Do We Have to Stay in the Fixed Income Trap?

Many institutional investors and wealthy individual investors are constrained by asset allocation policies that were appropriate when high quality yields of 5% or more were available. That is not now the case and instead of adapting this policy, we place capital at risk that we should not.

The Risk Reduction Concept of Asset Allocation

The original format for managing other people’s money and endowment was to have elements of the portfolio rising in value at the same time as other portions were going down. This concept worked well when interest rates rose, because the demand for funds sent down bond prices of issues already trading at the same time as the spiked demand increased the likelihood that prices would rise. Thus, Balanced funds of stocks and bonds were the first type of popular mutual fund in the US in the 1920s. From this practice, Balanced funds’ investment allocations were codified in their prospectuses to 60% in stocks and 40% in bonds within a 10% range of these midpoints. Over the last ninety years trustees looked to bonds first as a strategic reserve element that could recapitalize the stock portion of the portfolio when stock prices lowered the equity commitment to below 50%. Thus, the portfolio would have the ability to actually buy low at depressed prices. In subsequent years the bond portion was able to supply most, if not all, the current income needs to the family or endowment beneficiaries. This worked particularly well in high, by today’s standards, interest periods where there was need to pay out 5% of the principal. (One believes the 5% requirement instigated by the IRS on charitable funds was a subtle attempt to end the immortality of these funds.) In today’s world of high inflation, the expected spending rate should be no higher than 4% on average over an investment cycle. For tax-paying accounts, like wealthy families, the long term payout ratio should be 3%. I will be happy to discuss these views privately with both the receivers and givers of these funds.

Today’s Reality

With the interest rate on high quality bonds (for sake of argument, US Treasuries) historically low today and likely to rise due to inflation, the outlook for bond prices of the high quality nature is dim. Inflation is expected to rise in the near term due to the government and central banks’ manipulation through quantitative easing and similar measures, including this week’s currency intervention. Notice when the government does these things, it is called intervention; the same moves in the private/commercial world would be called manipulation. The second and more natural cause for increased inflation expectation is the cyclical recovery of many of the world’s economies, as demand comes up against short term supply capacity constraints.

Thus, I believe there is significant price risk to bonds larger than their annual coupon. The professionals call this interest rate risk, to identify when interest rates go up, forcing the prices of existing bonds to decline.


Current Practice

I sit on a number of non-profit investment committees who have evolved an asset allocation strategy of roughly 60% equities (split between so-called domestic and foreign stocks), 30% in bonds and 10% in short term cash instruments. The reason for the last 10% is to assure the recipients of a 5% spending rate that, even if the investment world would collapse and the other assets would be wiped out, they would receive payments for two years.

The Dilemma

We cannot produce a cash income equal to the desired long term spending rates from today’s portfolios. None of the allocations are producing current cash returns to meet the assigned needs. The last several years have demonstrated that while stocks in the long run produce superior results, the variability of their returns do not meet the annual needs each and every year. In today’s environment there are four methods of dealing with this problem:

1. Accept some capital risk and use lower quality (high yield) paper, usually bonds or very high dividend paying stocks.
   
   
2. Use an averaging technique in setting the spending rate on the basis of the average of a certain number of years. The most popular period advocated by many consultants (for their own business reasons) is three years. There is much history to indicate that one can get three year movements in one direction, unlikely then to be repeated in the immediate future. Four years works better in the US, perhaps due to the presidential cycle. My personal preference is five years, as it often links well with the strategies of many corporate CEOs.
   
   
3. Accept long term defeat by accepting a limit to the institution’s or family’s mortality by recognizing that the asset pool will shrink into eventual oblivion.
   
   
4. Adjust the current spending practices to today’s reality.

I have dealt with all four approaches and each can be appropriate depending upon the situation. My preferred approach is to turn my back on fixed income, keep a short strategic reserve for capital opportunities and adjust the spending rate to a long term average. To the extent that bonds are required, we have recently reduced our commitment to Intermediate US Treasuries in favor TIPS. There is a substantial give up in income, approximately 240 basis points at the ten year level. However, since the end of 2010, a TIPS fund has gained 2.88% compared with 1.04% for an Intermediate Treasury fund, roughly making up ¾ of the yield gap.

The Vacuum Will Be Filled

Among the most creative members of the financial community are the investment bankers focused on fixed income. I fully expect that the minds that created securitization of mortgages, credit card asset backed securities and other asset types are at work to fill the vacuum created by asset allocation requirements. This time, let us hope that they produce sounder products for investors. The other solution is that the courts will decide that including fixed income in asset allocation is not necessarily prudent. One has difficulty thinking of many large fortunes made through investing in bonds, but there are a number that have been diminished.

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Have We Created New Fiduciary Standards?

I am fortunate to be a member of various non-profit investment committees along with a number of very keen investors. In these settings we are able to share our experiences and relevant readings. I hope that this blog community benefits from these associations. An off-setting disadvantage is that perhaps I read too much.

This week I read an excellent review by the renowned law firm Milbank, Tweed, Hadley & McCloy on the enactment by the State of New York of the “Prudent Management of Institutional Funds Act.” All too often laws and regulations have the impact of lowering the investment returns of sophisticated investment institutions. This is not the case this time, at least through my interpretation of the fine Milbank Tweed article.

Diversification

Diversification or “diworsification” as it is known in some circles, is addressed intelligently in the new regulation. The law appears to require a written investment policy statement to demonstrate compliance with the diversification directive unless the institution determines that it would be better served without diversification. If the institution deems that it would be better served without diversification, that policy needs to be affirmed each year. Mathematically oriented investors might point to the anomaly that if one could find the single best investment, adding a second investment (which by definition would not be as good as the first) would lower the average investment return.

The uncertainty of determining the best possible return suggests that a number of alternatives could improve the potential return over a single investment. For some institutions a thorny issue may be encountered when an over-sized position occurs due to an extra large gift of a security or perhaps more intriguing, a stock position that disrupts diversification due to its way above average performance and expected future growth. Thus, there may be a conflict between diversification and expected benefit to the institution. As an investment advisor as well as a member of various investment committees, I believe the mere fact that the issue of diversification should be regularly reviewed is a breath of fresh air.

The act, and there are similar acts in most states, does not define diversification. In the past, the laws governing investment relied on the 1830 dictate of Judge Putnam, deciding against Harvard College as to what was required to be considered prudent. In effect, he created the whole performance measurement sub-industry that clearly benefited me and perhaps investors, by requiring the prudent investor do those things that other intelligent and prudent investors do with their own money. The recently enacted New York State law appears to define “prudent” as actions that consider eight factors without specific reliance on what others are doing. Thus, trustees need to make their own decisions as to what prudence requires without necessarily being led by others. In many ways this may liberate investors from slavishly following the current popular policies, e.g. emerging markets, private placements or ETFs. At the same time, this freedom is frightening to the less-knowledgeable investment committees. In determining the prudence required, some institutions may want to review the makeup of their investment committees and/or consider the addition of one or more external investment advisors.

The role of each investment

The act, or at least Milbank Tweed’s interpretation, appears to drill down to the individual security position. Apparently each position has to be an integral part of the portfolio. Portfolios can no longer be a mere collection of assets without relation to one another. From my viewpoint, this focus can be extremely useful in the long run. All too often a security that is down in price significantly is an immediate candidate for sale for many investment committees. I believe that all positions should be reviewed for their potential to add, or in the case of down markets, stabilize the future value of the portfolio. One of the ways I and others build portfolios is to include investments that are likely to do well under a certain investment climate. Almost by definition some or all of these “hedges” will do poorly under other market phases. When they do poorly I am reluctant to remove them if I still consider that there is a reasonable chance that the investment wind will shift in their direction. I get extremely nervous when all the securities in appropriately balanced portfolios are going in one direction. At a recent client meeting, I commented that all of our fund investments were producing positive returns for the first ten months of the year, and that I was nervous as there were no losers. In the future this would unlikely be the case.

Spending rate

Perhaps the most significant element in the article is the following quote: “….spending in excess of 7% of the fair market value of a fund (calculated based on quarterly estimates averaged over a five year period) will be presumed imprudent, which presumption may be rebutted.”

There are several important elements to the quote. The first is the identification of an imprudent level. Second, the use of a twenty quarter average return. Third, that the imprudence contention can be rebutted. That the law (or at least Milbank Tweed) is, in effect, rate-setting, goes beyond the normal principles-based regulation. (I find it perhaps ironic that the level chosen is one percent above the old impermissible level of usury at six percent.) The rate chosen is below numerous pension assumptions, thus could be a cause of concern in the business and labor communities.

The suggestion of a five year rolling quarterly measurement device is a step in the right direction. In the institutional community, three years is the most popular measurement period. The cynic in me believes that three years is the shortest period that many consultants use to urge the replacement of a manager and the initiation of another fee generating search. The analyst in me objects to using three years, as often the market can move in one direction for the entire period, which is not representative of longer periods. The SEC appears to agree with me in requiring performance calculations within fund prospectuses to include one, five and ten years along with since-inception reporting. Market historians and at least one major investment management group have found that the best single fit to the statistics is four years. I suspect in part this works because of the US presidential election cycle that some market pundits use.

What is refreshing is while the lawyers have gotten deep into the weeds of setting investment policies, they have accepted that these views can be rebutted successfully.

Conclusions

As investors and investment managers, we must be aware of changes that lawyers and regulators force on the artform of investing. In the case of the Prudent Management of Institutional Funds Act, some of the clarifications are positive and far reaching. As fiduciaries, all involved are going to be held to a higher standard of prudence not just copying what others are doing.

What are your views?
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