Martin Pelletier: What should a conservative investor do in this type of environment?
Traders work on the floor of the New York Stock Exchange. Photo by Spencer Platt/Getty Images files The past four decades have been outstanding for both stocks and bonds, especially since interest rates have been in a long-term downtrend. While equities have outperformed bonds on an absolute basis, adding bonds into a portfolio significantly reduced the standard deviation resulting in superior risk-adjusted returns.
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Though some may argue that standard deviations don’t truly represent risk, which by definition is a permanent loss of capital, we would argue that having a lower deviation prevents human emotion from wreaking havoc on a portfolio by allowing factors such as loss aversion into the investment decision making process. Simply look at the downside offered during large meltdowns such as in March 2020 when long-term U.S. treasuries surged over 45 per cent during the flight to safety.
The problem is the aggressive monetary easing we’ve seen over the past decade, something that rapidly accelerated following the COVID-19 shut-downs. Interest rates were pushed to record low levels, flirting with negative territory in some instances, leaving little to no room to fall further. This limitation is important because yields need to drop in order for bonds to offer meaningful downside protection during market corrections. As a result, the risk profile of bonds essentially turned asymmetrical, providing poor yields and little to no downside protection.
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Then something happened that we were told was supposed to be temporary, thanks to large fiscal deficit spending paired with supply disruptions. That something was inflation. Rising prices can wreak havoc on a bond portfolio by creating large losses, as central banks have little to no choice but to raise interest rates as their primary inflation-fighting mechanism. For example, we calculate that a U.S. 60/40 portfolio is down over 12 per cent this year with the Fed rate simply moving to 1.75 per cent, still well below its 2019 pre-COVID level of 2.5 per cent.
Things will get particularly troubling if this turns out to be a secular shift like the one in the 2000s, when according to Goldman Sachs Asset Management’s Nick Cunningham, vice-president of strategic advisory solutions, 60/40 investors suffered a “lost decade” in which they earned a meagre 2.3 per cent annual return that was actually negative on an inflation-adjusted basis.
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The big question is what should a conservative investor do in this type of environment?
Here is where risk-management expertise comes into play. Having someone who understands portfolio construction and position intercorrelations is imperative when it comes to replacing some or all of one’s fixed-income allocation.
Such a shift can include the use of alternative investments such as market-neutral strategies, private equity, even a slice of commodities. One has to be especially careful in managing this category for liquidity risk, the use of leverage, transparency and other factors.
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Article content We’ve also been a proponent of structured notes which we consider to be an equity/bond hybrid offering very attractive yields ranging from five to 15 per cent complemented by 20 to 40 per cent downside barriers. One has to be careful, though, of selling equities in this year’s correction and using notes as a replacement, as there is typically no upside beyond the coupon. That said, we do like them as a partial fixed-income substitute (especially for government bonds) even in the current market environment.
For those who have to own fixed income as an investment policy requirement, we like U.S. floating-rate bonds that offer upside from a strong U.S. dollar as well as rates that will participate with the Federal Reserve hikes. One must, however, be cognizant of inflation given real returns are currently negative. That means it is important to have some offsetting inflation protection exposure in other parts of your portfolio.
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Article content Finally, one has to be comfortable with not having all of one’s positions move together as a good manager will tactically manage the portfolio as a whole in order to generate an attractive absolute return while mitigating the associated risks as much as possible. This may take some getting used to for a traditional 60/40 investor, but it will quickly show its merit especially in markets like these.
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.
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