We have the privilege to receive modeled portfolios from advisors all over. They vary in risk tolerance and philosophy although most have some degree of blending passive and active/ tactical management. With each portfolio, we get a strong understanding of the underlying components in evaluating the good and bad.
We’ve noticed a trend of under-performance in conservative risk model performance vs. their benchmarks, highlighted during the March lows. BlackRock did a study on how advisor portfolios performed during the pandemic lows and really hit home with what we saw… advisors’ portfolios on the lower end of the risk spectrum drastically underperformed their benchmarks, especially when compared to more aggressive allocations. The poor performance for conservative portfolios from 2/20 – 3/23 showed that the stretch for yield and loosened credit parameters injected considerable equity-like risk into portfolios.
Source: Blackrock (as of 3/31/20)
The Backdrop:
Given the seemingly never-ending bull market in bonds, allocations have shifted from holding long-term government bonds to lower duration / higher credit risk securities to fill the income gap. The last several years this allocation shift has worked great, as most all fixed income sectors have profited from both falling interest rates and tighter credit spreads. At the depths of the pandemic outbreak, we saw a massive repricing in credit, severely impairing prices of credit securities (remember LQD was down >20%) and brought to light some ugly realities of portfolio construction.
This brings us to our question: what is the point of owning fixed income in the portfolio: diversification, income, or stability?
In the not so distant history, we believe all three could be accomplished with government bonds. Not the case anymore! In a Financial Times (FT) article written earlier this week, we believe they laid out the current fixed income environment quite well.
FT discussed how the reach for yield is getting harder, forcing investors to move ever further out the risk curve. It noted that a record ~86% of the $60T global bond market tracked by ICE Data Services traded with yields no higher than 2% as of June 30. The article also added that more than 60% of the market yielded less than 1%. In addition, just 3% of the investible bond universe currently yields more than 5%, a share that is close to a record low and represents a meaningful drop from the late 1990s when nearly 75% of bonds traded with yields above 5%.
Back to the point… diversification, income or stability?
Based on the metrics, we think it’s obvious advisors have bypassed diversification for income. The move from long-term government bonds to higher-yield allocations has led to a rise in credit risk and in turn greater exposure to drawdowns. As allocations shifted away from government bonds (duration exposure) to higher current income (credit exposure), we question the benefit of holding a bond allocation given significant volatility risk.
The rate environment has forced advisors to choose what they believe to be the lessor of two evils between diversification and income (cash might cover “stability” but zero return seems a high price to pay). We continue to ask ourselves…do we want to own an asset class that exposes us to substantial interest-rate risk? With little to no current income in hopes of price appreciation in a down equity market?
The numbers below run a few conceptual scenarios on 10yr Treasuries using basic bond math…you be the judge on the reward for risk. On the other end of the bond spectrum, we believe stretching for income injects significant volatility into portfolios and does little to weather bad equity market environments, as shown during the March selloff.
Source: Aptus Research / Bloomberg LP.
Moving Forward
In our next piece, we will dig into how we’ve altered our allocations in an attempt to combat incredibly low global interest rates without falling victim to constructing portfolios the default way. Our view is that the 60/40 portfolio of the future will need to look significantly different than it has historically. More on that to come.
Disclosures
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.
This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment and tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.
Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. More information about the advisor, and its investment strategies and objectives, is included in the firm’s Form ADV, which can be obtained, at no charge, by calling (251) 517‐7198. ACA-2007-56.
