Like any great voyage, eventually it comes to an end and you have to move on to what’s next. Quantitative easing also known as QE2 is Fed-speak for the Central Bank’s program of injecting liquidity into the economy by buying up mortgage bonds to the tune of $85 billion each month. This has done wonders at keeping interest rates down and stock prices up. But what happens when it ends? How are investors to prepare for weathering the storm to follow if there is one?
If you want to have more than memories from this long bull market voyage, you’d better have an investing plan for what’s next.
So what do I suggest? I still think that it’s a “risk-on” market.I subscribe to some technical trading services that monitor market conditions and signal for “risk on” or “risk off.” Right now everything but the US dollar is in the green indicating “risk on.” So that to me means staying the course. As uncomfortable as that may seem when we’re near Year 6 of a Bull Market, that means being invested in equities and keeping exposure to fixed income – albeit in the lower end of the allocation and with a shorter duration of about 3. Generally, I use Exchange Traded Funds and prefer low-cost ETF options like VTI for domestic equity exposure and VXUS for international. And I’ll use BOND, BND, BNDX, and MINT for the fixed income side.
For active bond fund managers, I’m a fan of Dan Fuss and his team over at Loomis Sayles. I don’t necessarily think it’s a bad time to get into bonds or bond funds. I think it depends on what type of bond you’re getting or the approach of the fund manager. To protect against rising rates – and to round out an overall asset allocation – I’ll look at anything that offers a way to pass through the impact of future inflation.
So I think that investors concerned about rising rates should look at floating-rate note funds and even high yield. Floating-rate funds get to pass along higher interest rates charged to businesses (think Adjustable Rate Mortgage here) which minimizes the impact on the fund. High yield funds (or “junk” bonds) offer higher coupons and in an expanding economy there is less operational risk which should translate to lower overall credit risk. That and the fact that the higher rates mean that the bonds are impacted to a lesser degree than other lower-rate bonds when interest rates rise means that investors get a bonus on yield.
And I like to use a variety of income-producing alternatives to bonds for investors. That’s why I have used and will continue to use high quality dividend paying funds like DVY, VIG and VYM. And another good way to offset interest rate risk is through energy master limited partnerships which can pass along higher costs which insulates them in a way from the impact of inflation as well. These are now accessible in ETF and mutual fund formats without the tax headaches of K-1s. So I’ll recommend an allocation to higher yielding options like AMLP and YMLI.
While I believe that strategic allocation has long-term value to an investor, I’m not inclined to simply “buy, hold and pray.” So I couple this core asset allocation approach with a good dose of cash as one way to hedge market risk. Depending on the client’s risk profile this may range from 5% to 15% in cash. Another risk tool is allocating a portion of funds (up to 10% depending on risk profiles) to a covered call program like the PowerShares S&P 500 Covered Call Buy Write Program (PBP). It offers a cheap, effective hedge to the S&P 500.
And I believe that there’s value in tactical overlays to help hedge markets like this. So I’ll be using a tactical ETF strategist to help hedge client portfolios. While I may believe in theory that markets are efficient, I know that markets are moved by animal spirits. And the best way to tame those spirits and minimize the impact of investing on emotion or gut is to use a rules-based program. At least a tactical strategist can offer this as a way to provide structure to the investment process and help protect gains made by limiting exposure to markets at the “wrong” time.
