A common question many clients have had over the years as they’ve asked us to take on managing their investments is “how do you manage my money?” Our answer to this for many years has been that we use a long-term focused strategy, accomplished through the use of low-cost passive index funds. A caution we give on a regular basis is that we won’t call to panic clients when the market is bad, telling them they must “sell sell sell” or calling to tell them “buy buy buy” when something exciting is happening in the market. Rather, we emphasize that we’ll change the allocation of the investments when the market is favorable in order to not make changes as an emotional reaction to bad news. That said, we always have given a caveat: We’re not going to stand in the way of a train when we see it coming. Today, we see a train coming and we’ve decided to step off of the tracks.
Changes in Our Investment Models to Date
Our current investment models have been in place for a little over two years at this point. As a result of our investment philosophy, in over fifty securities across thirteen portfolio models, we’ve only replaced two in the past two years. The first was an exchange of iShares Core Total USD Bond Market ETF (IUSB) for Vanguard’s Long Term Corporate Bond Index Fund ETF (VCLT) in Q1 of 2020. To be frank, we had waffled on a decision between the two when the models were first established in Q4 of 2019, and ultimately decided to switch over shortly after the model’s inception. That decision has netted that part of our client portfolios an additional 1.8% over the past two years; not much to write home about, but every dollar counts. The second change was in March of 2021 when we exchanged the Vanguard Health Care Index Fund ETF (VHT) with the Vanguard Information Technology Index Fund ETF (VGT) in order to underemphasize the healthcare sector going forward and overemphasize the technology sector. This decision to date has produced a difference of 8.17% to date in these positions.
Otherwise, we are proud to say that the other fifty-odd positions we hold in our client models have been top performers in their categories, scoring perfect and near-perfect scores in the fiduciary scoring methodology, and providing market-level returns at a nominal cost thus far. Staying true to our long-term focused philosophy, we’ve been well rewarded by returns in excess of historical averages, though we are always cautious and remember that historical performance is not a guarantee of future outcomes. That said, to date we have not seen any trains coming our way and have been fortunate not to be hit by any.
The Train We See Coming
The train we now see coming our way is that of the Federal Reserve, specifically its projection of three rate raises, and possibly even four rate raises in 2022. The markets opened this year on a trepidatious basis, with stocks and fixed income securities remaining relatively flat or pulling back in an anxious response to the possibility of a Federal Reserve rate raise happening sooner than predicted. At his confirmation hearing earlier this week, Federal Reserve Chairman Jerome Powell stated openly that the economy no longer needed aggressive stimulus, which has been caused to date by the Federal Reserve’s investment in the fixed income market (putting more cash into the economy directly) and keeping interest rates low, making borrowing money cheap. With a stance towards no longer providing easy money, and open statements of multiple Federal Reserve board members that rates are likely to raise, we can clearly see an impending risk to fixed income securities.
The Impact of that Train
In the fixed income market, there is a concept called “Macaulay’s Duration.” Without getting into the weird math of it (if you’re into it, it’s here), Macaulay’s Duration (we’ll just say “duration” going forward) describes the weighted average point that cash flows of a fixed income security are received. Duration is measured in years: the shorter the duration, the sooner that investment’s average weighted cash flow is received, and the longer the duration, the longer it takes to receive that cash flow. More importantly, duration describes the relative level of sensitivity a fixed income investment has to change in the risk-free rate of the market, which is presently set as the discount rate of the Federal Reserve, which is currently 0.25% and has been since March 16, 2020. If the Federal Reserve discount rate goes up from 0.25%, that will have an immediate and negative impact on existing fixed income assets. The shorter the duration of those fixed income assets, the lesser the negative impact, and the longer the duration of those fixed income assets, the greater the negative impact. The inverse was true prior to the March 16th date, when rates declined in response to the pandemic, the value of short duration fixed income assets increased modestly, while long duration fixed income assets increased substantially, and were some of the best performing assets of 2020.
Stepping Off the Tracks
Up to this point, our portfolios with fixed income assets have been weighted toward the intermediate and long term. This treated us very well in 2020 because of the aforementioned rate decreases and treated us decently in 2021 as those rates remained stable. However, now faced with imminent rate increases throughout the year, we have made the decision to get out of the way of that particular train. As a result, all of our fixed income holdings in the intermediate and long term are being converted to ultra-short and short-term fixed income assets. Specifically, this means divesting holdings of the Vanguard Intermediate-Term Bond Index ETF (BIV), iShares 20 Plus Year Treasury Bond ETF (TLT), Vanguard Long Term Corporate Bond ETF (VCLT), Vanguard Intermediate-Term Treasury Index ETF (VGIT), SPDR Nuveen Bloomberg High Yield Municipal Bond ETF (HYMB), and iShares National Muni Bond ETF (MUB). In turn, we are reallocating these funds to two positions: iShares Ultra Short-Term Bond ETF (ICSH) and Vanguard Short-Term Treasury ETF (VGSH). Respectively, these holdings have extremely low durations, and should experience very little if no losses due to the expected Federal Reserve rate increases that are expected to occur later this year. This doesn’t mean they are guaranteed to perform in any particular way, only that we are reducing the exposure to that particular risk.
The Consequences of Stepping Off the Tracks
The decision to shift our fixed-income portfolio to ultra-short and short durations has consequences. If the Federal Reserve does not raise rates this year, all things being equal, we would expect the yield of intermediate and long-term fixed-income assets to be higher than ultra-short and short-term fixed income assets. If for some reason, the Federal Reserve has been bluffing very boldly and publicly and does not do so, we will see lower returns from these fixed income assets than we otherwise would have. However, if the Federal Reserve does stick to its guns and follow through on its stated objectives, holdings in the intermediate and long-term fixed income categories are almost assured to lose value with each rate increase. As a result, while we are not happy to knowingly reduce the yields in our fixed income portfolio, we would rather deliberately reduce returns to avoid a high likelihood event that would cause actual portfolio losses, than gamble that those higher yields could offset very likely and very real portfolio losses in the event of the rate raise.
How This Affects You
If you are a client with an aggressive risk portfolio, no changes have been made your investments since your allocation has no fixed income assets. If your portfolio is anywhere between conservative to moderately aggressive, then your intermediate and long-term fixed income assets have already been sold and replaced with the aforementioned ultra-short and short-term fixed income ETFs. Later in the year, or possibly the next year, we hope to return to intermediate and long-term fixed income assets, assuming that the Federal Reserve indicates a stable reserve rate on a going-forward basis. We intend to hold the ultra-short and short-term funds only so long as we anticipate or expect the Federal Reserve to continue raising rates. We will contact clients directly regarding the potential tax-loss harvesting or capital gains incurred as a result of these portfolio changes. If you do not hear from us, we do not believe you have been directly affected. If you have any questions, please do not hesitate to ask.
Thanks for involving us in your decision making process. Even with your dumbing down the rationale, I still don’t quite get it but it gives me a general picture of what is happening in the market and why – that is worthwhile information and appreciated.
Pingback: Compromising Active vs. Passive
Pingback: Activity Doesn't Equal Results
Pingback: Everyone is Bad at their Job, So SVB Failed