For those of us who remember Professor Henry Higgins from
“My Fair Lady,” it took some time, but he did come around and see that Miss Doolittle was something more than just a project. The lyrics of “I've Grown Accustomed to Her Face,” clearly depict the unintended consequences of a modest wager! We are now in an unfortunate situation where the capital markets have “grown accustomed to the face” of continued, significant governmental stimulus. And as a result, we are observing a number of unintended consequences.
Case in point: Without the Federal Reserve's quantitative-easing program, the Bank of England's purchase program, the European Central Bank's bond-buying program, and the Chinese and Japanese support for their equity and capital markets, it seems pretty clear that no one is motivated to reduce cash positions and increase spending without some clarity somewhere.
DISFUNCTIONAL CONDITIONS
It's a dirty little secret in Economics 101 that if no one is spending or if everyone decides to pay down obligations at the same time, there will be reduced economic activity, resulting in slow or no growth. Witness the precipitous fall in oil prices. At the time of writing, crude is trading at $47.98, down over 55% from the $107.26 peak in June 2014. But for the domestic U.S. economy, is this halving of oil prices translating into a turbocharger for domestic growth? No. The reason? Consumers are sitting on savings, paying down debt, or simply replacing their incremental gas purchases with a like amount of modest spending. Unfortunately for the economists, no “multiplier” is evident.
Then there's Greece. It's hard to believe that the continuing Greek debt saga has been influencing the global credit markets for almost six years. Plus, we are seeing liquidity issues in the U.S. high-yield and corporate-debt markets, coupled with concerns about the Fed's plans to hike interest rates.
WHAT TO DO
When it comes to managing fixed-income exposures in client portfolios, many financial advisers turn to investments in large, index-driven mutual funds. Why? It mostly has to do with expectations. Since rates are expected to rise (which will have a negative impact on the value of fixed-income instruments), and the expected return profile will be modest, the decision to allocate assets to index funds is defensible to clients.
But with the current state of the fixed-income markets, such indexers are unlikely to capture the right total-return and income opportunities for investors. As such, advisers should devote more time and effort to seek out the best, diversified total-return opportunities — much like they do across the equity landscape.
The question is: Do complementary actively managed fixed-income alternatives exist? Where could they fit in the investing scheme? The answer lies in the nature of today's fixed income markets — and how wrong the conventional wisdom on rising rates has been.
MARKET OPPORTUNITIES
Market opportunities arrive sometimes predictably but often of their own volition — causing certain fixed-income asset classes or credit sectors to perform better (or worse) than others. The key is for advisers to find actively managed funds that capitalize on the opportunities created by market conditions, thereby generating more attractive returns when compared to the index. This includes managers who seek “long” investments (i.e., where the manager expects the value to increase) and “short” investments (i.e., where the manager expects the value to decrease) –— and manage both positions in a portfolio.
In today's market, long investments (or undervalued credits) may include tax-exempt and taxable municipal bonds or high-yield corporate bonds, while short (or rich bonds) investments may include U.S. Treasuries or selected investment-grade corporate bonds.
Does this mean there's no place for index-driven funds in an investor's fixed-income portfolio? Of course not. But with the current environment as unpredictable as it is, investors should allocate some portion of fixed income to actively managed instruments — particularly those with non-correlated volatility and return profiles — to add diversification and navigate periods of rising rates.
THE FED MISSED THE CYCLE
The tepid recovery took place, and the Fed is now about to commence a tightening cycle at the same time that a cavalcade of events could conspire to knock down the world economy. In choosing to place index-driven funds in client portfolios, advisers must beware of the unintended consequences of the actions they commit to — particularly when such actions are largely generated by policy or a need to demonstrate political correctness.
Fixed-income markets have been, and continue to be, directly affected by the many liquidity programs outlined above. In the end, it will be the unintended consequences of these and other attempts at “fixing” the capital markets that may encourage advisers to seek alternatives to large, index-driven mutual funds.
Alan Hart is chief investment officer at Cedar Ridge Partners.
