What This Strategy Aims To Do
This is our mainstream fixed-income offering and as such, aims to fill an important need for many investors: the need for effectively-diversified portfolios to include exposure to the more stable (relative to equities) asset class.
Why It’s Worth Considering
For most, and possibly all rational investors or savers, the need for exposure to this asset class is often self evident. For many, even the lowest-risk segments of the equity market involve too many ups and downs to justify investment of 100% of one’s assets. Indeed, we suspect that even those who portray themselves as aggressive gunslinger-speculators, the bravest of the brave, may have a lot more exposure to fixed income than they let on, if not in the account(s) we’re looking at, than in others squirreled away somewhere.
You don’t have to have your fixed-income exposure at Portfolio123 ADVISOR. Just have it somewhere. This strategy is worth considering for those who would like to use Portfolio123 ADVISOR for some or all of this exposure (which can be a good idea given the ease with which the allocations between fixed income and equities could be adjusted if it were all done through Portfolio123 ADVISOR).
How We Do It
Like other automated investment platforms with which you may be familiar, we use ETFs. These aren’t as pure as individual fixed income securities, each of which is expected to pay 100 cents to the dollar on a date certain (absent adverse credit developments). ETFs are typically permanent fixed income portfolios that do not mature (see our Bond Ladder strategy for an exception). The negative here is that the manager is usually not able to adapt to changing market conditions (i.e. by lengthening or shortening maturities as in the face of falling or rising interest rates). The obligation to do that falls to the investor by selecting the right ETFs given expected market conditions. If, however, you are a client of Portfolio123 ADVISOR, we assume this responsibility on your behalf as per our advisory role. That enables you to better enjoy the advantages of ETFs relative to ownership of individual fixed-income securities: ETFs are much easier for individuals to trade (in the fixed income market, a round lot is measured in millions) and compounding (fixed income securities typically pay interest twice per year, but fixed-income ETFs often pay “dividends” monthly).
The key to our strategy is our willingness to make advisory judgments about which fixed-income ETFs are most suitable under the market conditions we’re experiencing and expect. This is very different from the approach taken by other automated investment platforms, which rely on shopworn boilerplate extolling the supposed virtues of “passive” investment. We’re every bit as leery as they are about managers who trumpet their supposed unique genius or hunches. Fortunetelling is for entertainment. Investing is serious. So we hesitate to fall in love with our own bold predictions of the future. We know it’s hard to look ahead and how easy it is to be wrong. That said, some things are more predictable than other things, and some potential scenarios carry such obvious and high probabilities, that we believe it would be reckless for a duly registered adviser to ignore them simply to pay deference to marketing literature promoting passivity.
One such high-probability scenario involves the potential future movement of interest rates. The certainty that rates will not fall as they have for more than 30 years is as close to 100% as anything in the realm of financial probability can be. That’s because benchmark rates (risk-free rates that serve as jumping-off points for rates on securities that carry various kinds of risk) have fallen to and remain at near-zero levels. And they cannot and will not go negative.
We know you’ve likely read that negative interest rates have already been seen. That’s mere sophistry. What happened was that certain rates on overnight type inter-institutional loans have become fees. So in a fanatically technical sense, yes, those are negative interest rates. But that’s not the sort that can make fixed income securities rise in the future as they have in the past. For rates to truly go negative, we’d have to be able to take seriously the possibility that MasterCard or Visa, instead of charging you 15% to 20% on unpaid credit card balances will instead, pay you 5% to 10% or so to refrain from paying down your balances. Or imagine buying a house and having the bank pay you 6% annually to use their money to pay for it. Are such scenarios possible? Yes, anything is possible. But are they probable, or at least sufficiently probable that a reputable investment advisor can and should allow them to factor into a fixed-income strategy recommended for a client? We think not.
Unlike other automated investment advisory services, we exercise our professional judgment to assume that in the future, and aside from the near-random zigs ands zags that regularly happen, interest rates will be stable or will rise.
As of this writing, we are in a period of rate stability. That causes us to refrain from going all out on the shortest-duration ETFs we can find. Doing so would most effectively nullify interest-rate risk, but we believe the cost, in terms of foregone return, would be great, greater than we believe would be reasonable for the mainstream fixed-income investor. (For the most conservative investors, we suggest consideration of our “Smart Liquidity” strategy.)
That said, significant changes in market conditions are most visible well after they’ve taken hold, after it’s too late for those who positioned themselves the wrong way. We expect that to hold true if and when interest rates rise in the future. Given that rates today are so low, and given that there has been a perfect storm, so to speak, in factors that drive interest rates lower (such as low inflation, sluggish economic activity, restrained growth in the costs of many goods and services, and a financial culture that is extremely fearful of rate increases), we believe will be too easy for some sort of backtracking to occur, if not immediately, then at some time in the near or intermediate term future and for rates to experience some sort of upward movement.
Accordingly, for our mainstream fixed-income strategy, we chose to spread investments among the following three highly liquid, easily tradable, low credit-risk ETFs:
|iShares 3-7 Year Treasury ETF (IEI)||50%|
Vanguard Scottsdale Short-Term Corporate Bond ETF (VCSH)
(1-5 year target maturity)
Vanguard Scottsdale Intermediate-Term Corporate Bond ETF (VCIT)
(5-10 year target maturity)
Again, this is not a passive permanent allocation. We will alter it (the weightings and/or the choices of ETFs) if we determine that market conditions so warrant.
Is It Suitable For You?
As discussed above, we believe fixed income exposure is suitable for everybody, if not in your Portfolio123 ADVISOR account, then in some other. As to this specific fixed-income allocation, we believe it is suitable for those who agree with our assessment of interest-rate prospects, or those who feel uncomfortable assessing the situation and would like to benefit from our judgment.
Those whose views are more conservative should consider our “Smart Liquidity” strategy. Meanwhile, others who more of less agree with our expectations but would prefer to have them implemented in a more passive manner can consider our “Investment Grade Bond Ladder” strategy.
- Given the 50% target position in Treasuries with the balance in “investment” grade securities, cash-receipts risk is very low.
- Market risk is present given exposure to the intermediate-term positions, but the modest intermediate weighting and the absence of long-term positions combine to keep market risk low.
- Expect very low turnover.
- Aside from committing new money to or withdrawing money from this strategy, most trades will be small and for the purpose of restoring portfolio positions to target portfolio weight.
- Additional occasional trades will be made as portfolio selections are adjusted to changing market circumstances.