At RPg, we have always defined risk as how much an investor is willing to lose in a short period of time (maximum drawdown) before they are unwilling to stick with their long–term plan. Moreover, we think the biggest risk facing investors is not the short term volatility of returns, but the risk of an investor outliving their wealth.With extremely low interest rates globally, we expect the next twenty years will likely see rates rising. This is a problem for investors, since rising rates are bad for total returns on fixed income. More specifically, we believe there is the potential for dramatic interest rate changes amidst diminishing global quantitative easing and increasing uncertainty around fiscal and economic policy initiatives.A prudent defense is to employ a diversified tactical approach to the fixed income allocation of investors’ portfolios.As policy “normalization” continues, central banks around the world are likely to communicate a reduction to their reinvestments and the size of their balance sheets.Improving economic data and profits have supported this thesis and have reignited prospects for stronger global growth, higher inflation and potentially a faster pace of interest–rate increases. Most portfolios are allocated to traditional stocks and bonds as theindustry has promoted simplicity and convenience to stay “vanilla”. This leads to a reliance on stocks for all future returns, and traditional bonds for the diversification.The reality is that stocks and bonds are small parts of the investable universewhich opens the door for a tactical investor who can access many other sources of income and returns which maysignificantly improve the risk/return characteristics of advisors portfolios.RPgaccesses everything from niche asset classes, to generating returns by exploiting behavioral biases, to the massive exposures hidden in financial institution balance sheets. This expertise and diversification will help advisors keep clients on a successful glidepath within their investment portfolios.
We recognize that most investors have been diversifying into other types of alternatives within stocks and bonds, but we view that as only being helpful on the margin. Not only are these allocations generally small, but the correlations of these investments generally rise precisely when you don’t want them to… During market dislocations.
We have clearly presented expectations of a rising interest rate environment over the next 20+ years, however, we do not expect the path will be linear. There are many other factors such as the timing, size, and composition of future fiscal and monetary initiatives which we believe will present both risks and opportunities. A prudent defense will need to include the following characteristics:
August 2017
All managers need a “blueprint” for how to build a diverse, income generative portfolio. The tactical income portfolio can be dramatically better than the traditional fixed income portfolio following three simple guidelines:
Asset Class | Gross-of-Fee | Net-of-Fee | Source |
US Gvt Bonds | 0.35% | 0.25% | JP Morgan |
US Corporate Bonds | 1.85% | 1.25% | JP Morgan |
US Equities | 5.00% | 4.25% | JP Morgan |
“Better Beta” | 5.80% | 5.05% | Bloomberg, JPM |
Private Equity | 8.00% | 6.00% | JP Morgan |
Following these rules will lead investors down a different, more diversified, and arguable better path for their fixed income portfolio. Following Rule #1 supports the tactical approach as portfolios will need to find investments that generate enough income that they can mitigate some of the expected volatility we expect from fixed income markets. With the expected returns from US Government and Corporate bonds so low and risk profiles so unfavorable (low upside, large potential downside) they barely make sense to own. It appears to make sense to tactically seek a more diverse set of opportunities.
Following Rule #2 will demand a flexible mandate to the asset allocation. This implies an allowance of equity investments that can generate significant yield sand having a tactical approach to those investments. Following this Rule may improve the income level and provide a more durable income stream.
Following Rule #3 will lead to a liquid, bi–directional (credit, rates, spread), and tactical approach to portfolio construction. This process will lead to greater yield generation in a more diversified, risk–managed, process oriented portfolio.
Tactical investing can involve qualitative and quantitative models that are used in an effort to remove cognitive biases that enter the investment decision making process, limit losses, and reduce volatility. Many strategies look and sound logical and have mass appeal especially at times when investors have fresh memories of significant market declines and multi–year bear markets that decimated portfolio values.This happens with fresh memories of generally positive returns as well and can be misleading when making investment decisions. We have written about this in the past and we refer to this condition as “present bias”.
This “present bias” happens when we feel more compelled by the data that is in front of us now than by what is coming in the future. Employing a rules–based, tactical investment methodology for a portion of an investor’s fixed income portfolio can help remove the “present bias”, and may help keep investors on their long–term glide path with more durable income streams.
By employing financial and cognitive diversity within an income generative portfolio, Investors may have a higher likelihood of enjoying the benefits the tactical space works so hard to deliver; a systematic approach to increase income, reduce volatility, and loss avoidance.
These thought processes bring up several points to consider when building a tactical component to an income generative allocation. First is asking the right question about an investor’s biggest risks and building out from that point. We think it is essential to start with a needs–based solution focused on minimizing a shortfall of wealth in retirement. This process should have the flexibility to adjust as an investors needs change and/or asset valuations change. At RPg, we think a tactical approach can provide an objective way of seeking to avoid such a shortfall, and can be highly customizable in a way that seeks to solve the right challenge.
Second, we think employing a tactical approach during the accumulation phase and distribution phase is essential in helping investors stay on their necessary glide path seeking to preserve wealth through retirement. By tapping into a collection of intelligence we think investors will come to better conclusions in their fixed income portfolios which in turn should produce better outcomes.
Third, is the alignment of interests. If we define risk in a way that the investor does, and that has an effect of compressing volatility and providing a more durable yield in their portfolios, we think there is a positive chain reaction that begins with a better investment eco–system for the investor.
Important Disclosures:
Risk Paradigm Group, LLC (RPg Asset Management or RPg) is a registered investment advisor with the U.S. Securities and Exchange Commission (SEC). Tactical Allocation Group (TAG) joined Risk Paradigm Group, LLC and became a division of the firm on July 22, 2016. Additional information regarding Risk Paradigm Group, LLC can be found on our website at www.rpgassetmanagement.com. RPg does not provide tax or legal advice. Please consult an independent tax advisor for additional guidance.
This material has been prepared solely for informational purposes and is not to be considered investment advice or a solicitation for investment. Performance provided is past performance. Past performance is not indicative of future results. Investments may increase or decrease in value and are subject to a risk of loss. As with any investment strategy, there is potential for profit as well as the possibility of loss. No representation or warranty is made that any returns indicated will be achieved. Investors should consult their financial advisor before investing.
Any projections, market outlooks, estimates or expectations of future financial or economic performance of the markets in general are forward-looking statements and are based upon certain assumptions and should not be construed as indicative of actual events that will occur. Actual results or events may differ materially from those projected, estimated, assumed or anticipated in any such forward-looking statements. Information contained herein is as of the period indicated and is subject to change. Any views expressed herein are those of the author(s) at the time of writing and are subject to change without notice.
The information contained herein includes information obtained from sources believed to be reliable, but we do not warrant or guarantee the timeliness or accuracy of the information as it has not been independently verified. It is made available on an “as is” basis without warranty.
This material is proprietary and may not be reproduced, transferred or distributed in any form without prior written permission from RPg. RPg reserves the right at any time, and without notice, to change, amend, or cease publication of the information contained herein. RPg may change any exposures and compositions reflected herein at any time and in any manner in response to market conditions or other factors without prior notice.
References to Indexes: The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the equity performance of larger companies in the U.S. Please note that an investor cannot invest directly into an index.
Risk Disclosures: Concentration, volatility, and other risk characteristics of a client’s account also may differ from the information shown herein. There is no guarantee that any client will achieve performance similar to, or better than, the strategy mentioned herein.
Sources: Bloomberg.
For more information, including risks of investing in our strategies, visit our website at www.rpgassetmanagement.com.