I’ve been thinking a lot lately about portfolio construction, especially for retirees, in these computer-algorithm dominated investment markets which swing wildly every time someone from the Fed speaks. Markets today are unbelievably short-term focused and my clients aren’t paying me to day-trade their retirement portfolios. This means that portfolios which are built with a long-term view (i.e. based on long-term fundamentals, built to manage client-specific risks, etc.) will continue to diverge from short-term dynamics – not necessarily a bad thing, just something to keep in mind. I can say with a lot of confidence that the traditionally structured portfolios are going to disappoint investors over the next decade which means we have to continually adapt portfolios. We’re in an environment that is challenging for all investors but especially so for income oriented retirees with interest rates and yields so low. I’ve been making two transitions within portfolios that I wanted to bring to your attention. The first is a change I’ve slowly been making overt time to the structure of our “Income” allocation and the second is how I plan to hedge volatility/stock risk.
1. Adjusting our “Income” Allocation
When I sit down with a client to do a review, the first thing we look at it is their financial plan to make sure they’re still on track to reach their goals and to see if we need to make any changes to their portfolio allocation. This means that we track our performance against their plan, not some arbitrary benchmark like the market, tailor their portfolio to their plan, and let it (not the market) dictate when major allocation changes need to be made.
In terms of retirement planning, perhaps the biggest risk that people tend to underestimate is the impact of inflation over time. For retirees, some of the bigger expenses include food, healthcare and discretionary spending. We’ve seen the biggest increases in the cost of healthcare recently (with no signs of slowing…) while utilities, the cost of energy/gas and consumer tech products have been relatively flat or even falling in cost. For example, an iPhone or computer might cost the same as it did 5 years ago but think about how much more you get for your money today. Food has been somewhere in the middle.
Back in the good old days when one used to be able to earn some interest on bonds, an investor could ladder bonds to essentially keep pace with inflation and stagger the maturity of each bond to come due when they needed the money for their spending (set maturities at every 6 or 12 months). But the Fed took away this option by driving interest rates to the floor so investors have had to turn to other assets to produce income to cover spending, a popular option being dividend paying stocks.
The Fed’s main goal for all that Quantitative Easing (QE) the past few years was to inflate asset prices by forcing investment money down the risk spectrum, away from safer bonds by suppressing interest rates, into higher risk investments like junk bonds and stocks. They wildly succeeded on that one… but past performance is not indicative of future results. A few years back, it made sense to go along with the Fed and shift money away from bonds into higher yielding, dividend paying stocks. But after years of stock prices outpacing earnings growth, meaning these stocks are now trading at more expensive valuations, I have my hesitations about this investment thesis. Basically, I don’t think the reward potential is worth the risk at this point as an alternative for high quality bonds. But if bonds are paying paltry interest rates (many below inflation), what are we to do?
The way I am approaching portfolio construction more often these days is to look at a clients spending and try to match their investment assets accordingly by category. For example, if food makes up 20% of your annual spending then maybe 20% of your investment portfolio should be related to companies in the food and agricultural industries. That way if food prices rise, the companies in which you’re invested should benefit leading to higher profits/dividends that will offset your higher grocery and restaurant bills. The same goes for healthcare, insurance, auto expenses, consumer goods, utilities, etc. This means we’ll still need to focus somewhat on stocks for income, but we’re being very selective and only taking the additional risk where it makes sense based on their lifestyle. My goal remains to focus on stability and income as much as possible, but this ultimately means that some investments might have more of a “total return” orientation that should mimic changes in annual spending. I currently have my eye on a new stock investment that perfectly fits this approach so I’ll write a post after buying it to discuss further.
2. Adjusting How We Hedge Volatility & Stock Risk
I’m intending to change the way we hedge risk in our “Growth” allocation. We currently own put options on the S&P 500 which act as insurance against a falling stock market. However, I’m starting to realize that there’s a superior way to approach this and that’s through rising volatility. I said early last year that the one thing I was absolutely confident in was that we were going to begin seeing more volatility in the investment markets (see here and here). When it comes to stocks, there is a volatility index (the VIX) that measures investor’s expected volatility on the S&P 500 over the next 30 days. When stocks fall, the VIX rises, expressing higher expected volatility (as shown in the chart below). The way we’re currently hedging only benefits if stocks fall. If we use shorter term hedges through exposure to the VIX though, we’ll benefit if volatility rises, which would happen if stocks fall OR could also occur simply if stocks are choppy – as we have seen for the past 6 months.
S&P 500 (black) vs VIX (blue) – 1 year
To summarize, put options on the S&P 500 do us no good if stocks are volatile but ultimately finish where they started. Whereas, we’ll benefit by betting on rising volatility as long as volatility increases, whether that means stocks fall or simply are choppy. I’m making this change because each time stocks start to fall, the Fed comes out and “talks” the market back up by expressing economic concerns and implying that they won’t tighten monetary policy. You may be wondering why we’re even hedging in the first place then. There are two reasons. First, we utilize a rules-based system that has been backtested over the past 150 years to tell us when it’s worth hedging (and it says to be now). Second, the Fed has a fantastic track record of their meddling coming back to bite them you know where (you can’t manipulate free markets without unintended consequences). However, as long as the stock market still holds the belief in Fed omnipotence, conceptually it doesn’t make sense to hedge against falling stocks. Typically one would compare the cost of S&P put options to VIX call options and go with the cheaper route, but hedging through rising volatility appears to be the superior hedging metric for the time being regardless of cost.
Nick
Thanks. very informative.
Good to hear! Thanks, Frank.