investment grade corporate bond indexes.  For example, they qualified for indexes like the Barclays Capital Credit Index and the Markit iBoxx USD Liquid Investment Grade Index.  Markit, Barclays and most other providers fix the constituents of their indexes a few days before the end of the month, so the April 30^th Apple issuance won’t actually enter these indexes until the end of May.

Of course, unlike the indexes, ETFs can’t all add the new Apple bonds on the last day of the month.  Liquidity may not be available, and it may not make sense to try to make all of the purchases at one time.  Instead, funds will generally “leg into” a new issue, especially one as large as the Apple issuance.  In fact, if you take a look at the iShares Investment Grade Corporate Bond ETF, or LQD (which tracks the Markit Index referenced above), you will see that the fund has already begun to acquire Apple bonds (see current holdings here).  We can expect that by the end of the month, the fund will likely have increased its position, with the goal of having an exposure similar to that of the index.

Once the bonds go into the index and subsequently are included in relevant ETFs, you’d expect them to stay in there until they mature, or are called (if they have a call option), or stop meeting the index’s requirements (for example, fall below the minimum credit rating).  At that point, the process for removing a bond from an index and ETF is much the same as it is for inclusion, just in the opposite direction.  The bond would be kicked out of the index at the next rebalance, and sold out of the ETF on or around that date.

And of course if you want to know which of our funds have acquired Apple bonds then you need to look no further than our website iShares.com. Check out our Fund Screener tool, which allows you to search by security name (including bonds) and filter by asset classes (including fixed income).  You can track your exposure to Apple, or any other name that might be of interest.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to the iShares Blog.  You can find more of his posts here.

Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies.

Holdings subject to change.  There can be no assurance that any bond will remain in the funds.

My answer to both questions: no, with a caveat. As I write in my latest Market Perspectives piece, while stock prices aren’t yet in a bubble, some parts of the market do look more expensive than others.

That’s why I advocate that investors, especially those just starting to dip their toes in, focus on three areas of the market that look reasonably priced.

Certain International Markets: With investors paying a big premium today for safety, the US market looks somewhat stretched compared to its international peers. As such, I’d be more hesitant to commit a lot of new capital there. Instead, I’d focus on other parts of the world where valuations are lower.

Among emerging markets, I especially like the bigger ones such as Brazil and China. Among developed markets, I like smaller ones such as Hong Kong. While these international economies aren’t without their problems, they generally look fundamentally sound and have been punished for slower-than-expected growth. Too much pessimism is reflected in their prices.

US Mega Caps: Another idea to consider, particularly for those wary of investing in potentially more risky emerging markets, is to look toward US mega caps, accessible through the iShares S&P 100 Fund (OEF). They’re the cheapest area of the US market and they tend to be less volatile than small- and mid- cap names. Plus, if we do see some pick up in stock market volatility over the summer, as I expect, mega caps aren’t likely to suffer as much as small caps.

Certain Cyclical Sectors: In recent years, investors have been paying a big premium for the yield and relative safety of defensive sectors such as consumer staples and US utilities. In contrast, I’d put new money to work in cyclical sectors such as energy and technology, which arguably represent better long-term values than their more expensive defensive counterparts. These sectors are accessible through the iShares Dow Jones U.S. Technology Sector Index Fund (IYW) and the iShares Dow Jones U.S. Energy Sector Index Fund (IYE).

Looking forward, though I do expect that market gains will likely slow and become more volatile, I believe that global stocks will finish 2013 higher. Today’s slow, but still positive, global economic growth, generally benign inflation and likely continued accommodative monetary policy should be supportive of risky assets.

The bottom line: Instead of worrying about whether it’s too late to get into the market, investors looking to put cash to work should focus on where to find relative value.

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

Investing involves risk, including possible loss of principal. In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Technology companies may be subject to severe competition and product obsolescence. The energy sector is cyclical and highly dependent on commodities prices. Companies in this sector may face civil liability from accidents and a risk of loss from terrorism and natural disasters.

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

First, let’s consider two baseball teams. One has players at every position with a successful track record, including a mix of power hitters and singles hitters, starting pitchers and relievers. The other team…maybe the talent isn’t there, but the manager is pretty sure he can make some clever move at precisely the right time to win games.

Clever tactics can win games, but baseball fans know that a winning season depends on a solid lineup. But what is a solid lineup? What delivers value? What successful track records are likely to be maintained in the future?

Over the last 25 years, the specialized study of baseball statistics called Sabermetrics (on which Moneyball was based) has worked to develop answers to these questions.  Separating the signal from the noise in baseball been the subject of intensive research, as have methods of predicting player performance.

One of the most fascinating was developed by Nate Silver, famous for his election predictions, called PECOTA, which scores the similarity of current players against every player in baseball history. These scores are used to forecast a range of potential outcomes for players in the upcoming season. PECOTA digs into the stats and comparisons to identify the small differences that make one set of outcomes more likely than another.

And…what’s this have to do with retirement investing?

Sabermetrics and PECOTA illustrate the thinking that should go into your 401(k) investment. Maybe your retirement savings isn’t the place for you to prove how clever you are with high risk investments. Try to make choices with a reasonable range of expectations based on the strategic long-term consensus.

Also, think in terms of having a balanced set of skills in your investment lineup. Not every investment should be a high-risk, high-reward equity or a hot sector bet. Great lineups include less glamorous role players, like diversifying fixed-income funds or inflation-fighters like real assets.  You should also think about when to protect a “lead”  — the valuable nest egg you’ve accumulated as you approach retirement — by mixing in lower risk strategies, like short duration bond investments.

Target date funds do this for you automatically and they may be ideal for people who do not want to manage their lineup full time. Even if you do not invest in one, their asset allocation offers an excellent proxy for an age-appropriate investment lineup. Compare your retirement portfolio to the fund. Even if you have different ideas about your ideal lineup, the target date fund can help sharpen your own thinking when it comes to your retirement portfolio.

Chip Castille, Managing Director, is head of BlackRock’s US & Canada Defined Contribution Group. You can find more of his posts here.

Take a look at these side-by-side charts, showing the MSCI Equity Sector Weightings from 1995-2013. One chart tracks sector weightings among emerging markets while one tracks sector weightings among developed markets.

If I asked you to label one chart for emerging markets and one for developed, could you do it?  It turns out the one of the left is for EM and the one on the right is for DM. But what’s so surprising to me is that over this 18 year period, how similar the sector weightings between these two types of markets has become.

While investors often associate the emerging world with resources, these days, emerging markets are just as likely to be associated with banks. Financials make up 28% of the MSCI Emerging Markets Index, compared with a 22% combined share of energy and materials and, interestingly, a 21% financials share in developed markets.

My colleagues at the BlackRock Investment Institute recently pointed out that perhaps the label “emerging markets” has begun to outlive its use.  Market correlations in EM are at their lowest level since 2006, and the disparity is growing all the time as economies and markets mature at very different speeds.

How is this playing out when it comes to flows of emerging market exchange traded products?

EM ETPs finished 2012 with a record quarter of inflows. Bumper EM equity ETP inflows of $10.9 billion in January turned into outflows in February and March. While it seemed that the tide had swiftly turned on EM stock sentiment, as I pointed out in a recent blog post, the headline outflow numbers actually belied a flurry of activity below the surface.  Assets may have been leaving some of the larger EM equity ETFs, but there were still inflows occurring in some of the newer and more granular EM funds.

As the distinction between EM and DM becomes somewhat blurred, and the number of EM funds expand, we’re seeing investors seek more granular exposures to emerging markets.  Depending on investment objectives, some investors are choosing to add funds that offer exposure to the less risky EM countries, while others are looking for the stronger sectors within EM.

Now, none of this is meant to imply that emerging markets are no longer risky (they are) or that they have surpassed developed markets in terms of investment stability (they have not).  And we expect that broad, diversified EM equity funds will always have a place in many investors’ portfolios – particularly those who don’t have very specific views on emerging markets.  But the increased interest in individual countries and other narrow EM exposures could be an interesting byproduct of the changing nature of emerging markets themselves – and a good reminder to always check your portfolio to ensure you’re getting the exposure you expect.

Sources: BlackRock, Bloomberg

Dodd Kittsley, CFA, is the Head of Global ETP Market Trends Research for BlackRock and a regulator contributor to the iShares Blog. You can find more of his posts here.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

High yield spreads are historically tight, at levels not seen since the fall of 2007 as the chart below shows, meaning there’s currently a much smaller difference in yield between a high yield bond and a comparable Treasury. At the same time, some high yield prices have reached all-time highs. In other words, investors aren’t being rewarded that much for holding high yield, traditionally viewed as a risky asset class.

The chart above shows the Barclays US Corporate High Yield Average OAS through 3/13/2013. OAS stands for Option-Adjusted Spread, or the amount by which a bond’s yield exceeds the yield of a similar duration Treasury when accounting for any optionality embedded in the bond.

Does this mean it’s time for investors to abandon high yield? I continue to believe investors should have an allocation to high yield for four reasons:

1.)    High yield companies aren’t so junky anymore. Today’s tight high yield spreads are justified given high yield companies’ historically low default rates, which are thanks to an improving US economy, ample liquidity and very strong corporate balance sheets.

2.)    All bonds look expensive today. Absolute yields are close to record lows across the fixed income space as a result of continued bond buying by central banks around the world, from the Federal Reserve to the Bank of Japan. But while high yield appears fully priced, it still provides reasonable compensation — versus other fixed income alternatives — over the long term.

3.)    High yield has few alternatives. For yield hungry investors, there are few alternatives to high yield considering today’s record low Treasury and sovereign yields.

4.)    High yield isn’t as volatile as it used to be. While the bonds’ yields have fallen in recent years, their volatility has also dropped. In fact, the volatility of a high yield bond is roughly half of what it was last summer.

To be sure, the asset class is not without its risks. These include higher default rates than traditionally safer fixed income classes, a potential reduction in liquidity when the Fed begins to wind down its asset purchase program, and potential sensitivity to rising interest rates.  Also, if the economy turns south, high yield will likely be hurt more than other fixed income sectors.

As such, high yield is not for everyone. For speculative grade exposure that may help to insulate a portfolio in the event that rates continue to rise, I prefer floating-rate notes and bank loans over high yield. In addition, while high yield should be a key holding for more aggressive investors, I advocate that risk-adverse investors hold relatively small allocations. One way to access high yield is the iShares High Yield Corporate Bond Fund (HYG).

The author is long HYG

Source: BlackRock, Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

But while market cap has historically been the most popular weighting scheme for indexes, over the years the ETP industry has brought more and more products to market that are based on non-market cap weighted indexes.  Examples of this include indexes that are price weighted, fundamentally weighted (e.g. dividend weighted) and low volatility strategies.  And it appears that investors are taking notice of this diverse and dynamic category: Year-to-date, non-market cap weighted equity ETPs have captured 42% of equity ETP flows, compared with the 20% of flows they brought in last year (see below).

One of the more interesting trends in this category has been the increased interest in ETPs that offer exposure to a minimum volatility strategy.  These products seek to track indexes that weight securities based on their tendency toward volatility, with the goal of minimizing volatility in the portfolio.  We’ve been following this trend closely since the first minimum volatility ETF was launched in May 2011, and continue to see assets flow into these products as more investors learn about their potential benefits.  Minimum volatility ETPs have experienced steady inflows so far in 2013, attracting average monthly flows of $1.6bn – more than triple the average monthly flows of $416mn they received in 2012 (see below).

So where is this increased interest in minimum volatility ETPs coming from?  Market conditions – specifically, increased volatility – have certainly played a role in the growing popularity of these products.  However, it’s a common misconception that minimum volatility ETPs are just for volatile markets, when really they have features that can potentially benefit a portfolio on a long-term basis.  For example, historically some of these indexes have experienced better risk-adjusted returns than their market cap-weighted counterparts.

Of course, we believe ETPs that track the more conventional, market cap weighted indexes will continue to play an important role in portfolios.  In fact, with ETP inflows on track for another record-breaking year, we think this non-market cap ETP trend is indicative of investors using more ETPs overall as part of their investment strategies.  And with more and more intriguing, potentially beneficial options to choose from, we should continue to see that trend increase, as well.

Sources: BlackRock, Bloomberg

Dodd Kittsley, CFA, is the Head of Global ETP Market Trends Research for BlackRock and a regulator contributor to the iShares Blog. You can find more of his posts here.

Past performance does not guarantee future results.  There is no guarantee that minimum volatility funds will attain a more conservative level of risk, especially during periods of extreme market conditions.