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.
At the beginning of 2016, Newfound published our market outlook for the coming decade. In it, we state that successful investing going forward will require a portfolio that’s built not only on a foundation of classic stocks and bonds, but also with significant allocations to alternatives, risk-managed strategies and satellite income asset classes.
Market outlook pieces from large global investment banks and research shops like J.P. Morgan echo many of our thoughts: Global equity valuations are stretched, and estimates for bond returns are unappealing.
As such, a fully passive, market-cap-weighted core stock/bond allocation profile that ignores macroeconomic trends, valuations, fundamentals and current risk levels may be suboptimal. If you believe the projections are correct, and that core stocks and bonds have valuation and income head winds, simply combining these two asset classes won’t get it done like it has in the past.
Core Allocation Need A New Wrinkle
Things get more interesting, however, when the universe of investments is expanded to include higher-income asset classes such as high yield, bank loans and emerging market debt.
As a quick example, using the capital market assumptions from J.P. Morgan, an optimized portfolio that matches the volatility of a traditional 60/40 core stock/bond allocation has only 35% in core stocks, 3% in core bonds, and 62% in satellite fixed-income asset classes and alternatives. (You can dig in with two hands into the nuts and bolts in our recent commentary here.)
The takeaway is clear: For a balanced portfolio to offer better expected returns than a traditional core stock/bond allocation, it must look different in today’s environment.
To say that portfolio allocation “deviates from the norm” is an understatement. This may cause issues, as the success of any investment philosophy is first based on whether you can stick with it.
Consider A High-Income Sleeve
The dramatic allocation differences will create tracking error relative to traditional stock/bond mixes. While these differences are what create the higher expected returns, they must be balanced against the behavioral or emotional costs of deviating from common benchmarks.
In light of this behavioral reality, we currently advocate that investors holding a traditional, balanced stock/bond portfolio consider creating a 20-25% high-income sleeve, funding the sleeve equally from stock and bond positions.
For example, a traditional 60/40 may become a 50/30/20. Since many of these high-income asset classes currently have higher expected returns than both stocks and bonds, but with lower volatility than most stocks, the sleeve has the potential to increase expected portfolio return while simultaneously reducing risk.
When we consider that these asset classes also have added diversification benefits, we find that the whole is much greater than the sum of the parts.
The (Rate) Elephant In The Room
Any discussion of income generation inevitably circles back to assumptions on the direction of interest rates. This current market environment is no different, with almost daily pundit pontification of “will they or won’t they.”
We’re not saying the discussion should be completely ignored when strengthening a portfolio with satellite fixed-income allocations, but what is interesting is that the characteristics of these asset classes as a whole will appeal to both schools of thought.
If you’re on Team Lower for Longer, there is a significant opportunity cost to remaining in core fixed-income exposures. Investors looking to maximize success over the next decade must look toward asset classes that can generate additional, higher income.
Furthermore, if you believe rates will stay lower because economic growth will be muted, then structurally higher-income sources may actually also serve as a growth engine in a portfolio (click here for a full commentary).
If, however, you’re on Team Rising Rates, satellite income exposures still remain interesting, not only due to their structurally higher yields, but also because they introduce diversifying risk factors (e.g., economic growth risk, credit risk, currency risk, emerging market risk) that have historically buffered them from rising rates.
While there can be no guarantees that these other risk factors can necessarily diversify against the impact of rising rates, they at least offer the potential when compared with traditional fixed income.
The current investment environment of low interest rates coupled with high equity valuations creates a depressed forward outlook for traditional stock/bond portfolios.
Fortunately, ETFs now provide investors with low-cost access to many asset classes that can not only introduce portfolio diversification benefits, but also offer higher expected returns. For investors looking to prepare their portfolios for the next decade, satellite fixed income may truly be king.
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 liquid alternative asset classes. For more information about Newfound Research, call 617-531-9773, visit www.thinknewfound.com or email [email protected]. For a list of relevant disclosures, click here.