This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Steve Blumenthal, chairman and chief executive officer of King of Prussia (greater Philadelphia area), Pennsylvania-based CMG Capital Management.
Advisors manage portfolios to achieve a desired result within a specific time frame. Equity exposure over a market cycle remains an important part of the portfolio equation. Real life tells us that, for many investors, waiting out a full market cycle becomes more challenging as retirement nears.
BlackRock estimates that nearly 75 percent of investable assets in the U.S. will be in the hands of preretirees and retirees by 2020. Needs shift in retirement from growth to income. That's a lot of money that lacks the time needed to overcome a significant equity market decline.
That's a tall order for the retiree with fixed-income yields at just 2.22 percent—today's [Sept. 10, 2015] 10-year Treasury yield. Portfolios need to provide income and outpace inflation.
Overcoming The Challenge
But here's a fixed-income strategy that you may consider implementing to navigate the risks imbedded in the current low-interest-rate environment.
Some experts believe rates will be lower for longer. Such a view favors long-term government bond exposure. Others see higher rates in the years ahead. Their view is that rising defaults in emerging market debt, high-yield debt and sovereign bonds from Europe to Japan are raising the risk level for fixed income across the globe.
Collectively the developed countries owe too much. Some form of default is a risk we investors must consider. Investors will demand higher rates. Deflation and higher rates? It might happen ... I'm not sure.
Direction confusion remains. Twenty-five Wall Street economists felt interest rates would rise in 2014 to an average of 3.25 percent. None saw the yield finishing the year under 3 percent. They were all wrong and missed the fourth-best-performing year in the history of the U.S. bond market. The 10-year Treasury finished 2014 at 2.20 percent.
Pick Your Favorite Strategist And Position Accordingly?
I have my own expert view (put me in the "rates will be lower for longer" camp), but with rates so low and risk so high, frankly, I'm not so sure I'm comfortable investing in long-term bond ETFs. I, too, believed rates would rise in 2014.
However, I favor an approach that combines fundamentals and price trend to help me stay in line with interest-rate trends. In other words, despite my personal view that rates would rise last year, this process properly signaled to stay invested in longer-dated bond ETFs.
Don't Fight The Trend
For a targeted portion of your total portfolio, implement a defined investment process that allows you to stay in sync with the bond market's primary trend—importantly, one that may move you away from the negative impacts of rising interest rates.
Here is how it works:
I have long favored a tactical trend model created by the late great Marty Zweig. Marty looked at data going back to 1967 and established a process that follows five simple steps. Ned Davis, of Ned Davis Research, did some work with Marty on this process in the mid-1980s.
We subsequently recreated the model with the help of our friends at Ned Davis Research. In the upper left section of the following chart, you'll find the rules on how the model works. This is something you can track on your own.
The chart shows the hypothetical performance of the model (the blue Model Equity Line) versus the Barclays Aggregate Total Return Index (the black line). In the bottom right section of the chart, you'll find the annualized performance on "buy" signals versus "sell" signals. The yellow highlighted area reflects the current active "buy" signal (orange arrow).
For a larger view, please click on the image above.
Overall, the Zweig bond model has done a good job at enhancing return and reducing the risks present in rising rate environments. It moved to a "buy" signal on Sept. 9. It's a rules-based way to identify the primary trend. It's signaling that higher rates may be ahead, but note that it's a tactical process and should be followed closely if the trend evidence changes.
You can also click here to see how it works. There are just five simple rules to follow to identify the trend in interest rates.
What ETFs Work Best
Especially for the preretiree and retiree, it's important to have exposure to bonds, but with yields so low, risk is actually elevated. I believe that it's now the time to think more tactically.
An idea on how to implement using ETFs:
- On "buy" signals, own longer-term bond ETFs such as the iShares Barclays 20+ Year Treasury Bond ETF (TLT | A-85), the Vanguard Total Bond Market ETF (BND | A-94) and/or the iShares Core U.S. Aggregate Bond ETF (AGG | A-98). AGG closely tracks the index used in the Zweig bond model; however, there are many long-term-dated bond ETFs that you can use. Find one that trades commission-free at your custodian.
- On "sell" signals, switch to shorter-term-dated bond ETFs such as the SPDR Barclays 1-3 Month T-Bill ETF (BIL | A-62), the Vanguard Short-Term Bond ETF (BSV | B-69) and the iShares Barclays 1-3 Year Treasury Bond Fund ETF (SHY | A-97). Short-term bond market exposure will perform better when interest rates rise, giving you the opportunity to switch back to long-term exposure—hopefully at a higher yield. Clearly, not every signal will prove correct, and while the strategy doesn't trade too frequently, it is the big downtrends we want to protect against.
Material Risks Quantified
The risk of rising interest rates is material. In the next chart, you can see the impact each 1 percent rise in rates has on both 10-year and 30-year Treasurys. Should rates rise 2 percent, the bonds will decline approximately 16 to 32 percent in value (red circles). Should rates move lower by 1 percent, gains will be approximately 9 and 23 percent (green circles). Today [Sept. 10, 2015] the 10-year Treasury is yielding just 2.22 percent.
For a larger view, please click on the image above.
Note how much greater the loss is when rates rise just 1 percent by comparing a move from 2 percent to 3 percent (-8.58 percent) versus a move from 7 percent to 8 percent (-5.24 percent). Simply, there is more risk to your bond exposure when rates are ultra-low.
Sticking To The Plan
While Wall Street economists missed in 2014, the Zweig bond model remained bullish on longer-term bond ETFs. Of course, there are no guarantees in this business. Not every trade proves to be correct. It is a defined investment process that is systematic, and requires discipline to adhere to the process.
If you choose to follow the Zweig bond model process, or any other process for that matter, there are several important questions to ask yourself:
- Do you have the time to follow the model every day?
- Do you have the infrastructure in place to trade across multiple accounts?
- Can you execute ETF trades with little market impact and trade for very low commission?
- Do you have the conviction and belief necessary to follow the process through both losing trades and winning trades?
- Can you stick to the process over time?
A popular saying on Wall Street is "the trend is your friend." I believe that to be true, and the Zweig bond model has done a good job over the years at identifying the major interest-rate trends. It currently says "buy" longer-term-dated ETFs.
Rates are low today, and the Fed looks to take its first step toward "normalizing" interest rates. According to the CME Group FedWatch, there is a 24 percent probability the Fed will hike on Sept. 17. Should they, next week may bring fireworks. Think tactically with your ETF bond exposure.
At the time of writing, the author's firm owned shares of the securities mentioned above on behalf of clients. CMG is an ETF strategist specializing in tactical investing, using trend-following and relative-strength-based strategies. CMG Chairman CEO and CIO Stephen Blumenthal also writes for Forbes and speaks on various radio and TV shows. Contact CMG at 610-989-9090 or at [email protected]. Click here to receive his free weekly e-letter. For a list of relevant CMG disclosures, click here.