Portfolio Construction for Today's Markets

A practitioner's guide to the essentials of asset allocation

Russ Koesterich

• Publisher: Harriman House
• Year: 2018
• ISBN:
  9780857196309
• Edition: 1
• Topic: Business
• Subtopic: International Business
• Index: Business

For most of the past 50 years the simplest asset allocation solution was often the best. A balanced portfolio of stocks and bonds provided the investor with good returns. Unfortunately, this approach is not likely to work as well in the future. Interest rates are close to historic lows, equity valuations and bond prices appear stretched, and global economic growth has slowed. Investors need a new asset allocation solution.In Portfolio Construction for Today's Markets, BlackRock Portfolio Manager and investment expert Russ Koesterich addresses this problem by describing the step-by-step approach to building a portfolio consistent with investor goals and suited to today's market environment.This portfolio construction process is divided into six stages, beginning with setting objectives and moving through assessing risk tolerance, diversification, the importance of factors, generating return assumptions, and combining assets in a risk-controlled manner. In the final chapter, Mr Koesterich presents a highly useful summary of the five fundamental rules of asset allocation and a five-step checklist to follow when constructing portfolios.For investors and their advisors constructing portfolio in today's markets, this book is an indispensable new guide.

Chapter 1. Money for Nothing: The Challenges of a Low-Rate World

“This”, “time”, “it’s” and “different” have been said to be the four most dangerous words in finance. In the past they’ve very often preceded an argument attempting to justify a dicey investment scheme, overvalued asset or sometimes outright fraud. With that disclaimer in hand, in one big, important respect investors are today facing a very profound “this time it’s different” moment.

Money managers have been following the mantra of long-term portfolios for decades now. Success may have varied depending upon the period and how well the investor stuck to their plan, but for the most part, the classic approaches worked. Simple asset allocation models were effective.

The most well-known asset allocation model was based on a simple formula: invest 60% in stocks and 40% in bonds. This simple formula – the 60/40 model – provided a reasonable balance between long-term growth, income and manageable volatility. In certain decades, notably the 1980s and 1990s, when both stocks and bond markets rallied in unison, the 60/40 model provided better returns than most had expected.

If 60/40 has worked so well in the past, why change now? The simple but uncomfortable answer is: “this time it’s different.”

One potential argument for why things are different this time is valuations. As of this writing, stock markets are in the ninth year of a bull market and equity valuations, particularly in the United States, are stretched. While this does not necessarily suggest stock prices are in danger of an imminent collapse, it does suggest lower returns on equities going forward. That said, these high valuations are not really a game changer. After all, stocks have been overvalued in the past, before then dropping in price, and then subsequently bouncing back.

It is also worth noting that while obvious in hindsight, bear markets are rarely obvious before the fact. Even for those lucky enough to get out in time, few are so skilled as to re-enter the market at the exact bottom. More often they miss most of the subsequent rally before re-entering the market. The prospect or even likelihood of a bear market – we know at some point in the future one will occur – is not sufficient to throw out well-established asset allocation rules.

If a creaky stock market is not the game changer, what is? In one word: bonds.

It’s bonds

It is a cornerstone of finance that there is a time value to money. People prefer their money today rather than a year from now. Accordingly, for me to lend you my money you need to pay me a rate of interest. While interest rates have fluctuated dramatically over the thousands of years humans have been lending to each other, they have almost always been comfortably above zero. That can no longer be taken for granted.

The big change that has occurred in recent years, the one that upends the whole process of building a long-term portfolio, is what has happened to interest rates. They have plunged.

This brings us to bonds. While traditionally thought of as the boring, less sexy cousin of stocks, bonds are critical to a portfolio. They play three important roles: income, stability and a hedge against equity market volatility (in other words, diversification). However, all three roles are now under threat.

Income

The most obvious change has been income, or more accurately the lack of it. Today most bonds pay practically no income, even before accounting for taxes and inflation, because yields are so low. This means that under a 60% stocks, 40% bonds arrangement, a good chunk of the portfolio is doing little to produce returns. As a result, the rest of the portfolio – the part not invested in bonds – has to contribute more to make up the shortfall.

The income challenge is further exacerbated by the fact that a prolonged period of low rates has pushed up the valuation on other types of assets that generate income. In the United States in 2017, many dividend-paying stocks trade near record valuations as investors flee the bond market in search of a reasonable yield. As bond investors migrate to dividend-paying stocks in search of income, prices have risen. Higher prices mean that the dividend yield – defined as the annual dividend divided by the price – on many of these stocks and sectors is significantly lower than in the past.

As an example, consider the utilities sector. Utility companies, which are typically valued for their high dividends, now offer a yield of closer to 2%–3% rather than 4%–5%. This suggests that even if an income-oriented investor is willing to accept the greater risk of owning a stock rather than a bond, many of those stocks are now providing a significantly lower dividend yield than was the case 20 years ago.

Stability

Low interest rates inject another complication into the mix. A side effect of low rates is that bond durations, i.e. the sensitivity of the bond to changes in rates, are elevated relative to historical norms. Higher durations translate into more interest rate risk. In more visceral terms, as duration rises, bondholders will experience greater losses when and if interest rates rise. So, as things stand today, even a small rise in rates will inflict significant losses on the bond portion of portfolios.

Diversification

Low rates and higher durations imply less income and more risk. However, up until recently investors could at least rely on bonds for the third characteristic: diversification.

Even though rates have been low, bonds have still done one thing reliably well. For most of the post-crisis period they have provided a hedge against equity risk. In other words, when stocks have gone down, bonds have typically gone up. In more quantitative terms, bonds have had a consistent negative correlation with stocks.

Negative correlation is the holy grail in building portfolios. The negative correlation between stocks and bonds has helped to cushion the blow when markets have been volatile. In the few recent instances when stocks have declined sharply – summer of 2011 or early 2016 – bonds have been there to help mitigate the damage. Going forward, if stock/bond correlations are not as consistently negative, bonds will be less effective in mitigating overall portfolio risk.

Thus, we have established that the three priority roles for bonds in a portfolio – income, stability and diversification – are challenged by the current environment. We will return to look at these three areas in more detail later in the chapter.

Low for long, very long

Before taking each of these three challenges in turn, it is worth exploring why rates are as low as they are. Equally important is how low rates are relative to historical norms.

To say that interest rates remain close to historic lows sounds a bit like hyperbole. At least in the United States, the Federal Reserve has begun the process of tightening monetary conditions by raising short-term interest rates. This process is likely to continue in the coming years, which should see short-term rates continue to rise above the 0% level that defined much of the post-crisis environment.

At the same time, long-term bond yields have also risen. US ten-year government bond yields are roughly 1% higher than they were at the lows during the summer of 2016. Is it really accurate to still talk about ultra-low rates?

Despite marginally tighter monetary policy in the United States and a modest increase in bond yields, by any historical measure interest rates remain close to levels that would have been deemed unlikely, if not impossible, ten years ago. A good example of how truly unusual this period is comes from the United Kingdom, where financial records extend further back in time.

One of the longest continuous series of interest rates is from the Bank of England (BOE). Founded in 1694, the Bank of England has been setting short-term interest rates for the United Kingdom even before there was a United Kingdom (the Act of Union with Scotland occurred 13 years later).

According to the Bank ...