This is the third article in Seeking Alpha's Positioning for 2014 series. This year we have once again asked experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction.
Larry Swedroe is principal and director of research for both Buckingham Asset Management, LLC, a Registered Investment Advisor firm in St. Louis, MO, and the BAM Alliance, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. BAM Advisor Services currently has about 145 participating firms. Buckingham currently has about $6 Billion in assets under management, while the BAM network of advisors has about an additional $16 Billion in AUM. He is the author of thirteen books including the most recent, Think, Act, and Invest Like Warren Buffett: The Winning Strategy to Help You Achieve Your Financial and Life Goals.
Seeking Alpha's Jonathan Liss and Abby Carmel recently spoke with Larry to gain insight into his understanding of the fixed income landscape - and how he allocates to fixed income as part of an overall strategy to decrease portfolio risk and smooth out returns.
SA Editors (SA): The 'Larry Portfolio' has been profiled in the New York Times and elsewhere. For those of our readers that aren't familiar with how it works, how would you sum it up in its most basic form?
Larry Swedroe (LS): On December 23, 2011, Ron Lieber, financial columnist for the New York Times, wrote an article entitled "Taking a Chance on the Larry Portfolio" - and the "Larry Portfolio" (LP) was born. The "LP" is the technical term for a portfolio that basically limits its stock holdings to the highest returning equity asset classes available to individual investors in low cost, passively managed investment vehicles - U.S. small value stocks, developed markets small value stocks, and emerging market value stocks.
Limiting the stock holdings to the highest expected returning asset classes allows an investor to have a lower overall allocation to stocks and achieve the same expected return. The bond portion is limited to bonds of the highest investment quality. For the taxable account, it includes municipal bonds that are AAA/AA-rated and are also either general obligation bonds or essential services bonds. For the tax-advantaged accounts, it holds both FDIC insured CDs and DFA's Short-Term Extended Quality Fund (DFEQX), though ideally, it would hold all TIPS, which is what it did before real rates collapsed (and the cost of inflation protection relative to FDIC insured CDs rose to relatively high levels). If there are real yields again in the area of 2 percent, holdings could move back to TIPS. Holding this "bar bell" type portfolio allows one to have a much lower equity allocation and still have the same expected return of a portfolio that holds a more market-like stock portfolio. The benefit of the LP is that it cuts the tail risks, meaning you sacrifice the potential for great returns (given the low equity allocation) but also minimize the risks of very poor returns (like we experienced in 2000-02 and again in 2008). To me that's the Holy Grail of investing, same returns with much lower risks.
(SA): What are the major risks facing retirees and those approaching retirement in 2014 and beyond?
(LS): There are several important risks retirees should be addressing in their plans. The first might be called: Is 3 percent the new 4 percent? The problem for today's investor is that current stock valuations and bond yields provide estimates of future real returns that are well below historical returns - raising the issue of asking if conventional wisdom is right - is 4 percent still a safe withdrawal rate?
We'll begin by looking at stocks. While the historical real return to stocks has been 6.8 percent (9.8 nominal return minus 3.0 percent inflation), most financial economists are forecasting real returns well below that. While there is no generally agreed upon best metric for estimating future returns, the Shiller CAPE 10 (cyclically adjusted price-to-earnings ratio) is considered by many to be at least as good, if not better, than other metrics. As I write this it's currently at 25.85, well above its historical average. To forecast future real returns, you begin by taking the earnings yield (the inverse of the Shiller PE ratio). Today, the earnings yield is about 3.9 percent. However, because the Shiller PE is based on the lagged 10-year earnings, we need to make an adjustment for the historical growth in real earnings, which is about 1.5 percent. To make that adjustment we then multiply the 3.9 percent earnings yield by 1.075 (.015 x 5), producing an estimated real return to stocks of about 4.2 percent, or 2.6 percent below the historical return. Other methodologies come up with similar results, with most financial economists forecasting real future returns in the range of about 4 to 5 percent. And this assumes no reversion to the mean of valuations. If that were to occur, returns would be lower, possibly much lower.
Turning to bonds, the picture is similar. Historically, intermediate to longer-term bonds have provided real returns in the range of about 2 to 2.5 percent. Today, real yields are much lower. For example, the yields on five- and 10-year Treasuries are currently about 1.6 and 2.9 percent, respectively. Subtracting the current consensus estimate for inflation from the Philadelphia Federal Reserve of 2.3 percent, we get estimated real returns of -0.7 percent and +0.6 percent, respectively. Again, we see that future returns are likely to be below historical returns.
The current low real yield on bonds has a very important implication as for most investors the bond allocation tends to increase as we approach and enter retirement.
There should be no doubt that current valuations and yields have changed the safe withdrawal rate (SWR). While each investor should run a Monte Carlo Simulation to determine the right asset allocation and SWR for their personal situation, it seems likely that the old SWR of 4 percent is at best now 3 percent. That has significant implications for many investors. For those still in the labor force, among the considerations should be:
• Should I plan on working longer?
• Do I need to increase my savings rate and/or lower my spending goal?
Changes in these two areas can have dramatic impacts on the odds of not outliving your assets. Another way to improve your odds of success is to make sure you use only low-cost, passively-managed funds to implement your plan. The costs of active management are likely to be a significant drag on returns. And finally, increasing your allocation to the higher expected returning asset class of small value stocks can improve your odds of success (and allow for a lower stock allocation as well).
There are, however, other non-financial risks that should be considered. The primary one is the "risk" of living longer than expected. The way to hedge that risk is to consider purchasing longevity insurance in the form of a fixed annuity. A deferred payout annuity should be considered for those for whom this is a real risk. A related risk is the potential need for long-term care which can be addressed by purchasing long-term care insurance.
In other words, financial planning is about much more than just investment planning. Investment plans can fail for reasons that have nothing to do with the returns on your portfolio. That's why it's so important to integrate your investment plan into a well-thought-out estate, tax and risk management (insurance of all kinds) plan.
(SA): The 10-year Treasury yield has recovered a fair bit since we spoke this time last year but still remains at low levels historically speaking. With bonds selling off for the first time in years on tapering fears (recently finally enacted on a minor scale by the Fed), where have you been having retirees turn for income in this environment?
(LS): Our approach remains exactly the same. Balancing the dual risks of inflation and reinvestment, we build laddered bond portfolios with average maturities in the range of 4-5 years. Based on the academic research, which all of our advice is based on (as opposed to someone's opinions), we will extend maturities a bit when the curve is very steep (that is when term risk has been best rewarded) and to shorten them up a bit when the curve is very flat. But we always want to keep that balance between the two risks.
The other important part of our strategy is that we only invest in the highest quality bonds. For municipals, we limit our holdings to AAA/AA and only general obligation and essential service bonds, and for taxable bonds, we generally limit our holdings to government agencies, Treasuries, and FDIC insured CDs. For smaller accounts, we use investment grade bond funds that don't take any call risk (as there is no evidence that it has been well rewarded).
The bottom line is that we don't ever stretch for yield by taking more credit risk or extending maturities. That means we don't ever purchase the typical suspects as substitutes for safe fixed income: high-yield bonds, preferred stocks, MLPs, REITs (though we do recommend considering including REITs as part of the equity allocation), or high-dividend stocks. And here's a warning to those who have done so.
The prolonged period of low rates has led to a dramatic increase in the flow of funds into higher-yielding assets such as high-dividend stocks, REITs, and MLPs. And the recent performance of these investments has been quite good. As the popularity of these investment "fads" increases, in the short term it can become a self-fulfilling prophecy (which is how bubbles occur). However, investors who know their history know that such trends ultimately can become self-defeating, and most often end badly. The reason is that investors chasing the latest fad cause valuations to rise. And the evidence is clear that the best predictor of future returns is a valuation metric such as the P/E or P/CF (price-to-cash flow) ratio. The Vanguard REIT Index Fund (VGSIX), for example, is now trading at a price-to-cash flow ratio of over 14, twice the ratio of the S&P 500. And the Alerian MLP ETF (AMLP) has a P/E of about 26. Those kinds of valuations have generally turned out badly for investors.
(SA): Let's talk risk/reward assessments as they relate to the yield curve. Where is the sweet spot currently located? (i.e. the spot offering the best yield relative to interest rate risk) Are there segments of the fixed income market you're having clients avoid entirely?
(LS): It's worth a brief discussion on the outlook for interest rates as over the past several years so many investors have been "talked into" staying short with their maturities due to the risk of inflation caused by the Fed's easy monetary policy. To begin, while there's certainly the risk of higher inflation and thus higher interest rates, one of "Swedroe's Rules of Prudent Investing" is that if you know something, so does the rest of the market. Thus, it's too late to act on it. In other words, the market is also expecting rates to rise and that means that the expectation is built into prices. We see that in the yield curve which is at historically steep levels, with almost 300 basis points between the Fed Funds rate and 10-year Treasuries. That's well above historical averages. For investors to benefit by staying short, anticipating rate increases, rates actually have to rise faster than expected. What many investors fail to understand is that it might be that short-term rates rise, but the intermediate to longer part of the curve doesn't move very much, if at all, (because the rise in rates was expected). Consider the evidence in the following table which covers the period 1980-2012. The table shows the return on Barclays Intermediate Government/Credit Index for only the years when the Federal Funds rate increased by more than 1 percent.
Year | Year Increase in | Barclays Intermediate Government/Credit Index Return (%) |
1980 | 2.2 | 6.4 |
1981 | 3.0 | 10.5 |
1984 | 1.1 | 14.4 |
1989 | 1.6 | 12.7 |
1994 | 1.2 | -1.9 |
1995 | 1.6 | 15.3 |
2000 | 1.3 | 10.1 |
2005 | 1.9 | 1.6 |
2006 | 1.8 | 4.1 |
In only one of the nine years, 1994, when the Federal Funds rate rose by more than 1 percent, did an investment in intermediate term bonds lose money.
So, that brings us right back to our strategy of balancing the dual risks of inflation and reinvestment by staying in the middle part of the curve, where it also happens to be the steepest. That's an average maturity of about five years. And we're staying disciplined by continuing to invest in only the highest quality bonds.
(SA): Over the last few years, there has been a real push to chase yield, risk be damned. Why do you think the risks associated with asset classes like dividend stocks and corporate bonds are so poorly understood?
(LS): One reason is that investors often confuse yield and return. Yet, they are obviously not the same thing. Another reason is that they are often sold products based on a history of relatively low correlation with stocks. The problem is that with all risky assets, when crises occur, the correlations tend to rise towards one. In other words, just when the benefits of low correlation are needed most, correlations turn high. For example in the fourth quarter of 2008, when stocks were getting crushed, high dividend stocks fell 21.3 percent and MLPs fell 20.3 percent. In the very next quarter, when stocks continued to crash, high dividend stocks fell 23.1 percent and preferred stocks fell 19 percent. And in the third quarter of 2011, when stocks again came under pressure due to the European crisis, high dividend stocks fell 8 percent, preferred stocks fell 7.6 percent, and MLPs fell 7 percent. On the other hand, during these three quarters, five-year Treasuries returned 7.5 percent, -0.6 percent, and 3.9 percent, respectively. In other words, while the correlation of Treasury bonds to stocks is about zero, during crises the correlations tended to turn negative - at just the right time these bonds tend to have above average performance. With high dividend stocks, preferred, and MLPs, there was a tendency for the correlations to rise at the wrong time.
(SA): What is your assessment of the Muni market heading into 2014, especially following the Detroit bankruptcy? Have the fears here been 'much ado about nothing', or are tax considerations not sufficient to justify some of the risks inherent here?
(LS): This year we have seen a fair share of headlines highlighting significant defaults on the municipal bonds of such cities as Detroit, Stockton, and San Bernadino. For many investors, defaults such as these brought back memories of the December 19, 2010 forecast by Meredith Whitney. Appearing on 60 Minutes she forecasted that a tidal wave of defaults would occur in the municipal bond market in 2011: "You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."
While there have been some significant defaults, the massive scale of problems that Ms. Whitney had anticipated didn't occur because governments have taken actions to address the problem, cutting spending and raising revenues. Unlike the federal government, all states except one are required to balance their budgets. As a result, budget gaps are being closed by layoffs of public employees, greatly reduced services, and increased taxes and fees. The outcome was a dramatic decrease in the budget gaps. From 2009 through 2012, the gaps were closed by well over $400 billion. And 2013 saw significant further progress as the economic recovery, while slow, has led to rising revenues, and further cuts have been made.
The closing of budget gaps, and the reluctance of the public to approve new debt issuance, has also meant that new bond issuance has shrunk dramatically. Reduced supply is a positive for investors. Through November, long-term issuance has fallen 15 percent this year. Additionally, the sharp drop in rates has allowed many municipalities to refinance higher rate debt, further closing budget gaps. The net effect is that the level of issuance in 2013 hasn't been sufficient to offset the calls and maturities this year, leaving the market with net negative new issuance.
All of this has been good news for municipal bond investors. Further good news was received when U.S. Bankruptcy Court Judge Steven W. Rhodes accepted Detroit's petition enabling it to seek protection under Chapter 9 of the U.S. bankruptcy code, and he ruled Detroit may legally reduce public pension benefits, despite protection of public pensions under Michigan's constitution. Rhodes' ruling has positive implications for municipal bond holders across the country.
Even Illinois, the state with by far the worst situation, finally managed to take some positive steps to address their long-term pension obligation problem - though nowhere near enough, so I continue to recommend avoiding Illinois bonds.
Finally, I would add that even in the Great Depression the highest quality muni bonds (the ones I recommend limiting your holdings to) had default losses that were very close to zero. The bottom line is that relative to Treasuries, high quality municipals have often been "screaming buys" over the past few years. And they are still highly attractive with the 10-year Treasury yield at about 2.9 percent and AAA municipals at about 2.8 percent (or about 97 percent of the Treasury yield). That's historically a very high ratio. Unfortunately, too many investors were scared off by forecasts such as the one made by Ms. Whitney. Investors need to learn to take Warren Buffett's advice, who admonishes investors to ignore all market forecasts because they tell you nothing about the market but a lot about the person.
(SA): Let's take the other side of the coin - investors that are so risk averse that they may not reach their financial goals in retirement. How do you coax someone into making sure they're sufficiently exposed to riskier asset classes to not run out of money in retirement?
(LS): My experience is that the best way to address this issue is to put things in "black and white." The way to do that is to show them the results of a Monte Carlo Simulation. An MCS shows them the odds of running out of assets while still alive based on their current spending requirements and their asset allocation. Seeing the odds of failure being at unacceptable levels can produce the required "wake up call." The message is that if you don't do something, we estimate that there is an unacceptably high chance that you will be alive with no assets. And that's unthinkable to most. That leads to the discussion on what alternative strategies can be adapted to reduce that risk. Depending on the situation the answer could be:
If still in work force, plan on working longer and/or raise your savings rate (cut current expenditures).
Change your asset allocation to include more equities, or within equities raise your allocation to small value stocks (the highest expected returning asset class), which is my preference.
The one thing we want to avoid doing is taking risk on the bond side, meaning do not stretch for yield by extending maturities or taking credit risk.
(SA): 'Smart beta' and alternative weighting schemes have been all the rage and continue to gain assets as we head into 2014. What is your feeling about chasing back-tested results? How do you determine when a new strategy is scientifically sound?
(LS): First, there should be a good basis for the hypothesis behind the strategy. By that I mean there has to be a good explanation for the outcomes from back-testing. (You should have the theory first, otherwise it's a good chance the outcome is a result of data mining). If there is a logical risk explanation for the performance (riskier assets should have higher expected returns), that gives me more confidence than if it's a behavioral one, because risk cannot be arbitraged away. Thus, a premium is likely (not certain) to persist. On the other hand, if there's a behavioral story, that doesn't mean it's not a good one. Behavioral anomalies (mispricings) can persist.
The reasons behavioral anomalies can persist include both the fact that human beings don't seem to learn from their mistakes (they often cannot help themselves as their brains are hard wired to make mistakes), and there are limits to arbitrage that prevent institutional investors from arbitraging the anomaly away. So, while I have more confidence in risk-based explanations, I would not rule out behavioral ones. The way to think about it is that I would be willing to have a higher allocation with a risk-based explanation than with a behavioral one.
Turning to the question of knowing if the strategy is sound, there are three tests to apply. The first we have already discussed - there should be a good explanation. The second is that the evidence must be highly persistent. The more persistent the evidence, the more confidence we can have in it. The data should cover long periods so that we see how it holds up across various economic regimes. This is important because we want to know not only the size of any premium created by the strategy, but how the addition of the strategy impacts the risk and return of the entire portfolio. We want to know not only how the strategy correlates with the rest of the portfolio assets, but when does the correlation tend to rise and when does it tend to fall? The third is that the evidence be pervasive. It should persist not only across geographic regions but asset classes as well. Let's look at a couple of examples.
The value premium has persisted over the very long term and for decades after its "discovery". It also exists virtually everywhere we look. And it persists across asset classes, including even currencies (high yielding currencies outperform low yielding ones) and commodities (those in backwardation outperform those in contango). And while the source of the value premium is debated, it's hard to make the case that at least part of the value premium isn't a risk story. On the other hand, momentum is clearly a behavioral story. Yet, it too has persisted for decades, and for decades after its "discovery". And it persists virtually everywhere around the globe (with exception of Japan), and it persists across stocks, bonds, currencies, and commodities.
(SA): What advice would you offer a 'do-it-yourself' fixed income investor as we approach the new year?
(LS): Read The Only Guide You'll Ever Need to the Winning Bond Strategy! And then stick to the principles laid out in the book. Put simply, buy only the highest quality bonds, avoid call risk, avoid hybrid securities that have equity-like risks (such as junk bonds, preferred stocks, emerging market bonds, convertible bonds), and balance the dual risks of term (inflation) and reinvestment (disinflation/deflation). The more exposure one has to the risk of unexpected inflation, the shorter the maturities of your nominal bonds should be. The more exposed you are to the risks of unexpected deflation, the longer the maturities should be. In other words, tailor the average maturity to your unique ability, willingness and need to take risk. And finally, do not pay attention to any, and I do mean any, forecasters (that goes for both stock and bond forecasters) because none knows where the market is going. They either only think they do (and should know better), or they are getting paid a lot of money to pretend they do.
(SA): Any additional considerations you'd like to share with readers as they ponder their investing strategy in 2014 and beyond?
(LS): One of my favorite expressions is: If you think education is expensive, try ignorance. Wall Street preys on the ignorance of investors, creating products that best serve to transfer assets from your wallet to theirs. The best investment you'll ever make is in your own education about how markets really work and what strategy will most likely allow you to reach your goals. Thus, spend some time (you don't even have to spend money as libraries are free) educating yourself on financial economics. I've written 13 books on the subject. The one I'm most proud of is Wise Investing Made Simple. It's a collection of 27 stories that use analogies to sports betting, movies, and history, to make the difficult concepts of financial theory easy to understand. Many readers have told me that in reading the book they had an "aha" moment. They finally understood how markets really work. If you're interested in the evidence on active versus passive strategies, read The Quest for Alpha. And there's an "Only Guide" series that includes one on stocks, one on bonds, one on alternative investments, and one on developing a financial plan. Other authors I would highly recommend include William Bernstein and John Bogle. And if you're already highly knowledgeable about financial theory, I'd recommend Antti Illmanen's Expected Returns.
Finally, a benefit of reading my books is that I'm always happy to answer questions from readers. My email address is in each of my books.
Disclosure: Larry Swedroe's fixed income exposure is through DFA Short Term Extended Quality Fund (DFEQX), FDIC insured CDs, as well as via individual AAA/AA municipal bonds that are General Obligation and Essential Service Revenue bonds. He doesn't own any Treasuries directly. His equity exposure is through Bridgeway's Omni Tax Managed Small Value Fund (BOTSX), DFA's International Small Value Fund (DISVX), DFA's Emerging Market Value Fund (DFEVX) and DFA's World ex-US Targeted Value Fund (DWUSX).
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