Are You Spooked?

Tesla (TSLA) may go down in history as the best performing large cap stock ever for its phenomenal performance over the last two years.  From December 31, 2019 through today, Tesla has gone from $83.67 (adjusted stock price) to $1,033.77, an unheard of total return of +1,136% being literally off-the-chart compared to the S&P 500 up +42% (the relatively flat blue line; see below)!  My reason for pointing this out is that there continues to be lots of doubt in the resiliency of these equity markets as we continue to climb a “wall of worry” to new heights.

Tesla is the significant outlier here, of course, but other stocks and broad indices have managed to capture investor interest with new recent all-time highs for the S&P 500 (large cap) and Russell 2000 (small cap) indices.  If stocks keep testing new highs, what is there to worry about?  Plenty, it seems!

In the aftermath of the COVID pandemic, a laundry list of economic issues persists.  The list includes worries about inflation (and hyperinflation) from unending fiscal stimulus to prop up impacted businesses and individuals and an easy-money Fed keeping the spigots open.  Other economic concerns include slower economic growth than potential due to supply chain shocks keeping businesses from fulfilling orders; especially in light of an economy with plenty of pent-up demand due to the COVID slowdowns.  Also, there still is festering unemployment amongst the economic sectors still fighting to recover fully.

On the other side of the coin, why should we take this all in stride and stay the course?  We could go on and on about productivity gains due to technical innovation, comparative advantage of a global economy, and new entrepreneurial ventures creating new economic paradigms, but the answer could be much simpler.  Simply, no matter how bad it ever gets, things have always gotten better.  The book “The Rational Optimist”, by Matt Ridley, discusses in depth the historical precedence that no matter how bad things get, they always have gotten better; we just need to be patient and have a long enough time horizon!

As readers of this blog well know, no one can call the market and our view is that a long-term strategic investment strategy developed to achieve your goals is the best approach.  If you have a long time horizon and income/net worth sufficient to support your needs and wants, stay in the market and wait it out.  If not, we can develop a strategy that recognizes the risks and positions you for a high probability of success.

Back to the Future

Often times, it is good to look back at what your thinking was to see how it turned out.  Last year on October 15, 2020, I wrote a blog post titled, “Where Do We Go From Here?”, that reviewed market thoughts and outlooks put out by Wellington Management.  At that time, we stated that “This all sounds very logical and reasonable to me and consistent with a long-term strategic approach that captures the broad trends in the economy and the capital markets”.  Let’s see what they said and how it all worked out!

Wellington Management is a well-respected Boston-based investment management firm with $1.6 trillion (trillion with a “T”) assets under management.  Their write-up last year focused on the COVID-19 situation, potential for another shutdown, and fiscal and monetary supports.  In summary, they felt the economic and capital market situation favored overweights in U.S. growth equities and U.S. corporate and high yield bonds with underweights in U.S. value stocks, international and emerging market equities, and U.S. Treasuries.

Per the table below, you can see that U.S. growth equities, indeed, did perform exceptionally well, but U.S. value stocks beat them out by a bit.  Likewise, international and emerging market equites performed well, but not to the level of U.S. value stocks.  In the bond space, it was easy to call for weakness in U.S. Treasury returns given the historic low level of yields and simple bond math; something that D&A has been reporting for quite some time.  Adding a bit of credit spread to bond holdings adds some return while reducing overall portfolio risk.

Though D&A is a believer in long-term strategic investing with a mostly passive approach, it is often appropriate to shift long term targets to reflect underlying shifts in the environment.  Such is the case with an underweight to U.S. Treasury bonds where the simple bond math indicates that forecast total returns are likely to be weak compared to historical returns over the near to medium term.  In equities, however, bets between value and growth and international exposures are less likely to be predictable and are not something to which we manage.  For most client accounts, we are currently overweight to equities in all equity classes and underweight in U.S. treasury bonds to reflect this long term strategic view.

Q3 Reversal of Fortune

Despite the pickup in volatility and marked weakness during the end of September, Q3 showed some continuation of the capital markets embracing the “re-opening” economy.  A dovish Fed (despite some hawkish rumblings) mixed with more fiscal stimulus in the pipeline is a recipe for healthy equity markets. The uptick in rates started to put pressure on stock valuations, but with bonds still offering almost no yield and almost no upside, stocks continued to be the only place in town to deploy new capital.

The rotation we observed early in the year from core equity to diversifying positions notably reversed during Q3 with large cap blend equities (IVV) regaining the crown as top equity asset class up a bit at +0.59% during Q3 (see table below).   Diversifying equities that lagged were small cap (SCHA, -3.64%), mid cap (SCHM, -1.70%), REITs (SCHH, +0.23%), developed international (SCHF, -1.90%), and especially emerging market equities (SCHE, -7.30%).   Mathematically, bonds delivered on their promise for low yields and low returns with relatively low risk during Q3 with core bonds (SCHZ) offering only -0.10% return.  Bonds with some credit spread like investment grade corporates (LQD, -0.45%) and high yield bonds (HYG, +0.34%) offered comparable return during Q3.

 It is not “market timing,” but simply arithmetic that bonds will be a drag on portfolio total returns with yields still near historic lows.  For client accounts that can tolerate a bit more risk, we are targeting at least a 5% underweight to bonds.  As I said in my January 3, 2021 blog post, “2020 Q4: Reversion to Mean?”, core bonds do not look like a good place to be in 2021:

“…core bonds delivering as much return as it could in the first part of the year [2020]; mathematically, with rates so low there is almost no potential return left in the U.S. Treasury market.  …we should not expect much return in 2021 from these holdings.”

Lump Sum vs. Pension Payments?

Lots of times, we get buried in the weeds of analysis and lose sight of the main objective.  A good case in point is the lump sum versus pension payout decision.  If you are lucky enough to work for an organization that offers a pension plan, when you retire you might be asked to decide if you want a stream of payments over a set period of time or until you or your spouse die, or a lump sum all delivered today; or some combination of these choices!  There are plenty of quantitative approaches to help get to the “right” answer for YOU, but it is best to start at the top and then drill down.   Following is the thought process we use at Dattilio & Ash.

Taking a pension as a stream of payments is a valuable benefit for some people.  It removes your responsibility to manage investment risk and provides “guaranteed” payments over a set time frame, either until you or your spouse die or over another set time frame.  The guarantee is only as good as the pension sponsor’s ability to manage the plan effectively, however, but even if they run into trouble there is a federal guarantee program to help backstop their guarantee. 

Sounds good so far, but there are some negatives.  The actuaries determine your pension payout based on your life expectancy; live longer and economically you are a winner, die early and you lose since you only get payments shorter than expected!  Embedded in your pension payment, in addition to other expenses, is this mortality charge that helps set your payment.  Another negative is that most pension plans offer only “fixed” payments and do not include adjustments for inflation (the notable exception is Social Security!)

So, how do you decide what is best for you?  First thing is to recognize your current and expected financial situation.  Since pension payments are calculated assuming some level of mortality risk and other expenses, if you can “self-insure” this risk you are saving economic value for yourself.  The key determinant to help decide if you can self-insure is your amount of liquid investments.  If you are fortunate enough to have accumulated a large investment portfolio that is materially sufficient to cover all your expenses and goals during your retirement years, you likely do NOT need to pay the expenses embedded in pension payments and can instead use your investment portfolio to replicate pension payments customized to your specific needs.

Here is a case study with real numbers to show how this works.  Let’s assume that you have the option of receiving either a $350k lump sum or $25k per year until you die.  Which do you choose?

First thing is to calculate a simplistic break-even point; the point where the sum of all payments equates to the lump sum, assuming some net investment rate.  Embedded in this pension payment is a 0% interest rate that results in a break-even point of 14 years ($350k/$25k); live longer than 14 years and you win, shorter and you lose.  Another way to look at this is to evaluate if you think you could earn more than a 0% net investment rate over the next 14 year.  Though there are no guarantees, I can pretty much assure you that the capital markets will net return more than 0% over the next 14 years.    

So, if you have the capability to self-insure investment risk and mortality risk, taking the lump sum is an economically preferable solution.  Alternatively, if you need (or want?) the benefit of a guaranteed payment into the future, then the pension payment is the right solution for you.  At Dattilio & Ash we can help you go through the decision process to get to the right decision for you.

Catch-up Time

The last twelve months have been chaotic with pandemic ups and downs, political drama, and mostly normal market volatility.  The S&P 500 Index, the index of large cap equities in the U.S., gets most of the attention from the popular press and has certainly been on a tear since the large drawdown at the outset of the pandemic back in March 2020.  But, what about all the other major asset classes like small- and mid-cap stocks, real estate investment trusts, international developed and emerging market equities, not to mention the sub classes in the bond market?  Here’s how they did!

A well-diversified portfolio needs a mix of stocks and bonds that complement each other and have some correlations that offset or are at least less than perfectly correlated.  This allows your portfolio to diversify its exposure to capture some of the gains from other asset classes that rally while the S&P 500 may pause.  This is the case we have seen over the past twelve months!

Per the chart below, it is interesting to note that the S&P 500 (VOO, the medium blue line near the middle) grew from a $10,000 investment on September 30, 2020 to $13,491 on August 31, 2021, a +34.9% gain!  However, that large total return is NOT from the best performing asset class.  Over the last twelve months ended August 31, 2021, the top performing major asset class is small cap equities (SCHA, the dark blue line at the top of the chart) that is up to $15,173, a +51.7% gain!  Also besting the S&P 500 are large cap, high dividend value-focused equities (DVY, the dark green line) up +45.8%, mid cap equities (SCHM, the yellow line) up +44.2%, an active computer-assisted strategy (AIEQ, the pale orange line) up +39.9%, and real estate investment trusts (VNQ, the dark orange line) up +37.5%.  International and emerging market equities continue to trail the U.S. markets and have room to grow.

We have seen the same kind of diversifying exposure performance from the bond market.   Core bonds, mostly defined by the Bloomberg Barclays Aggregate Bond Index (AGG, the light gray line at the very bottom), produced a total return of -1.7%, not unexpected given the historic low level of rates we have seen over the past year.  Other diversifying fixed income sub-asset classes did better such as preferred stocks (PFF, the brown line) at +8.1%, high yield bonds (HYG, the navy blue line) at +5.0%, and bank loans (BKLN, the pale blue line) at +1.8%.

Every market is different and there are a lot of extenuating circumstance underlying this particular market checkpoint.  Most importantly, this is a short time horizon after a major market dislocation, so a lot of the excess returns shown over the last year simply show a “catch-up” from an oversold position during the height of the pandemic.  But, we always believe that being properly diversified consistent with your risk tolerance will produce higher risk-adjusted returns and make you better able to achieve your financial goals.  

Should I Go All In?

In February 2020, I wrote a blog post about how to invest a lump sum of new cash into the market, either Invest All at Once, or Over Time? There are pros and cons to either strategy, and I discussed dollar-cost averaging as a “lower risk” approach to avoid market timing and the potential loss if invested at an inopportune time. Of course, the results you get are “scenario-dependent” and if the market keeps going up during the dollar-cost averaging period this could turn out to be a losing proposition. Let’s look at a real life case study of a client who recently put a large sum into their account and how it worked out!

The client had “new” cash available that they were ready to invest and had an approved long term strategy in place. Because the new cash was a large percentage of their total net worth and was part of their retirement funds, we decided that a dollar-cost averaging approach was an appropriate strategy. This would add risk to their overall portfolio slowly and avoid the potential of mis-timing the market. This is NOT a market timing exercise but instead is intended to smooth performance by avoiding market timing.

We started putting the funds to work on July 26, 2021; in hindsight, a period of time where the S&P 500 kept plodding higher. The total proceeds were invested into a diversified portfolio of stocks and bonds, however, so during this time some new positions did better and some did worse.

As you can see from the chart below, this dollar-cost averaging approach achieved its goal. The Joint Taxable (JT) account grew from $10,000 to $10,150, almost exactly the same as its benchmark, the iShares Core Growth ETF (AOR), if it was invested all at once on July 26. As it turned out, the overall risk for both approaches over this short time horizon was about the same, but it could have been much different. Most notably, the dollar-cost averaging approach avoided putting all the funds to work at some recent high points on August 13 or August 27 that would have diminished it performance. Alternatively, we did miss some low points on August 19 that would have improved performance. But this is the point, no one knows!

So, luckily there was no market downturn to avoid during this short time period and the new funds were invested neutral to its benchmark. At Dattilio & Ash we look at both risk and return and strive to manage all aspects of your investment needs in a prudent manner as we manage your portfolios to help achieve your goals.

Keep or Sell?

I was faced with an interesting challenge earlier this year by a client who received a gift of Amazon Inc. stock shares.  The question, of course, was what to do with them?  Keep them or sell them and reinvest into a diversified portfolio of something else?  Tough decision since Amazon shares had been on a tear with some hugely positive momentum; up an amazing +76% during 2020!

The first step in the decision process was to confirm the client’s risk profile and overall financial situation.  The youngish client had a capacity for risk and certainly could handle the risk of a single-stock portfolio, but the Amazon shares made up about 50% of her net worth.  Should she take the risk?

This is where we get into “idiosyncratic” risk, the risk specific to an individual stock that cannot be eliminated but can only be reduced by holding that stock in a diversified portfolio.  Though Amazon certainly has proven itself to be a “great company” through its tremendous growth, product/service mix and service model, that does not mean it is a “great stock”.  A growth stock that is “overpriced” with an intrinsically high level of risk and no potential for the same level of future appreciation is not a great stock.  No one knows, of course, how Amazon will do in the future.

After careful discussion, the client and I decided to sell the Amazon shares on March 10, 2021 and buy a mostly passive globally-diversified exchange-traded fund (ETF) with an aggressive risk profile, the iShares Core Aggressive Allocation ETF (AOA); an ETF with an 80% equity weighting and 20% fixed income weighting.   A review of the risk profiles of these two investments showed that AMZN shares had a historical risk profile more than double that of AOA!

As you can see in the chart below, there were some tense moments over the past five months; AMZN (the blue line) took some big leaps during April and July but came crashing back down in August such that the AOA investment (the red line) is now outperforming AMZN over that time horizon, +9.06% versus +7.92%.

No telling if Amazon stock will find its way back to extraordinary performance, and the short time horizon and impact of end-period bias makes this analysis inconclusive, but for now my client can rest assured that her diversified investment in AOA will help lead her to a more balanced path of growth to help achieve her goals.

The Social Security Conundrum

Social Security benefits are a great source of financial support for most Americans as they enter retirement.  I like to think of social security as one leg in a three-legged stool to support retirement including a company pension and savings in taxable and tax-deferred accounts.  After years of contributions, it is heartening to see the benefits start to come in!

If you haven’t checked your Social Security benefits summary recently, you should register online and take a look at it.  There is lots of talk about the newly designed “personalized” Social Security benefits materials.  The new design highlights the benefits of delaying receiving payments personalized for you in an easy-to-understand graphical format!  Following is a generic table highlighting this info (https://www.ssa.gov/pubs/EN-05-10147.pdf).  As you can see, for each year you delay your benefits the benefit amount increases by about 8%.

So, how do you decide when to take the benefit?  Most all academics in the financial planning field say that the economics of the claiming benefits strategy always favors delaying as long as possible to earn the extra 8% per year of benefit increase.  This is based of large population samples and broad averages, so this is not the answer for everyone, especially if you don’t live a long life consistent with broad actuarial tables.

One way to help make the decision is to think about the “break even point”, the point in time that the cumulative benefits for a strategy surpass the as-soon-as-possible strategy.  It helps to determine the age after which delaying benefits would lead to an increase in total lifetime benefits.

There are many financial calculators that can help calculate the break-even point and Dattilio & Ash uses the holistic approach employed by the MoneyGuidePro investment planning model.  The benefit of this model is that it integrates the social security claiming strategy with your total financial profile including projected retirement expenses, income and invested assets to ultimately calculate an overall “probability of success,” the probability that you will have enough assets and income to get you to your end of plan.

Per the chart from MoneyGuidePro below, you can see all the potential social security claiming strategies for our fictional couple who are currently working.  They both expect to claim close to the maximum amounts but need to think about when to start claiming within the context of their total financial situation.

As expected, the model shows that the maximum lifetime benefit tops out at scenario 5 at $2.083 million if they both delay claiming until they both reach age 70 (the age where increased benefits stop accruing).  The MoneyGuidePro model also shows that integrating this strategy with their overall financial profile results in an 85% probability of success, a very good result.  The Break Even Point is also heartening since this means that the couple only needs to live to ages 76 and 75, well below the current average life expectancy of about 80 years (depending upon how it is defined), whereby all benefit payments after that age are a net increase in lifetime benefits.

Also as expected, claiming as early as possible at age 62 in scenario 2 produced the worst lifetime benefit of $1.445 million and only a 53% probability of success for their plan, not a good result.  If the couple didn’t want to wait until age 70 for whatever reason, waiting to full retirement age (FRA) at about age 67 in scenario 4 would give a reasonably good result of $1.890 million in lifetime benefits and a 76% probability of success, a good result.

So, there are decisions to be made based on both a quantitative and qualitative approach and there is no “right” answer for everyone.  Arguably, if you don’t need the benefits to pay retirement living expenses and expect to live past the break even point, the answer to delay until age 70 is easy.  But if you need the benefits to pay retirement expenses, calculating the Break Even Point, total lifetime benefit, and probability of success give you the numbers to evaluate within the context of your expected life expectancy and comfort with a calculated probability of success.

A Bumpy Ride!

Hang on, kid.  It’s gonna be a bumpy ride, but I finally know where I’m taking you!

The Disney+ Star Wars spinoff, The Mandalorian, has gotten rave reviews by the critics and has done a good job keeping the saga alive.  In it, the Mandalorian finds himself in a position to save (and save, again!) the Baby Yoda character from danger and finally to deliver him to a safe homeland.  The cliffhanger of season 2 has the Mandalorian tell Baby Yoda the above quote.  Season 3 of the series (still in production) deals with the continuing journey to get him to his final destination.

This saga is not unlike the journey we all take to get to our desired retirement!  We all want to arrive safely, but aren’t necessarily sure where we are going or how to safely get there!  Finding our way, as in The Mandalorian, requires us to avoid pitfalls that could steer us off course and to continually seek the right path to get there.

One critical misstep in your journey is to manage to an asset mix that is inconsistent with your risk capacity and risk tolerance.

The academic work on the impact of asset mix selection on long term total return is clear:  though riskier, a larger allocation to equities will produce a higher total return.  The challenge is to balance the risk of an asset mix against the potential return.

As seen from the table below, per the Dow Jones Relative Risk Index Series, moving from a Conservative Strategy to a Moderately Conservative Strategy results in a pickup of 2.35% in annualized total return over the 10-year horizon ended on June 30, 2021.  Granted, this data table just shows one snapshot in time for a specific 10-year period and MANY forecasters are saying projected returns will be MUCH lower than historical returns from today, but the message is clear: a larger equity content shows a higher total return with more risk.

Translated to news you can use, if you have a long-term time horizon (greater than 10 years) you likely have a “capacity” to accept more risk and, consequently, earn more return.  However, you also need to have a risk “tolerance” that matches your risk “capacity”!  If you would not be comfortable with periodic drawdowns in your portfolio that are a normal part of the capital markets, then a lower risk strategy would be more appropriate for you with the corresponding lower expected total returns.

"Bob-a-longs"

When I was in high school, I was a self-professed “journalist” taking sports pictures and writing an occasional article for my local newspaper (I was also co-editor-in-chief of my high school newspaper, too, but that is a different story!)  The editor of that local newspaper was Robert A. Long and he wrote a weekly column titled “Bob-a-longs”; a word that usually means to proceed in a disorganized way, but a clever self-deprecating play on his own name for a newspaper column!

Consequently, instead of writing a full-fledged column, he would simply list blurbs that he thought were interesting.  So, in honor of Robert A. Long, here is my investment version of Bob-a-longs; somewhat unrelated things that caught my attention over the past few weeks that bear mentioning.

• Every time the equity markets hit an all-time high, there is always someone who comes out with a forecast for a correction.  Of course, occasionally one of those forecasts will be correct making that prognosticator a “market expert.”  Don’t believe it!

• Exchange-traded funds (ETFs) are wonderful vehicles and are the most efficient and inexpensive way to own broad (and narrow) slices of the markets.  However, some ETFs are both inefficient and expensive, so beware!  An often-overlooked aspect of the ETF vehicle is the bid/ask spread, i.e., the difference between what you buy and sell an ETF for.  For long-term buy-and-hold accounts, this cost can be amortized over a long time horizon so can be minimal, but for actively traded accounts using thinly traded ETFs, this cost can become quite large.

• Many employees of high-flying tech companies are fortunate to receive shares of company stock in either outright grants/options or at a discount to market price.  Some of these stock perks can be large to start with, but add in some tremendous market appreciation and you have the makings of a pretty nice investment portfolio, albeit hyper-focused in one name!  It always depends, but I usually recommend a conservative 20% cap on exposure to the stock of the company you work for.  The road is littered with high-flying tech companies that hit the skids; I know it can’t happen to you, but just think about shareholders/retirees with positions in GE who saw huge volatility and huge writedowns in their market value.

• When I meet someone new in a social setting and they ask what I do, I tell them I manage investments.  Invariably, they then ask me to recommend a good investment.  Of course, without knowing their financial situation there is no way I could recommend any one investment or even any single strategy.  I could easily say that international and emerging market equities are historically “cheap” relative to U.S. equities, but those asset classes are also “risky” investments.  I could also say that U.S. Treasuries are historically “rich” and probably not a good buy unless you need absolutely “guaranteed” return of principal at some future date.  Then there are lots of things in the middle! It really does “depend”.

A Balanced Bullish Q2

As I reported at the end of 2021 Q1, the financial effects of the global pandemic started to ease with many signs of a recovery.  This trend continued into Q2 as the CNN and Moody’s Analytics “Back-to-Normal” Index currently indicates a value of 94% (from 86% at the end of Q1) representing more progress to a complete financial recovery.  Since this an aggregate measure of financial health, however, some of the indicators and individual U.S. states are not at the same strong level so more targeted work is needed for a complete recovery.  Certainly, continued strong fiscal stimulus and infrastructure spending programs combined with an accommodative Fed (despite recent hawkish comments) are in place to support the continued rebound.

I used the term “resiliency” last quarter to describe the markets and that term is apropos again as the markets continue to rebound from bouts of short-lived panic to scale higher.  As seen from the table below, the S&P 500 (IVV) added to its strong 6.33% Q1 return with another 8.38% return during Q2 to produce a year-to-date return of 15.24%.  Also, while not besting the S&P 500, other diversifying asset classes like small- and mid-cap equities (SCHA and SCHM) kept pace with returns of 4.75% and 5.43%, respectively.  Not to be outdone, however, is the real estate investment trust (REIT) asset class with another strong quarter of 11.93% Q2 return working to recover from its negative return during 2020.

Notably, large cap high dividend value stocks (DVY), representing a “re-opening” market view, also kept pace with the broad market indices with a Q2 return of 3.05%, which when combined with its Q1 return continues to lead all the major asset classes with a year-to-date return of 23.29%.  Meanwhile, other global markets including international developed and emerging market equities (SCHF and SCHE) were likewise strong at 5.77% and 4.10%, respectively.

Bond markets, coming off weakness in Q1, maintained their low return profile producing modest Q2 returns.  Broad core bonds (SCHZ) generated returns of 1.76% during Q2 while investment grade corporates were stronger at 3.92%.  High yield bonds (HYG) were in the middle of the pack during Q2 with a +2.01% return but bested all fixed income on a YTD basis with a total return of +2.60%.

As the equity markets seek new highs and bonds come off record low interest rates, return prospects for the future are cloudy, so caution prevails.  In fact, as I reported in my May 6 blog post, Got Risk?:

But nothing is forever, and we need to be cautious.  Some forecasting models, like the one at Research Affiliates, have much lower expectations for future returns due to the poor return prospects for fixed income assets and the historically high valuations for equities; this firm forecasts only a 2.1% nominal return over the next 10 years for a 60/40 portfolio!

The REIT Story

Everyone is abuzz about inflation!  And why not?  With out-of-control fiscal spending and perpetual easy money from the Fed it seems like hyperinflation is the only possible result.  However, aside from the “transitory” blips in inflation that we have seen as we emerge from the depths of the global pandemic, we have not seen anything that appears to be long-lasting.

So, whether we see inflation or not, we must be diversified to protect ourselves from it since a decline in purchasing power over time is a certain way to ruin a retirement!  One of the ways to hedge your inflation risk is to own assets that are positively correlated with inflation.  Academic studies continue to show that equities, including the real estate asset class structured as real estate investment trusts (REITs), are a good hedge against inflation.

The simplest way to get exposure to the REIT asset class is through the exchange-traded fund (ETF) vehicle.  There are many low-cost, passively-managed REIT ETFs that have provided relatively high income, strong historical returns, and low correlation/good diversification to other equity types.  The top five REIT ETFs by assets under management are Vanguard Real Estate Index (VNQ, $40.1B), Schwab U.S. REIT (SCHH, $5.8B), iShares U.S. Real Estate (IYR, $4.8B), Real Estate Select Sector SPDR (XLRE, $3.0B), and iShares Core U.S. REIT (USRT, $2.0B). 

As seen from the chart below, so far in 2021 investment performance has been very good with them all clustered towards the top of the performance chart with 20%+ returns easily outpacing the S&P 500 (IVV, the green line at the bottom) after lagging last year with pandemic-induced negative returns.  No one knows if real estate will be forever damaged from the pandemic, but performance so far this year does offer some comfort.

Being passively-managed, the REIT ETFs all follow a published index and strive to replicate the index performance, less the management fee.  The ETF sponsors all use indices from the major index providers like MSCI, FTSE, and Dow Jones/S&P.  Interestingly, the indices all look relatively similar with the main differences being the level of diversification, the individual REIT weighting approach, and number of holdings.

For example, the Vanguard ETF (VNQ), the largest at $40.1 billion, restricts the sum of the weights of all issuers representing more than 5% of the fund to not exceed 50% of the fund’s total assets whereas the Schwab ETF (SCHH) restricts the sum of the weights of all issuers representing more than 4.5% of the fund to not exceed 22.5% of the fund’s total assets; quite a difference in approach with neither one necessarily being better or worse.  No one knows in advance which indexing approach will be the top performer over any market cycle, so best to select one and stick with it.

All these ETFs are low-cost with investment management fees less than 12 basis points (0.12%), except IYR that is at 42 basis points (0.42%).

There are other asset classes that also provide a good inflation hedge including gold, commodities, and other common stocks, but none of those provides the extra benefit of the REIT asset class with relatively high cash income that can be used to pay living expenses in retirement or reinvest/rebalance into the fund over time.

Rotation Elation!

Here we go!  The “re-opening” economy seems to be getting into high gear!  Some mega cap tech stock darlings from last year are lagging this year while traditional brick-and-mortar plays are leading the pack.  Nowhere is that more fully seen than in the dramatic shift in the holdings of the iShares Momentum ETF (MTUM)!

As you may recall from my previous blog post last September (OMG, MTUM!, https://www.dattilioash.com/our-blog/2020/9/2/omg-mtum), MTUM is a factor-type investment focused on large- and mid-cap US equities that show relatively higher momentum characteristics.  Momentum is broadly defined as a calculation of “excess return” compared to other equities in its universe.  So, this ETF simply buys stocks that have recently outperformed other stocks, rebalanced semiannually.  And, who wouldn’t want to buy investments that have performed well?  This is part of the behavioral bias on why academics show that the momentum factor over time outperforms investments that don’t exhibit positive momentum.

The MTUM ETF turned in phenomenal performance in 2020 with a +29.85% total return compared to the S&P 500 return of +18.4%.  So far in 2021, however, it has lagged the S&P 500’s YTD return of +12.7% with its mediocre +5.70% return; ostensibly since MTUM’s holdings have not yet been rebalanced to reflect the transition of the equity market leadership to the re-opening economy.  During MTUM’s semiannual rebalance cycle that just ended, we can see some dramatic shifts in holdings to boot holdings that have lagged the market and insert holdings leading the re-opening rally.

Kicked out are household tech names like Apple, Microsoft, and Amazon replaced with other household names like JP Morgan, Berkshire Hathaway, Disney, and Bank of America; totaling an 18.5% shift in portfolio allocation worth $2.7 billion (see chart below for chart of relative performance of the leaders compared to S&P 500 (IVV))!  Sticking around during this rebalance cycle are stocks like Tesla, Paypal, and Alphabet.

The trouble with a strategy like this, of course, is that it depends mostly on the stocks with positive momentum continuing their upward trend; generally considered the major weakness seen in momentum strategies.  A reversal in the current leadership would result in a “whipsaw” effect of “buying high and selling low”, not a good thing. Long term commitment to strategies like this, however, have been shown to outperform despite the risks.

A Time for Bonds?

Views on my blog posts have picked up recently, so I checked to see which topics seem to be the most popular.  To my surprise, my recent posts on bond credit spreads have gotten the most “hits”!  So, in honor of that result, here is an update on how credit spreads have trended recently and how that impacts my views on long term strategic investing.

Per the chart below, it is clear to see that credit spreads (red and blue lines) have normalized to flat-line over the past few months in the face of generally rising rates (green line).  This is in no doubt due to significant pricing support from the Fed through bond ETF purchases and other actions.  Through April 30, 2021 the Fed holds $8.6 billion of bond ETFs in the investment grade and high yield sectors (source: federalreserve.gov) including $2.3 billion of iShares IBOXX Inv Grade Credit (LQD) and about $1 billion in iShares IBOXX High Yield (HYG) and SPDR High Yield (JNK).

As of today, 10-year Treasuries yield a modest 1.64% with corporate investment grade credits yielding 2.56% (+0.92% spread) and high yield corporates yielding 5.04% (+3.40% spread).  Unlike late last year with 10-year rates in the 0.70% range, these higher yield levels offer a better entry point into bonds and provide a better, but not necessarily meaningful, alternative to equities.

The best way to handle this market dynamic is to opportunistically rebalance outsized equity market gains back into bonds consistent with long term strategic asset allocation targets that are meant to help an investor achieve their goals.  In this way, you will be selling equities “high” and buying bonds “low” after the recent rise in rates.  Of course, if rates trend higher from here, there is the potential for bond values to erode further, but there is also the added benefit from the higher “carry” from the higher yield to offset that erosion plus preserving the equity market gains with lower risk fixed income holdings.

Mortgage or Pay Cash?

Oftentimes, couples heading into retirement either trade up to their dream house or put a sizable amount of cash into their existing house to celebrate their retirement.  Should you finance it with a mortgage or pay cash?  Aside from the qualitative aspects such as the comfort knowing that a cash transaction eases the stress of required cash flow payments to fund the liability on the property, what are the quantitative aspects to consider?

At Dattilio & Ash, we use the quantitative software package MoneyGuidePro to help us answer this question.  The software allows us to look at the situation holistically with a full financial profile of the situation including expected expenses and income during retirement plus all invested assets and then run an investment scenario test to calculate the “probability of success”.

Our hypothetical couple is a husband and wife, both 66, who just retired.  They are both in good health and plan that they will live to an average life span of 92 years for the husband and 94 years for the wife. 

They live a simple lifestyle and expect to spend about $7k per month on basic expenses plus another $10k per year on Medicare/health expenses.  They also plan to spend $15k per year on travel for the next 15 years.  This totals about $109k of expenses in the first year, not including the model’s 2.25% inflation rate each year.  For income, they do not have a pension but do have close to a maximum social security benefit of about $35k per year each totaling about $70k income each year. This translates to a deficit each year of about $39k per year.

But, not to fear!  The couple did a good job saving during their working years and have accumulated about $1.5 million in assets for retirement including a $1 million IRA between them and $500k in taxable accounts that includes $225k in cash.  Invested assets are managed to a moderate risk profile including 60% equities and 40% bonds.

When we run this situation through the model with 1,000 different investment scenarios, the results are very positive with a 94% probability of success, i.e., there will be enough cash flow and investments to fund all expenses through to the “end of plan”.  So, despite the negative cash flow of about $40k each year, the invested assets are invested appropriately with the right risk profile to fund all cash flow needs. 

But what about the major $200k kitchen and master bath renovation they wanted to add to their house?  Should they reduce their cash holdings to pay for it with cash or take out a home equity loan and fund it over 15 years?  Let us simply add in a new cash expense of $200k in the first year or a 15-year mortgage of $1,500 per month to see how it shapes up!

When we add a 15-year mortgage with a 4% interest rate at $1,477 per month, the probability of success decreases from 94% to 79%; still a good result but maybe lower than a preferred answer.  On the other hand, paying $200k cash for the major renovation only lowers the probability of success from 94% to a better solution of 82%; still a good answer and better than taking out a mortgage (see chart below showing the paths of all scenarios and the Average Return green-colored line). Quantitatively, this is the best solution!

But, what if the client would rather stay in the 90% range for probability of success?  Downsizing the major renovation by half is one alternative, improving the probability of success for the cash purchase from 82% to 90%!

These are just some of the ways Dattilio & Ash can help you plan and manage your investments.  

Got Risk?

Target date funds do it one way; simply systematically reducing equity content as time marches towards its funding horizon.  Thoughtful investment advisers, on the other hand, think it through and customize an approach that factors in all investment considerations for the specific investor.  We are talking about managing exposure to risky equity investments.  Aside from tactical funds that make it their business to go “risk-on” or “risk-off” depending upon their current views of the markets, a long term strategic approach focuses in on your long term objectives and tolerance and/or capacity for risk.

The equity markets have been risky, but very beneficial to investors in stocks over the last 10 years.  Certainly, if you could tolerate the risk, a 100% allocation to the S&P 500 index (IVV) has been a rewarding, if not nerve-wracking, experience generating a 14.32% annual total return and a risk level of 13.62% standard deviation of return over the last 10 years.

A first step to deciding on your risk tolerance is to understand the tradeoff between risk and return.  Risky assets like stocks often need to be offset by less risky fixed income holdings.  A good way to judge the relative attractiveness of risky portfolios is to compare portfolios with different broad equity weightings.

One of my favorite data sets includes the return profiles of the S&P Dow Jones Portfolio Indices.   They include five separate modelled portfolios from Conservative to Aggressive with equity weightings ranging in 20% increments from 20% (for Conservative) to 100% (for Aggressive).  Not surprisingly, the chart below shows the DJ Aggressive Portfolio (the aqua blue line on top) with a 100% equity content leading the pack over the last ten years!

But, what about the road it took to get there!  This ten-year time frame does not include the Credit Crisis of 2008/09, but it does include other crises including the Pandemic crash of 2020.  Looking at the chart you can observe that during 2020 the Aggressive portfolio actually lost so much return that it came close to the cumulative return value of the Conservative Portfolio (the darker blue line at the bottom); thus, negating almost all of the accumulated excess returns garnered over the previous nine years.

So, what lessons can we learn from this chart.  At least four things, including:

1.      No one knows when the next credit crisis or pandemic is going to hit and how long the crisis may last.  Trying to manage equity risks based on a “gut” feeling will only work if you get “lucky”.

2.      Over a long time horizon, the riskier portfolios with a larger equity content outperform the less risky portfolios with less equity content, but depending upon the selected time horizon, the less risky portfolio actually could outperform the more risky portfolio!

3.      The return profiles for each of the DJ portfolios show an incremental pickup of about 1.5% of excess total return for each 20% increase of equity content.  In other words, over the 10-year horizon the Moderately Aggressive portfolio with an 80% equity content generated total return of 9.02% compared to the Moderate portfolio with a 60% equity content that generated only a total return of 7.53%; an average annual give-up of 1.49% over 10 years, something that is very material.  If you can tolerate the risk and have a long time horizon, it certainly paid off to accept more risk.

4.      But nothing is forever, and we need to be cautious.  Some forecasting models, like the one at Research Affiliates , have much lower expectations for future returns due to the poor return prospects for fixed income assets and the historically high valuations for equities; this firm forecasts only a 2.1% nominal return over the next 10 years for a 60/40 portfolio!

Next Week's Blog Post, Today!

I had a few ideas for this week’s blog post but had a difficult time deciding which one to develop into a full-fledged post.  Instead, I am posting here my random thoughts about the current capital market and economic environment, so you know what I am thinking about.  I will pick one out of this list and fully develop it for Next Week’s Blog Post.  Stay tuned!

• With interest rates and credit spreads now just off their historic lows combined with an accommodative Fed, unless you need to fund an absolute cash flow guarantee in the future or need to reduce risk in your portfolio, mathematically, now is a bad time to buy bonds.

• Equities, on the other hand, now seem to be a good place to allocate capital since the economy seems primed to continue its strong recovery from the global pandemic.  This view is mostly supported by Q1 earnings results so far, where 81% of S&P 500 companies have reported positive earnings surprises through last week, the second highest percentage of positive surprises since FactSet started tracking the data in 2008.

• Though minimizing investment fees is a good way to help investors achieve their investment goals, getting the right asset allocation is even more important.

• Inflationary fears are heating up due to the huge amount of fiscal stimulus with huge budget deficits.  Traditional inflation hedges like stocks and real estate should be part of everyone’s portfolio to hedge that risk.  The consensus view on commodities and inflation bonds (TIPs) is less clear based on current market levels.

• What is ESG (environmental, social and governance) investing?  Should I get involved?

• Do you have enough income and assets to retire?  I am ready to do an update on the generic analysis posted last year, Is there a “Number” for You? where I calculated the probability of success of a hypothetical investor.  If you want me to customize it specifically to you with our MoneyGuidePro analytical software, let me know and I would be happy to help!

We Must Forecast!

Many of the large investment banks provide free analytical services on their web sites to registered investment advisers.  One of the most interesting tools they provide is a scenario generator; a tool to shock the capital markets for external events to see how a portfolio will perform.  Let’s take a look!

Depending upon the web site you visit, the available scenarios to test against vary a bit.  Some common scenarios include COVID-19 Conquered and COVID-19 Continues, as well as more generic scenarios like Oil Spike, Inflation Spike, and Interest Rates Rise.

I am a firm proponent of long-term strategic investing targeted to a client’s specific objectives and not prone to making tactical shifts based on market outlooks, but I find it interesting to see how client portfolios would perform under different scenarios.  I ran the scenario generator from the JP Morgan Asset Management web site and came up with the following statistics based on an income strategy I currently manage (see chart below).

As seen above, the Sample Income Portfolio performs better than the benchmark portfolio in half the scenarios (and worse than half!) while the variance amongst the scenarios is relatively small.  My view is that this is the best anyone can do when trying to outguess external events.  I would not be happy if the Sample Income Portfolio showed a strong bias in either direction implying bets are being taken on a specific scenario.  In that case, I would need to re-think the management of that portfolio since I might be taking unknown bets.

Alan Greenspan, former Fed Chairman, is known for his outspoken opinions on all kinds of topics.  His view on forecasting is well documented and goes something like this (paraphrased), “we aren’t very good at forecasting, but we must forecast since embedded in every portfolio is a market outlook.”  So, in the above case, the embedded long-term strategic forecast of the Sample Income Portfolio delivers an outcome that mostly mirrors the benchmark to satisfy client objectives over different scenarios; a satisfactory result for most investors. 

Investments 101: Risk and Return

Everyone knows about the tradeoffs between risk and return.  Generally, the more risk you take, the greater the return and vice versa.  A way to express this graphically is the classic risk-return chart; returns are along the y-axis and risk is on the x-axis.

The chart below represents the forecast 10-year returns for the major asset classes, including U.S. large cap equities, international and emerging market equities, and U.S. aggregate core bonds (chart and forecasts provided by Research Affiliates, LLC).  I removed the axis values for the forecasted returns and risk since I think the most value can be garnered from the relative placement of the dots.  Let’s talk about them!

As one would expect, emerging market (EM Equity) and international developed equities (EAFE) (the two red dots in the upper right quadrant) take the prize as having relatively more risk than most all the other major asset classes (along with U.S. small cap and REITs), but they also provide the highest expected returns.  U.S. large cap equity, perhaps not unsurprisingly given its phenomenal 10-year run and relatively higher current earnings multiples, shows a much lower relative level of returns despite having only modestly less risk.

Bonds (light blue dots) cover the lower left quadrant forecasting low risk and low return.  Again, this is not surprising given the recent historic lows in yields. 

The six dark gray dots connected by the dotted line represents “efficient” portfolios of combinations of all the major assets classes.  In other words, for a given level of risk, each dot represents a combination of assets that produces an expected return that is superior to any other combination.  From an academic perspective, there are many assumptions that cause this framework to be merely a theoretical exercise, but it still provides an interesting thought process.

From this data we can see that a portfolio management approach of diversified investments is superior to any individual asset class for a given level of risk over a long-time horizon.  This approach is core to my investment philosophy.

By the way, if you are curious what Research Affiliates has forecasted real returns and risk to be for U.S. Large Cap equities they are -0.5% return and +15.4% standard deviation risk.

Are you Feeling Normal?

How do you feel?  Are you 86% back to normal?  CNN and Moody’s Analytics created the “Back-to-Normal” Index to measure progress from the pandemic back to “normal” at the state and national level based on a large set of indicators including unemployment rates, small business work hours, job postings, and consumer credit.  Based on continued Fed support and a huge $1.9 trillion fiscal package, it is not inconceivable that normalcy seems nearby.  At the end of March 2021, the Index showed a level of 86% at the national level, where 100 is back to the pre-pandemic period, with most individual states over the 80% level.  This is the highest the Index has been since its low of 60% on April 16, 2020.

Certainly, capital markets have shown much resiliency, and volatility (!), during Q1 2021 with the S&P 500 index reaching new all-time highs at the end of March.  As seen from the table below, the S&P 500 (IVV) produced a strong Q1 return of 6.33%, while a rotation to better performing small cap (SCHA) and mid cap (SCHM) equities bested that with 12.24% and 9.28%, respectively.  Large cap high dividend value stocks (DVY), representing a “re-opening” market view, led the broad market indices with a robust 19.64% return.  Meanwhile, other global markets including international developed and emerging market equities (SCHF and SCHE) were likewise strong at 4.47% and 3.69%, respectively.

Bond market returns, as postulated at the end of last year, kept their part of the bargain producing weak Q1 returns coming off all-time low interest rates last quarter.  Broad core bonds (SCHZ) produced -3.35% returns during Q1 while investment grade corporates were slightly weaker at -5.47%.  High yield “junk” bonds (HYG) eked out a small positive return of 0.58% mostly due to its credit spread component.  Current 10-year Treasury yield rates of 1.7%, as part of the “back-to-normal” view, are now at levels seen near the beginning of 2020 before the pandemic took hold.

As I reported in my February 10, 2021 blog post, The Trouble with Tribbles, a return to “normalcy” will support investment strategies targeted to long term strategic views:

 So, the pandemic has hurt the total return of income strategies though today, but there are signs that as we emerge from the impact of the pandemic and the economy starts approaching “normalcy” there will be a “rebound” recovery within that universe of investments.  My blog post of January 3, “2020 Q4, Reversion to Mean” addresses the shifting trends we have started to see.