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The greatest challenge facing any Financial Advisor today is finding acceptable growth at manageable risks for their portfolio of clients. Gone are the days when a well-diversified portfolio gave you peace of mind – the volatility of world market has ensured that no economy has escaped the wrath of our times. Economists are struggling to provide answers – that is any prediction within even an acceptable mean - so where does it leave us … the man in the street.
If holding cash for the past 3 years then have not only missed some interim cycles but you have probably earned negative returns – returns lower than inflation. At least you have more Rands today than yesterday but at what cost? So where can we find an answer? My view – in time only! Meaning your time horizon would be defining the strategy to be followed today. Even though the past is not a definition of the future the “University of Life” has shown those with patience that real returns are achievable irrespective of any cycle (s).
I would prefer to refer to an article I have read recently and the author were guiding his readers as to where to from here. He talks about “5 imperatives for constructing portfolios for the sideways market ahead”. Do read the summarised article for more detail.
5 Strategies are as follows:
- Know the role of cash
- Seek spread for real yield
- Don’t overpay today for tomorrow’s returns
- Get paid while you wait
- Own some zig to buffer the zag
The old cliché still stand – it is therefore not the TIMING OF the market that matters but rather the TIME IN the market.
In summary: While the five strategies will help guide (investors) advisors in drafting strategies for a long sideways market, they are also fairly standard portfolio building blocks. Cash, bonds, stocks and alternatives are probably already in most client portfolios. New breakthroughs in investment strategies are unnecessary. Rather, advisors (investors) should continue to plan according to their clients’ needs but with an eye toward the probable future investing environment.
Here are five imperatives for constructing portfolios for the sideways market ahead.
Strategy 1: Know the role of cash
Cash may have a place in a portfolio, but investors need to accept that cash is a negative real-return investment! Bank accounts, CDs and money markets currently yield less than inflation, so simply sitting on cash is a losing proposition for investors seeking positive real returns over time.
Should cash be avoided completely? No. Cash serves a purpose. Its value doesn’t fluctuate in nominal terms, and for people who are near or in retirement, the stability of cash has value above a simple interest rate. Understand, though, that this view of cash is from the planning perspective, not the investment perspective. If a client needs six months or two years of cash on hand, they should have that cash available regardless of the investing environment.
Strategy Considerations
Looking at cash as an investment is different. Because cash currently earns a negative real yield, there is an investing cost (opportunity loss) to holding it. At the same time, holding some cash allows investors to take advantage of market opportunities as they arise.
Strategy 2: Seek spread for real yield
So where is there positive spread? Corporate bonds (investment-grade and high-yield), emerging-market debt and some mortgage-backed securities offer positive spread with risks that we view as reasonable given the expected returns.
Strategy Considerations
Investors and advisors need to ask themselves if credit risk — always present in corporate bonds — is worth the spread. Speaking broadly, we think so.
Strategy 3: Don’t overpay today for tomorrow’s returns
If the secular valuation decline argument is in our future, how can we still obtain some equity exposure while protecting ourselves from P/E contraction? To state the obvious, don’t overpay for your investments!
Strategy Considerations
With long-term deleveraging and slow economic growth anticipated for the foreseeable future, it’s reasonable to assume that the secular decline in P/E’s will continue. Owning stocks that already look cheap but still have some growth potential is a very good way to participate in the cyclical upside offered by stock investing while also protecting, on a relative basis, against the secular drag of valuation decline. Other considerations, such as balance sheet health and competitive advantage, are also important.
These value-style focused strategies help investors stay in front of the secular decline.
Strategy 4: Get paid while you wait
Market index’s suffered numerous cyclical bull and bear markets over numbers of years, but at the end of the period, the index value was almost always exactly where it started. And this isn’t even considering the damaging effects inflation had on purchasing power over this time frame. Investors made nothing, right?
Well, some investors made nothing. Some may have done just fine and earned an acceptable return given the risks they took. Those who pursued a dividend strategy and, even better, a dividend-reinvestment strategy would have done better than those who did not. Dividends are attractive today and have been so for many years – tax breaks been unmistakably the greatest benefit.
The benefit of pursuing a dividend strategy (especially a dividend-reinvestment strategy) is clear. It is perfectly reasonable to earn a carry through dividends while waiting for a sideways market to run its course. There are also indirect benefits to dividend strategies. For example many tend to be lower beta than the market and remember dividend-paying stocks on average have earned better long-term returns than non-payers.
Strategy Considerations
While plenty of stocks offer attractive dividends, we caution investors to avoid the temptation to simply load up on high-dividend payers. As with Strategy 3: Don't Overpay for Tomorrow's Returns, you need a more holistic approach to selecting appropriate holdings. A high dividend that is supported by cash flows (especially free cash flows) and a healthy balance sheet is a better investment than a high-dividend that has resulted from a massive share price decline.
Finally, we caution those who look into dividend strategies to beware of sector weights. Many dividend weighting schemes drastically overweight certain sectors, which can present a new set of risks. Know what is in your dividend strategy, and be sure to stay diversified.
Strategy 5: Own some zig to buffer the zag
We view the alternative space in two ways. There are alternative asset classes, and there are alternative investment strategies. While alternative asset classes such as commodities, REITs and currencies have been available to retail investors for some time, a lot of alternative investment strategies have come out in mutual funds and ETFs only in the last few years. This has given main street investors similar access to opportunities previously afforded only to accredited investors.
Alternative asset classes and strategies are designed for the most part to offer one major benefit: reducing portfolio volatility by zigging when more traditional asset classes zag (or at least they should zag less). In other words, they should allow you to build a more diversified portfolio, one that moves the efficient frontier line up and to the left.
Earlier, we said the likely future path of the stock market as one that is characterized by volatility and declining valuations. If that is the case, it makes a great deal of sense to add exposure to some alternatives. If alternatives do their job, allocating to them will reduce the volatility of the portfolio even if the market remains choppy.
Strategy considerations: Alternative asset classes
Concerning alternative asset classes, REITs don’t look like a screaming value to us right now. Nor do commodities. At the same time, for a strategic-allocation oriented investor, there is strong historical precedent that those two asset classes will be good diversifiers, and at times, produce outsized returns.
Concerning REITs, investors need to remember that these securities must, by law, distribute 90% of their earnings to investors. Yields on REITs are currently low. That tells us that earnings power is not terribly high in the sector (or the sector has been bid up too high to make the cash flows attractive). Commodities can be a good diversifier, but that effect has come down in recent years as the risk-on-risk-off trade has prevailed, causing correlations with stocks to rise.
While opportunities can be found in single-commodity ETFs, their lack of diversification will increase, not decrease, overall portfolio volatility.
Strategy considerations: Alternative strategies
Alternative strategies, which can vary widely, include market neutral, managed futures, hedged equity, global macro, event driven and merger/arbitrage. Thorough due diligence when researching these strategies is crucial – you are not simply buying an asset class. You are buying a management team who should have detailed expertise implementing a unique strategy, so you have to know the team and understand its strategy.
Expense ratios can be high with alternative strategies, but that is not always the case. There are decent managers with decent expense ratios. At the same time, there are some pretty poor performance records offered at unattractive expense ratios. Clearly, these should be avoided.
Most alternative strategies either seek alpha or information ratio (returns that are generated independent of market gyrations), or they seek to minimize downside risk. Managed futures is a classic example of a strategy that has a history of negative correlations to stocks. Broadly speaking, market-neutral strategies and hedged equity have a similar history of low correlations to stocks. While it is likely that they will serve as a portfolio drag in boom times, they should earn their keep during market turbulence.
Conclusion
While the five strategies above will help guide advisors in drafting strategies for a long sideways market, they are also fairly standard portfolio building blocks. Cash, bonds, stocks and alternatives are probably already in most client portfolios. New breakthroughs in investment strategies are unnecessary. Rather, advisors should continue to plan according to their clients’ needs but with an eye toward the probable future investing environment.
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