At the dawn of a cycle of rising interest rates, some of the efforts to help financial advisers and investors move beyond the tired old fixed-income allocations of the past are refreshing.
The latest example comes from Robert Isbitts, founder and chief investment strategist at Sungarden Investment Research.
Among a handful of separate-account models at the two-year-old firm is something called the cash-flow-focused strategy, which is essentially a marriage of
dividend equity and long-short investing.
By now, income-seeking investors should know that the ground is shifting and asset allocation models based on historical bond performance won't likely work.
While it might be OK to make equity allocations based on historic market returns over multiple cycles, such applications for the bond side of a portfolio could leave income-seeking investors wildly unprepared.
“It used to be that your bonds would balance your stocks, but in an era of rising rates, we can no longer count on that,” Mr. Isbitts said. “The best hedge of a stock portfolio is something that by design moves in the opposite direction of the stock market.”
In other words, you might not need bonds at all for a modern-day bond allocation.
On the surface, the Sungarden cash-flow-focused strategy is relatively straightforward.
The first of three components includes
dividend stocks that are yielding a least 1 percentage point above that of the S&P 500, which is currently yielding about 2%.
“The overriding goal of the portfolio is for the total yield to be 3 percentage points over the yield of the S&P,” Mr. Isbitts explained.
That is essentially the long side of the portfolio. It will hold up to 20 stocks, and positions will be either full or half, representing either 4% or 2% of the strategy. But the strategy is extremely flexible, and the total equity allocation could range from 80% to as low as 10%, depending on the outlook and broader market analysis.
The second piece of the strategy is the hedge.
Mr. Isbitts uses broad-market-inverse exchange-traded funds for the short side of the strategy, which typically is a 20% short position.
The ultimate objective is to provide low-volatility income that looks and feels like historic bond allocations.
“In general, we have found that our equities will run somewhere in the 80-to-85 beta range if we're fully invested,” he said. “But by being fully hedged, our beta can get down to around 50.”
Mr. Isbitts said the strategy's target beta, or percentage of the S&P's volatility, is at 50, but that he recognizes a “beta comfort zone” of between 35 and 65.
The third component of the strategy is what he describes as diversifiers or “smoothers,” which include some bank loan and master limited partnership ETFs.
“We call it a smoother component because we are buying things that have a much lower beta, but this component is not a requirement of the strategy,” he said. “It's all part of the process of getting the beta to add up to where you want it to be.”
And therein lies the key to the strategy. Like a bond allocation, it is less about the performance than it is about reducing risk.
“It's always about a risk-return tradeoff, and that's how we target the total market exposure,” he said. “The question we ask ourselves all the time is: Will the market's next 10% move be up or down?”
