DWM 3Q13 Market Commentary

Detterbeck_sample_for_title_page_(just_mountains)[1]It is hard to get excited about the near term outlook for financial markets given the negative news we constantly deal with. For example, the government is currently in shut down mode, we face another debt ceiling impasse in a few weeks, and the Fed has decided that the US economy isn’t strong enough for the Fed to taper bond buying yet. In the bizarro world of investing, traders actually like to hear “bad news” like that the economy isn’t that strong. Why? Because then the accommodative Fed policy can continue. And that is reason #1 behind the stock market rally since 2009 and why markets continued to be strong in 3Q13. Times will be a’changing when this artificial foot on the gas takes a break.

Almost all asset classes jumped in 3Q13. Equity markets, and not just the domestic ones, had big returns. The S&P500 was up 5.2% and diversified international stock funds were up 10.2%. Fixed income markets, after a disastrous 2Q13, bounced back nicely with the average taxable bond fund up 0.8% for the quarter. And the liquid alternative funds that we followed generally posted modest, yet solid returns.

To reiterate our view on investment management philosophy, we would like to point out a few things. First things first: it is not about which individual stock one holds. That is, its not whether you own Coke or Pepsi in your portfolio. If you want to play individual names, you certainly can, but we wouldn’t advise a big allocation to that. Why? Because it’s kind of like going to Vegas. Vegas is fun, but that’s gambling, not investing. DWM is about controlled investing. We don’t look to hit home runs. We look to preserve capital by protecting the downside and growing the portfolio in a controlled manner.

Empirical studies show that what it is all about is how much you have allocated to the different asset classes. That is, how much you have in stocks, bonds, and alternatives. Keep in mind that these asset classes all behave very differently.

  • Stocks historically offer the greatest rate of returns, but come with the most volatility. Furthermore, some market timers would tell you that stocks are “long in the tooth” right now given the amazing run they’ve been on since bottoming out in early 2009.
  • Fixed Income has historically been viewed as a “safe haven” and has provided 7-9% returns over the last 30 years. Yet that coincided with a steady declining interest rate environment that is most likely now over. Fixed income still provides a significant role in everyone’s portfolio as a diversifier and capital preservationalist, but expected returns going forward should be significantly lower than the high single-digit percentage rate that investors have become accustomed to.
  • Lastly, alternatives provide an additional asset class that can produce new sources of returns with lower correlation and reduced volatility. We expect volatility and returns to be somewhere between what you would expect of stocks and bonds, with an extra bonus emphasis on downside protection.

We all should be glad that these asset classes operate very differently as it provides the “smoothing effect” on the overall portfolio. Because of this, overall portfolio returns may lag what equity markets do in bullish times, but more importantly, they shouldn’t experience huge downside losses when times get rough. And without those big holes – like the 35-50% holes all-out equity investors found themselves in 2008 – it takes a much smaller time to dig out and hence geometric compounding can do its thing, leading to ultimately better long term results.

That said, we have enhanced our quarterly reports by breaking out asset class performance. Clients will see this near the end of their reports. We also are providing an Asset Allocation “soil chart” which shows the client’s asset allocation over time. We think this helps explains exactly how and why the overall “household” portfolio is performing the way it is.

Drop us a line if you have any questions on asset allocation or investment philosophy. Or even better; come to one of our upcoming seminars this month focusing on how to invest in a rising interest rate environment, followed by an hour of fun. In Charleston October 23rd, and Palatine October 30th. We hope to see you soon!

Brett M. Detterbeck, CFA, CFP®

DETTERBECK WEALTH MANAGEMENT

Media Scare Tactics: The Coming ‘Bond Bubble’

Is the media scaring you about the so-called coming ‘Bond Bubble’? Block out the noise and focus on what matters: asset allocation.

With all the hoopla going on about fixed income being the possible next “bubble”, I thought it prudent to talk about asset allocation. Fixed income is just one part of a well-balanced portfolio. At DWM, we believe in multiple asset classes including traditional asset classes like fixed income and equities, along with alternatives.

You do not want to all-out avoid or shun an asset class. We’ve seen people that have been out of equities since 2008 and they’ve missed one of the biggest bull markets in history.

You also do not want to load up in just one asset class. We saw people that were in 100% stocks going into 2008 that felt the full pain of a 35-50% drop. That’s a deep hole to dig out of.

The key is balance. A case can be made that everyone should have about at a minimum 20% allocated to each asset class. So how does one determine what percentage of equities, stocks, and alternatives their portfolio should have? DWM does this by identifying your goals, risk tolerance, return objectives, income needs, time horizon, and other special requirements. As every client is unique, so is each client portfolio. A younger client with a high risk tolerance may be 50% equities / 20% fixed / 30% alternatives. An older client with low risk tolerance may be 20% equities / 50% fixed / 30% alternatives.

Take a look at the graphic below which shows a sample individual investor portfolio versus an institutional portfolio from 2009:

pie charts 061313

You can see that institutions have the majority of their assets allocated to alternatives. And because of it, they have had pretty good success. The individual investor is just starting to catch up, as access (or rather the previous lack thereof) to alternatives has changed. Until the last several years, only institutions and the extremely wealthy had access to alternatives. Furthermore, there were high minimums, lock-up periods, bad transparency, and high expenses that were not practical for the individual investor. But that is really changing. We at DWM have been using liquid alternatives for the last several years. More and more of these liquid alts come available almost every day.

In a time and age where the 30 year bond bull market may be coming to an end and a time when the equity market is being called “overheated”, alternatives may offer a complementing asset class that can give your portfolio better overall risk-adjusted returns. Alts can play many different roles in a portfolio from return enhancer to fixed income substitute to diversifier. They can provide investors insurance against declines to the traditional 60 / 40 model. They can mitigate downside risk and lower volatility.

Now, don’t get me wrong: there is no silver bullet. Not all alternatives are created equal, and not all are going to be consistent winners. But with a diversified portfolio consisting of all asset classes, you should have a much smoother, consistent ride which can ultimately lead you to better financial success.