Solving The Core Conundrum?

The recent comments by Fed Chair Janet Yellen of keeping interest rates artificially low for another 2 years should have savers yellen’.  Today’s near zero interest rates are causing savers to take uncomfortable credit risk or duration risk to earn a reasonable yield on their “safe money”.

The Core Conundrum

The problem of low yields has coincided with a dramatic change in the composition of the index that is most often used to measure bond performance.  Institutional and individual fixed income investors are dealing with the market realities of yields as the flagship bond benchmark (Barclay Aggregate Bond Index) languishing around 1.9%.  The artificially low yields held down by the Fed has created a chasm between investors’ return targets and the realities of a benchmark with negative real yields.  Bridging this gap, without assuming undue credit or duration risk, requires a shift away from the traditional view of core fixed-income management in favor of a more diversified, multi-sector approach.

Unfortunately, in an environment where the benchmark index has become approximately 75% allocated to low-yielding government and agency securities, maintaining a low tracking error and pursuing total return targets have seemingly become contradictory objectives.

Barclay Agg Index – Not What It Used To Be

Over the past five years, the composition of the Barclays Agg has changed by the massive volume of Treasuries issued in response to the US financial crisis.  According to the Congressional Budget Office this trend should continue to explode.  “The US Treasury debt balance totaled $4.5 trillion in 2007.  By the end of 2012, it had skyrocketed to over $11 trillion. Yet, it is projected to go even higher – hitting $18.9 trillion by 2022.”

As Treasuries climbed from 19% of the core fixed-income universe to 35% over the last five years, the market-capitalization weighted Agg has followed suit.  Treasuries currently comprise 37% of the Agg, and combined with agency debt, total US government-related debt comprises nearly 75% of the index with a weighted-average yield of 1.6%, as of January 31, 2013.

Anchored to a benchmark heavily allocated to sectors yielding negative real rates of return has forced investors to reassess the traditional, benchmark-driven approach to core fixed-income management.

Active Asset Allocation Matters in Today’s Environment

In today’s low yield environment, investors should embrace active management across a global multi-sector fixed income portfolio to generate higher yields AND to control drawdowns.  As the Fed takes it’s foot off the gas of monetary easing, volatility in equities, bonds and interest rates should continue to increase.  Just how fast and how far interest rates move is a key question but extremely difficult to predict.

Given the level of Central Bank intervention across the globe, the US Fed is likely to intervene to help limit market disruptions.  Unfortunately, the blunt instruments of monetary easing and fiscal policy have not proven responsive enough to prevent sharp moves across the interest rate curve.

Defending Portfolios Against Drawdowns

Traditionally active asset allocation has limited the amount of cash a strategy could raise to minimize tracking error from its benchmark.  However, investors have begun to realize that a 60/40 core portfolio may not be enough to limit the amount a portfolio could lose from peek to trough (drawdown).  Especially with the growing amount of US Treasury and Agency exposure to the popular Barclays Agg Index.

Options, futures, long/short, risk parity, and other traditional alternative investments have long been used to reduce correlations of core portfolios.  But the challenge of adding these alternative strategies can come with the added cost of losing upside return capture when the return enhancing asset classes are performing.

As a result investors are plowing assets into strategies that are flexible enough to go to 100% cash, as they are looking for cost effective ways to defend their portfolio’s against drawdowns…while minimizing the added cost of limited upside capture.  Being tactical about tactical can allow investors to participate up and protect down.

Return Enhancers 

Keeping strategic (long-term) allocations to the satellite asset classes may not be the most effective way to enhance the risk adjusted returns of a portfolio.  For example, adding a strategic allocation to Emerging Market equities or even EM bonds over the last few years would have had been difficult for many investors.  However, tactical exposure to these return enhancing asset classes could have avoided much of the pain, and kept the portfolio on track to meet investor objectives.

Some satellite asset classes to consider as return enhancers to a portfolio:

• Emerging market equity
• Emerging market bonds (hedged, unhedged)
• MLPs
• Real estate
• High yield bonds
• Levered loans
• Corporate floating rate notes
• Commodities
  • Energy
  • Agriculture
  • Base metals
  • Gold

By incorporating a single risk-managed solution around the return enhancing asset classes of a core 60/40 portfolio, investors maybe a big step closer in solving the core conundrum.

Other Article / Videos related to this topic:

• Bogle: We need to fix the bond index (Morningstar)
• Yellen’s mind-the-gap goals rule says rates stay low (Bloomberg)
• Retirees, brace yourselves for rising interest rates (CNBC.com)
• The shift toward value continues (BlackRock – Russ Koesterich)
• Diversification is difficult when correlations are rising (BlackRock)

 

Liquid Alts – So much work, so little time

The proliferation of liquid alternative strategies is causing many advisors to take a ridiculous amount of time away from serving their clients.  It has been said, you’ll spend 90% of your time looking at alternatives, and it will make up just 10% of your portfolio.

According to Morningstar the number of mutual funds in the alternative category has exploded from 116 in 2004 to 429 funds as of February 2014; with $22b exploding to $144b over the same time frame. In 2013 alone net inflows into the category were an astonishing $40b.

To help wade through the maze of liquid alternatives, advisors would be better served to examine WHY they are incorporating alternatives in the first place.  Is it as a risk-mitigator?  Is it as a return enhancer? Or, is it both?  With a foundational understanding, advisors can be prepared to incorporate liquid alternatives while maintaining scalability so they can continue to serve their clients.

RISK MITIGATOR?

With near zero interest rates and the prospects of higher interest rates on the horizon, many advisors are preemptively turning to liquid alternatives to anchor the portfolio from equity volatility, and to provide some alternative sources of yield to a portfolio.  The challenge remains, since so many liquid alt strategies are single asset class or strategy specific, how do you know which will be the “hot dot” and the right one to include in your client portfolios.  The answer is you don’t…much like predicting the future return profiles of traditional asset classes its almost impossible.  So diversification can be used to smooth client returns, and to keep clients focused on reaching their goals.

Do multi-alternative strategies provide an advisor diversification benefits?  Maybe, it’s scalable, and defensible in client meetings.  But how much can an advisor really allocate to a liquid alternative portfolio, when the strategy has significantly higher costs, will likely never outperform in up markets, and will most always be a performance drag?  Wouldn’t lower cost, flexible income funds, with allocations to floaters, TIPS, and convertibles be enough in a rising rate environment?

RETURN ENHANCER?

Many clients and advisors turn to liquid alts as return enhancers.  Investors have been conditioned to invest like an institution, as many sales professionals point to the long-term out-performance of the ivy league endowments.  Unfortunately, most advisors don’t have the ivy league resources or the 100 year time horizons of those institutions.  This can leave many advisors to setting high expectations and under-delivering returns.

So many advisors try to pick the hot liquid alternative asset class, or hot manager that happens to be in the sweet spot of the market and currently outperforming albeit with the ability to hedge a portfolio when the market turns.

Here lies the time-trap.  Picking the right liquid alt strategy even some of the time, requires an extraordinary amount of time, diligence, and discipline that most advisors don’t possess.

BOTH RISK MITIGATOR & RETURN ENHANCER?

If the 30 year bond bull market wasn’t over, would there be so many assets flowing into liquid alternative strategies?  If investors hadn’t experience the “Great Recession” when even a diversified portfolio lost more than 30%, would liquid alternatives be where they are today?

Clearly, the demand for liquid alternatives is real and for good reason.  But advisors shouldn’t have to make the trade-off of risk mitigator vs. return enhancer.  If advisors step back and re-examine WHY they are allocating to liquid alts, they would be in a better position to sort through the noise.

The two common investment problems, that many advisors are trying to solve with liquid alts are:

1) Diversification can disappear when needed the most.  In 2008-09, fixed income was not enough to limit drawdowns and many traditional return-enhancers such as emerging market equities, REITs, and commodities all lost more than 60%, exacerbating large core equity market losses during the same period.

2) Non-core exposures (including liquid alts) can significantly underperform core exposures in the short to medium term (ex., 2006, 2008, 2012, & 2013).

For these reasons and more, some advisors are turning to “outcome-oriented solutions” to limit portfolio drawdowns.  These solutions seek to deliver return-enhancement AND risk mitigation while bring scale into advisor practices. These real world solutions, can put the clients’ interest first, and allow advisors to focus their time and attention on serving the client, not navigating the maze of liquid alternatives…Unfortunately, too many of today’s liquid alternative strategies limit their “outcome-oriented solution” to just being a bond fund alternative.

    The perfect storm: Why alts make sense (Investment News)   The modern financial advice industry may have never experienced a time when the case for allocating assets into alternative strategies made perfect sense.  Until now. With the equity market at an all-time high, bond yields hovering near record lows, volatility spiking and global geopolitical risks rising, diversifying into products and strategies designed to hedge risk can mean that clients can sleep soundly at night…