•• But don’t these alternative income sources have higher risks than Treasurys?
That’s absolutely true, and a very important point. The hypothetical diversified portfolio does display higher overall volatility than the traditional bonds, as reflected in its higher standard deviation measure. It also shows a higher maximum drawdown, meaning the largest single peak-to-valley drop in value during the period.
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Our analysis found that a hypothetical diversified income portfolio would have outperformed traditional bonds during the 1941-81 bear bond market.
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But investment professionals also look at an additional metric, namely, risk-adjusted return, which is usually measured by a portfolio’s Sharpe ratio. If you believe that investors should be compensated with higher returns for the risks they are assuming, the Sharpe ratio is worth considering. The higher the Sharpe ratio, the better the risk-adjusted return. On that basis, our analysis shows that the hypothetical portfolio would have delivered rewards more than commensurate with the risks.
•• Did you do any other portfolio testing? What can investors draw from your findings?
Yes, we did. Given the risks associated with potential interest rate hikes, I wanted to see how a diversified portfolio would have performed during the periods of rising interest rates starting in the late 1970s, by which time there was better asset class performance data.
Just to be clear, the time span covered by the exhibit included periods of declining interest rates and others in which rates were rising. The performance shown is only for those periods when interest rates were rising. You might notice that I tested somewhat different asset classes than I did in the 1941 to 1981 analysis. By the ’70s, investors were able to take advantage of emerging asset classes that hadn’t existed before.
Once again, several income-producing asset classes matched or exceeded the yield from a broad-based index of U.S. bonds, and all the income alternatives generated higher total return (Figure 8). They also experienced higher volatility. But if interest rates rise, in all likelihood investors would be earning more yield to help offset that risk – though investors should always take to heart the disclaimer that past performance doesn’t guarantee future results.
Figure 8. Treasurys Lagged Some Other Asset Classes as Interest Rates Rose
Comparison of Asset Class Performance during Periods of Rising Interest Rates
January 1, 1989 – December 31, 2012
Note: Total portfolio returns and other performance characteristics are not shown, as return and yield data are reflective only of index performance during periods when interest rates rose 5% or more.
Source: Ibbotson Associates
Past performance does not guarantee future results.
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To my mind, it’s precisely because the world is so unpredictable that a diversified approach to investment income makes sense in any market climate.
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•• This whole discussion has put the notion of “safe and solid” bonds in a whole new light. What do you recommend that investors do now?
In my view, anyone who is concerned about the risks we’ve been discussing would be well advised to talk with his or her financial advisor. I’d want to know exactly how my portfolio is positioned from the standpoint of bond market risks and future income-generating potential. Then you’ve got a good basis for discussing whether you want to shift your portfolio allocations and what alternative income sources you might want to consider.
•• Any final thoughts?
Just another cautionary note – which is to say that only time will tell if the bull market in bonds is truly over. But to my mind, it’s precisely because the world is so unpredictable that a diversified approach to investment income makes sense in any market climate. I can’t think of any possible future market trend that should discourage investors from casting a wider net for investment income.
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Definition of Terms
Affordable Care Act is the federal statute signed into law in March 2010 as a part of the healthcare reform agenda of the Obama administration.
Basis points are units that are equal to 1/100th of 1%, and are used to denote the change in a financial instrument.
Bear markets describe a market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment to be self-sustaining.
Bull markets are characterized by optimism, investor confidence and expectations that strong results will continue. It’s difficult to predict consistently when the trends in the market will change. Part of the difficulty is that psychological effects and speculation may sometimes play a large role in the markets.
Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance.
Earnings yield is the earnings per share for the most recent 12-month period divided by the current market price per share. It is the inverse of the P/E ratio, and shows the percentage of each dollar invested in the stock that was earned by the company.
Emerging Markets describe a nation’s economy that is progressing toward becoming advanced, as shown by some liquidity in local debt and equity markets and the existence of some form of market exchange and regulatory body.
Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.
Maximum drawdown is the greatest drop that has occurred from the highest value of an asset over a course of time. The maximum drawdown is used in finance to evaluate how risky an investment is.
Risk-adjusted return is a concept that refines an investment’s return by measuring how much risk is involved in producing that return, which is generally expressed as a number or rating.
Sharpe Ratio is a ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate-such as that of the 10-year U.S. Treasury bond-from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.
Short selling is defined as the selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.
Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance.
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Definition of Indexes
Barclays High-Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.
Barclays Municipal Bond Index is an unmanaged index considered representative of the tax-exempt bond market.
Barclays U.S. Mortgage Backed Securities Index is an unmanaged index measuring the performance of investment grade fixed-rate mortgage-backed pass-through securities of GNMA, FNMA, and FHLMC.
Barclays U.S. Corporate High-Yield Bond Index is an unmanaged index that covers the universe of fixed-rate, noninvestment-grade debt.
Barclays U.S. Credit Index is an unmanaged index considered representative of publicly issued, SEC registered U.S. corporate and specified foreign debentures and secured notes.
Barclays U.S. Treasury Index is an unmanaged index of public obligations of the U.S. Treasury with a remaining maturity of one year or more.
FTSE NAREIT All Equity REITs Index is a free float adjusted market capitalization weighted index that includes all tax qualified REITs listed in the NYSE, AMEX, and NASDAQ National Market.
JPMorgan Emerging Market Bond Index measures the total return performance of international government bonds issued by emerging market countries that are considered sovereign (issued in something other than local currency) and that meet specific liquidity and structural requirements.
Ibbotson Associates SBBI U.S. Intermediate-Term
Government Bond Index is an unweighted index which measures the performance of 5-year maturity U.S. Treasury Bonds. Each year a one-bond portfolio containing the shortest noncallable bond having a maturity of not less than five years is constructed.
MSCI World High Dividend Index is designed to reflect the performance of the high dividend yield securities contained within the broader MSCI World Index.
S&P 500 Index is a capitalization-weighted index of 500 stocks traded on the NYSE, AMEX and OTC exchanges, and is comprised of industrial, financial, transportation and utility companies.
One cannot invest directly in an index.
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The new direction of investing
The world has changed, leading investors to seek new strategies that better fit an evolving global climate. Forward’s investment solutions are built around the outcomes we believe investors need to be pursuing – non-correlated return, investment income, global exposure and diversification. With a propensity for unbounded thinking, we focus especially on developing innovative alternative strategies that may help investors build all-weather portfolios. An independent, privately held firm founded in 1998, Forward (Forward Management, LLC) is the advisor to the Forward Funds. As of December 31, 2012, we manage $5.7 billion in a diverse product set offered to individual investors, financial advisors and institutions.
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Nathan Rowarder is a registered representative of ALPS Distributors, Inc.
Forward Funds are distributed by Forward Securities, LLC.
Not FDIC Insured. No Bank Guarantee. May Lose Value.
©2013 Forward Management, LLC. All rights reserved.
All other registered trademarks or copyrights are the property of their respective organizations.
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About the Author
Nathan Rowader
Director of Investments at Forward Management, San Francisco Bay Area. Area of interest: Financial Services.
Previously worked for OppenheimerFunds and Wall Street On Demand.