Avoiding Consensus

Over the last couple of months there started to be more pundit sentiment that investors needed to add duration in the fixed income sleeve of their portfolios in belief that the shortest of rates had peaked, would start going down leading to the yield curve breaking out of its inversion and then intermediate and longer term yields would start working lower too. That expected sequence became the argument to add duration. That argument might pan out but being cynical for a moment, how many pundits who have been saying to add duration here, were right about avoiding duration for investing as opposed to trading for gains at any point when yields were at all time lows and going lower?

I've been pushing against adding duration for ages and continue to do so. For many years, more than 10 years, was that the yields were not enough compensation for the the risk if yields were to ever normalize. The threat being you lock in 15 years at 2-3%, yields go up, you take a 30% hit on paper (no loss until you sell) forcing you to sit with a below market yield until six months before maturity. 

That's pretty much what happened starting at the very end of 2021. I don't think of that as prediction that I made because in terms of timing it was wrong for years. It was simply isolating what I thought was an obvious risk and simply avoiding that risk in case there was ever a consequence for that risk.

Correlations between stocks and bonds have gone up. We've looked at that here and you can find plenty of content on that point from other people. If duration is meant to diversify equity exposure but correlations go up, then duration starts to lose it's appeal. The last couple of years have also reminded/taught us that duration can be almost as volatile as equities, sometimes more so. So if correlations have gone up and duration is almost as volatile, then why own it other than to speculate on it going up in price as you might with an equity? I don't see the diversification benefit which as an ongoing theme forces us to think differently about how to build a 60/40 portfolio. I don't think 60/40 is dead, I just think the 40 needs to be overhauled to avoid meaningful exposure to duration.

That's a year to date chart. The people calling for adding duration might turn out to be correct but they can be correct and it can also be true the correlation remains elevated with more volatility. And the point here is just wanting to avoid that volatility. We've probably written a 100 posts about how to build portfolios that avoid duration, giving a better result with lower volatility than something like the Vanguard Balanced Index Fund (VBAIX) which is a benchmark for a 60/40 portfolio.

The building blocks for this idea are pretty simple. Assuming a "normal" exposure to equities is appropriate for the end user, the majority of the portfolio would be in plan vanilla equities whether that means one or two broad based index funds or a narrow based portfolio comprised of individual stocks and narrow based sector/industry ETFs. 

Then a small slice into one or two holding you believe to be reliably negatively correlated to equities. I think managed futures are pretty good at this as just one example. It is important to understand the math though. If you put 80% into an S&P 500 fund and 20% into an inverse fund, then your net long exposure is 60%. There's an assumption here that the daily reset of the inverse fund doesn't work against the example in a horrible fashion. That was just an example, 20% into an inverse fund is way more than I would want to start with. 

And then some sort of allocation to a combo of alternatives that unlike managed futures bring more either absolute returns or have no correlation to equities as opposed to having a reliable negative correlation. 

In past posts, we've been able to model equity allocations of 70-75% that when used as described above have done the same or better than 60/40 with lower volatility. 

The long term results of 60/40 are enough to get the job done provided there is an adequate savings rate and panic selling can be avoided. The goal then is to build something that gets similar results as 60/40 with less volatility. 

The idea of this might sound better than navigating with it as I would expect to lag 60/40 here and there. No portfolio concept can always be best. Any valid idea you come up with for your portfolio will lag at times. I think what I'm describing above will have smaller drawdowns and maybe lag in big up years. We can rationally accept we will lag at various points especially at the start of a new year but then the psychology we confront when it is actually happening is when investment discipline becomes harder, similar as in the middle of a large decline. 

If duration is volatile and you choose to avoid volatility from the fixed income portion of your portfolio, then sometimes volatility will be the "good kind" and duration will go up in price without you. Where equities are the thing that goes up the most, most of the time, that is where I would prefer to get growth and use other asset classes to bring in yield (without much duration) and manage portfolio volatility. 

Adding duration seems like the type of consensus to avoid. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.