With the benefit of hindsight, there have been few investments as attractive as core U.S. fixed income over the last 30 years. Capital preservation, income, diversification, and even hedging volatility: was there anything fixed income did not provide?
With 10-year U.S. Treasury rates nearing all-time lows, however, the cost/benefit math may be less in favor of this once heroic asset class. Our fear is not necessarily rising rates, rate volatility, or even the risk of a spike in inflation. Rather, quite simply, low present rates imply low forward returns, making large allocations to traditional fixed income a potentially costly choice.
Living in the unprecedented era of globalized, experimental central bank policy, we believe reexamining the size and role of fixed income within our portfolios is warranted. Given all that core fixed income has been able to achieve for investors historically, is there a way to go about replacing this exposure while simultaneously reducing our exposure to interest rates?
At Newfound, we believe the answer is to unbundle and rebuild: unbundle the objectives, solve for them individually, and rebuild a solution from the sleeves.
Unbundle
The first step of the process is to build a solution for each of the four objectives.
Capital Preservation
We believe that short-term fixed income is still one of the best ways to preserve capital. Positions in ETFs such as GSY and MINT, which focus on finding enhanced yield opportunities in the short duration space, may help an investor achieve the necessary safety while at least dampening the impact of inflation.
Finding Income
To satisfy income needs in today’s interest rate environment, we believe that investors should look towards extended fixed income sectors like high yield bonds (JNK and HYS), bank loans (SRLN), emerging market debt (EBND), and high yield municipals (HYMB). While each of these sectors comes with its own significant idiosyncratic risk, we believe an actively managed and thoughtfully diversified portfolio of such exposures can help mitigate these risks.
Diversification
The continued proliferation of exchange traded funds means that many diversifying, alternative strategies that were once only available in hedge fund structures are now available to all investors. The benefit of many of these approaches is that they can offer diversification to both traditional equities and fixed income.
Related: Alternative ETFs Have a Volatility Problem
The categories we look to employ at Newfound include: hedge fund beta (HDG), equity long/short (FTLS, GURU, RALS), dividend swaps (DIVY), event-driven (MNA), volatility (HVPW), and currency carry (DBV). Again, while each of these approaches comes with it significant risks, by diversifying within across many we can control our overall volatility profile and exposure to traditional market risks.
Hedge
For many investors, Treasuries serve as the asset class of last resort, giving it crisis alpha qualities that make it a tremendous diversifier against both instantaneous and prolonged equity crashes. In this sleeve, we believe that a position in longer-dated Treasuries is still warranted (e.g. IEF), but other exposures may also work well, including managed futures (WDTI), exposure to the U.S. dollar (USDU), or even equity long/shorts that run a negative beta (BTAL).
Rebuild
The benefit of an unbundle and rebuild approach is that it allows us not only to construct out the portfolio for each objective as we see fit, but also rebuild our overall allocation with greater consideration of our personal risk tolerances and objectives. For example, the Barclay’s U.S. Aggregate has a 60%+ allocation towards U.S. Government Treasuries and Agencies, indicating a reduced potential for current income but a strong utility as a flight-to-safety hedge.
A retiree, for example, might be less concerned about having a flight-to-safety hedge, as their overall profile is already extremely conservative, than they are about finding and delivering stable income. They may choose to allocate more towards the income sleeve than the hedging sleeve.
A growth investor, on the other hand, may have no real need for current income, and is only using the fixed income exposure as a ballast to their significant equity exposure. In this case, they may choose to put a larger focus on the diversification and hedging sleeves.
In Practice
At Newfound, we employ this unbundle and rebuild approach in our Total Return portfolio.
We focus on specifically building sleeves that meet the income, diversification, and hedging objectives, and then use a simple volatility-weighting portfolio construction process such that each sleeve contributes equally to the overall risk of the portfolio.
By doing so, we believe that we can create a portfolio with an overall risk profile similar to that of core fixed income, but with a more diversified source of returns, significantly reducing our overall exposure and reliance on interest rates as a return driver.