In other words, efforts to boost the total return of fixed income investments by moving toward high‐yield varieties not only increase portfolio risk, but decrease portfolio diversification as well. Low risk and a high diversification benefit are the cornerstones of the rationale for having fixed income as an asset class. Reaching for yield erodes this foundation.
There must be a better solution.
In our first article, we also introduced the concept of Risk‐Managed Investing (RMI) — an approach that imbeds volatility dampening and/or downside risk mitigation directly within the equity investment itself. To the extent that RMI can successfully manage equity risk explicitly, it relieves the fixed income portfolio component of the burden to do so. The implications of this are paradigm‐shifting and may change the way we think about portfolio construction. It is not hard to see how “80/20 could be the new 60/40,” with RMI investments in the 80% portfolio component replacing part of the conventional equity exposure that constitutes the traditional 60% component.
This raises many questions, however. How can RMI provide this equity risk management? At what cost? Is the cost so high and/or the upside potential of equities so diminished by RMI that it is not cost‐effective over a full market cycle? What would an RMI‐infused portfolio look like, and what would its risk/return profile be? These are questions we will be addressing in depth in future installments of this series. We look forward to your feedback along the way.
Jerry Miccolis is the Founding Principal and Chief Investment Officer at Giralda Advisors, a participant in the ETF Strategist Channel.