It’s not just about having a balanced portfolio of stocks and bonds – it’s also about which stocks and bonds are in that portfolio, how they interact and how they’re managed. Read more from James Camp, CFA, Managing Director of Strategic Income, Eagle Asset Management.
Balanced-account portfolios have had their best year-to-date (YTD) return through the first three quarters of the 2019 since 2009, as both equities and fixed income have outperformed their long-term averages. The median balanced portfolio, based on the Callan Total Domestic Balanced database, posted a 14.4% total return in the first three quarters of 2019. The average return over the last 25 years for this database is around 8.8%.
Coincident with this positive performance of both stocks and bonds, complacency appears high in financial markets. One measure of such overconfidence is the size of the net short position in futures contracts on the Volatility Index (i.e., VIX), which measures the volatility of the S&P 500 Index. Market participants are betting, at record levels, that volatility will remain subdued when the VIX is already hovering around its one-year low.
However, we believe investors should remain cautious. It’s important to actively manage exposure in a year during which there have been high correlations between asset classes that have traditionally been uncorrelated (as these asset classes have the potential to return to historical trend). Dislocations in markets can last longer than many would anticipate, leading to a false sense of security. However, when conditions revert back to the mean, it can be a rude awakening for investors who didn’t take proper risk management steps.
It’s said that higher-than-normal returns are often borrowed from the future. Yet fixed income asset flows suggest that many investors are particularly susceptible to poor market timing. Historically, bond flows follow performance, which is counter to long-term performance results. We have seen this play out multiple times during the current expansion as the economy has now experienced three downturns during which the yield on the 10-year U.S. Treasury note has touched 1.5%.
The traditional 60/40 model was effective in a more normal interest rate environment (i.e., when the structure of the bond market was very different from what it is today). We are now in a new age of central bank intervention, rate volatility, and high leverage that must be actively managed on the bond side. Fixed income as a pure yield vehicle at these interest rate levels is challenging. However, the appropriate fixed income allocation remains critical to offset to risk assets in the equity portfolio in a balanced-account strategy. That said, not all bonds behave the same during equity market downturns.
An evaluation of the same Callan database based on the fourth quarter of 2018 (when market volatility surged due to the shift in the macroeconomic backdrop) shows a significant variation between the top- and bottom-performing balanced-account portfolios. The median portfolio held up well (-9.0%) relative to the S&P 500 (-13.5%). However, a portfolio that ranked in the tenth percentile performed significantly better (-3.9%), while a portfolio in the ninetieth percentile performed almost as poorly as just owning all stocks (-12.3%).
Risk mitigation is one of the biggest advantages in active fixed income management. One way to ensure gains are insulated is to shorten the duration of fixed income portfolios. With ultra-short-term U.S. Treasuries now paying nearly the same as longer-term government bonds, active managers can lock in gains, preserve yield, and redeploy (when interest rates move higher and/or corporate-credit spreads widen).
Income investors should also be conscious of the disparity in yields between stocks and bonds given that the yield curve remains generally flat. Corporations can use borrowed money from the bond market to pay shareholders in the form of higher dividends and share buybacks. Yield is only one factor for any investment, but relative value among asset classes should include yield comparisons.
The key to long-term success rests in recognizing that it’s not just about having a balanced portfolio of stocks and bonds. It’s about which stocks and bonds are in that portfolio, how they interact with each other, and whether they are managed through a repeatable process that is mindful of asset class labels, or one that potentially exposes investors to undue volatility by conflating the risks of stocks and bonds in the pursuit of unsustainable yields or returns.
All expressions of opinion reflect the judgment of Eagle Asset Management and are subject to change. Past performance may not be indicative of future results. The performance noted does not include fees and charges which an investor would incur. Asset allocation does not guarantee a profit nor protect against loss. Dividends are not guaranteed and will fluctuate. Eagle Asset Management is an affiliate of Raymond James & Associates, Inc., and Raymond James Financial Services, Inc.