It's Always Something!

Many years ago I recall an advertisement by a major insurance company with the tag line, “It’s Always Something!”  The ad was accompanied by a picture of the earth with earthquakes, blizzards, hurricanes, and other natural disasters causing calamity.  The financial markets have a little bit of that now with inflation fears, rising rates, dropping stock prices, not to mention the turmoil in the Ukraine, all contributing to a discouraging January!  But, how bad is it?

Last week I posted a blog dealing with drawdown risk, the amount of value lost from a recent peak to trough.  The drawdown for the S&P 500 (IVV) through January 26 was a notable -9.3% (that recovered somewhat through today).  Given that the S&P 500 was up +28.8% last year, it took only less than one month to give up about 32% of last year’s gains!

Based on a statistical analysis over the last 10 years, assuming a normal distribution for stock returns, the S&P 500 index delivered a monthly standard deviation of return of 3.77% and average monthly return of +1.19%.   This means that for a 1 standard deviation (SD) event, there is a 68% chance of a monthly S&P 500 return being between -2.58% and +4.96%, for a 2 SD event a 95% chance being between -6.35% and +8.73%, or for a 3 SD event being between -10.12% and +12.5%.  The S&P 500 January 31 monthly return of -5.3% turns out to be a -1.41 SD event; not common, but certainly not a crazy extraordinary “tail” event.  

Per the table below we can see other returns and standard deviations of return for different investment strategies. For investors wanting, or needing, a lower risk strategy, the Dow Jones Moderate Portfolio Index with a 60% equity and 40% bond allocation delivered a historical average monthly return of +0.71% and a standard deviation of 2.44%; less return, but also less volatile than the 100% S&P 500 equity strategy.   The Dow Jones Moderately Aggressive Portfolio Index shown with an 80% equity and 20% bond allocation produced commensurate level of return and risk between the 60% and 100% equity portfolios.

So, no surprises here!  The risk/return tradeoff is alive and well; more risk has produced a higher level of return over the past ten-year horizon.  If you have a long time horizon and can tolerate market volatility, a larger equity content has been shown to reward investors.  D&A strives to ensure that client accounts are carefully managed to the appropriate level of equity content and risk suitable for each client.

Risky Business

The recent market volatility and decline has been disappointing and has highlighted the problem with “drawdown” risk; the risk of a decline in portfolio value from a recent high.  Other measures of risk like standard deviation of return measure the statistical volatility of returns, but drawdown risk is more easily understandable and observable (and hurtful!)

As seen from the bottom half of the chart below, we have seen a recent drawdown in the S&P 500 (IVV, the green line) of -8.3% drawdown from a recent high and a maximum drawdown experienced during the last twelve years of -33.8% due to the COVID outbreak in March of 2020!  But, the offset to this is that IVV has also shown a cumulative total return over this 12-year period of +390.5%; one could argue that is a fair tradeoff of return versus risk.  Other less risky portfolios that include varying allocations to bonds, like the iShares Core Aggressive ETF (AOA), iShares Core Growth ETF (AOR), and the iShares Moderate ETF (AOM) have shown less drawdown and a commensurate lower total return.  The portfolio with the least risky profile, the iShares U.S. Aggregate Bond ETF (AGG, the blue line towards the bottom) as a 100% investment grade bond portfolio, has shown very low risk and the lowest return.

As I have recounted many times, for clients that have a long time horizon with sufficient income and net assets to cover their lifestyle and can tolerate the potential for large drawdowns, a portfolio with a large allocation to equities has proven to be an effective strategy to earn higher total returns during this time horizon.  Clients with a shorter time horizon or unique circumstances are better off maintaining a portfolio with reduced equity exposure to target a “smoother” ride shown by the portfolios with reduced equity exposure (AOA, AOR, or AOM).

Journey to "Nothingsville"

The theme from the early parts of 2021 persisted into Q4 with broad capital markets continuing to set all-time highs in the face of a persisting global pandemic, higher inflation, supply chain disruptions, and pockets of political gridlock.  Most thought leaders attribute this to the “re-opening” mindset and the fact that the economy is learning and adapting to the new reality of operating within the global pandemic.  Continuing fiscal support and an accommodative Fed (again, despite some hawkish rumblings) with interest rates staying within a narrow trading range completed the picture to support higher stock prices.

However, all is not rosy!  The broad capital markets like the S&P 500 continued to surge during Q4 and for all of 2021, but the strength was not universal.  Diversifying asset classes like U.S. small and mid-cap equities and emerging market and international developed equities lagged; some by a wide margin.  Core bonds continued their mathematical journey to “Nothingsville” as historically low yields continued to produce low total returns.  [For clients who can tolerate more risk, D&A continues to underweight bonds by up to 10% of target.]

Per the table below, the S&P 500 (IVV) has been on a tear with 2020 and 2021 annual total returns of 18.40% and 28.66%, respectively, easily beating every other major asset class over the last two years.  Other major asset classes like small- and mid-cap equity (SCHA and SCHM) produced strong returns in 2021 of 16.35% and 19.33% but was a drag on total portfolio performance.  Emerging market equities (SCHE) were a disappointment in 2021 with a -0.72% return.  Finally, not unexpectedly, core bonds lagged with a total return of -1.74% in 2021.

The array of disparate quarterly returns in the table above once again highlights the difficulty in predicting capital market returns.  From my blog post Are you Spooked? on October 27, 2021:

As readers of this blog well know, no one can call the market and our view is that a long-term strategic investment strategy developed to achieve your goals is the best approach.  If you have a long time horizon and income/net worth sufficient to support your needs and wants, stay in the market and wait it out.  If not, we can develop a strategy that recognizes the risks and positions you for a high probability of success.

A Thousand Words

Through Friday, December 10, 2021, the global capital markets have shown a bumpy ride.  Amidst the global pandemic, supply chain impacts, governmental and Fed responses, and resultant economic effects, we have seen very volatile, and varied, results.

Per the chart below of the five major asset classes, U.S. large cap stocks (IVV), U.S. small cap stocks (SCHA), developed markets (SCHF), emerging markets (SCHE), and U.S. core bonds (SCHZ), you can clearly see the dispersion of returns.  In the equity universe, U.S. large cap stocks are the big winner so far in 2021 with a robust +27.2% return (the green line at the top) and emerging market equities the big loser with a 0.0% return (yes, 0.0%!).  In the bond space, U.S. core bonds lagged with a -1.8% total return.

As has been the case over the last three years, diversification has mostly hurt portfolio performance because U.S. large cap stocks have been the undisputed top cumulative performer with all other asset classes lagging, often by a LOT!  Diversifying positions in international and emerging markets has been a drag, as has any exposure to core bonds. 

As we have said here many times, bonds have been a bad bet to make recently purely due to the math!  Historically low interest rates provide almost no yield and very little potential for bond price appreciation.  Recognizing this fact, D&A client accounts that can afford to take more risk have been underweighted bonds by up to 10%.

All is not lost, however!  Even with diversification being a drag on performance, a naïve diversified portfolio with a 60% equity and 40% bond weighting like the iShares Core Growth ETF (AOR) has generated a total return of +10.43% so far in 2021.  This is strong portfolio performance that exceeds the current inflation rate and carries much less risk than a 100% equity portfolio.  Of course, past performance is no guarantee of future returns!  As we all know, markets can turn on a dime and disappoint!  Best to ensure that your risk profile is consistent with your objectives and you are invested accordingly to achieve your goals.

Beats Me! (Again!)

On the surface, there are plenty of positive signs about the current economic situation.  For example, in the post-pandemic environment the unemployment rate has fallen from 14.8% in April 2020 to 4.6% in October 2021, a recent low but still much higher than the recent pre-pandemic low of about 3.5%.  Economic growth has picked up, too, with real GDP recovering nicely from the pandemic lows with quarterly growth rates of +6.7%, +6.3% and +2.1% over the past three quarters in 2021.  So why are we all worried about the future?

Though we live in an uncertain world, the capital markets don’t like uncertainty!  The largest uncertainty we all face is the potential for a re-emergence of covid-19 in a potentially more-onerous mutated form.  That is still to be seen, but the omicron variant announced last week is certainly causing a stir in the capital markets.

Aside from the externalities like covid impacting the markets, the potential for rampant inflation seems to be on everyone’s mind as they leave the gas station and grocery stores seeing much higher prices!  Certainly, inflation has picked up with the Consumer Price Index showing a +6.1% increase from prices a year ago.  Even excluding the more volatile prices from food and energy, inflation still shows a spike of +4.1%.  As seen from the chart below, after the drop in prices during the pandemic, we have seen a marked increase in prices from the beginning of the year, “transitory” or not!

Just like trying to predict the capital markets, no one knows if rampant inflation is on the horizon.  The period after the Credit Crisis back in 2008/09 likewise saw many thought leaders postulate much higher inflation due to extreme Fed easing and fiscal stimulus, which, of course, we never saw!  This time there are supply chain issues and other factors that very likely will be solved by market forces and time so there is good reason to be bullish on the inflation front.

This situation reminds me of insights from my favorite Chief Investment Officer at a former employer.  At every quarterly investment review meeting he would lead off the discussion with a lengthy discussion about the current economic situation and capital markets telling a good story about where we are.  He would close by saying, “So, what is the market going to do? Beats Me!”

Finally, from my blog post, Beats Me!, from way back in August 2019:

As I am wont to say, plenty of reasons to be cautious, but no reason (yet!) to run for the hills.  New money should go into the market slowly, since that is ALWAYS the low risk approach to get market exposure.  Investors with a long term strategic approach properly diversified and positioned in the risk profile appropriate for their situation should stay the course.

Investment Planning for Retirement (VLOG)

Retirement planning is a complicated process dealing with innumerable unknowns. It is best handled with advanced computer modeling software to stress test different assumption sets and investment scenarios.

Please watch my 5-minute video where I present a high level overview of a sample retirement case with our industry-leading software, MoneyGuidePro. We are happy to prepare and present a completely customized analysis for you. Please contact me at tony.ash@dattilioash.com for more info.

The EM Puzzle

If everyone loves EM, why isn’t it outperforming??  “Emerging Markets Look Poised for a Good 2021”, “…the case for emerging markets is looking more attractive…” and “Emerging Market Equities Set for Outperformance” was the battle cry as thought leaders ruminated over prospects for 2021.  The consensus views from Lazard Asset Management (April 20, 2021), Barron’s (October 6, 2020) and The Outsourced Chief Investment Officer (February 16, 2021) and many others all carried the same message: this is the year for emerging markets (EM) to outperform!

With EM equities underperforming the U.S. markets in 8 of the last 10 years, including year-to-date 2021, many prognosticators had been predicting this on a somewhat annual basis! What has been going on and where do we go from here?

The emerging market equity space is usually defined as countries where the financial markets are less developed than in the U.S. or the major European financial centers.  The list of countries usually includes the largest names such as China, Taiwan, India, South Korea (but not always), Brazil, Russia, Saudi Arabia, and Mexico.  Other parts of Asia are also considered emerging markets, but Japan is considered developed.

During the post-Covid period, U.S. markets rallied strongly and the thought was that emerging markets would follow suit.  The reasoning went that EM equities were relatively much cheaper on a value basis than U.S. equities and that would encourage the flow of capital to those markets, all while overseas factories geared up to replenish stockpiles depleted by the pandemic.

Of course, that is not what has happened; so far! As seen from the chart below, many of the largest countries in the emerging markets, including China, South Korea, and Brazil have racked up large negative returns YTD detracting from the overall EM market (the IEMG ETF, second from right) producing a +3.60% YTD total return compared to the robust +26.27% total return shown by the U.S. large cap market (IVV, rightmost column).  Other EM ETFs that do not include South Korea as EM equity still underperformed miserably, including SCHE with a +4.13% total return.

Philosophically, Dattilio & Ash believes in long term strategic investing and does not try to time the market.  We certainly believe and understand that EM equities are relatively “cheap” compared to U.S. equities, but that does not mean we can time when that value will show up!  We believe that a well-diversified, global, multi-asset approach will reward long term investors over time.

Is "The Trend Your Friend"?

“Don’t fight the tape!” and “The trend is you friend!” are well-known idioms that persist in the financial world.  The idea that a stock price will keep going up since it has been going up has been around for a while.  And it seems logical, too!  Who wouldn’t want to buy a stock that has been doing well?  Have you ever heard someone ask about buying a stock that has performed poorly?

This phenomenon is specifically termed momentum and bucketed in the financial lexicon as a factor.  Academic studies into it have shown it to be a broad factor that encompasses other factors and it has a history of driving investment returns.  As the theory goes, the momentum factor serves as a diversifier and has the potential to add extra return to a portfolio.

A well-diversified passive portfolio, over the long term, will produce returns that mimic the broad indices. This is not necessarily a bad thing since active management has been shown to underperform a passive approach over time (check out the S&P Indices versus Active, SPIVA®, papers here for more info).  Consequently, it pays to seek out low-cost passive additions to a portfolio to potentially push performance ahead of the broad indices.

Over the recent time horizon, the momentum factor has put in good performance helping it achieve that goal.  Let’s take a look at the recent performance.

The iShares MSCI USA Momentum Factor (MTUM) exchange-traded fund (ETF) is one of the largest passive ETFs that follows a momentum investing strategy with assets under management of $17.2 billion.  It is low-cost (0.15% expense ratio) and follows a rules-based approach to investing.  It mechanistically rebalances twice per year (May and November), swapping out stocks that lag in momentum for stocks that have gathered momentum.

As deduced from the chart below, over the last 3.9 years from January 1, 2018 through November 9, 2021, the MTUM ETF (the orange line, mostly on the top) has generated an annualized total return of 18.26% compared to the S&P 500 (IVV, the blue line) of 17.47%.  The MTUM ETF showed some significant outperformance during the latter half of 2020, but gave back some of it during the beginning of 2021 before rallying again recently.

Dattilio & Ash Capital Management strives to achieve investment results to help its clients achieve their goals.  We continually monitor the capital markets for investment instruments and strategies that help us do that.

Are You Spooked?

Tesla (TSLA) may go down in history as the best performing large cap stock ever for its phenomenal performance over the last two years.  From December 31, 2019 through today, Tesla has gone from $83.67 (adjusted stock price) to $1,033.77, an unheard of total return of +1,136% being literally off-the-chart compared to the S&P 500 up +42% (the relatively flat blue line; see below)!  My reason for pointing this out is that there continues to be lots of doubt in the resiliency of these equity markets as we continue to climb a “wall of worry” to new heights.

Tesla is the significant outlier here, of course, but other stocks and broad indices have managed to capture investor interest with new recent all-time highs for the S&P 500 (large cap) and Russell 2000 (small cap) indices.  If stocks keep testing new highs, what is there to worry about?  Plenty, it seems!

In the aftermath of the COVID pandemic, a laundry list of economic issues persists.  The list includes worries about inflation (and hyperinflation) from unending fiscal stimulus to prop up impacted businesses and individuals and an easy-money Fed keeping the spigots open.  Other economic concerns include slower economic growth than potential due to supply chain shocks keeping businesses from fulfilling orders; especially in light of an economy with plenty of pent-up demand due to the COVID slowdowns.  Also, there still is festering unemployment amongst the economic sectors still fighting to recover fully.

On the other side of the coin, why should we take this all in stride and stay the course?  We could go on and on about productivity gains due to technical innovation, comparative advantage of a global economy, and new entrepreneurial ventures creating new economic paradigms, but the answer could be much simpler.  Simply, no matter how bad it ever gets, things have always gotten better.  The book “The Rational Optimist”, by Matt Ridley, discusses in depth the historical precedence that no matter how bad things get, they always have gotten better; we just need to be patient and have a long enough time horizon!

As readers of this blog well know, no one can call the market and our view is that a long-term strategic investment strategy developed to achieve your goals is the best approach.  If you have a long time horizon and income/net worth sufficient to support your needs and wants, stay in the market and wait it out.  If not, we can develop a strategy that recognizes the risks and positions you for a high probability of success.

Back to the Future

Often times, it is good to look back at what your thinking was to see how it turned out.  Last year on October 15, 2020, I wrote a blog post titled, “Where Do We Go From Here?”, that reviewed market thoughts and outlooks put out by Wellington Management.  At that time, we stated that “This all sounds very logical and reasonable to me and consistent with a long-term strategic approach that captures the broad trends in the economy and the capital markets”.  Let’s see what they said and how it all worked out!

Wellington Management is a well-respected Boston-based investment management firm with $1.6 trillion (trillion with a “T”) assets under management.  Their write-up last year focused on the COVID-19 situation, potential for another shutdown, and fiscal and monetary supports.  In summary, they felt the economic and capital market situation favored overweights in U.S. growth equities and U.S. corporate and high yield bonds with underweights in U.S. value stocks, international and emerging market equities, and U.S. Treasuries.

Per the table below, you can see that U.S. growth equities, indeed, did perform exceptionally well, but U.S. value stocks beat them out by a bit.  Likewise, international and emerging market equites performed well, but not to the level of U.S. value stocks.  In the bond space, it was easy to call for weakness in U.S. Treasury returns given the historic low level of yields and simple bond math; something that D&A has been reporting for quite some time.  Adding a bit of credit spread to bond holdings adds some return while reducing overall portfolio risk.

Though D&A is a believer in long-term strategic investing with a mostly passive approach, it is often appropriate to shift long term targets to reflect underlying shifts in the environment.  Such is the case with an underweight to U.S. Treasury bonds where the simple bond math indicates that forecast total returns are likely to be weak compared to historical returns over the near to medium term.  In equities, however, bets between value and growth and international exposures are less likely to be predictable and are not something to which we manage.  For most client accounts, we are currently overweight to equities in all equity classes and underweight in U.S. treasury bonds to reflect this long term strategic view.

Q3 Reversal of Fortune

Despite the pickup in volatility and marked weakness during the end of September, Q3 showed some continuation of the capital markets embracing the “re-opening” economy.  A dovish Fed (despite some hawkish rumblings) mixed with more fiscal stimulus in the pipeline is a recipe for healthy equity markets. The uptick in rates started to put pressure on stock valuations, but with bonds still offering almost no yield and almost no upside, stocks continued to be the only place in town to deploy new capital.

The rotation we observed early in the year from core equity to diversifying positions notably reversed during Q3 with large cap blend equities (IVV) regaining the crown as top equity asset class up a bit at +0.59% during Q3 (see table below).   Diversifying equities that lagged were small cap (SCHA, -3.64%), mid cap (SCHM, -1.70%), REITs (SCHH, +0.23%), developed international (SCHF, -1.90%), and especially emerging market equities (SCHE, -7.30%).   Mathematically, bonds delivered on their promise for low yields and low returns with relatively low risk during Q3 with core bonds (SCHZ) offering only -0.10% return.  Bonds with some credit spread like investment grade corporates (LQD, -0.45%) and high yield bonds (HYG, +0.34%) offered comparable return during Q3.

 It is not “market timing,” but simply arithmetic that bonds will be a drag on portfolio total returns with yields still near historic lows.  For client accounts that can tolerate a bit more risk, we are targeting at least a 5% underweight to bonds.  As I said in my January 3, 2021 blog post, “2020 Q4: Reversion to Mean?”, core bonds do not look like a good place to be in 2021:

“…core bonds delivering as much return as it could in the first part of the year [2020]; mathematically, with rates so low there is almost no potential return left in the U.S. Treasury market.  …we should not expect much return in 2021 from these holdings.”

Lump Sum vs. Pension Payments?

Lots of times, we get buried in the weeds of analysis and lose sight of the main objective.  A good case in point is the lump sum versus pension payout decision.  If you are lucky enough to work for an organization that offers a pension plan, when you retire you might be asked to decide if you want a stream of payments over a set period of time or until you or your spouse die, or a lump sum all delivered today; or some combination of these choices!  There are plenty of quantitative approaches to help get to the “right” answer for YOU, but it is best to start at the top and then drill down.   Following is the thought process we use at Dattilio & Ash.

Taking a pension as a stream of payments is a valuable benefit for some people.  It removes your responsibility to manage investment risk and provides “guaranteed” payments over a set time frame, either until you or your spouse die or over another set time frame.  The guarantee is only as good as the pension sponsor’s ability to manage the plan effectively, however, but even if they run into trouble there is a federal guarantee program to help backstop their guarantee. 

Sounds good so far, but there are some negatives.  The actuaries determine your pension payout based on your life expectancy; live longer and economically you are a winner, die early and you lose since you only get payments shorter than expected!  Embedded in your pension payment, in addition to other expenses, is this mortality charge that helps set your payment.  Another negative is that most pension plans offer only “fixed” payments and do not include adjustments for inflation (the notable exception is Social Security!)

So, how do you decide what is best for you?  First thing is to recognize your current and expected financial situation.  Since pension payments are calculated assuming some level of mortality risk and other expenses, if you can “self-insure” this risk you are saving economic value for yourself.  The key determinant to help decide if you can self-insure is your amount of liquid investments.  If you are fortunate enough to have accumulated a large investment portfolio that is materially sufficient to cover all your expenses and goals during your retirement years, you likely do NOT need to pay the expenses embedded in pension payments and can instead use your investment portfolio to replicate pension payments customized to your specific needs.

Here is a case study with real numbers to show how this works.  Let’s assume that you have the option of receiving either a $350k lump sum or $25k per year until you die.  Which do you choose?

First thing is to calculate a simplistic break-even point; the point where the sum of all payments equates to the lump sum, assuming some net investment rate.  Embedded in this pension payment is a 0% interest rate that results in a break-even point of 14 years ($350k/$25k); live longer than 14 years and you win, shorter and you lose.  Another way to look at this is to evaluate if you think you could earn more than a 0% net investment rate over the next 14 year.  Though there are no guarantees, I can pretty much assure you that the capital markets will net return more than 0% over the next 14 years.    

So, if you have the capability to self-insure investment risk and mortality risk, taking the lump sum is an economically preferable solution.  Alternatively, if you need (or want?) the benefit of a guaranteed payment into the future, then the pension payment is the right solution for you.  At Dattilio & Ash we can help you go through the decision process to get to the right decision for you.

Catch-up Time

The last twelve months have been chaotic with pandemic ups and downs, political drama, and mostly normal market volatility.  The S&P 500 Index, the index of large cap equities in the U.S., gets most of the attention from the popular press and has certainly been on a tear since the large drawdown at the outset of the pandemic back in March 2020.  But, what about all the other major asset classes like small- and mid-cap stocks, real estate investment trusts, international developed and emerging market equities, not to mention the sub classes in the bond market?  Here’s how they did!

A well-diversified portfolio needs a mix of stocks and bonds that complement each other and have some correlations that offset or are at least less than perfectly correlated.  This allows your portfolio to diversify its exposure to capture some of the gains from other asset classes that rally while the S&P 500 may pause.  This is the case we have seen over the past twelve months!

Per the chart below, it is interesting to note that the S&P 500 (VOO, the medium blue line near the middle) grew from a $10,000 investment on September 30, 2020 to $13,491 on August 31, 2021, a +34.9% gain!  However, that large total return is NOT from the best performing asset class.  Over the last twelve months ended August 31, 2021, the top performing major asset class is small cap equities (SCHA, the dark blue line at the top of the chart) that is up to $15,173, a +51.7% gain!  Also besting the S&P 500 are large cap, high dividend value-focused equities (DVY, the dark green line) up +45.8%, mid cap equities (SCHM, the yellow line) up +44.2%, an active computer-assisted strategy (AIEQ, the pale orange line) up +39.9%, and real estate investment trusts (VNQ, the dark orange line) up +37.5%.  International and emerging market equities continue to trail the U.S. markets and have room to grow.

We have seen the same kind of diversifying exposure performance from the bond market.   Core bonds, mostly defined by the Bloomberg Barclays Aggregate Bond Index (AGG, the light gray line at the very bottom), produced a total return of -1.7%, not unexpected given the historic low level of rates we have seen over the past year.  Other diversifying fixed income sub-asset classes did better such as preferred stocks (PFF, the brown line) at +8.1%, high yield bonds (HYG, the navy blue line) at +5.0%, and bank loans (BKLN, the pale blue line) at +1.8%.

Every market is different and there are a lot of extenuating circumstance underlying this particular market checkpoint.  Most importantly, this is a short time horizon after a major market dislocation, so a lot of the excess returns shown over the last year simply show a “catch-up” from an oversold position during the height of the pandemic.  But, we always believe that being properly diversified consistent with your risk tolerance will produce higher risk-adjusted returns and make you better able to achieve your financial goals.  

Should I Go All In?

In February 2020, I wrote a blog post about how to invest a lump sum of new cash into the market, either Invest All at Once, or Over Time? There are pros and cons to either strategy, and I discussed dollar-cost averaging as a “lower risk” approach to avoid market timing and the potential loss if invested at an inopportune time. Of course, the results you get are “scenario-dependent” and if the market keeps going up during the dollar-cost averaging period this could turn out to be a losing proposition. Let’s look at a real life case study of a client who recently put a large sum into their account and how it worked out!

The client had “new” cash available that they were ready to invest and had an approved long term strategy in place. Because the new cash was a large percentage of their total net worth and was part of their retirement funds, we decided that a dollar-cost averaging approach was an appropriate strategy. This would add risk to their overall portfolio slowly and avoid the potential of mis-timing the market. This is NOT a market timing exercise but instead is intended to smooth performance by avoiding market timing.

We started putting the funds to work on July 26, 2021; in hindsight, a period of time where the S&P 500 kept plodding higher. The total proceeds were invested into a diversified portfolio of stocks and bonds, however, so during this time some new positions did better and some did worse.

As you can see from the chart below, this dollar-cost averaging approach achieved its goal. The Joint Taxable (JT) account grew from $10,000 to $10,150, almost exactly the same as its benchmark, the iShares Core Growth ETF (AOR), if it was invested all at once on July 26. As it turned out, the overall risk for both approaches over this short time horizon was about the same, but it could have been much different. Most notably, the dollar-cost averaging approach avoided putting all the funds to work at some recent high points on August 13 or August 27 that would have diminished it performance. Alternatively, we did miss some low points on August 19 that would have improved performance. But this is the point, no one knows!

So, luckily there was no market downturn to avoid during this short time period and the new funds were invested neutral to its benchmark. At Dattilio & Ash we look at both risk and return and strive to manage all aspects of your investment needs in a prudent manner as we manage your portfolios to help achieve your goals.

Keep or Sell?

I was faced with an interesting challenge earlier this year by a client who received a gift of Amazon Inc. stock shares.  The question, of course, was what to do with them?  Keep them or sell them and reinvest into a diversified portfolio of something else?  Tough decision since Amazon shares had been on a tear with some hugely positive momentum; up an amazing +76% during 2020!

The first step in the decision process was to confirm the client’s risk profile and overall financial situation.  The youngish client had a capacity for risk and certainly could handle the risk of a single-stock portfolio, but the Amazon shares made up about 50% of her net worth.  Should she take the risk?

This is where we get into “idiosyncratic” risk, the risk specific to an individual stock that cannot be eliminated but can only be reduced by holding that stock in a diversified portfolio.  Though Amazon certainly has proven itself to be a “great company” through its tremendous growth, product/service mix and service model, that does not mean it is a “great stock”.  A growth stock that is “overpriced” with an intrinsically high level of risk and no potential for the same level of future appreciation is not a great stock.  No one knows, of course, how Amazon will do in the future.

After careful discussion, the client and I decided to sell the Amazon shares on March 10, 2021 and buy a mostly passive globally-diversified exchange-traded fund (ETF) with an aggressive risk profile, the iShares Core Aggressive Allocation ETF (AOA); an ETF with an 80% equity weighting and 20% fixed income weighting.   A review of the risk profiles of these two investments showed that AMZN shares had a historical risk profile more than double that of AOA!

As you can see in the chart below, there were some tense moments over the past five months; AMZN (the blue line) took some big leaps during April and July but came crashing back down in August such that the AOA investment (the red line) is now outperforming AMZN over that time horizon, +9.06% versus +7.92%.

No telling if Amazon stock will find its way back to extraordinary performance, and the short time horizon and impact of end-period bias makes this analysis inconclusive, but for now my client can rest assured that her diversified investment in AOA will help lead her to a more balanced path of growth to help achieve her goals.

The Social Security Conundrum

Social Security benefits are a great source of financial support for most Americans as they enter retirement.  I like to think of social security as one leg in a three-legged stool to support retirement including a company pension and savings in taxable and tax-deferred accounts.  After years of contributions, it is heartening to see the benefits start to come in!

If you haven’t checked your Social Security benefits summary recently, you should register online and take a look at it.  There is lots of talk about the newly designed “personalized” Social Security benefits materials.  The new design highlights the benefits of delaying receiving payments personalized for you in an easy-to-understand graphical format!  Following is a generic table highlighting this info (https://www.ssa.gov/pubs/EN-05-10147.pdf).  As you can see, for each year you delay your benefits the benefit amount increases by about 8%.

So, how do you decide when to take the benefit?  Most all academics in the financial planning field say that the economics of the claiming benefits strategy always favors delaying as long as possible to earn the extra 8% per year of benefit increase.  This is based of large population samples and broad averages, so this is not the answer for everyone, especially if you don’t live a long life consistent with broad actuarial tables.

One way to help make the decision is to think about the “break even point”, the point in time that the cumulative benefits for a strategy surpass the as-soon-as-possible strategy.  It helps to determine the age after which delaying benefits would lead to an increase in total lifetime benefits.

There are many financial calculators that can help calculate the break-even point and Dattilio & Ash uses the holistic approach employed by the MoneyGuidePro investment planning model.  The benefit of this model is that it integrates the social security claiming strategy with your total financial profile including projected retirement expenses, income and invested assets to ultimately calculate an overall “probability of success,” the probability that you will have enough assets and income to get you to your end of plan.

Per the chart from MoneyGuidePro below, you can see all the potential social security claiming strategies for our fictional couple who are currently working.  They both expect to claim close to the maximum amounts but need to think about when to start claiming within the context of their total financial situation.

As expected, the model shows that the maximum lifetime benefit tops out at scenario 5 at $2.083 million if they both delay claiming until they both reach age 70 (the age where increased benefits stop accruing).  The MoneyGuidePro model also shows that integrating this strategy with their overall financial profile results in an 85% probability of success, a very good result.  The Break Even Point is also heartening since this means that the couple only needs to live to ages 76 and 75, well below the current average life expectancy of about 80 years (depending upon how it is defined), whereby all benefit payments after that age are a net increase in lifetime benefits.

Also as expected, claiming as early as possible at age 62 in scenario 2 produced the worst lifetime benefit of $1.445 million and only a 53% probability of success for their plan, not a good result.  If the couple didn’t want to wait until age 70 for whatever reason, waiting to full retirement age (FRA) at about age 67 in scenario 4 would give a reasonably good result of $1.890 million in lifetime benefits and a 76% probability of success, a good result.

So, there are decisions to be made based on both a quantitative and qualitative approach and there is no “right” answer for everyone.  Arguably, if you don’t need the benefits to pay retirement living expenses and expect to live past the break even point, the answer to delay until age 70 is easy.  But if you need the benefits to pay retirement expenses, calculating the Break Even Point, total lifetime benefit, and probability of success give you the numbers to evaluate within the context of your expected life expectancy and comfort with a calculated probability of success.

A Bumpy Ride!

Hang on, kid.  It’s gonna be a bumpy ride, but I finally know where I’m taking you!

The Disney+ Star Wars spinoff, The Mandalorian, has gotten rave reviews by the critics and has done a good job keeping the saga alive.  In it, the Mandalorian finds himself in a position to save (and save, again!) the Baby Yoda character from danger and finally to deliver him to a safe homeland.  The cliffhanger of season 2 has the Mandalorian tell Baby Yoda the above quote.  Season 3 of the series (still in production) deals with the continuing journey to get him to his final destination.

This saga is not unlike the journey we all take to get to our desired retirement!  We all want to arrive safely, but aren’t necessarily sure where we are going or how to safely get there!  Finding our way, as in The Mandalorian, requires us to avoid pitfalls that could steer us off course and to continually seek the right path to get there.

One critical misstep in your journey is to manage to an asset mix that is inconsistent with your risk capacity and risk tolerance.

The academic work on the impact of asset mix selection on long term total return is clear:  though riskier, a larger allocation to equities will produce a higher total return.  The challenge is to balance the risk of an asset mix against the potential return.

As seen from the table below, per the Dow Jones Relative Risk Index Series, moving from a Conservative Strategy to a Moderately Conservative Strategy results in a pickup of 2.35% in annualized total return over the 10-year horizon ended on June 30, 2021.  Granted, this data table just shows one snapshot in time for a specific 10-year period and MANY forecasters are saying projected returns will be MUCH lower than historical returns from today, but the message is clear: a larger equity content shows a higher total return with more risk.

Translated to news you can use, if you have a long-term time horizon (greater than 10 years) you likely have a “capacity” to accept more risk and, consequently, earn more return.  However, you also need to have a risk “tolerance” that matches your risk “capacity”!  If you would not be comfortable with periodic drawdowns in your portfolio that are a normal part of the capital markets, then a lower risk strategy would be more appropriate for you with the corresponding lower expected total returns.

"Bob-a-longs"

When I was in high school, I was a self-professed “journalist” taking sports pictures and writing an occasional article for my local newspaper (I was also co-editor-in-chief of my high school newspaper, too, but that is a different story!)  The editor of that local newspaper was Robert A. Long and he wrote a weekly column titled “Bob-a-longs”; a word that usually means to proceed in a disorganized way, but a clever self-deprecating play on his own name for a newspaper column!

Consequently, instead of writing a full-fledged column, he would simply list blurbs that he thought were interesting.  So, in honor of Robert A. Long, here is my investment version of Bob-a-longs; somewhat unrelated things that caught my attention over the past few weeks that bear mentioning.

• Every time the equity markets hit an all-time high, there is always someone who comes out with a forecast for a correction.  Of course, occasionally one of those forecasts will be correct making that prognosticator a “market expert.”  Don’t believe it!

• Exchange-traded funds (ETFs) are wonderful vehicles and are the most efficient and inexpensive way to own broad (and narrow) slices of the markets.  However, some ETFs are both inefficient and expensive, so beware!  An often-overlooked aspect of the ETF vehicle is the bid/ask spread, i.e., the difference between what you buy and sell an ETF for.  For long-term buy-and-hold accounts, this cost can be amortized over a long time horizon so can be minimal, but for actively traded accounts using thinly traded ETFs, this cost can become quite large.

• Many employees of high-flying tech companies are fortunate to receive shares of company stock in either outright grants/options or at a discount to market price.  Some of these stock perks can be large to start with, but add in some tremendous market appreciation and you have the makings of a pretty nice investment portfolio, albeit hyper-focused in one name!  It always depends, but I usually recommend a conservative 20% cap on exposure to the stock of the company you work for.  The road is littered with high-flying tech companies that hit the skids; I know it can’t happen to you, but just think about shareholders/retirees with positions in GE who saw huge volatility and huge writedowns in their market value.

• When I meet someone new in a social setting and they ask what I do, I tell them I manage investments.  Invariably, they then ask me to recommend a good investment.  Of course, without knowing their financial situation there is no way I could recommend any one investment or even any single strategy.  I could easily say that international and emerging market equities are historically “cheap” relative to U.S. equities, but those asset classes are also “risky” investments.  I could also say that U.S. Treasuries are historically “rich” and probably not a good buy unless you need absolutely “guaranteed” return of principal at some future date.  Then there are lots of things in the middle! It really does “depend”.

A Balanced Bullish Q2

As I reported at the end of 2021 Q1, the financial effects of the global pandemic started to ease with many signs of a recovery.  This trend continued into Q2 as the CNN and Moody’s Analytics “Back-to-Normal” Index currently indicates a value of 94% (from 86% at the end of Q1) representing more progress to a complete financial recovery.  Since this an aggregate measure of financial health, however, some of the indicators and individual U.S. states are not at the same strong level so more targeted work is needed for a complete recovery.  Certainly, continued strong fiscal stimulus and infrastructure spending programs combined with an accommodative Fed (despite recent hawkish comments) are in place to support the continued rebound.

I used the term “resiliency” last quarter to describe the markets and that term is apropos again as the markets continue to rebound from bouts of short-lived panic to scale higher.  As seen from the table below, the S&P 500 (IVV) added to its strong 6.33% Q1 return with another 8.38% return during Q2 to produce a year-to-date return of 15.24%.  Also, while not besting the S&P 500, other diversifying asset classes like small- and mid-cap equities (SCHA and SCHM) kept pace with returns of 4.75% and 5.43%, respectively.  Not to be outdone, however, is the real estate investment trust (REIT) asset class with another strong quarter of 11.93% Q2 return working to recover from its negative return during 2020.

Notably, large cap high dividend value stocks (DVY), representing a “re-opening” market view, also kept pace with the broad market indices with a Q2 return of 3.05%, which when combined with its Q1 return continues to lead all the major asset classes with a year-to-date return of 23.29%.  Meanwhile, other global markets including international developed and emerging market equities (SCHF and SCHE) were likewise strong at 5.77% and 4.10%, respectively.

Bond markets, coming off weakness in Q1, maintained their low return profile producing modest Q2 returns.  Broad core bonds (SCHZ) generated returns of 1.76% during Q2 while investment grade corporates were stronger at 3.92%.  High yield bonds (HYG) were in the middle of the pack during Q2 with a +2.01% return but bested all fixed income on a YTD basis with a total return of +2.60%.

As the equity markets seek new highs and bonds come off record low interest rates, return prospects for the future are cloudy, so caution prevails.  In fact, as I reported in my May 6 blog post, Got Risk?:

But nothing is forever, and we need to be cautious.  Some forecasting models, like the one at Research Affiliates, have much lower expectations for future returns due to the poor return prospects for fixed income assets and the historically high valuations for equities; this firm forecasts only a 2.1% nominal return over the next 10 years for a 60/40 portfolio!

The REIT Story

Everyone is abuzz about inflation!  And why not?  With out-of-control fiscal spending and perpetual easy money from the Fed it seems like hyperinflation is the only possible result.  However, aside from the “transitory” blips in inflation that we have seen as we emerge from the depths of the global pandemic, we have not seen anything that appears to be long-lasting.

So, whether we see inflation or not, we must be diversified to protect ourselves from it since a decline in purchasing power over time is a certain way to ruin a retirement!  One of the ways to hedge your inflation risk is to own assets that are positively correlated with inflation.  Academic studies continue to show that equities, including the real estate asset class structured as real estate investment trusts (REITs), are a good hedge against inflation.

The simplest way to get exposure to the REIT asset class is through the exchange-traded fund (ETF) vehicle.  There are many low-cost, passively-managed REIT ETFs that have provided relatively high income, strong historical returns, and low correlation/good diversification to other equity types.  The top five REIT ETFs by assets under management are Vanguard Real Estate Index (VNQ, $40.1B), Schwab U.S. REIT (SCHH, $5.8B), iShares U.S. Real Estate (IYR, $4.8B), Real Estate Select Sector SPDR (XLRE, $3.0B), and iShares Core U.S. REIT (USRT, $2.0B). 

As seen from the chart below, so far in 2021 investment performance has been very good with them all clustered towards the top of the performance chart with 20%+ returns easily outpacing the S&P 500 (IVV, the green line at the bottom) after lagging last year with pandemic-induced negative returns.  No one knows if real estate will be forever damaged from the pandemic, but performance so far this year does offer some comfort.

Being passively-managed, the REIT ETFs all follow a published index and strive to replicate the index performance, less the management fee.  The ETF sponsors all use indices from the major index providers like MSCI, FTSE, and Dow Jones/S&P.  Interestingly, the indices all look relatively similar with the main differences being the level of diversification, the individual REIT weighting approach, and number of holdings.

For example, the Vanguard ETF (VNQ), the largest at $40.1 billion, restricts the sum of the weights of all issuers representing more than 5% of the fund to not exceed 50% of the fund’s total assets whereas the Schwab ETF (SCHH) restricts the sum of the weights of all issuers representing more than 4.5% of the fund to not exceed 22.5% of the fund’s total assets; quite a difference in approach with neither one necessarily being better or worse.  No one knows in advance which indexing approach will be the top performer over any market cycle, so best to select one and stick with it.

All these ETFs are low-cost with investment management fees less than 12 basis points (0.12%), except IYR that is at 42 basis points (0.42%).

There are other asset classes that also provide a good inflation hedge including gold, commodities, and other common stocks, but none of those provides the extra benefit of the REIT asset class with relatively high cash income that can be used to pay living expenses in retirement or reinvest/rebalance into the fund over time.