Bloodied Broken Models
Summary
- So-called "low risk" investment models are losing as much and could lose even more than high risk models.
- Most models rely on bonds for protection. That’s why they no longer work: bonds are not protecting.
- New and better models protect with cash and TIPS. The Nobel Prize winning Capital Asset Pricing Model demonstrates why risk is best controlled with cash.
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Several years ago, I wrote Broken Models that advises the integration of age into model portfolios. The following article deals with risk control and warns that bonds are now risky, so they are not a good risk control. Recent bond performance has bloodied broken models.
Most investment consultants and money managers use models. They "customize to your needs" by matching you up to an off-the-shelf model. The model in the middle, between conservative and aggressive, is the famous 60/40 you hear about all the time.
Much has been written lately about the problem with the ubiquitous 60/40 stock/bond model, in articles like this recent Barron's article.
The problem is that the 40% in bonds is not safe. So far this year that concern has been confirmed. Bonds have suffered losses similar to stocks. Consequently, all models have disappointed because they all use bonds to defend, as shown in the following.
Target Date Solutions
Interest rates are going up and they will keep going up for a long time. As a result, "low risk" models will suffer similar, or even worse, losses than high risk. And near-dated target date funds (TDFs) will suffer similar or worse losses than long-dated.
That's not supposed to happen. "Safe" models are supposed to protect against losses. The old models don't work.
The damage to target date funds so far
Near-dated TDFs are not defending, and won't defend for a long time. The following graph shows the performances of TDFs. The "Industry" is the S&P target date index, a composite of all TDF mutual funds. TSP is the Federal Thrift Savings Plan, the largest savings plan in the world, at $800 billion
Target Date Solutions
The Industry defends with bonds. By contrast, the TSP protects with a government-guaranteed G fund, similar to Treasury Bills. Consequently, Industry 2020 funds are 85% risky at the target date when you classify bonds as risky, versus 95% at long dates, so about the same. By contrast, the 2020 TSP fund is only 30% risky.
PIMCO & Target Date Solutions
A first
"Low risk" funds are not supposed to lose more than high risk in a down stock market, and they never have before. 2022 could be the first year ever when bonds do not protect in a falling stock market. As shown in the following graph, bonds have never failed to protect before in a down stock market.
Target Date Solutions
Going forward
To fight inflation, the Federal Reserve is raising interest rates and tapering its bond buying that maintains ZIRP: Zero Interest Rate Policy. Some say that the Fed will react as it did in 2013's "Taper Tantrum." Tapering in 2013 caused the stock market to fall, so the Fed reversed course and reverted back to ZIRP.
But unlike 2013, inflation is raging now, so reverting to ZIRP will fuel the inflation fire that the Fed has said it will extinguish. Wall Street sees the Fed opting for ZIRP, allowing inflation to escalate, but ZIRP will become increasingly expensive as inflation rises because investors do not like to lose in real terms (earn less than inflation).
Many see interest rates rising to historical averages of 3% above inflation. In an 8.5% inflation environment, that's 11.5% yield on 10-year bonds.
Going forward, interest rates are likely to continue to increase for many years.
Sequence of return risk
It is well documented that investment losses suffered by people near retirement can ruin the rest of their lives. Accordingly, TDFs are supposed to protect those near retirement, in 2020 funds, but they will not protect going forward because interest rates will continue to increase for a long time, crashing bond prices.
The disappointment is just beginning. Investment models and TDFs are built on a foundation that is crumbling because bonds are not protecting. Investors need to embrace the new reality, especially the 78 million baby boomers who are in the Risk Zone spanning the five years before and after retirement.
Protect now
Target Date Solutions
The "new" protection is the "old" protection - Cash and TIPS (Treasury Inflation Protected Securities). But you won't get this protection in most TDFs nor most model portfolios. You'll need to do it yourself.
Dr. William F. Sharpe won a Nobel Prize for his Capital Asset Pricing Model that demonstrates why risk is best controlled with good old-fashioned cash. Advisors have shied away from using this model because clients don't want to pay an advisory fee for cash
TDFs could protect with a Safe Landing Glide Path that is U-shaped because it is very safe in the 5 years before and after retirement. In the jargon of TDFs, it is both "To" and "Through."
Conclusion
The warnings about the risk in bonds are being substantiated. Bonds are losing money and will continue to lose for years.
The challenge now is replacing bonds as a "safe" asset. In this inflationary environment, "safe" should also protect against inflation. Treasury Inflation-Protected Securities (TIPS) can help. Other inflation protection comes with uncertainty, like precious metals and commodities, but these are worthy of consideration as well.
All model portfolios - not just 60/40 - are topsy-turvy. "Safe" models are not protecting. But there's education to help you.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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Comments (5)
""Interest rates are going up and they will keep going up for a long time.""
""2022 could be the first year ever when bonds do not protect in a falling stock market.""Hi Ronald, I couldn't agree more! Right on target.Below is a very long term chart of 10 yr bond yields. It has trend channels defining the last time we had a long term rise in interest rates, and a trend channel defining the downtrend in interest rates since 1982.gyazo.com/...The uptrend shown started in the 1940's at 1.90, and ended in 1982 at 16.56%. The downtrend shown started in 1982 at 16.56 and ended in Mar 2020 at 0.42%. Notice how the top of the channel has served to turn back multiple attempts to make a new high in interest rates over the past 40 years. It;s too early to tell for sure, but it looks like this rally will be the time the rates break out above the top of the downtrend channel. It is slightly above the top of the channel now. If it does break out here, I believe we will see much higher interest rates into the next decade(s).This supports your idea that we may now be entering a long term rise in interest rates that could last for a long time -- [probably decades]. And being in bonds is not safe. And 2022 could be the first year ever when bonds do not protect a falling stock market.What is happening now is reminiscent of what happened from 1968 to 1981 -- when Inflation was high, Interest rates went up, and Commodities had a very long bull market. The effect on most stocks was a VERY LARGE retraction in PE, with sideways correction of over 10 years with multiple BIG corrections.Commodity related stocks, on the other hand, did OK to Good. Note that debt levels were very manageable back there. Rates were driven VERY HIGH by the Fed to break the inflation trend. Moderate increases did not work.The fly in the ointment NOW is the high levels of Govt debt and the enormous cost of carrying that debt as interest rates rise. There will probably be an effort to control inflation with only modest increases in short term rates. When that doesn't work they will be forced to try other things. But -- if rates get high enough -- watch out! Higher interest rates and debt costs will force pressure on the dollar and drive rates even higher. Hopefully, that;s a few years away.
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