Why Alts?

2015-12-27 Janet PAINT (002)We get this question a lot, particularly as the events of the Great Recession fade away in our mental rearview mirror and the current equity bull market plods on.

Drop a dime in the jukebox and throw on “What Have You Done for Me Lately” by Janet Jackson as that is what many investors are asking about alternatives (“alts”) these days. In most cases, the answer is “not much, Janet (or Miss Jackson if you’re nasty).” But that shouldn’t cause us to change course and remove this extremely valuable asset class from your portfolio.

In fact, this is exactly the time when alts are essential to a diversified portfolio. Let’s reiterate why alts are such an important portfolio component: they are in there as a diversifying complement to the rest of your portfolio asset classes; the zig to their zag. This diversification comes in quite handy when equity returns decline, volatility increases, and interest rates rise. All of which are happening now.

So, you’re correct Miss Jackson, alts have not done much for us lately. But, as we pointed out at our fall seminars, what happens lately doesn’t dictate what will happen in the future. Recency bias is the erroneous significance that people put on recent events. As humans, we are innately emotional and hard-wired to think that these recent events will continue indefinitely. But that’s not how market cycles work. Many times, the best performer in one calendar year is one of the worst the following year. For example, REITs (Real Estate Investment Trusts) were one of the top performers in 2006 only to be at the bottom in 2007. Emerging markets were one of the best performers in 2007, only to be the worst performer in 2008. On the flip side, investment grade bonds were near the bottom of the class in 2010, only to be one of the better performers in 2011. International stocks were near the bottom in 2011 only to be one of the best performers in 2012. Hence, just because equities (and large caps in particular) have had several relative strong years in a row and alts have had muted results, doesn’t mean that will be the case for the next several years.

From 2009 through early this year, equities were providing the bigger returns and a well-diversified investor benefited accordingly. But things are changing. The Fed just raised rates, oil continues to slide, consumers aren’t spending as much, and investors could see 2015 as the first negative calendar year total portfolio return since 2008.

And speaking of 2008, let us not forget how gruesome that year would have been for many investors if not for the alternative asset class that kept returns in check. Alts like precious metals, currency strategies, and others were actually up in a time when equity benchmarks were down huge!

A basket of alternatives that DWM follows hasn’t exactly been “chart-toppers” the last few years. But that’s okay. We don’t expect for these to be double-digit return producers. As a whole, we are expecting the alternative asset class to return somewhere around 4-7% per annum for the next several years. But more importantly, our expectations for alts is that they won’t be down dollar for dollar when equities have a 10% or worse correction.

And that’s the real beauty. By using alternatives and avoiding a blow-up like many hard-core equity investors did in 2008, you don’t have a huge hole to dig yourself out of. The bigger the hole, the harder it takes just to get back to break-even, move forward, and secure those long-term financial goals of yours.

So, you’re right Miss Jackson. Alts haven’t done much for us lately. But, if you don’t fall prey to recency bias, you may understand that it is what they may do for us soon that can be so important.

How Much Stock Should You Own?

asset allocation dog
(Click above for full size image)

The Wall Street Journal directed that question to retirees Monday. It’s really a good question not just for retirees, but investors of all ages. Research shows that asset allocation accounts for more than 90% of investment returns.

Let’s start with retirees. The old “wisdom” was that you subtracted your age from 100 and that was how much of your portfolio should be allocated to stocks. The balance was suggested to be in fixed income. So, this rule of thumb would conclude that most investors age 70 would have 30% allocated to stocks and 70% allocated to fixed income. That’s likely the wrong allocation today for three reasons:

  1. The equity allocation may be high or low.
  2. The fixed income allocation is likely too high these days.
  3. There are no alternatives in the allocation.

For retirees and investors of all ages, the answer lies not in the age of the investor but their risk profile. Our regular readers know that risk has three components:

  • Risk Tolerance – Are you a risk taker? This is typically reviewed through use of a questionnaire.
  • Risk Capacity – How much money can you afford to lose? This is typically reviewed by estimation of worst case outcomes in relation to your net worth.
  • Risk Perception – This is a subjective judgment people make about a given risk at a point in time.

Every investor has their own unique characteristics as far as goals, income, expenses, net worth, legacy wishes, expected longevity and risk profile. We have clients in their 60s, 70s and 80s with a “growth” or “aggressive” risk profile. They may or may not be working, don’t withdraw a large percentage annually from their portfolio, are comfortable with risk overall, have enough net worth where they can afford to lose an expected given portion of their assets and they have a low perception of danger of a given risk. Hence, based upon their unique characteristics, their asset allocation might be 60% equity, 20% fixed income, and 20% liquid alternatives. A far cry from 30% equity and 70% fixed income based on their age alone.

Conversely, we have some young clients who don’t like risk and have a “defensive” or “conservative” risk profile. Their asset allocation could be 30% equity, 35% fixed income and 35% alternatives. Everyone is different.

Another rule of thumb that needs review is the 60/40 portfolio. The traditional “balanced risk” portfolio is 60% stocks and 40% bonds. Some financial advisers recommend this 60/40 portfolio to their clients of all ages and all risk profiles. To them, the mix is what Goldilocks would say is “just right.” They recommend you “set it at 60/40 and forget it.” Unfortunately, it hasn’t worked well since 2000. Many of their clients should have had less allocated to stocks and more to bonds through 2011. And, now with the bond bull market seemingly over, they face the prospect of reducing the bond allocation but don’t want more in equity.

These first five weeks in 2014 remind us that the stock market doesn’t always go straight up and diversification is key. It’s no surprise that we continue to see more and more industry literature suggesting investors and advisers consider liquid alternatives for a portion of their portfolio – something we’ve been doing for ourselves and our clients for over seven years. Instead of a 60/40 portfolio, the DWM allocation for an investor with a balanced risk profile these days might be 50% stocks, 25% bonds and 25% alternatives.

Lastly, risk profiles change over time. Many risk profiles are different today than they were in early 2008. We live in a different world today than six years ago and it’s always changing. That’s why we are continually monitoring and managing the investment environment and meeting with our clients to help them with their financial goals and review their risk profiles. That’s what we call Total Wealth Management or “TWM.”

Beware of advisers that rely on antiquated rules of thumb (such as using your age for your asset allocation) or suggesting a 60/40 set-it-and-forget-it portfolio. Identifying and maintaining the appropriate asset allocation requires a lot more work. It requires a robust financial planning and investment management process like DWM’s TWM. If you’d like more information please give us a call.

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®


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.