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VOL. 6 | NO. 23 | Saturday, June 1, 2013

Balancing Act

Financial advisers rethink the 60/40 investment model

By Andy Meek

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It’s past time to rethink the old 60/40 notion of investing, say a wide range of Memphis financial professionals, as the ground continues to shift beneath the feet of investors in this low-yield world of investing dominated by unprecedented action from the Federal Reserve.

Years ago, the 60/40 model – in which a portfolio is 60 percent stocks and 40 percent bonds – arguably was a more popular investment guidepost. The thinking was that stocks were considered a reliable generator of return for the portfolio, while bonds provided steady income and a relatively safe haven.

(Illustration/Emily Morrow)

Today, meanwhile, plain vanilla bonds like U.S. Treasuries don’t generate attractive levels of income and won’t be much help if interest rates rise significantly. The 60/40 model may once have been viewed as providing an optimal mix of risk and return, but investment managers from a variety of firms in town have a range of notions about how to maintain an allocation to core fixed income today while at the same time shifting to categories that provide more income and interest rate exposure.

With the important caveat, of course, that what’s always been true still remains so – there’s no such thing as a free lunch.

“We’ve been asked about this a lot, about this whole notion of 60/40 or really any other kind of asset allocation,” said Jerry Laurain, chief investment officer for the wealth management division of First Tennessee Bank. “The way I’m thinking about that now, those are called kind of strategic asset allocations for institutional investors. They’re policy portfolios. An investment committee will come up with a policy statement, risk constraints, a return requirement, things like that.”

At the individual investor level, though, he thinks it’s more appropriate to take a different approach.

“What I’ve seen in the industry – and I’m rapidly adopting this as our approach – is more of a needs-based allocation rather than an asset-based allocation,” Laurain said. “Just to say, in a perfect world there is an ideal equity portfolio. But nobody can tolerate that much volatility, so that’s how you end up with these blends.”

Laurain recommends that people put any money they won’t need for 10 years into the stock market and then work backward into their preferred asset allocation from there.

Andrew Buzan, a financial analyst with Kelman-Lazarov Inc., said his firm still believes in the concept of using 40 percent to hedge equity risk in a portfolio but that they look at the 40 percent in a different light due to interest rate risk. And the firm has dealt with that risk in the fixed-income portfolio in a few ways.

For one, the firm owns few U.S. government bonds, which it views as “return-less risk.” The firm shortened the duration, or interest rate sensitivity, on U.S. corporate bonds and increased international bond exposure.

“Bond prices are inversely related to interest rates, so as the Federal Reserve has lowered interest rates to all-time lows, bond prices have risen to all-time highs,” Buzan said. “Further complicating the matter, after two major stock market corrections in 10 years, fearful investors sold equities and bought conservative bonds, further pushing up their prices. Now the 40 percent conservative portion carries much more risk than it has historically. The 10-year U.S. Treasury bond yields 1.8 percent, so if 10-year interest rates rise 1 percent, the bond will lose around 9 percent of its value, or the equivalent of five years of interest.”

Overall, he said the firm has not significantly changed its equity management style, though it has favored a slight overweight in equities rather than rebalancing those profits back into fixed income.

Meanwhile, Robert Trimm, chief investment officer for Legacy Wealth Management, agreed the 60/40 split is not necessarily “dead” but that current times require investors to think more actively about how they allocate their fixed-income exposure.

He said Legacy uses the 60/40 equity-to-bond split as its base portfolio allocation because it represents an historical average distribution between stocks and bonds held in the U.S.

“One good aspect of fixed income, generally speaking, is that the asset class generates very low price volatility, relatively to equity,” Trimm said. “An asset class with a low historic risk combined with a reasonable return produces an investment vehicle demanded by risk-averse investors, but also properties desirable in portfolio construction.

“While it may be true that the U.S. and other developed countries’ central banks are engaging in expansionary monetary policy and are openly calling for higher inflation, which lowers the value of financial instruments paying a fixed coupon, such as a bond, financial markets do offer investors the ability to maintain a certain fixed-income portfolio weighting along with the option to move out of areas considered risky. For example, an investor could have 40 percent of my portfolio allocation in U.S. bonds and this, I would argue, would be more risky given current Federal Reserve policy than the rear-view mirror would suggest. Alternatively, one could allocate some or all of their 40 percent fixed-income exposure away from markets they considered to be problematic down the road, such as the U.S.”

That could be accomplished in several ways. For example, an investor could hire a fixed-income manager with a so-called “opportunistic mandate” that allows them to invest anywhere in the world, or use exchange-traded funds to add fixed-income exposure from other countries or regions, such as emerging markets.

“Investors who are not comfortable investing outside of the U.S. still have options,” Trimm said. “If future inflation or interest rate risk is a concern, then there are investment vehicles that invest only in bonds with floating coupons, short-duration bonds, and inflation linked securities, all of which can reduce the risk of higher interest rates, but currently have a price – very low yields.”

John Phillips, the chief investment officer for Red Door Wealth Management, agrees with Trimm that the 60/40 model is outdated but probably not dead. However, he says the new reality is that investors need to “buy and monitor” as opposed to “buy and hold.”

Historically, Phillips said, that “buy and hold” model has been a good starting point to use to determine where to park your money, forget about it and let it grow.

“Unfortunately, now with the Fed manipulating interest rates, you have to be more selective,” Phillips said. “Most important, you have to be cautious of what kinds of bonds you are buying and how sensitive they are to a rising interest rate environment. There are pockets of the fixed-income world where you can hide, such as short duration, corporate and floating rate bonds, but you need to know what you’re doing.”

He’s also noticed recent investor willingness to move into other interest-bearing strategies instead of bonds in search of yield – so, things like dividend stocks, real estate investment trusts and other non-bond alternatives.

“On the stock side, it’s essential to diversify outside the U.S.,” Phillips said. “It’s a global economy, and your investment allocation should reflect that. The bottom line for a 60/40 allocation going forward is to understand that the risk-reward payoff will be more difficult. To achieve similar historical returns, investors will have to take on more risk, which opens the door to larger potential losses.”

Duncan-Williams Inc. executive vice president Demetri Patikas comes from the school of thought that investing allocations constantly need to be reviewed and monitored for each client.

“We simply would never make a blanket recommendation to move away from or toward an allocation set based on factors such as the Fed,” Patikas said. “Monitoring is one of the four cornerstones of our client lifecycle. Markets do react to outside factors – which begs the question that you are asking – but we are not market timers, nor do we want to be as this is a strategy that proves to fail more often than not. On the other hand, throughout a client’s investing life their current position relative to their end goal changes. More than anything, this position is of paramount importance to our financial advisers in their ability to make appropriate recommendations to our clients.”

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