My 'Buy-And-Hold' Portfolio Allocation Strategy

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Includes: HYG, IEF, SPY, TLT, VNQ
by: Long/Short Investments

Summary

This article provides a basic skeletal approach to how to allocate assets for "buy-and-hold" investors.

One simple, low-/no-maintenance approach is to buy a low-cost S&P 500 fund, but this approach is excessively slanted toward relying on an environment that beats growth and inflation expectations.

However, I believe this can be optimized by allocating assets in such a way that can allow the portfolio to mostly thrive regardless of the market scenario.

Simply, you want assets that can thrive when growth outperforms expectations, when growth underperforms, when inflation outperforms, and when inflation underperforms.

If you can allocate assets to each of these four corners and adjust the weightings to your volatility and risk tolerances, you will come out with a fairly balanced portfolio.

The ideal holding period for any security is forever. This nonetheless can't always be the case as economies change, markets change, and companies change. There are also personal circumstances to consider surrounding time horizons, returns expectations, risk tolerances, and other such matters.

So every now and then, changing up a portfolio is a decision that is only natural. But the idea of a true "buy-and-hold forever" portfolio still holds sway. It entails minimal commissions and more time to focus on other aspects of life.

First, there's Warren Buffett's idea of buy-and-hold investing, which involves putting one's money into a low-commission S&P 500 index fund, such as SPDR S&P 500 Trust ETF (NYSEARCA:SPY) or Vanguard S&P 500 Index Fund (NYSEARCA:VOO). Investing in SPY and calling it a day is a good strategy, especially if you are young and have a long time horizon. Given enough time, it's guaranteed to provide better returns than cash equal to the nominal growth rate of the S&P 500 going forward, which, as calculated in this article, is approximately 5.6%-5.7%. (I will publish an update to this tomorrow.)

If you invest your money in the safest way possible outside of cash, say 10-year US Treasuries, you're only getting about 40 bps of real yield, when factoring in about 2.3% in nominal yield and 1.9% in terms of the expected inflation rate over the duration of the investment.

This is still better than cash by whatever the yield on the 10-year is (assuming cash sits in the bank with no interest or even negative interest (i.e., ridiculous account fees) as is the case with most bank accounts these days). But you'll still underperform stocks by about 3.7%-3.8% in real annualized terms over the long run.

The only way a portfolio invested in 100% Treasuries might make as a buy-and-forget idea is if you already have all the money you could ever want and simply want to more or less match the long-run inflation rate (to avoid losing money in real terms) plus maybe a few extra pennies beyond that.

At least by investing in stocks today, you can rather confidently say that you'll outperform cash over the long-run by about 5.5%-6.0% in nominal annualized terms. It's virtually a guarantee that, provided enough time, stocks will outperform cash otherwise the entire purpose behind capitalism wouldn't work.

On the same token, investing purely into stocks will provide a fairly volatile ride. This may not make a pure stock portfolio the best idea for those who are more risk-averse or those who have more limited investing time horizons. This means fixed-income instruments, such as bonds, are a vital part of this portfolio approach, as they tend to involve less risk.

Why are stocks more volatile than bonds? Because equity is subordinate in a company's capital structure to debt, which means in a hypothetical liquidation scenario, equity holders would get paid last, making their investment riskier. Companies in the S&P 500 are fairly highly leveraged. Non-financial corporate debt as a percentage of nominal GDP is around an all-time high at approximately 32%.

(Source: St. Louis Federal Reserve)

However, non-financial corporate debt as a percentage of profits don't appear anywhere near as bad as those seen before the 1987 crash, the 1990-91 recession (from a bubble in high-yield credit and commercial real estate), and in the lead up to the dot-com crash.

(Source: St. Louis Federal Reserve)

But it's still fair to say that we're a bit more leveraged relative to what we're accustomed to historically.

So even if earnings and cash flow are subpar, but leverage is higher, the asset returns derived from this cash flow production will be magnified. If companies could not leverage, then the returns of equities would be similar to those of bonds with relatively similar risk profiles as well. In a debt-free company, stockholders wouldn't have to compete with debtholders for assets in a liquidation scenario (though debt-free companies more or less don't go bankrupt), but it also tends to dampen investors' returns expectations given less risk involved.

But both bonds and stocks have their place in a long-term hold portfolio and are in some way a natural hedge against each other. The problem with an all-stocks portfolio is that it does well in a certain kind of environment - namely, when growth and inflation outperform expectations.

Granted, this hasn't been entirely true since the financial crisis as stocks, since their March 2009 nadir, have gone up 245% (3.45x) while nominal GDP growth in the US has increased just 32% (17% in real terms).

(Source: St. Louis Federal Reserve)

The landscape has been heavily altered due to central bank initiatives that have compressed interest rates very low, which allows cash flow to be discounted at lower rates, thereby boosting underlying asset values. Quantitative and credit easing initiatives have effectively lowered rates beyond that in addition.

Ideally, one would have a nice balance of assets such that the portfolio will have a reasonable chance of doing well in all environments - when growth is outperforming expectations, when growth underperforms, when inflation runs higher than expected, and when inflation runs lower than expected. Some mixture of stocks and bonds is required to make this occur, given the way the way their returns exceed cash over the long-run while often performing in uncorrelated ways.

Things I don't recommend include commodities and currencies. These are entities that are basically pure trading instruments, normally to express a macroeconomic or speculative viewpoint. Trading these is basically a zero-sum game (or a negative-sum game if you include commissions cost and other broker fees).

The portfolio under discussion here is not designed to make directional bets or require oneself to be correct about market timing or a certain instrument or security. The only foundational principle is that holding some combination of stocks and bonds will provide real returns when held over the long run.

When we look at equities, you're buying into markets where there is actually real wealth being created. With bonds, you're basically renting out your money with the expectation that the passage of time will generate a real return (or at least a return greater than that of cash).

At the same time, the balance of asset in the portfolio is important as well. The correlation between the S&P 500 and long-dated US Treasuries as represented by the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) is quite strong, with a coefficient of +0.86 over the past 15 years. Stocks are more volatile than long-dated Treasuries (effective duration of 17.4 years), but not to the extent that you would expect. Annualized volatility since July 30, 2002 for the S&P 500 has been 12.5% versus 10.4% for TLT (just 20% higher).

Accordingly, for bond holdings, long-dated Treasuries probably aren't the best to hold alongside equities. Shorter duration instruments would be better.

If we use a basket of 7-10 year US Treasuries (NYSEARCA:IEF), correlation is only marginally lower at +0.82, but volatility is just 5.2% on an annualized basis (i.e., stocks 2.4x more volatile). Since the above mentioned date, stocks have returned 8.8% annualized at 12.5% volatility versus 5.2% annualized for IEF at 5.2% volatility, meaning the latter has performed better from a risk-adjusted standpoint.

Shorter-duration, safe assets will also hedge against market downturns as investors put their funds into safe havens to weather the down-cycle. Between July 20, 2007 and March 6, 2009, IEF was up 16.1%. This contrasts to the S&P 500, which was down 55.1% between those two dates. A discrepancy of over 70% is phenomenal and speaks to the market circumstances surrounding that period.

Bonds also bring something different in that they'll tend to outperform other assets when inflation runs under expectations. Consequently, in a low growth/low inflation environment, shorter-duration bonds will tend to outperform other assets. Relatively speaking, the more disastrous the market, the better safe-haven bonds will perform as investors go into "risk-off" mode.

Assets for high growth, low inflation environments

A high growth/low inflation environment will favor instruments such as REITs and bonds of lower credit quality.

REITs are essentially equities, but largely operate independently of the broader equities market. So the advantages here are plainly obvious. You get access to a separate asset class with relative ease (real estate), a high level of liquidity relative to physical properties which can take months or years to liquidate, strong income/total return capacity given 90% of earnings must be paid out to shareholders, and a high level of both overall and intra-industry diversification. REITs invest into multi-family, single-family, industrial and retail properties, in addition to storage units, hospitals, hotels, etc.

Lower interest rates are generally beneficial for REITs, as these entities basically operate by generating an income off a spread. If cap rates are higher than the cost of capital (of which the interest on debt is a large contributor), REITs will create value. Currently, REITs don't have anywhere near the upside they had coming out of the crisis, but can make sense as a long-term hold.

In terms of ETF selection, Vanguard REIT Index Fund (NYSEARCA:VNQ) is a good low-expense choice and provides diversification to over 100 different REITs.

With respect to lower-quality/higher-yielding bonds, iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) is the most popular and liquid ETF in this space. HYG is similar in risk to equities but will tend to outperform stocks when inflation runs under expectations.

Real yields increase on fixed-rate bonds when this occurs and incentivizes investors to go long riskier bonds when growth is still sufficiently high. But like stocks, these will tend to underperform when growth runs under expectations.

Assets for low growth, high inflation environments

A low growth, high inflation backdrop - which may mean stagflation, or may simply entail growth running below broader anticipations and inflation running above to whatever extent - is generally the most difficult environment to excel in for those who stick to stocks and bonds exclusively.

The most well-known and well-studied example of true stagflation - the US in the 1970s - was a decade of losses for both stocks and bonds. Usually in this type of environment, you need to move out into commodities and precious metals. Commodities tend to do well in inflationary environments - or are sometimes the root cause of inflation in the first place - while precious metals serve as a hedge against inflation given their place as an alternative currency.

I mentioned above that I don't recommend allocating funds to these, as I don't believe commodities and precious metals are appropriate for long-term "buy-and-forget" time horizons.

Some might disagree and believe gold (NYSEARCA:GLD) is always important to have in this type of a portfolio and could protect against losses in this type of an economic scenario. Gold or silver can protect against losses here, but if we're talking about a portfolio you might consider holding over the course of decades, gold is going to perform a little bit better than cash (inflation will generally be hedged out) and that's about it.

Precious metals, commodities, and currencies are more for traders and global macro funds and instruments that are best actively traded in and out of. There is no real wealth being created from these and are best avoided for long-term buy-and-hold investors. Exposure to commodities will also be provided most explicitly through stock and bond selections in oil and gas and mining companies.

Summary

To summarize the basic construction:

High growth, high inflation - SPY or VOO

High growth, low inflation - HYG, VNQ

Low growth, high inflation - Favors commodities and precious metals, but I don't recommend explicit inclusion of these

Low growth, low inflation - IEF

In terms of a weighting breakdown, this would be one consideration:

  • 40% IEF (Short-term safe bonds)
  • 30% SPY (US equities)
  • 15% HYG (US high-yield bonds)
  • 15% VNQ (REITs)

For those who are investing over a 30+ year time frame, decreasing the allotment to IEF could make sense. This will increase your risk and overall volatility but will also boost your expected forward returns.

For those who have already built up a nest egg and are concerned about preserving wealth above all else, increasing the allocation to safe bonds might be a better solution. In general, as is broadly accepted wisdom, increasing your exposure to less volatile bonds and decreasing exposure to equities is a safe way of balancing risk and reward as you age.

Having a plain SPY portfolio is okay on the surface given it provides diversification among the 500 largest companies in the US. If you had adopted that strategy toward the latter stages of the financial crisis, you've made phenomenal returns since.

But returns will be fairly lumpy at 11%-13% expected annualized volatility and your portfolio will be mostly slanted toward performing well in an environment where growth and inflation exceed embedded expectations.

Adopting something closer to the four-headed approach discussed here will lower your portfolio's volatility, smooth returns over time, and decrease your chances of losing money in any given period.

In general, if you can add a greater number of positive-return-generating assets to your portfolio while reducing the portfolio's overall covariance (i.e., the more uncorrelated their returns over time, the better), the lower the volatility and the lower the probability of losing money.

(Note: You will notice in my disclosure that I am long iShares 20+ Year Treasury Bond ETF and short HYG, but these are part of trades wherein I'm betting on matters such as future credit spreads and the shape of the yield curve as I've discussed in previous articles. These positions are more short term in nature and have no relation to the subject matter contained within this post, which is exclusively focused on long-term, non-directional buy-and-hold investing.)

Disclosure: I am/we are long TLT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Short HYG