The Portfolio Dilemma
The stock market continued its march onward and upward during the second quarter. The US is slowly getting back to normal as the number of vaccinated adults now outnumber the unvaccinated.
The number of daily COVID cases, hospitalizations, and deaths from this virus continue to shrink – though certainly not in other parts of the world like India. The pent-up demand coupled with an excess supply of stimulus funds, while the world continues to work through spot supply disruptions, has caused prices to rise across a broad spectrum of goods and services. Interest rates are starting to rise, though they are still historically exceptionally low. While earnings growth surges as the pandemic wanes, stock valuations remain at high levels. This isn’t to say the market is in a bubble. It’s expensive, however so expectations for future returns need to come down. Low interest rates with a renewed threat of rising inflation in the fixed income markets and lower expectations for stock returns lead to a portfolio dilemma…How can we achieve our growth objectives and balance risk?
Not Your Grandfather’s Portfolio
In the not-so-distant past, a balanced portfolio of 60% stocks and 40% bonds provided a retiree with both good growth prospects from the stock portion of the portfolio as well as stable and consistent returns from bonds.
When stocks ran into trouble, bonds would pick up the slack. When stocks ran strong, bonds still provided a relatively high-income stream. When I began my career in 1989, the 30-yr Treasury yield was around 8%. The cyclically adjusted price to earnings (CAPE) ratio was around 15. The CAPE ratio is a pretty good long-term indicator of value in the stock market. The lower the CAPE, the higher the expected rate of return. One could reasonably expect about a 10% - 12% return in the stock market over the next decade or so with a CAPE at 15. In fact, total returns in the stock market have averaged about 10½% since I entered the field. With these return expectations, retirees could easily withdraw 5% of their assets per year and still expect to see their portfolio value grow in purchasing power.
The investment landscape today is very different. The 30-yr Treasury yield is presently 2¼%. The CAPE ratio is sitting at 37. At that level, one should only expect about a 5% - 7% return on stocks over the next decade. This makes managing cash flows in retirement much more difficult. While the bonds may still provide some cushion during market downturns, they’ll fall short in providing a very robust stream of income. If inflation pressures persist beyond the next year of recovery, investors will lose purchasing power over time holding a large portion of their portfolio in fixed income.
The remedy for this dilemma is diligent planning, methodical diversifying, and a little creative portfolio management. Modeling your cash flows throughout retirement is a necessary first step in building a successful retirement plan. Most plans will show that withdrawing much more than 3½% of your portfolio will lead to declining purchasing power over time. Each plan is different, so it is important to take even this rule of thumb with a grain of salt.
On the portfolio management side, we continue to diversify our clients’ portfolios in the traditional way: adding international investments in both the developed and emerging economies and other asset classes such as gold. We also keep exposure to speculative parts of the market to a minimum. Large growth and some technology companies are starting to fit that description, and we completely stay away from the “meme” stocks (see our last quarterly letter on GameStop). A good balance between growth and value, US and international, large and small, stocks and (where appropriate) bonds will provide some stability during turbulent times. Still, low bond and dividend yields limit this strategy’s effectiveness.
We have begun adding alternative investments to client portfolios where appropriate. A very simple definition of alternative investments is securities that aren’t stocks or bonds.
There are a wide range of alternative investments that come in a variety of forms, and all come with different trade-offs. The most basic type of alternative investment that is available to most investors is an interval fund. These funds look like mutual funds in your holdings report. You buy them like you would a mutual fund. However, you can only sell them at certain intervals – usually quarterly. Also, the fund company does not have to honor your sale request if there are too many redemptions at once. This is because these funds typically invest in illiquid assets.
Two such funds we have started adding to portfolios invest in real estate and private loans. Given the cash flows of these two funds, we have categorized them as alternatives to bonds. Both have expected returns much higher than what you’d expect from a traditional bond (especially with the Treasury rates as low as they are today). They also have the added benefit of having some form of inflation protection. For the real estate fund, this protection comes in the form of the possibility of raising rent rates as inflation rises. In the private loan portfolio, many of the loans are tied to a floating rate such as the 3-month treasury bill rate. So, if inflation picks up and rates rise, so too will the income from these loans. They are riskier than bonds and would most likely not be saleable during major downturns. Still, taking a long-term view of the portfolio, they can make a lot of sense in today’s environment.
The more common format for alternative investments are partnership agreements. The investor agrees to invest a certain amount (called a capital commitment) for an extended period (often 6-10 years and sometimes longer), and there is no ability to sell until the agreed upon time passes. The investor must be either an accredited investor (have a net worth over $1.0mm and/or have income of over $200,000/year for two years) or a qualified purchaser (have investable assets that exceed $5.0mm) depending on the fund. These drawbacks make them more appropriate for pension funds or endowments but can make sense in certain client portfolios from time to time. These funds typically have much higher return expectations than what you could get in either stocks or bonds and will frequently give access to areas of the economy that aren’t available to equity investors. One such example is investing in infrastructure. Typically, these projects are done at the municipal level with long-term contracts between the city and private companies. There are no stocks that take advantage of this directly, but there are some alternative investment funds that do.
Credit Where Credit Is Due
There are a wide range of alternative investments that come in a variety of forms, and all come with different trade-offs.
Any security other than a guaranteed US government treasury bill will add risk to the equation. Risk comes in many forms. If you buy a longer dated US government note or bond, you take on duration risk. You are still guaranteed to get your money back and some interest, but you take on the risk that as time goes by, rates may rise and thus you will have missed an opportunity to invest with higher interest. If you invest in corporate bonds, you take on an additional risk known as credit risk. The corporation may run into trouble, and there’s no guarantee they’ll pay you back. With stocks, you take on ownership risk. Will the managers running the company create value over time? Did you pay an appropriate price for this value?
Alternative investments add liquidity risk to the equation. During turbulent times, you won’t be able to liquidate the investment and convert it to cash. In today’s environment, taking on duration or credit risk provide limited financial benefit, so adding liquidity risk makes sense. Balance and diversification are still important, so they do have a place in a well thought out portfolio. For some clients, these risks are inappropriate at any level. For others, they offer a potential solution to the portfolio dilemma.
Anthony J DiGiovanni, CFA