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Posted by on Aug 11, 2015 in ETF Strategist, Investment Perspective

Putting Adaptability To Work

Putting Adaptability To Work

By Roger Nusbaum, AdvisorShares ETF Strategist

 
In our last post we looked at the importance of adaptability to overcome obstacles that impede retirement plans. This may also turn out to be especially important for portfolio management going forward, more so than in the past.

Michael Kitces has a great post up that provides a detailed account of how well the 4% rule has worked for investors, even those who had the bad luck of retiring at terrible times like 2000, 2008 and other years that were at the onset of very poor stretches for equity markets. The following snippet captures the article quite well;

…in general a 4% withdrawal rate is really quite modest relative to the long-term historical average return of almost 8% on a balanced (60/40) portfolio!

The 8% number wasn’t sourced or defined in terms of time but assuming it is a good number it includes what some have called the greatest bull market in history for bonds which makes up 40% of Kitces’ assumption. Even if rates don’t go up from here they cannot repeat the move of going from 15% for longer dated treasuries to 2-ish percent as they have done over the last 30+ years.

In a Twitter exchange with Kitces where I asked if he was concerned that bond market results could struggle he replied over several tweets including “Certainly lower bond returns are concerning. But they’re arguably also supporting higher stock prices that help. In other words, I don’t think we can treat sequence of BOND returns and stock returns as independent of one another. Instead, the ‘harmful’ paths of one still tend to move opposite beneficial effects of the other. Which smooths the outcome.”

While of course he could turn out to be correct, the line of thinking relies more on the past than I would be comfortable with. I don’t believe there is anything different with the stock market cycle. We are more than six years into a bull market for equities. That bull will end at some point, there will then be a bear market followed by the next bull. (Note the terms bull and bear are used for economy of words).

I do think the bond market is different for the reason stated above; maybe yields won’t go up but they cannot repeat the decline from 1981. So then the concern that stems from Kitces comment is that when the bear market starts and the offset from bonds can’t be as large as it was in past equity declines, then portfolios must find a way to adapt.

There are several paths here to adapting for those inclined to be concerned about the bond market. One is to increase the equity portion of a portfolio (with dividend oriented equities) but this comes with a huge downside. In a down 40% world, most investors are unlikely to take much solace when their 4% yielding potato chip stock only goes down 20%; great for an equity but lousy for a bond proxy. Keep in mind, things like REITs and MLPs can go down a lot in equity bear markets and finding that out after they go down a lot is a bad place to be. Not that you should own REITs and MLPs, just they should not be expected to be bond-like when you most need them to be.

There are of course plenty of actively managed ETFs and traditional funds that will attempt to manage the bond market for you which is a valid route as there will be managers who successfully navigate the market if/when rates rise.

Investors and/or their advisors can manage this risk more directly with funds that hedge interest rate risk, there are more and more of them coming to the market and again, I believe plenty of them will deliver mostly as advertised.

Finally I will throw in that certain alternative strategies will deliver bond like returns and volatility but obviously not every strategy or fund. A long short equity fund with a 130/30 mandate seems unlikely to deliver a bond like result for example and if a fund with the term market neutral or absolute return in the name has traded all over the place then it might not be a candidate for bond like results.

The conclusion I draw is a combination of several different approaches to get the job done.

david@mediaworksllc.com

The AlphaBaskets blog provides frequent market insight and commentary by AdvisorShares Investments, LLC, created by AdvisorShares and other leading active managers.  AdvisorShares Investments is an SEC-registered investment adviser and the investment adviser to the AdvisorShares actively managed ETFs. The views expressed on AlphaBaskets should not be taken as investment advice or a recommendation for any of the actively managed ETFs advised by AdvisorShares.

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