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After a challenging 2015, we sat down with Loren Walden, CFA, co-founder and partner at Blue Oak Capital and member of PIMCO’s RIA Advisory Board, to discuss how he’s approaching year-end client conversations and constructing portfolios, as well as the challenges facing the RIA community, including selecting and implementing alternative strategies.
Walden: In 2013 and 2014, the S&P 500 dominated, which made diversification difficult for clients to appreciate. In 2015, however, we saw lackluster performance across all market segments. But, coming off of a few years of lost relative momentum, conversations about diversification have been challenging. “Why not just buy the S&P 500?” – was a question we were hearing. This year, so far, that question hasn’t come up. Market volatility has shifted the focus to capital preservation, and clients see that downside risk can potentially be mitigated by cash, bonds and alternatives.
A helpful conversation we have with clients is to direct their focus on managing portfolios to meet their objectives rather than an index return benchmark – lowering their return expectations is an important part of that discussion. Educating our clients about the importance of avoiding large drawdowns for a finite time horizon of say 10- to 30-years is a top priority as well.
Walden: When constructing portfolios, we consider low starting yields and total return in the context of low inflation, and perhaps deflation. Based on our estimates, our nominal five-year total return target for U.S. equities is low at 3%, international developed market equities is 4%, and emerging market (EM) equities is 6%. Our core U.S. fixed income target return is 2.5%, and EM fixed income is 5% in U.S. dollar terms. Thus, from a risk/return perspective, we believe it pays to underweight equities and overweight EM fixed income with a preference for U.S. dollar-denominated sovereigns. For now, clipping downside with lower equity beta allocations is our preferred strategy.
To that point, the upper tiers of high-yield credit look attractive now, and we are currently hunting in that spectrum. What was yielding about 4.5% in early 2015 – but should have been yielding 8% in our view – is now yielding around that 8% level (and may further reprice towards 10% given slow global growth and difficult credit markets). With credit spreads widening, we believe there are opportunities to find attractive yield, and perhaps even better yield if market technicals break further.
In our view, emerging markets and commodities – today’s hated asset classes – have embedded opportunities for yield and capital appreciation in both the debt and equity markets. EM U.S. dollar-denominated sovereigns and corporates are among our favorite hunting grounds. Oil-related issues have attractive dividend yields, and with a critical eye to credit analysis, look appropriate to us currently. Our strategy is to start dollar-cost averaging into active management strategies in both of these sectors now and build full positions over the next 18 months. While consensus may view these trades as too early to buy, we doubt we will pick the bottom, so we will methodically average in.
Walden: As I alluded to earlier, equity dominance and the performance challenges faced by multi-asset portfolios over the last few years have diminished client trust in our management skills. It may sound cynical, but episodes of downside volatility help demonstrate our value. Accounts with traditional 60% U.S. equity beta/40% Barclays Aggregate proxy allocations have had the upper hand for a few years. But many, if not most investors, professional or otherwise, do not understand just how much equity beta is embedded in that traditional strategy. Mean reversion suggests other asset classes will have their turn at leadership.
Additionally, slow growth, divergences in global monetary policies and the start of the Fed’s tightening cycle – quantitative easing is behind us and interest rates are flat to up – have changed the game, creating a fresh tailwind for managers to regain credibility with diversified sources of return potential. That said, these game changers have brought additional challenges to the RIA community, such as finding returns while protecting portfolios from drawdowns, accepting non-equity beta alternatives as a potential source of higher risk-adjusted returns, sizing exposures to alternatives appropriately, as well as educating clients about alternatives.
Walden: From my perspective, the RIA community doesn’t have an appropriate process for evaluating alternative managers. Generally, these managers are bringing ideas to our offices and trying to sell us on the benefits of their particular alternative products. So, to a certain degree, we’re relying on the creators of these products to educate us on how they work within the portfolio context, which may not be ideal. One of the ways we’ve tried to share due diligence responsibility at Blue Oak Capital is by hiring “managers of managers” – but even then, we are on guard for potential conflicts and fees.
Educating clients on why they should use alternatives and how they should be incorporated in their portfolios is part of the challenge, and I think in some ways managers are putting up a defensive shield, by saying, “if I can’t explain it to clients, I shouldn’t be using it.” The reality is – at least when managing money for individuals and families – that we are educating clients at a pretty high level, on the basic concepts of correlation and sources of return. Most of our clients wouldn’t understand the nuances of the strategies we’re employing; they trust us to do the due diligence required to find the best sources of return that aren’t correlated to traditional stocks and bonds.
Finally, I think a lot of managers may be hesitant about using alternatives because they don’t understand them themselves, and I can speak for myself on this point. I recently had a meeting about a managed futures strategy. On a concept level, the methods that are employed within the strategy were understandable, but the actual day-to-day mechanics of the tools were beyond me. To understand how the strategy works, I’d have to sit down with the investment team and dig into it. I can examine the math, the results and determine how the strategy may fit into a portfolio, but on some level, I have to trust the track record and management team.
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Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Diversification does not ensure against loss.
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