Managing Fixed Income for Equity Clients

When you start a business, no matter how much research you do, you don’t know all of the issues that you will run into. What has struck me since I wrote the piece On Bonds in Retail Accounts is that I need to run a bond strategy.

Now, I played with synthetic alternatives, and I may still offer some of them.  I could offer clients that I partially hedge my equity holdings.  Synthetically, on the hedged portion they earn something close to a t-bill rate on average, which is near zero these days, and after my fees negative, though after my performance, hopefully positive. Here is what I ended up writing to a couple clients of mine:

I think I’ve said it before, but market-timing is not a core skill of mine.  Can’t do it.  What I can do is pick stocks.  I’ve had discussions like this with a few others, and if they have a taxable account, and want to hedge their positions, I’ve been toying with an idea, and I’d like to bounce it off you.  For taxable accounts, I offer long only and market neutral, but there’s no reason why I couldn’t offer any percentage hedging in-between zero and full. That would allow people to implement their view of the markets, and if their views change, hopefully not at the wrong time, they could change their hedge amount.

I hedge by shorting Spiders [SPY] against the longs in the portfolio.  My beta seems to be around 0.95, even with the cash I hold, so a fully hedged account of $100,000 looks something like this:

$ 85,000 stocks

$110,000 cash

-$95,000 SPY

I’ve thought about this three ways.  Someone could say to me:

1) Take down the SPY hedge bit by bit over ## months

2) Leave me ##% hedged until I tell you otherwise

3) Here’s a schedule of how much net equity exposure I want at various levels of the S&P 500.

And, I think I could do any of those for clients.  Remember, this is only for taxable accounts at present.  I have not figured out a cost-effective way for doing this on tax deferred accounts.  I suppose I could do it by going to cash or high quality bonds, but is that something people would want for their IRAs?

But when I think about it, the synthetic strategies are only for those who believe deeply in my stock picking abilities, to the degree that any sort of bond strategy versus cash is blown away by the alpha of my stock picking.  In the past, that would have been true.  In the future who can tell?  My good performance could have all been “luck.”

At a prior employer in the mid-2000s, I ran a balanced strategy that was 50% my stock strategy and 50% a bond strategy that I developed.  Though the stock strategy provided most of the alpha, the bond strategy provided much more alpha than most bond strategies did.

In basic, my bond strategy is this: analyze bond spreads relative to likely losses.  Invest accordingly.  If all of the major risk factors are underpriced, invest in foreign bonds, analyzing which countries are willing to accept appreciation of their currency.  I don’t want to put words in the mouth of PIMCO, but this is what I think their unconstrained strategy looks like.

As for me, with smaller accounts, I will be using ETFs and CEFs. The fees will be a lot lower than what I charge for equities.  There are accounts that need bonds as well as equities and don’t want to have multiple accounts.  I am facing that reality, and have come to the conclusion that I have to offer a bond strategy.

To my readers, do you have any advice for me?  Since I am mainly serving individuals, I think I have to go this way, and not be “equities only.”  Let me know.

4 Comments

  • Mike C says:

    David,

    FWIW, here are my thoughts. BTW, I worked as an analyst at a bank investment and trust department so I know how we did it there, and now I’m doing the same thing on my own (although I substantially simplified what we were doing at the bank – way too many gradations of bond allocations). I also know that many RIA/investment advisors basically structure client portfolios as layed out below because when I was at the bank we talked to some different places to get a sort of “best practices” perspective

    At the bank, we had an Aggessive allocation, a Growth allocation, a Moderate Growth allocation, a Balanced allocation, etc on down the line. If I recall, it was 100%, then 85/15, then 65/35, then 50/50 where the first percentage is the stock/risk asset allocation and the 2nd percentage is the bond allocation. Personally, I think the difference between say 85/15 and 65/35 is not big enough to really make a huge difference so I simplified to this:

    Aggressive Growth – 100% stocks/risk assets
    Growth – 75% stocks/risk assets – 25% bonds
    Balanced – 50-50
    Conservative – 25-75

    Client interaction, risk tolerance, IPS (investment policy statement) drives the allocation.

    Given your background, I would think managing the bond portion would be almost a triviality. I would assume for bigger accounts you could do individual bonds effectively, and I understand for smaller accounts going the CEF/ETF route. I am genuinely curious why for smaller accounts you would totally avoid actively managed bond funds. This is what I currently do. I use Hussman Total Return and PIMCO Total Return for my bond allocation, but I have been thinking about further diversifying that. I’ve been thinking of adding Jeff Gundlach’s new fund now that he is on his own. My understanding is he is considered one of the top bond fund managers. I’ve also heard Dan Fuss from Loomis Sayles is really good. My thought with the bond allocation is to put it on auto-pilot as much as possible, and focus my efforts on generating alpha in the risk asset part of the portfolio.

    On a broader point, I think you are right about offering this, because I think most people are looking for a “total solutions” provider. If one only manages the equity allocation, then I think you almost have to stress that to the client, and then they are still left to their own devices on what to do with the rest of the investable money. My thought is why give up that business and more importantly are you really helping that person by basically saying I only do A and you are on your own for the rest. In my view, managing the total portfolio is really win-win for both the advisor and client, and I am actually surprised at the number of advisors who only do stock-picking. My thought is they largely only do that because that is what they like.

    Anyways, I hope this has been somewhat helpful, and I’d love your feedback on some of the funds I mentioned if you care to offer it.

    On a different note, I genuinely hope you are feeling better. Your blog is on my top 5 reading list, and your content is second to none in stimulating thought. I’ll also say I really appreciate your demeanor. I recently had some negative/very unprofessional interactions with another blogger over genuine differences in investment beliefs. You are able to clearly show your superior knowledge while staying humble and not coming across as pompous.

  • RedSt8r says:

    @DM
    Mike C has very good comments, especially as they are from the advisor point of view. I’m coming from the other side as a prospective investor. My objective is to earn “X%” (6%) on my portfolio. I’m retired and depend almost entirely on my portfolio earnings plus SSA benefits. My investment timeframe is about 35 years out to age 100. Based on some previous posts of yours I should be allocated 50/50 given my age. If you don’t offer a bond allocation then I must do so on my own (as Mike C noted).

    That’s okay as far as it goes. I currently have a 33% bond allocation (almost all individual bonds) and 55% large cap stocks (again, mostly individual issues) and 10% cash. The remaining 2% are small caps and international mostly from small accounts in a couple of mutual funds. My problem with bonds today is the inability to earn a decent return. My positions were entered early in 2009 and originally were 3-6 year terms, investment grade with yield to maturity of about 6%. Regrettably several bond issues have been called. I replaced them with dividend stocks.

    Side note: I willingly paid the unconscionably wide spread charged to individual bond investors and understood I’m only given a list of cast off bonds to choose from. I’m not a bond trader. If I got the yield/quality I wanted/needed for my purposes (6% YTM, investment grade, intermediate term) then I was satisfied.

    I do disagree with Mike C regarding bond funds. No matter how well run the fund may be, since all funds maintain a fixed investment horizon (short, intermediate or long) the fund investor will take a serious capital hit when (as) yields rise. Given the Fed’s ZIRP there is no likelihood of current yields declining and only a small potential for them to remain flat. For that reason I’ve chosen individual bonds and will hold to maturity. I would not want to pay an advisor to pick a mutual fund. I can do that. I would especially not want a PIMCO or similar fund as there is a large front end fee (good for the advisor, not the investor). I don’t think there is enough advantage from a PIMCO type bond fund versus a low cost Vanguard or Fidelity or T. Rowe Price index bond fund to justify their fee.

    If a talented advisor selects fixed income ETF’s or CEF’s that provide a significant advantage that is acceptable. But you already noted you’re not a market timer. How would you avoid the risk of a capital loss as yields rise? I may be over reacting to that potential but I would certainly prefer individual, intermediate term, decent bonds that can be held to maturity so as to be more certain of my income and capital. After all, isn’t that the purpose of a bond allocation? Mike C has correctly noted that many investors are likely to be looking at an advisor to provide a more complete service than just stock picking. Given your talents and history I would want you to provide a bond allocation – just not a bond fund.

    Having said that, if all you want to do is pick stocks and that is made clear up front I can live with that. I can always pick a low cost bond index fund as a worst case to pick up the bond allocation. Still, given your skill set if you can select individual bonds or well timed ETF/CEF fixed income picks that would be a significant plus. As an investor looking at my total portfolio my objective is to earn “X%” (6% in my case). This could be a portfolio that is 50/50 with a 4% yield on individual bonds and 8% gains on an alpha boosted set of stocks (dividends + price appreciation). The million dollar question is, “can this be accomplished with some confidence on a long term basis?”

  • Mike C says:

    Redstar,

    Excellent comment. Your comment was helpful to me as an advisor considering the client perspective. Let me address a few of your points.

    Firstly, and this is VERY IMPORTANT, it is clear to me from your comment that you are a sophisticated, knowledgeable investor in your own right. As far as the overall client base of average, ordinary people your knowledge obviously far exceeds the average person. The average person wouldn’t have a clue what duration is, the relationship between interest rates and bond prices, and I’d bet a good number couldn’t define the difference between a U.S. Treasury bond, municipal bond, corporate bond, and mortgage-backed security.

    I mention that because it potentially speaks to the value-add proposition of selecting bond mutual funds to buy and hold for the bond allocation. I’ve wrestled myself with “how much value” am I adding there. Couldn’t someone “do that themself”. Someone like you? Sure. You don’t need me to pick out PIMCO Total Return for you and pay me to do it. The average person I doubt it. The average person can blow themselves up in the bond allocation just like the stock allocation. I’d love to know how many bond portfolios got blown up in 06-08 by overdosing on high-yield bond funds and mortgage-backed funds that were selected on NOTHING but current yield. So I guess my thought is if I can put together 2-3 good quality bond funds that serve the function of providing some decent return and smoothing portfolio volatility then I’ve done my job relative to someone blowing up that part of their portfolio if they do it on their own.

    I’ll say that in my opinion 6% nominal returns on a 50/50 portfolio is awful ambitious given current interest rates and overall stock valuations as of today. As Hussman said in a recent commentary, the returns of the last 2 years have probably borrowed significantly from the future, but who knows how much of a stock bubble current policy can end up blowing. Birinyi thinks we are going to 2800 on the S&P 500. That will get you your 6% and a heck of a lot more.

    I replaced them with dividend stocks.

    Roger Nusbaum of Random Roger blog has had some compelling posts why dividend stocks should NOT be viewed as bond substitutes. I would tend to agree with his view.

    I do disagree with Mike C regarding bond funds. No matter how well run the fund may be, since all funds maintain a fixed investment horizon (short, intermediate or long) the fund investor will take a serious capital hit when (as) yields rise.

    Maybe yes, maybe no. Presumably with a well chosen bond fund managed by a skilled manager you have a manager who is actively managing duration and very cognizant of duration risk. I know Hussman has kept a very short duration, and I believe Bill Gross is doing the same. So I’m not sure the capital hit would be “serious” and once the “hit” gets taken the fund yield is going to move up and be reinvested in the fund at lower prices if automatic fund reinvestment is taking place. I really think it is less an issue of individual bond versus bond fund and more a question of how much interest rate risk you have period. If you have individual bonds, and rates begin moving up due to higher inflation, sure you’ll get your principal at maturity but in the meantime your the real value of your interest payments is declining as you are locked into those positions. If you sell the bond, take the capital price loss, you can turn around and buy a bond with a higher yield. Either way, if you are really long duration, and rates begin moving up rapidly, you are screwed either way whether you have a long duration bond fund, or a bunch of individual bonds that don’t mature for 10-20 years. I’m a bit outside my bailiwick here, so I hope David will correct me if he thinks I am totally off-base here.

    BTW, most fund families including PIMCO have share classes that do NOT have up-front fees. From recollection, PIMCO class A shares have the upfront load while class D shares do NOT. I would NEVER buy a fund with an up-front load for a client account. I’d have to check the numbers, but I’m pretty sure Bill Gross has outperformed the Vanguard or Fidely Bond Index Funds by enough of a margin to pay the fees. I hope David will expand on using ETFs and CEFs for all or part of the bond allocation. Perhaps I need to expand my competency. I have never used CEFs but I am guessing there is an alpha opportunity if purchased at the right discount to NAV. Again, I hope David will talk about this and maybe do a post on CEFs.

    I would also add that my thought on the purpose of the bond allocation is to reduce portfolio volatiilty, get some real uncorrelated diversification in risk asset downcycles, and obviously provide some decent minimal return although it is tough in this credit environment I would think.

    Anyways, again, great comment that gave me some stuff to think about.

  • Piper says:

    I have read this blog for a couple years and was struck yet again by how civil and informative the comments are. I often learn more from comments than from the article, which is a pretty high bar to exceed. And I think Mike is right – that tone is entirely attributable to the care that David takes in laying out his discussion, and how he deals with the occasional flames. Those readers who go for bombast probably tune out quickly :) So a belated thanks for a great blog that has helped me approach investment decisions more rationally.

    On topic: while your portfolio is by no means an index, I think that it would very likely fare not much worse than the broad market during a sudden downturn. So I tend to dismiss that risk. If you want to diversify your offerings to become a single-stop investment for clients, then your ETF/CEF/bond strategy is sensible. But I question whether that do an adequate job as a bear market hedge. From the little that I know, an appropriately scaled SPY short or a short ETF like SH is a more efficient hedge against stock portfolio losses in a rapid bear market than a fixed income position is. Of course, the easy answer is why not offer both the fixed income and more “pure” hedging options? If the answer is your ability to provide quality investment options in both areas without having the stock picking suffer, then I think you should choose which goal (offering stock/bond balance or hedging against stock portfolio tanking) is more important to David and offer that option for now.