Systematic Relative Strength

A recent Vanguard commentary has a very good description of the confusion facing bond investors right now—and judging from the recent heavy flows into bond funds, that’s a lot of investors.

These days, the airwaves seem filled with market commentators offering one of three popular suggestions for bond investors. All three groups urge investors to alter their investment strategy in this low-rate environment.

The first group suggests bond investors take on more interest-rate risk in an effort to earn more income today, say, by moving your assets from a short-maturity bond fund to a longer-maturity bond fund. The second group suggests investors do the exact opposite and reduce interest rate risk, say, by moving assets out of one’s bond portfolio into a savings vehicle in an attempt to sidestep a future rise in interest rates. Obviously, both groups of investors are trading with each other. Which group “wins” will ultimately depend on the future path of interest rates (more on this in a moment).

Like the first group, a third group of market commentators suggests taking on more risk, but of a different sort. They point to the U.S. investment experience of the late 1940s and early 1950s—the last time U.S. interest rates were this low—as a rationale for moving strategically out of low-yielding conservative bond portfolios and into traditionally more-volatile assets, namely stock funds.

I think that is a pretty good encapsulation of what bond investors are hearing right now. And, exactly as Vanguard points out, the “right” answer if you go with a forecast will only be determined in hindsight. You could have a pretty horrific experience in the meantime if you guess wrong. Their article points out, correctly I think, that although some of these outcomes may be more probable than others, there’s no way to know what will happen. The endgame could be anything from Japan to hyper-inflation. There are just too many variables in play.

If you are a strategic asset allocator, Vanguard suggests broad diversification. I am a little surprised by this, as they make a salient point about bonds.

We as investors first need to recalibrate our expectations for future bond returns. Unfortunately, the most direct implication of this low-rate environment is that bond portfolio returns are likely to be fairly puny going forward. As I wrote in March (“Why I still own Treasuries“), arguably the single best predictor of the future return on a bond portfolio is its current yield to maturity, or coupon.

I would think that a strategic asset allocator would severely underweight bonds if future forecasted bond returns are going to be small. (At least that’s what Harry Markowitz says to do.)

Another path through this minefield is tactical asset allocation. Hold the asset classes that are strong and avoid the rest. If bonds are strong because rates continue to fall, because Treasurys continue to be a safe haven, or because the US enters a low-growth Japan-like environment, then they will be welcome in a portfolio. If bonds are weak because rates start to rise or because the US begins to flirt with solvency concerns at some point, then many other asset classes are likely to perform better.

In the end, tactical asset allocation might be safer. Bond returns may be low, but they might end up being higher than the returns from some alternatives. Or bonds could turn out to be an unmitigated disaster. Tactical asset allocation driven by relative strength frees you from the need to forecast. Bonds will be in your portfolio—or not—depending only upon their performance.

Source: buzzle.com