• Markets have climbed a wall of worry — but worry continues
  • Uncertainty stems from both policy and fundamentals
  • Consider new strategies for building risk-aware portfolios

A goldilocks economy gets little respect

The bull market in stocks is seven years old, but it may be the most unloved bull market in generations. Growth is moderate, interest rates and inflation are low, and yet the benefits that most people would normally expect to see — higher incomes and robust confidence — simply haven’t materialized.

Instead, uncertainty appears to be the spirit investors can’t shake.

Sticking with a long-term financial plan when market conditions turn challenging always requires dedication. But, the challenge today is unlike any that investors and their advisors have seen, largely due to the unprecedented monetary policy conditions that were in place for many years.

With the Fed beginning to normalize policy and other changes at hand, it’s imperative for investors to consider newer strategies for building diversified portfolios. Markets in the next few years could easily be more volatile than during the bull market.

Indexes may not be the answer for income-oriented investors

In 2013, when Fed policy makers merely revealed a discussion of “tapering” the central bank’s quantitative easing program, the Barclays U.S. Aggregate Bond Index delivered its first negative annual result in more than a decade, returning -2.02%. And, today, interest-rate risk in the index is just as high — if not higher — than in 2013.

Lots of duration for little yield in the Barclays Agg

Interest-rate risk, also called term structure risk, is the first and — we think — most prevalent risk facing bond investors today. Investors with strategies aligned with indexes such as the Barclays U.S. Bond Aggregate Index could experience an uncomfortable level of volatility if rates begin to march higher.

Active strategies for managing interest-rate risk — those that can bring down the sensitivity to higher rates, as measured by duration — can be a beneficial complement to traditional income solutions.

Explore opportunities at the short end of the yield curve

Money market funds are undergoing a rare regulatory overhaul. While they should continue to offer attributes similar to what investors have learned to expect of them in recent decades, the introduction of reforms makes it a worthwhile time to take a broader view of how to target investing near the short end of the yield curve.

Effectively, debt securities that until recently were deemed to be money market eligible but are now off limits have been given a new lease on life: By being excluded from the money market category, they offer a slight yield advantage relative to their more constrained money-market-eligible counterparts. In this way, short-term investment vehicles that can exploit the space between money markets and ultra-short bond funds may simultaneously offer a robust capital preservation profile as well as real higher yield potential.

Balance a portfolio with modern diversification strategies

The classic diversification strategy familiar to many is a balanced portfolio of 60% stocks and 40% bonds. While it’s simple, it could lack effectiveness in reducing portfolio risk. That’s because 90% of the risk in a balanced portfolio still comes from stocks, based on historical data.

That is why it is important to globalize allocations and consider adding a broader set of asset classes to the traditional balanced formula. Small-cap stocks and high-yield debt securities are examples of assets that could broaden diversification, but might be left out of a classic balanced portfolio. Of course, diversification does not guarantee a profit or ensure against loss, and it is possible to lose money in a diversified portfolio.

In addition, it’s worth considering an absolute return approach that seeks uncorrelated sources of return. The absolute return philosophy is, by nature, extremely flexible, with greater independence from traditional benchmarks. Along with asset class and geographic flexibility, absolute return strategies can include use of derivatives that seek to gain exposures more efficiently or seek to isolate and mitigate specific types of risks.

Keep a wide-angle view of risk

It’s clear that this economy has reasons for both optimism and pessimism, but given widespread uncertainty, flexible strategies that have room to maneuver can offer value to a portfolio. Most of us do not have the luxury of waiting for conditions to appear more certain in order to pursue investment goals, and sticking to a well-diversified financial plan remains the best course for most. It only makes sense to consider taking advantage of the best in newer and traditional strategies in building a plan.