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15% + 32(QEx3) = 2.65%

Buy Bonds from this man at 15%? Maybe not such an easy answer back in 1981 or '82. At the time, the economy was in deep recession; then-Fed Chairman Paul Volcker had squeezed short-term interest rates to 20% to fight double-digit inflation, while unemployment soared to 10.8%.

So, in light of those extraordinary times characterized by dismal investor sentiment, it would have taken a discerning investor to see great value in owning long-term bonds. Now 32 years later, after a great bull run in interest rates capped off by multiple rounds of Fed bond buying (QEx3), we find ourselves with near zero T-bill rates, inflation at 1.5%, 10-year Treasury yields at 2.65%, declining unemployment at 6.6%, and new all-time highs for the S&P 500.

These two polar opposite periods in both Fed policy and interest rates serve as a backdrop for a survey of popular online and automated portfolio management. Because most investors have been forced to increase risk and rely primarily on capital gains to meet return objectives, this article sets out to determine what online advisors are recommending to individual investors and how their portfolios stack up.

Online Investment Advisors: Portfolio Management for All

Online advisors provide portfolio management solutions to individual investors with minimums as low as $5,000. These providers define themselves as low cost, tax efficient, all-in-one portfolio solutions for individuals holding either taxable or retirement accounts. To date, online advisors have helped to redefine the 401(k) space by providing an alternative low-fee investment solution by emphasizing low-cost and commission-free index-based ETFs, as opposed to more expensive mutual funds. Given the growing popularity of online portfolio managers, we decided to test how these advisors and their team of software engineers would define an optimal portfolio in our current ultra-low interest rate environment.

Client Profiling

We chose two relatively well-known firms, Jemstep and FutureAdvisor, and set up accounts. We then went to profile a somewhat complicated client, one who requires a near equal balance of wealth preservation and growth - a 50-year-old, whose primary goal is retiring in ten years to coincide with the first year private retirement benefits become available without penalty. The profile questions were basic, such as age, time horizon, and risk tolerance. The latter question offered only one-word choices, ranging from 'conservative' to 'aggressive' to answer a rather complex question. This section did not allow for comprehensive client profiling and relevant surveys to assess not only risk tolerance, but other important client-specific traits, such as those elicited by employers to match individuals to specific jobs and online dating firms to match singles to potential mates.

Recommended Asset Allocation

Note: Within each advisor's portfolio, the results were the same regardless of asset size, ranging from $25,000 to $1 million. This uniformity in portfolios brought attention to the limitations of one-size-fits-all investment solutions, such as target-date funds and their well-documented problems. However, this observation is not the focus of this survey.

The two advisors' resulting recommended portfolios in Figure 1 are materially different in how they balance growth, income, and principal protection given the same basic client profiling input of age, time horizon and risk tolerance. Jemstep's (JS) portfolio is biased towards growth and seeks it with a larger stock/bond ratio near 60/40. FutureAdvisor's (FA) portfolio is biased towards fixed-income with a stock/bond ratio near 40/60. Same client, different portfolios.

On the surface, the FA portfolio may appear to be much more conservative than the JS portfolio because of the heavy bond allocation. However, by applying a portfolio construction technique known as 'risk budgeting' or 'risk allocation' we can identify an inordinate amount of concentrated risk in the FA portfolio contrary to conventional wisdom.

ASSET ALLOCATION: Figure 1

Asset Class

Risk Factor

Jemstep (JS)

FutureAdvisor (FA)

US Stocks

Equity

35%

18%

Foreign Stocks

Equity ~ Currency

13%

10%

Emerging Market Stocks

Equity ~ Currency

6%

7%

Investment Grade Bonds

Interest Rate

28%

35%

IG Corporate Bonds

Interest Rate ~ Credit

6%

0%

Inflation Protected Bonds

Interest Rate ~ Inflation

0%

24%

Commodities

Inflation

5%

0%

REIT's

Equity ~ Inflation

6%

6%

Cash

1%

0%

Data: Jemstep, FutureAdvisor.

Diversified or Not? Introducing Risk Budgeting

A risk budgeting approach starts by identifying primary risk factors or 'risk buckets' inherent in the asset mix of a portfolio. The five primary sources of risk are: interest rate risk ~ credit risk ~ inflation risk~ equity risk~ currency risk.

Figure 2 shows these five primary risk factors, along with the widely held asset classes that provide exposure to them. Once these factors are identified, we then assess the risk exposures relative to a client's investment objective and profile, define an appropriate risk budget, and finally reallocate funds to risk rather than to assets. Risk budgeting methodology augments modern portfolio theory (MPT) by identifying unintended or hidden risk exposure and provides a framework to further enhance portfolio diversification. Because MPT defines risk only as volatility, a risk budgeting approach provides a more comprehensive way to evaluate, limit, and ultimately diversify key portfolio risks that affect and drive asset prices.

Risk Factors and corresponding Asset Class Exposure: Figure 2

(click to enlarge)

Inputs: Wurts Associates, Vanguard, Pimco, JP Morgan

Consider the following two examples:

Example A: In 2013, Treasury Inflation-Protected Securities lost 8.65% as measured by the sector's largest ETF (NYSEARCA:TIP), while year-over-year inflation dropped from 2.1% to 1.5%.

Fund / (Ticker)

Duration

Wtd Avg Maturity

Wtd Avg Coupon

iShares TIPS (TIP)

7.57

8.26 yrs

1.09%

Data: iShares / BlackRock

Normally with a drop in inflation, one would assume that interest rates would decline on the heels of falling prices and drive TIPS prices higher. Yet to the contrary, 10-year US Treasury yields rose from 1.78% to 3.04%; TIPS holders took a significant loss because most widely held TIPS funds are highly sensitive to changes in interest rates (or, have a high duration*). Figure 3 shows that TIPS have a surprisingly low correlation to inflation risk (0.08) while being much more correlated to interest rates (0.76). (A correlation of +1 means that two assets move in perfect lockstep, while -1 indicates that two assets are inversely correlated.) By recognizing that TIPS are exposed to both inflation and interest rate risk, investors can act to mitigate these risks by, for example, substituting a TIPS fund that is less sensitive to interest rate movements (or, has a shorter duration*), and/or supplementing with commodities, REITs, and real return funds to provide inflation exposure without significant rate risk.

*Duration refers to the measure of a bond's price movement given a one percentage point change in interest rates. For example, if interest rates rise by one percent, a bond fund with duration of 7 would drop in price by roughly seven percent, with the reverse holding true as well.

Example B: In 2008, high yield ((NYSE:HY)) bonds lost nearly 30% of their value over the ten weeks following the day Lehman Brothers filed for bankruptcy, spiraling down in near unison with US stocks. Figure 4 shows that HY bonds have been more closely correlated to the risk factors commonly associated with equities (0.76) and much less so to interest rates (-0.02). So, by recognizing that HY bonds hold equity-like risk, investors can, for example, move to combine HY bonds with stocks to better manage their overall stock market exposure.

In examples A & B, each asset is part of its own distinct asset class, namely inflation-protected and high yield bonds respectively. Yet each one is greatly influenced by risk factors contrary to its name: TIPS theoretically provide 'inflation protection', yet are comparatively more sensitive to interest rates than they are to inflation; HY bonds behave more like stocks, yet have little in common with interest rates, which influence traditional bonds. So, rather than solely adding or subtracting asset classes based on historical return and volatility data, by introducing risk budgeting into your asset allocation decision, you now have another method to view and diversify key risk factors that ensure greater portfolio diversity.

Correlation of TIPS to Inflation and Interest Rates: Figure 3

Data: Morningstar Direct, Bloomberg, Nuveen Asset Management, USBLS (from 2/1999 - 12/2012). Inflation risk represented by CPI for Urban Consumers / Interest rate risk represented by Barclays Aggr. Bond Index

Correlation of High Yield Bonds to Equity & Interest Rate Risk: Figure 4

Sources: S&P, FRB, Barclays Cap., MSCI, Credit Suisse/Tremont, NCREIF, DJ UBS, JP Morgan Asset Mngt. Data: Quarterly from 12/2003 - 12/2013 / Equity risk factors represented by S&P 500 Index / Interest rate risk represented by Barclays Aggr. Bond Index

Risk budgeting allows us to measure the contribution of each asset class to overall portfolio risk -- Dennen & Moore, NEPC Consulting

Two Automated Portfolios: Two Distinctly Different Concentrations of Risk

By applying a risk budgeting methodology, we're able to identify the true drivers of risk within each firm's recommended asset mix. Additionally, this approach provides a systematic way to uncover unintentional and concentrated risk exposure, thus allowing for more efficient reallocation of funds to better reflect both investment objective and risk profile. Figure 5 shows the five prominent risk factors and their percentages for each of the portfolios.

Primary Risk Factors/Risk "Buckets": Figure 5

Primary Risk Factor

Jemstep (JS)

FutureAdvisor (FA)

Interest Rate

34%

59%

Credit

6%

0%

Equity

60%

41%

Inflation

5%

24%

Currency

19%

17%

Risk budgeting unveils a high concentration of interest rate risk (59%) in the FA portfolio, centered primarily in government issued or agency related bonds - the consequences being little bond diversification and marginal yield or income enhancement. Because online advisors almost exclusively use low-cost bond index funds, their portfolios will, by definition, be dominated by low-yielding government securities.

Additionally, FA's low credit risk score (0%), indicates no direct exposure to domestic and foreign corporate, high yield, and emerging market bonds. Figure 6 shows each advisor's bond holdings and confirms the heavy bias towards low-yielding, longer duration government-related securities.

Bond Index Funds = Uncle Sam plus Siblings

Many widely-held bond funds are designed to track the Barclays US Aggregate Bond Index, which holds over 75% in US Treasury and other government-related instruments. To paraphrase Vanguard founder John Bogle, benchmark bond indexes are so heavily dominated by government bonds that they provide little diversification and very low yields. Because of that, bond indexes "are deeply flawed" and simply need to be fixed. Moreover, Mr. Bogle suggests investors should alternatively hold about one-quarter to one-third of their bond allocation in government debt, and another one-half in short to intermediate corporate bonds.

Online Advisor's Bond Allocation: Figure 6

Fund / (Ticker)

Jemstep (JS)

FutureAdvisor (FA)

12-month Yield

Duration

iShares 3-7 Yr Treasury Bond ETF (NYSEARCA:IEI)

16%

0.80%

4.52

iShares Int. Credit Bond ETF (NYSEARCA:CIU)

6%

2.67%

4.12

iShares MBS ETF (NYSEARCA:MBB)

12%

1.31%

4.57

Schwab US Aggr Bond ETF (NYSEARCA:SCHZ)

23%

1.98%

5.12

Vanguard Total Intl. Bond ETF (NASDAQ:BNDX)

12%

1.52%

6.62

iShares TIP Bond ETF (TIP)

24%

1.08%

7.43

Source: Jemstep, FutureAdvisor / Data: BlackRock, Schwab, Vanguard

As expected, the FA bond allocation exhibits high price sensitivity to movements in interest rates with extremely low yield. Figure 7 shows that each firm's bond portfolio provides zero to negative real (inflation-adjusted) cash flow yields. And comparatively, FA's portfolio has a nearly fifty percent higher duration vs. the JS portfolio, with only a slight pickup in yield for the added risk. In other words, FA's reliance on index-based, longer-term bonds with no real income enhancement exposes the overall portfolio to an undue amount of interest rate risk.

Bond Allocation: Yield & Price Sensitivity to Interest Rates: Figure 7

Portfolio

Wtd Avg Yield

Wtd Avg Duration

Jemstep (JS)

1.31%

4.47

FutureAdvisor (FA)

1.52%

6.36

Note: CPI for Urban Consumers (2013): 1.46% Data: USBLS

Asset class correlations are typically higher than risk factor correlations because most asset classes contain indirect exposure to equity risk -- Sebastien Page, Pimco

Putting it all Together - Reallocating to Risk as opposed to Assets

From here, we'll apply a risk budgeting approach and reallocate funds to risk as opposed to assets to provide a more diversified blend of income, growth and principal protection. Figure 8 illustrates a diversified risk portfolio using the five primary global risk factors.

Diversified Risk Portfolio: Figure 8

Data: Wurts Associates. Note: Hypothetical example for illustrative purposes only. Risk allocations representative of a balanced portfolio.

As noted, FA's portfolio is highly sensitive to interest rates with little income enhancement to help offset price risk. JS's portfolio is centered on equity risk with minor regard to inflation, and like the FA portfolio, holds marginal yield enhancement. So, we'll focus on these problem areas and reallocate to the appropriate risk buckets to seek a more optimal balance.

Keep in mind that global currencies overlap with the other four primary risk factors, and therefore will be included in those allocations. For the sake of continuity and simplicity, we'll reallocate to ETFs already in each portfolio, and when the necessary exposure and preferred choice is unavailable, we'll first seek out low-cost ETFs before moving on to other funds. Figure 8 shows the recommended portfolio and allocation from each advisor. The last two columns show the results of a diversified risk portfolio after reallocation.

Fund Allocation: Current Portfolio vs. Diversified Risk Portfolio: Figure 9

Fund / (Ticker)

Yield / Expense

Duration

Current Allocation (FA)

Current Allocation (JS) Risk Allocation (FA) Risk Allocation (JS)

SPDR S&P 500 ETF (NYSEARCA:SPY)

1.82% / .095%

23%

0

12.78%

Vanguard Total Stock Mkt Index ETF (NYSEARCA:VTI)

1.86% / 0.05%

7%

6%

0

Vanguard Value Index ETF (NYSEARCA:VTV)

2.44% / 0.10%

7%

6%

0

Vanguard Emerging Market ETF (NYSEARCA:VWO)

2.98% / 0.18%

7%

6%

6%

3.33%

iShares EAFE ETF (NYSEARCA:EFV)

3.08% / 0.40%

4%

3.43%

0

Vanguard Tax-Managed Intl ETF (NYSEARCA:VEA)

2.7% / 0.10%

4%

13%

3.43%

7.22%

Vanguard Small Cap ETF (NYSEARCA:VB)

1.28% / 0.10%

4%

3.43%

0

Vanguard FTSE All-World ex-US Small Cap ETF (NYSEARCA:VSS)

2.77% / 0.25%

2%

1.71%

0

Vanguard Mid-Cap ETF (NYSEARCA:VO)

1.31% / 0.10%

9%

0

5%

iShares S&P Small-Cap ETF (NYSEARCA:IJR)

1.06% / 0.17%

3%

0

1.67%

Total: Global Equity

30%

30%

iShares 3-7 Yr Tsy Bond ETF

0.80% / 0.15%

4.52

16%

0

0

iShares Int Credit Bd ETF

2.67% / 0.20%

4.12

6%

0

0

Osterweis Strategic Income (OSTIX)

4.71% / 0.93%

1.92

20%

20%

ProShares Short-Term USD EmMkts Bond ETF (BATS:EMSH)

3.97% / 0.50%

2.13

2.5%

2.5%

iShares Global ex-USD Corp High Yield Bond ETF (BATS:HYXU)

4.87% / 0.40%

3.01

2.5%

2.5%

Total: Global Credit

25%

25%

iShares MBS ETF

1.31% / 0.27%

4.57

12%

0

0

Schwab US Aggr Bond ETF

1.98% / 0.05%

5.12

23%

0

0

iShares Int Govt/Credit Bond ETF (NYSEARCA:GVI)

1.72% / 0.20%

3.73

12.5%

12.5%

Pimco Enhanced Short Maturity ETF (NYSEARCA:MINT)

0.72% / 0.35%

0.67

7.5%

7.5%

Market Vectors EM Local Currency Bond ETF (NYSEARCA:EMLC)

5.43% / 0.47%

4.55

5%

5%

Vanguard Total Intl Bond ETF - USD Hedged

1.52% / 0.20%

6.62

12%

0

0

Total: Global Rates

25%

25%

iShares TIPS Bond ETF

1.08% / 0.20%

7.43

24%

0

0

Vanguard ST Inflation-Protected Sec ETF (NASDAQ:VTIP)

0.05% / 0.10%

2.4

8%

8%

Elements Rogers Intl Commodity ETN (NYSEARCA:RJI)

0 / 0.75%

5%

6%

6%

Vanguard REIT ETF (NYSEARCA:VNQ)

2.78% / 0.10%

3%

6%

3%

3%

Vanguard Global ex-US Real Estate ETF (NASDAQ:VNQI)

3.41% / 0.32%

3%

3%

3%

Total: Global Inflation

20%

20%

Total: Currency

25.07%

21.05%

Note: Newly added funds in bold.

Summary of Changes - Diversified Risk Portfolio

Global Interest Rates:

Both online advisors suggest that a middle-aged client with a clear eye towards retirement be largely exposed to longer-term bonds that are highly price sensitive to a rise in interest rates - all without regard to the macro environment, negative real interest rates, ultra-low inflation, and the effects of the Fed's bond buying program. Here's where the judgment and experience of a savvy portfolio manager clash with online algorithms based on theory and historical data. As an alternative, we chose to reduce this concentration of highly rate sensitive index-based bond funds, and reallocate a fraction to intermediate high-grade bonds, which coincides with John Bogle's recommended allocation to this class. The allocation itself provides some protection against another potential financial or economic dislocation reminiscent of 2008, when investors sought safety in the highest-grade assets. The remaining allocation goes to currently out-of-favor EM sovereign local currency bonds, where yields now exceed 5%, and a short-term enhanced yield fund that provides some cash flow and relative price stability in exchange for the flexibility to reinvest later when the outlook for rates is more favorable.

Global Credit

Figure 9 highlights the cash flow to price risk trade-off between investment grade and non-investment grade bonds, where low annual yields in IG bonds fail to offset the duration risk or potential price change for a one percent move in interest rates. This current relationship provides little protection against a possible rise in interest rates before losses are incurred; therefore, we focus credit exposure on short term, non-investment grade bonds, where yield to price risk is clearly more favorable.

Based on this circumstance, we chose an unconstrained, absolute return-oriented strategy that provides enhanced yield, less interest rate sensitivity, and a proven record of good relative performance when risk aversion rises. In our view, the higher yield without extending duration, coupled with management's ability to seek out superior relative value in a difficult rate environment, justifies the higher expense ratio. The remaining two allocations provide credit exposure to short-term USD emerging markets, and to foreign developed markets, with both funds providing higher yield and the latter providing broader currency exposure.

Select Investment & non-Investment Grade Bond Indexes - Yield to Price Risk

Index

Avg Yield

Avg Duration

BofA ML Treasury & Agency Index

1.62%

5.49

BofA ML 1-3Yr Treasury & Agency Index

0.41%

1.89

BofA ML US Corporate Index

3.35%

6.53

BofA ML 1-3 Yr US Corporate Index

1.14%

1.86

BofA ML US Cash Pay High Yield Index

5.86%

4.35

BofA ML 1-3 Yr US Cash Pay High Yield Index

4.76%

1.64

Data: St. Louis Fed, Bloomberg (as of 12.31.2013)

Overall, with our bond allocation, a risk budgeting approach enables us to reduce interest rate risk, enhance cash flow, and protect against US dollar debasement, while allowing greater flexibility to reinvest when the outlook for rates is much more attractive. Figure 10 shows the details of these enhanced metrics.

Risk-based Bond Allocation: Yield/Duration/Currency/Short-Term: Figure 10

Portfolio

Wtd Avg Yield

Wtd Avg Duration

Currency (%)

Duration below One-Year (%)

(New) Diversified Risk Portfolio

3.41%

2.51

7.5%

15%

(Old) Jemstep (JS)

1.31%

4.47

0

0

(Old) FutureAdvisor (FA)

1.52%

6.36

0

0

Currencies:

The two online advisors show symptoms of home country bias* with relatively low overall foreign currency exposure, highlighted by all US dollar-based funds in each firm's bond allocations. To offset this deficiency, we added exposure to the euro and emerging market currencies to provide some protection against further debasement of the US dollar.

*Home country bias is a behavioral investing term that describes tendencies by investors to prefer familiar names/assets in their home country as opposed to less familiar foreign names/assets, causing persistent under-diversification.

Global Equity:

As previously mentioned, the relative percentage allocations and fund choices remain the same within the context of our risk budgeting approach for the sake of continuity. We have reallocated from a comparatively high equity risk bucket (e.g., JS portfolio, 60%) to address shortfalls in credit, inflation, and currencies for broadened diversification.

Global Inflation:

The major adjustment in the portfolios is to reduce the excessive interest rate risk from TIPS (e.g., FA portfolio, 24%) and reallocate to a combination of short duration TIPS, broad commodities , and global REITs - the result being a wider source of global inflation exposure with the inclusion of hard assets to complement bonds.

Applying the above changes, we recommend the following portfolios:

Risk-Allocated Portfolios for a Diversified Investor: Figure 11

Investment Objective

Balanced

Balanced

Diversified Risk Portfolio - New

Risk Allocated (FA)

Risk Allocated (JS)

Fixed Income

Short Investment Grade

7.5%

7.5%

Intermediate Investment Grade

12.5%

12.5%

Unconstrained Absolute-Return-Oriented

20%

20%

Emerging Market Local

5%

5%

ST Emerging Market USD

2.5%

2.5%

Intl High Yield

2.5%

2.5%

Intermediate Inflation-Protected

8%

8%

Equity*

Large Cap

12%

12.78%

Mid Cap

0

5%

Small Cap incl Intl

5.14%

1.67%

Foreign Developed

6.86%

7.22%

Emerging Market

6%

3.33%

Real Assets

Global REITs

6%

6%

Commodities

6%

6%

*Relative percentage allocations and fund choices remain the same within the context of our risk budgeting approach. Note: For illustrative purposes, we omitted a cash allocation, which we would otherwise recommend at 3%.

If you're getting a return, you have to try to understand what are the risks you are taking to obtain that return -- Jeff Scott, Wurts Associates

In Closing

In this article, our survey shows that the aforementioned online advisors produce standardized portfolios that are laden with unintended and concentrated risk. We then introduced a technique known as 'risk budgeting' that all investors can use to identify and mitigate such risk in any investment portfolio. Risk budgeting provides an efficient way to improve diversification, and as importantly, customize a portfolio to one's specific investment objectives, risk profile, and economic views. By applying this framework to these generic models, investors can build in better diversification and a more suitable asset mix to avoid pitfalls that hinder long-term performance. Moreover, by viewing assets in terms of risk buckets, an investor will not only be able to apply one's own personal investment views, but have a means to discern between smart and inappropriate investment advice.

Source: Applying Risk Budgeting To Online Portfolio Management: A Survey