First, there was flourless chocolate cake. Later on, they invented milk that was not from a cow, but from almonds. And if you are in the mood for a hamburger, you no longer need meat inside of that bun, thanks to plant-based substitutes. What will they think of next, a bond portfolio without bonds? Yes! And financial advisors would be well-served to consider adding that concept to their menu, so to speak.
Let’s review why advisors should even consider moving off of their long-standing “stocks and bonds” balanced portfolio framework and how they can position themselves and their clients for a move to alternatives.
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How Low Can You Go? Pretty Low
It should be obvious to most financial advisors by now that interest rates are low, and they are starting to move higher. Meanwhile, your clients see headlines about inflation, rising rates on mortgages and maybe even a little lift on their certificate of deposit, or CD, rates, but they may not understand the implications of that shift the way you do. This is both a threat and an opportunity for you, the advisor.
It all depends on how you address it. That’s because this era of low bond yields has been obscured from their view, because their stock portfolios have done so well. As a result, clients have not likely realized the bare truth about bond investing today: The prospective returns on many traditional bond investment strategies are at or below what clients pay you in management fees.
Who’s Swimming Naked?
If you split a client portfolio 50/50 between stocks and bonds, and the stocks average 16% as they have in recent years, a zero return on the bonds still nets a hefty 8% total return on their portfolio. But as January has shown us, that era of high equity returns is being threatened. And, unlike in the past four decades, bond returns won’t make up for weak, even negative, long-term stock returns.
This should sound alarm bells for advisors, since an era of low returns in stocks and bonds will turn up the heat on you to justify your asset-based fees. It is the advisor’s version of the famous Warren Buffett quote, “When the tide goes out, you can see who was swimming naked.” In other words, you don’t want clients to suddenly discover that their expected bond returns don’t stand a chance of outperforming what they pay you, at least not by much. Fortunately, there are solutions. You just have to expand your mind a bit to consider them.
[Read: 5 Strategies for Charity-Minded Clients in 2022.]
Beyond Bonds
There is no shortage of “bond alternatives.” They have been around for more than a decade. However, many tend to be sensitive to interest rates, carry credit risk, are too volatile or have limited liquidity. Many strategies carry two, three or even all four of those risks. Recall that your initial goal was to replace what bonds used to do for clients. Thus, it is easy to see how many standard offerings from bond-replacement land are like stepping out of the financial frying pan and into the fire. For instance, high-yield, corporate and convertible bonds, as well as preferred stock, all carry credit risk, and performed more like stocks than high-quality bonds during the 2020 stock market crash.
Furthermore, whatever solution you come up with should do more than just work. You need to be able to explain it clearly to clients. That means educating them on the risks, potential rewards, expected income, liquidity constraints and likely range of volatility. After all, if you are replacing bonds with something other than bonds, current market conditions require some trade-offs.
First: Create a New Lane and Stay In It
To craft an alternative solution, start by explaining that it is not the cash flow from coupon interest payments you are going to replace. Doing so automatically means courting more risk. You can’t turn a 2% coupon bond today into a bond that magically pays a 5% coupon. So, replace the old-fashioned interest-income approach with a strategic goal of delivering consistent returns. You know this better as “low standard deviation.”
In other words, it may be better to target a strategy that aims to deliver a return of 4% to 7% annualized over most or all three-year periods, with the understanding that there might be some years when the total return is slightly negative, and others when it might reach into the low double-digits. This narrow, more predictable range of possible outcomes is realistically the closest thing they will get to the days of yore, when investors could see a 6% coupon rate of interest hit their account in a year.
[READ: Known Unknowns: Tax Planning Amid Uncertain Law Changes.]
Second: Put Your Offense and Defense on the Field at the Same Time
The exchange-traded fund, or ETF, universe is perhaps best-suited for bond replacement approaches. ETFs are liquid, fairly simple to explain, and can be rotated in a portfolio to take advantage of a wide variety of market segments. Think “sector rotation,” but with many dozens of sectors, industries, themes and styles in the stock, bond, commodity and currency markets. Importantly, innovative ETFs now exist that combine offense (equity upside) and defense (a tail-risk hedge or diversification method). When you tactically rotate among ETFs and include a wide variety of long, short and style-diverse funds in your research universe, there is no limit to what you can create. It follows that you can devise tactical ETF rotation models that target specific outcomes, in percentage return terms.
As a result, it won’t require having 15 to 20 ETFs in a portfolio to get the job done. Depending on the nature of the mission and size of the account, bond replacement can be accomplished with three to five ETFs, or even just one for smaller accounts. The key, as with any investment method you adopt, is to understand it thoroughly, convince yourself of its merits, and be honest with yourself about what could cause it to miss your objectives.
When you consider the depth and range of ETF strategies that can be combined, you can start to visualize a realistic and futuristic method of what the industry has traditionally referred to as “asset allocation.” But in this case, your calling is well beyond a stock-bond-cash world. In this case, the financial markets have presented your clients with a generational problem, one not seen since at least the 1970s: inflation on the rise, at a time when bond yields were so low to begin with, traditional bond allocation approaches are rendered useless.
This is where you, their trusted, fiduciary advisor, get to play hero, if you so choose. The tools are there, the situation demands it, and the solution is one that might just make you the most differentiated advisor in your neighborhood. Go beyond bonds, and help your clients confront the most critical investment issue of this decade.
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Beyond Bonds: How Advisors Can Build Modern Alternative Portfolios originally appeared on usnews.com
