A PDF version of this commentary can be downloaded here.
Benjamin Graham, father of value investing, once said: “in the short run, the market is like a voting machine but in the long run, it is a weighing machine.” The psychology factor that can dominate market returns and volatility in the short-run is often washed out in long-run annualized returns, which is dominated by economic and valuation factors.
While valuations may serve as an anchor, asset prices can deviate wildly – and irrationally – from these levels. To quote John Maynard Keynes: “the market can remain irrational longer than you can remain solvent.” So trying to time the market using valuation factors is notoriously difficult. Often valuations can have you sitting on the sidelines during tremendous bull markets.
Bloomberg had an article this week (http://www.bloomberg.com/news/articles/2015-05-18/nobel-winner-s-math-shows-s-p-500-unhinged-from-reality-or-not) pointing out that the Tobin’s Q Ratio – a measure devised by James Tobin, Nobel laureate in economics, to measure the true ‘replacement cost’ of a business – has flashed a sell signal.
The theory behind the glide path is easily distilled: as we grow older and approach retirement, we transition from an primary objective of growth to one of capital preservation. Our allocation profile, therefore, should follow this transition.
Close to retirement, when capital preservation is paramount, stocks are riskier than bonds. Further from retirement, when growth is more critical, bonds are actually riskier than stocks.
As glide paths go, that's where the agreements end and the disagreements begin.
For a simple concept, glide paths are a complicated beast. We have to consider things such as:
- To versus through: Do we assume the investor is going to hold this portfolio to the date of retirement or through their retirement?
- Risk preference assumptions: All investors do not share the same risk preferences, but when we ascribe a global glide path, we assume they do. How those risk preferences are modeled, however, can have a huge impact on the shape of the curve.
- Asset class constraints: Glide paths are often the delineating line between stocks and bonds – but what about alternatives? What about high carry hybrids? If, how, and what category these asset classes get lumped into can dramatically change the shape of the curve.
- Income growth rates & savings rates: Investors tend to both earn more, on constant-dollar basis, as well as save more, later in life.
- Asset class growth rates: The expected return, volatility, and correlation profiles of the asset classes that get put into the process can dramatically skew the resulting curve.
As a tactical asset management firm, we seek to offer a full range of downside risk managed investment strategies, covering all parts of an investor's portfolio. We believe that controlling drawdown and smoothing volatility is a critical objective, as periods of capital loss often coincide with the need for liquidity (e.g. getting fired during a recession), which ultimately forces the realization of losses, eroding the capital base and damaging a portfolio's ability to recoup losses.
Market conditions in the past 30+ years have been favorable for traditional long beta exposure in fixed-income, providing significant total returns with little volatility. Historically, high and declining nominal interest rates served as a powerful return stabilizer within fixed-income. However, with rates now at all time lows, the stabilizing impact of yield is reduced – and even worse, with rates poised to rise, this factor may now serve as a source of capital loss.
We believe a tactical fixed-income approach is more relevant today than it has ever been before.
Many recent articles discuss rising rates with a focus on how to weather them along with some predictions of when they will occur and how much they will rise. Duration is a common theme among the articles since it quantifies how much a particular bond is likely to lose when rates rise. We've written many blog posts in the past about duration (for instance: this and this), and earlier this year, we published a thought piece entitled Beyond Duration that covers some nuances of duration that may be forgotten when looking at portfolios or ETFs. One key issue when working with a portfolio of bonds is that even though the portfolio will have a single number as its weighted average duration, that value is only relevant if the yield curve shifts in parallel.
I recently read an article by Schwab entitled The Bond Investor's Trilemma: Positioning for a Fed Rate Hike. The first dilemma the author covers is the issue of short-term interest rates rising more than longer-term rates with the conclusion that the sweet spot is in the intermediate (5-10 year) part of the yield curve. The article goes on to state that investors who are worried about price declines can add in some short-term bonds to mitigate the impact of rising rates.
With some assumptions, we can actually see how much a bond portfolio such as this would be affected under different rising rate scenarios. Let's assume that you currently are playing the sweet spot of the yield curve by holding the iShares 7-10 Year Treasury Bond ETF (IEF) and are considering substituting in some of the iShares 1-3 Year Treasury Bond ETF (SHY) to lower the duration and attempt to reduce the impact of rising rates.
A PDF version of this commentary can be downloaded here.
Newfound will be hosting its next monthly strategy review session on Thursday, May 14th from 2:00- 2:30PM EDT.
We’re fortunate enough to have a guest panelist joining us: Brett Hammond from MSCI. He will be discussing factor-based investing and MSCI’s portfolio construction methodologies that underlie many of the ETFs Newfound utilizes. We’ll also be discussing how tactical strategies can be incorporated into an existing portfolio framework.
We hope you can join us! You can register by going to the following link: https://attendee.gotowebinar.com/register/8709604704067592450.
Warren Buffet famously said to “never invest in a business you can’t understand.” The same advice should undoubtedly be applied to pooled investment vehicles. The advent and rapid growth of the ETF has made it easier than ever for investors to know what they own.