3 Steps You Need to Know to Reduce Portfolio Downside Risk
Posted on: 01/09/2018
Contributed by iSectors Chief Investment Officer, Chuck Self
Nine years old! That will be the age of the US equity bull market in March 2018, and what a bull market it has been:
- Not a single year since 2008 has had a negative return.
- Seven of the nine years have had total returns greater than 10%.
- There have been five corrections between 10% and 19% with the largest taking place between April and August of 2011.
No one knows when the bull market will end, but there are signs that should make advisors cautious of the 2018 stock market (according to Paul J. Lim of Fortune):
- The Federal Reserve halted the increase of its balance sheet (quantitative easing) in October 2014. It held the balance sheet steady until October 2017 when it began to pare back its holdings. At the same time, the targeted Federal Fund rate has risen 125 basis point over the past two years. The simultaneous tightening actions of the Fed may not be good for stock prices.
- New Fed Chairs stepping into their role after a long bull market has had missteps historically. Alan Greenspan in 1987 and Ben Bernanke in 2006 both aggressively raised rates, which may have contributed to the subsequent bear markets. Hopefully, Jerome Powell will be more circumspect in 2018.
- There is record amount of debt throughout the US economy. Revolving credit totals $1.021 trillion beating the previous April 2008 record. Student loans have surpassed these levels with almost $1.5 trillion outstanding. Margin debt is at a high of 3.0% of GDP ahead of the 2.8% 2000 mark. And how much debt has been incurred to invest in cryptocurrencies?
Comprehensive Diversification Leads to Downside Risk Reduction
Advisors should not sell all their clients’ stocks hoping that the end of the bull market is at hand. We know the equity market rises over time but very few clients can stomach the volatility of a 100% stock portfolio. Therefore, comprehensive diversification is the key to reducing portfolio downside risk to levels clients can tolerate.
We have previously indicated that diversifying risk within the equity portfolio using a combination of tactical and strategic allocations is a key method for managing equity declines (see “How to Have Thriving Clients in the Next Market Correction”). In this study, we look at diversifying asset classes that advisors should consider in client portfolios. We researched the asset classes that exhibited no correlation to US stocks in 2017 and found that when used in a portfolio, they should significantly reduce downside risk when equity markets decline.
Portfolio Downside Protection Steps
- For taxable bond portfolios, include a heavy dose of municipal bond funds. The client not only receives tax-free income but the returns are non-correlated to the equity market since state and local finances are not significantly affected by corporate health. We recommend a variety of maturities, credit quality, and both passive and active funds (see “How to More Effectively Manage Tax-Free Bond Portfolios.”)
Advisors of tax-exempt investors or clients in low tax brackets may wish to consider taxable bond funds. These are issued by municipalities for purposes that are not specified under IRS tax-free rules. For instance, the interest from bonds issued to cover unfunded pension liabilities are taxable in nature. Also, a special class of taxable municipal securities were issued pursuant to the 2009 American Recovery and Reinvestment Act (“Build America Bonds”) and were backed by the US government. There are mutual funds and ETFs that specialize in these bonds. Be careful when investing in these funds since many of them will close in the coming years given the maturities of the bonds issued.
- Short-term taxable bond funds were also uncorrelated to equities in 2017. Even though the credit risk portion of these funds stem from corporate financial activities, a diversified portfolio will minimize the effect of this risk on total value. Also, the unrelenting search for yield will keep demand for these securities strong. We recommend defined maturity bond ladders and strongly diversified strategies for the most protection (see “Lowering Bond Portfolio Volatility”).
- Finally, all client portfolios must own assets beyond stocks and bonds. Although long-term correlation between the two asset classes have been estimated at between 10% and 20%, in any one year the correlations can be greater than 80% (see “The Stock-Bond Correlation” by PIMCO.) Therefore, advisors should consider commodity funds as a third asset class that is not typically correlated to either stocks or bonds. We recommend a broadly diversified portfolio of hard asset funds including energy, real estate, and timber funds. The other benefit for having a 10% to 20% allocation to these funds is that they tend to perform well in the rising inflation environment we anticipate in the coming years.
As an alternative to creating these comprehensively diversified portfolios themselves, advisors can take advantage of separately managed accounts (SMAs) of these funds available from leading investment managers directly, or on brokerage and third-party platforms. Utilization of these SMAs can often take place at fees lower than mutual funds, increase transparency to advisors and clients, and allows the advisor to spend more time on client servicing and marketing.
iSectors® Allocations to Reduce Downside Risk
iSectors offers solutions to help advisors take these steps to comprehensively diversified portfolios. These solutions include:
- Municipal bonds – The iSectors Tax-Wise Income Allocation is a model portfolio strategically managed for tax sensitive investors seeking income for their portfolio. This SMA Allocation invests in:
- Laddered defined maturity municipal bond exchange-traded funds (ETFs)
- Passive ETFs targeted to specific municipal bond sectors
- Low cost active funds whose goals are to invest in the most attractive tax-exempt securities in a diversified manner
- Short-term fixed income – The iSectors Capital Preservation Allocation has been constructed for investors with a desire for principal stability over a 2-3 year period by creating a portfolio of investments with relatively low volatility. Nominal portfolio yield is a secondary goal of the model. The model targets fixed income ETFs, primarily those that invest in short-term investment-grade debt instruments. A smaller portion of the assets may target ETFs holding short-term high-yield instruments, within the context of limiting duration to approximately 3.0 (or less) while maintaining an overall investment grade rating for the entire portfolio.
- Commodities – iSectors offers two solutions that are extensively invested in commodity funds. The iSectors Inflation Protection Allocation strategic model holds a diversified portfolio of securities that historically have been resistant to inflationary pressures. Security holdings within the model may include precious metals (including gold & silver), real estate, commodities, (including timber, agriculture & energy), emerging market stocks and bonds, and inflation-protected bonds. The iSectors Precious Metals Allocation is intended to offer investors a simple and cost-efficient approach to acquiring a diversified portfolio of precious metals. This allocation model invests in ETFs that hold portfolios of gold, silver, platinum or palladium bullion. This allocation provides for ease of purchase, storage, cost savings, and liquidity when compared to directly acquiring and holding physical precious metals bullion.
If you are a financial advisor that wishes to learn more about effective methods to reducing downside risk, please contact Scott Jones at 800-869-5184 or firstname.lastname@example.org. Alternatively, you may wish to register on our website www.isectors.com to review information on the iSectors Allocations described above.
Individual investors can contact Scott Jones for a referral to a recommended iSectors advisor that can help them determine the best iSectors asset allocation for their portfolios.
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