By Coryanne Hicks, U.S. News &World Report featuring Brian Spinelli, CFP®, AIF®, Chair of Investment Committee/Senior Wealth Advisor at Halbert Hargrove
DIVERSIFICATION USED TO be simpler: To decrease the volatility risk inherent in stocks, you added bonds to a portfolio, mitigating swings and adding a nice income component at the same time. But with quality bonds offering a pittance in terms of yield, many investors are unimpressed by the fixed-income allocations in their portfolios. This dissatisfaction translates into pressure for financial advisors to find new ways to reduce risk without asking their clients to give up too much return potential.
Accomplishing this can require some creative thinking in terms of asset allocation, which happens to be an area of expertise for Brian Spinelli, chair of the investment committee and senior wealth advisor at Halbert Hargrove, who researches nontraditional approaches to investments. We spoke with Spinelli about areas advisors can look for unique return and diversification opportunities. Keep reading to see excerpts from that interview.
For many decades, a common way investors diversified their portfolios from stock volatility was by including investment-grade bonds in their allocations. Following the central bank’s actions earlier in the year, most investment-grade bonds now have very low expected returns going forward. Deconstructing the Bloomberg Barclays Global Aggregate Index, about 85% of bonds yield less than 2% now. Going one step further, 66% of bonds yield less than 1%.
I’m not saying that owning investment-grade bonds is a bad idea at this point – just that it’s likely to create a drag on portfolio performance going forward. Clients needing to draw from their portfolios should have stable and liquid assets as part of their allocations. However, holding investment-grade bonds will be similar to holding cash long term in a portfolio. For example, a portfolio holding 40% in investment-grade bonds is going to have to depend on the other 60% of assets to work harder if there is a need to hurdle a 2% annual return. Advisors are aware of the issue, but there are differing views on how to navigate this low-yield world. Advisors need to be open to exploring investment opportunities with a forward-looking view.
Instead of relying mostly on investment-grade bonds to help mitigate portfolio risks, we think advisors should be exploring other types of diversifiers and reducing their allocations to investment-grade bonds. At Halbert Hargrove, areas we have looked to are direct/private credit, insurance revenue streams, private real estate and buffered equity return solutions.
While each has its risk attributes, we do see better return potential and diversification benefits at this point than solely depending on investment-grade bonds to mitigate portfolio risk from owning stocks. Most of these alternatives (are not based on stock prices), except for the buffered equity component I mentioned. Their revenue streams are different from stocks and the pricing day to day does not fluctuate nearly as fast since they are not extremely liquid. Transactions are not pricing every second of the trading day, and these areas tend to be controlled by investors who have much longer time frames. By not participating in the daily market swings, these do tend to smooth out portfolio returns and have the diversification benefits traditionally filled by investment-grade bonds.
Advisors should work with clients to review where they are in terms of the phase of their investing life as it relates to their goals. For example, a client who is still accumulating assets, who has the ability to work and save for many years to come, should probably be more stock-oriented and willing to take on more risk. Alternatively, clients who are transitioning or are in a spending phase need to evaluate how they are taking risks to get their returns. Once you hit this phase, it’s more important to protect your nest egg and reevaluate what your goals are for the future.
This critical life phase aspect is where looking to the options we use to reduce investment-grade bonds becomes a larger part of portfolios. A lot of financial advice has traditionally referenced age and risk tolerance in building portfolios; we’ve moved past this philosophy. Although risk tolerance and age are still factors, we are more focused on the individual client and family goals for now and in the future.
Where it frequently has not done as good a job is in explaining to investors how significant a role their contributions, current assets and desired spending should play when in the process of building portfolios. For example, if current investments are smaller than expected portfolio additions, we would show that breakdown with a reason to be more aggressive in the portfolio. This might be a disconnect with the client’s risk tolerance but creates a discussion on why they could or need to bear more risk to hit long-term goals.
On the opposite side, a client who is funded well to meet all their future needs may not need to take as much risk as they could tolerate. They may have had risk-taking in the past pay off, but there is no guarantee the next time it will. In those cases, we don’t want excessive risk-taking to jeopardize their ability to reach their goals, especially if they already have enough to achieve them. In other words, we strive to educate investors on why they have invested a certain way beyond mainly depending on age and risk tolerance.
We do think the next few years will present challenges for bond yields. That doesn’t mean abandoning all bonds in a portfolio. Rather, look to add other diversifying elements with better risk and return attributes so that you’re not just depending on stocks for portfolio returns. This could (mean looking at) private debt markets, private real estate and participating in insurance revenue streams. These are just a few examples where investors can look to expand their yield opportunities going forward.
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