Commentary | Aug 06, 2020

Past Is Not Prologue


The Heavyweight Champion of Wealth Management

The modern investment management industry was built on the shoulders of the standard balanced portfolio – 60% invested in stocks and 40% invested in high-grade bonds. If you use an investment advisor, chances are that your portfolio strongly resembles this investment strategy.

The 60/40 mix has worked well over the past 40 years, largely due to strong secular tailwinds. Improvements in technology, communications and global trade spurred disinflation. The resulting decline in interest rates created a rising tide for asset valuations and helped keep the correlation between stocks and bonds low, thereby reducing the volatility of balanced portfolios.

While conventional portfolios have performed well for the past four decades, there are several factors at play that suggest that they may fail to do so going forward.

According to legendary investor and father of value investing Benjamin Graham, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Unfortunately, in the current environment balanced portfolios involve risk with little to no hope of return.

The Trouble with Bonds

Given historically low yields, the likelihood of bonds posting returns anywhere near their historic levels is close to zero. PIMCO Co-Founder and “Bond King” Bill Gross commented in 2016 that in order to repeat the bond market’s 7.5% annualized return over the past 40 years, yields would have to drop to -17%!

Bonds have historically provided downside protection in bear markets. When stocks tumbled, bonds rallied, thereby serving to mitigate the losses of balanced portfolios. During the tech wreck of the early 2000s, a balanced portfolio that was 60% weighted in the S&P 500 and 40% weighted in 7-10 year U.S. Treasuries declined 16.41%, as compared to a fall of 42.46% for the all-stock portfolio. In the global financial crisis of 2007-2009, the balanced portfolio lost 23.92% vs. a loss of 45.76% for the all-stock portfolio.

Going forward, it is highly unlikely that bonds will provide a similar degree of diversification and protection. At the onset of the tech wreck, the 12-month average yield on ten-year U.S. Treasuries was 6.66%, which fell to a low of 3.87% in 2002. Prior to the global financial crisis in late 2007, it stood at 4.52%, and declined to a low of 2.43% in 2008. With yields currently hovering between 0.55% and 0.6%, the math just does not work.

Further complicating matters, there is a risk that stocks and bonds could move in the same direction, which would increase the risk of balanced portfolios. Notwithstanding that these two asset classes have exhibited minimal correlation over the past 40 years, there have been long periods during which they were positively correlated. In 89% of months since 1883, stocks and bonds have been moderately or highly correlated.

The unprecedented amounts of monetary and fiscal stimulus that are being injected into the global economy could spur inflation. As yields have fallen to record lows, bonds have become more exposed than ever to inflation and a related rise in rates. Even a moderate rise in rates would result in severe capital losses in government and other high-quality bonds.

Between a Rock & A Hard Place

Given the challenges facing traditional portfolios, you can:

  1. 1. Increase your allocation to equities.
  2. 2. Apply leverage to the bond portion of your portfolio.
  3. 3. Shift your bond allocation towards riskier, higher yielding securities.
  4. 4. Allocate some or more of your portfolio to alternative investments.
  5. 5. Implement some combination of numbers 1-4.

Increasing your exposure to equities entails obvious risk, as markets pay no heed to the convenience of mortals, and stocks have a nasty habit of suffering severe losses in bear markets. Furthermore, the cyclically adjusted P/E ratio of the S&P 500 currently stands at 30, which is 46% higher than its 50-year average of 20.5. Such elevated multiples have historically limited upside potential, if not foreshadowed bear markets. At the very least, it seems unlikely that stocks will make up for record low bond yields, thereby making it even less likely that traditional balanced portfolios will deliver adequate results over the medium to long-term.

Last March clearly demonstrated that both levered bond portfolios and/or lower quality debt securities can suffer severe losses when the proverbial tide goes out. The de-risking in markets served as a stark reminder that credit spreads have a habit of rising at the most inopportune times. It is only by the grace of Fed Chairman Jerome Powell that many of these strategies not only survived but have recovered most of their losses. Furthermore, there are no guarantees that such assistance will be forthcoming in future market turmoil. In other words, if you jump out of a third storey window and don’t suffer a life-threatening injury, it doesn’t mean it was a good idea.

Finally, alternative investments such as hedge funds, private debt, private equity, etc. involve their own set of issues, including lack of transparency, extreme crowding, elevated valuations, high fees and poor liquidity. Moreover, many of these asset classes have underperformed stocks over the past decade.

Dangerous Complacency

According to John Maynard Keynes, “Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally.” Unfortunately, the complacency and recency bias of many wealth managers renders them reluctant to deviate from what has worked in the past, thereby leaving them ill-equipped to protect their clients from severe losses or achieve satisfactory returns going forward.

At Outcome Metric Asset Management, we are both willing and able to deviate from the crowd in order to achieve these objectives. Our benchmark-free, unconstrained Global Tactical Asset Allocation (GTAA) strategy uses statistical analysis and machine learning to dynamically allocate across multiple asset classes in response to changing market conditions. Specifically, the strategy shifts allocations between stocks, bonds, and REITS, and can also tactically alter its geographic, credit, and interest rate exposures. Lastly, our GTAA mandate can participate in the upside of cyclical bull markets within larger secular trends in order to deliver relatively strong risk-adjusted returns during prolonged periods when both stocks and bonds perform poorly and 60/40 portfolios falter.

Since its inception in May of 2017, this method has enabled our clients to participate in rising markets while avoiding large losses during both the fourth quarter of 2018 and the first quarter of 2020. We believe that this strategy constitutes an efficient, transparent and liquid path to navigating markets in the current environment of elevated risk and uncertainty and achieving superior risk-adjusted returns over the long-term.