This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Andrew Gogerty, vice president of investment strategies at Boston-based Newfound Research.
Rising interest rates are the new reality. Since hitting a low in June 2016, the 10-year U.S. Treasury rate has almost doubled, from 1.49% to 2.94%, through Feb. 21 this year. The two-year rate has also risen nearly fourfold, from 0.59% to 2.26%. The market doesn’t anticipate a pause in coming Fed meetings either: Goldman Sachs, for example, estimates a 95% chance of another rate hike this March.
If rising rates do stall the equity market, or even send it into a tail spin, the Fed will have less wiggle room to employ its usual course of rate reductions. Despite the current trend, yields still are materially lower today compared with the 2007-2008 financial crisis. The 10-year rate started at 4.68% before sliding to 2.25% during that time. That reduction of 2.43 percentage points, if it happened today during an equity slide, would leave interest rates just north of 0.5%.
Moreover, equity sell-offs due to rising interest rates often mean higher correlations between stocks and bonds. So, what is an income-oriented investor to do?
Thinking Outside The Box
Simply piling into the highest of the high-income asset classes such as REITs, high yield and MLPs can be a recipe for disaster, as these asset classes have experienced sizable max drawdown losses. Even core bond sectors, such as Treasuries and corporate debt, have experienced notable losses.
Implementing a dynamic, diversified framework can offer the ability to take meaningful positions in satellite asset classes. These noncore allocations can help better navigate the current yield environment while also managing large drawdowns. As an example, satellite asset classes such as bank loans and high yield can be paired with hybrid asset classes such as preferreds and convertibles to build a more robust allocation.
As an exercise, we built a hypothetical, equal-weighted portfolio of these four asset classes, represented by the following ETFs:
- iShares U.S. Preferred Stock ETF (PFF)
- SPDR Bloomberg Barclays Convertible Securities ETF (CWB)
- iShares iBoxx $ High Yield Corporate Bond ETF (HYG)
- PowerShares Senior Loan Portfolio (BKLN)
This portfolio would have gained an estimated 13% from July 2016 through January 2018 compared with a typical core bond allocation’s slight loss of 0.15% using the Vanguard Total Bond Market ETF (BND) as a proxy. Our hypothetical portfolio’s relatively low .45 and .47 correlation to the SPDR S&P 500 ETF Trust (SPY) and BND, respectively, are also attractive from a diversification perspective.
An equal-weight portfolio of alternatives is a strong starting point to a core bond portfolio, but is certainly not without its own risks. The one certainty about the future is its uncertainty. Using a dynamic framework and incorporating satellite and alternative income asset classes can help navigate a wider spectrum of market environments and outcomes going forward.
For a professionally managed solution, Newfound’s Multi-Asset Income strategy provides an objective, rules-based approach to managing the risks and opportunities of investing in these asset classes. Strategy information can be found here.
At the time of this writing, the following ETFs were included in the potential investment universe of one or more Newfound Research LLC investment strategies: AMJ, BKLN, BND, BWX, CWB, EMLC, HYG, IDV, LQD, PBP, PCY, PFF, REM, SPY, TLT, VNQ, VNQI, VYM. The individual ETFs may or may not be owned at any given time. Newfound is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed income, and alternative asset classes. For more information about Newfound Research LLC, call 617-531-9773, visit www.thinknewfound.com or email [email protected]