First, for those who wish to go straight to the New Interesting Articles they are at the bottom of this post. This is to help you find them but also to hopefully get you to scroll through my musings along the way.
As I write this, those of us in the Northeastern part of the U.S. have enjoyed what has been a glorious holiday weekend outside. For those in other areas, I hope you have also had a nice time with family and/or friends.
Unfortunately, the past few weeks have not been such a pretty place for the equity markets. The S&P 500 has been steadily moving down and is now only up approximately 4.8% for the year. Keep in mind that this is a pull back from the 3-31 YTD number of over 12.5% and puts the trailing 1 year return of the S&P back in the negative at -1.0%.
The U.S. treasury bond market on the other has had a very strong rally, which is not necessarily a good thing. The 10 year treasury is now back close to record lows. This means that people might be having doubts about our recommendation to lighten up on bonds at the end of Q1 when rates were at approximately 2%. We admit that we were wrong in the short-term but with rates this low we are inclined to lighten up yet again.
The problem is that if one were to reduce an asset class at this time, where do you put the money.
U.S. treasury rates should go higher, but as long as Greece and the worry about its problems spreading to Spain continue, U.S. rates could stay very low for some time. When rates turn though, and they certainly will at some point, the impact will be large. I wrote about this in a Blog titled “This Week’s Big Question”. As an update, I have put a link below to a WSJ piece that I encourage you to read. Unfortunately, the WSJ does not paint an easy road or pretty picture.
Equities have pulled back approximately 10%. Normally this type of decline can be a good buying opportunity. With large parts of world either slowing (Europe and China) or only experiencing slow / modest growth (U.S.), however, demand for products and services could also slow, which in turn could affect profit margins. Companies can only improve productivity so much, and a few signs lately have suggested that productivity gains might be tapering off. At the end of the day companies need to grow top line (revenue / sales) from end demand for products and services. This said, if the Greek tragedy takes even a little turn for the better, equity markets could have a nice relief rally.
Versus making any large calls, for now I am sticking to my standard lines. I feel all should be long-term investors, remain broadly diversified, be somewhat contrarian, not follow the herd and make sure that a portfolios are invested to meet an individual’s or institution’s goals, not the models or goals of others.
On the investment side, we feel that investors might be well served to take this time to look outside the box and become more comfortable with what historically might have been thought of as smaller parts of the asset allocation pie. Assets that come to mind are higher quality high yield bonds, convertible bonds, high dividend equities (these once were market favorites but fell out of favor in the late 80s and 90s), and what we call hybrid high income equities (MLPs, REITs, etc.). I am starting to question why some of these securities have historically had such a small allocation slice. When you look at the long-term risk and return charteristics of some of these securities or asset classes, they can be quite attractive. I touched on this a few weeks ago in my Blog titled “Does Lower Risk = Higher Returns in the Equity Market”.
Next, be ready for new products. Wall Street will almost certainly start creating new types of investment opportunities based on what could be a new normal. The Street is very good at filling demand for new ideas. Some of them will be prove to be worthy over the long run (think MLPs from the early 90s) but many will have to be carefully watched for flaws (auction rate securities, etc.). Being the first to buy a new product often does not turn out that well in the investment world. Please only invest in things that meet your plan and that you understand well.
As for your plan, if you have not laid out a true investment and wealth strategy, this is a wonderful time to get anchored on a good road map for achieving your goals. This plan should include an Investment Policy Statement or Framework that sets long-term targets for various asset classes and maximum and minimum risk control ranges around the targets. This way, regardless of the emotion of the market, you can keep yourself from making big bets that can turn into big mistakes. An example would be having a long-term target of 40% in bonds with a range minimum of 25%. With rates so low, you to go closer to you minimum but not below it. This would keep you from going so low that you are not in bonds when rates go from the “should not go much lower” than 2% level down to 1.7% (yes, just happened).
This approach will also allow you to stay invested in equities when thing look the worst. A long-term target of 60% in equities with a low end range of 45% would have caused you to move up in equities in March 2009 to avoid going below your minimum. Very few people did this as the S&P 500 hit the “world is going to end” level of 666 during this time period. The old you should “invest when blood is in the street” saying often holds true. As of last Friday’s close, the S&P 500 is now at 1,317.
In addition, we recommend that all take time to understand real risk exposures and true liquidity profiles.
Above I mentioned high yield bonds. I think they have attractive return and risk characteristics over most time periods (they have outperformed equities and government and investment grade bonds over the past 3 and 5 year periods), but they are not regular bonds. As an example, if you move out of investment grade bonds such as U.S. treasuries and into high yield bonds it is a bond for bond swap. It is not, however, a like risk for risk swap. You are going from something that historically has very low volatility (if rates move higher faster it will not feel this way) into something that has what we call moderate risk / volatility. If you are not prepared for this, a swing the wrong way might cause you to get out of an investment such as high yield bonds at the wrong time. Because of this we have started talking to clients in terms of high, moderate and low risk, versus just the traditional stock, bond and cash classifications.
We are also focused on understanding a client’s true liquidity position. Many large endowments went through this painful exercise recently. Investments can sound and indeed be good but global markets change, and it is always nice to be able to change within a range when appropriate (remember the comments above about ranges). A potentially more important reason to put a premium on liquidity is that the manager or the management of an investment strategy can change. We often say that a strategies do not blow up, managers do. If you are locked up in an asset class or investment vehicle for a month, quarter, year or in some cases multiple years, with notice periods that can be 30-90 days prior to the start of a redemption period, you can find yourself trapped in an investment at the wrong time. Remember, a fund that states quarterly liquidity with 90 days prior notice is really giving you only semi-annual liquidity (quarterly + 90 days notice = 6 months of advanced planning before you have access to funds).
Illiquidity can also cause you to get outside your ranges because of distribution needs. If you have a big outflow need (medical, distribution requirement from a trust or charitable entity, etc.), and you have low liquidity in certain areas of your portfolio, it might require you to take funds from an asset that is attractive because you can not get funds from any other area. An example might be that you have a solid bond portfolio that is generating attractive income and offering some downside protection and diversification as compared to other investments. You need to take a distribution from your portfolio but other areas are illiquid. This puts you into a position of having to sell your bonds and hold the illiquid investments that might not be well positioned for the future. Next thing you know, all the good planning you put in place to have a low end range of 25% in bonds goes out the window. You have to move significantly lower than 25% at what might be the wrong time because you cannot get funds from any other area.
To help with this, we are starting to lay out investment frameworks for clients with maximum and minimum ranges for high, moderate and low liquidity investments. When combined with the more simplistic high, moderate and low risk metrics, we feel it gives us another way to help clients think through a plan. This is not the only way; just another way that might be a little outside the box and hopefully helpful. Over the next few weeks we will post an example of some of this work and will welcome comments.
Finally, at this time of uncertainty, I would encourage individuals to take time to do planning around things that are certain. Taxes and death. I know these are uncomfortable topics, but planning in these areas is an important part of an integrated wealth plan. Versus trying to take this to a detailed discussion of various complex tax and trust and estate planning techniques, which might be dangerous for all, I encourage everyone to look at some current opportunities. As an example, taxes on capital gains are likely to go up. Take this time to review legacy positions and managers that might have large unrealized gains. If they are still appropriate then hold, but if you can optimize your portfolio to increase quality, diversification, liquidity and/or lower fees, don’t let taxes drive the decision.
I am also encouraging clients to speak with tax and trust advisors to discuss making taxable gifts now. Again, I am not a tax or trust professional, but it is generally less expensive to give money away while you are living and rates could move higher soon. Other wealth transfer strategies such as GRATs (grantor retained annuity trusts) are also very attractive now due to low interest rates.
In summary, I am not sure that large allocation moves are appproprite at this time. However, I do feel that it is a great time to get a better understanding of how your plan is structured.
Do you have a good understanding of all of your true risk and liquidity positions?
Do you have an investment plan that is being optimized based on the current, and likely future, state of income and estate tax laws?
Try to get or stay anchored on your plan and things you can control versus what is happening with Facebook, Greece or Spain. By doing this, hopefully we can all enjoy weekends more.
Now, if you have made it this far, and wish to read more from commentators that are more well known, please consider clicking on the links below to a few recent pieces that I think are worth a few more minutes.
GMO – Flaws of Finance – “Why We Need a Hippocratic Oath in Finance”
James Montier again has put out a great piece that will probably not be popular with some of his investment peers. It is long but worth a scan of at least the first and last sections.
Richard Bernstein – Diversification Remains Difficult
and
Richard Bernstein – An Alternative to Alternatives
Like Montier at GMO, Rich is not afraid to take the path less traveled and question the industry. In these pieces, he lays out the importance of a well diversified long-term plan and then suggests, as I also believe, that we need a back to the future look at alternative investments (hedge funds, etc.). He nicely points out that many (not all) alternatives investments can be bettered by good old fashion asset allocation among stocks, bonds and cash. The old fashioned way, however, has the advantage of high liquidity, high transparency and low fees.
WSJ – How to Play the Bond Market Now
I have been meaning to post this for quite some time. It gives a good overview of the current risks in the bond market. Going forward, the risk of bonds (both volatility and the potential for loss of value) might increase.