Advisors: Don’t Let Bonds Ruin Another Year
For investment advisors, the past few years have been filled with busted beliefs.
Those who believed that bonds would always rescue stocks in down markets met the year 2022, when that didn’t happen.
While the SPDR S&P 500 ETF Trust (SPY) fell by 18% that year, ETFs that track the bond market, such as the Vanguard Total Bond Market ETF (BND) fell by 13%. For BND, that followed a slightly down year in 2021. Diversifying into corporate bonds via funds like the iShares Core US Aggregate Bonds ETF (AGG) did not move the needle, so to speak, as that ETF fell 13% as well.
I guess we’re not in the market’s version of Kansas from the Wizard of Oz anymore. Because the potential for the Fed to continue its “higher for longer” stand against inflation means that rates may not simply stabilize and plunge lower, lifting bond prices. That was the classic case for the better part of 40 years prior to 2022. But BND and AGG straddling the zero-return line for the past five years, advisors are one equity market correction away from having to explain why that bond allocation is still there. Best case, bonds rally in that event, and the long-term returns lift a bit.
Time For a More Flexible “40” in That 60/40 Mix
But there has been more than just a little buzz lately about that old financial wrecking ball, “stagflation,” in which a no-growth economy exists with stubbornly high inflation. That would leave their proverbial their third roommate—the investment advisor—feeling frustrated and looking for an alternative to simply putting a traditional bond allocation alongside clients’ equity ETF portfolio.
Indeed, the iShares Core Growth Allocation ETF (AOR), a 60/40 stock/bond surrogate, gained 5.2% a year the past five years, and that was nearly all from the 60% in stocks. And that is at a time when the stock market at large was bailed out by the outstanding performance of the Nasdaq leaders.
So, what should advisors do if bonds keep ruining the non-equity part of their portfolios? Here’s one potential, alternative method of portfolio construction that advisors have not had to consider since the ETF business was in its early days.
But as a former boutique investment advisor with a conservative client base who needed to think full-time about risk management, during periods of weak bond prices or low bond rates, I identified an uncommon, yet potential viable approach that some advisors may find worth researching and considering in the future.
Say Hello to My Friends Inverse and T-bill ETFs
Building a more flexible 40%, the non-equity segment of a classic 60/40 stock/bond allocation, could simply extend beyond high quality bonds to high yield and convertibles, among others. But those asset classes have dragged as well, with flat and negative returns respectively, over that period from the start of 2022 until now.
That’s why an out-of-the-box approach using a combination of inverse ETFs and T-bill ETFs, alongside that equity base, might accomplish three things for the advisor.
First, it shields some of the equity decline the next time around. Second, it capitalizes on the highest yielding part of the US Treasury yield curve, the shortest end, namely Treasury Bills out to 12 months of maturity. Third, it might just remind clients that their advisor is thinking about how to solve client concerns and address risks, rather than assume what worked before this new era of rate hikes and higher yields commenced in 2022.
Creating Alternatives to Traditional 60/40 Portfolios
I constructed a hypothetical, simplified version of this as a starting point for advisors who are curious about this type of non-traditional approach to asset allocation. Specifically, I allocated 60% to the iShares Aggressive Allocation ETF (AOA), which is about 80% in global stocks and 20% in bonds. The other 40% was split evenly between the ProShares Short S&P 500 ETF (SH) which aims to move opposite SPY, and the iShares Short Treasury Bond ETF (SHV) which invests across the T-bill spectrum.
The results from the start of 2022 through last Friday show that it is possible for advisors to fight the tide of higher rates, volatile equity markets and the possibility that they stick around for a while. That 60/20/20 mix gained 4% over the 28 month period, which may not sound like much until considering that AOR, the 60/40 traditional mix, was slightly negative, and iShares Core Conservative Allocation ETF(AOK), a 30/70 stock bond mix ETF, fell by 5%.
Perhaps more significant from an emotional standpoint, the 60/20/20 alternative mix has not trailed AOR or AOK at any point since that inception date of the study, at the start of 2022.
This only goes to show that the meaning of “conservative investing” can get turned upside down when, as we have not seen since last century, bond rates rise and don’t quickly fall back down. This is just an introduction, conceptually, to the idea that there’s more to complementing equities than simply plugging bonds into the asset allocation software. Taking that extra research step to look beyond the traditional might just make the difference in some client relationships going forward.