CIO on adjusting the 60/40 mix and why he's marrying non-traditional strategies with fixed income
It’s a conundrum – what to do with the 60/40 portfolio? The income disparity is challenging retirement plans and with baby boomers retiring in their millions, this staple of portfolio thinking no longer looks adequate.
This is nothing new, of course, and Neil Azous, founder and CIO of Rareview Capital, told WP that wholesale structural change regarding portfolio construction is already under way. The considerations are clear: where do you get the income you need and how do you manage the risk with regards to weightings?
Azous believes his firm has found an innovative solution for a specific area of the wealth curve, when retirees spend their assets while also preserving enough of their nest egg to pass on. Its first two actively-managed funds – the Rareview Dynamic Fixed Income ETF (RDFI) and the Rareview Tax Advantaged Income ETF (RTAI) – are designed to deliver consistent high yield by combining the traditional benefits of fixed income with the non-traditional advantages of closed-end funds.
Azous said the problem with 60/40 is simple – about 80% of interest rates in the G-10 are below 1%. A near-retiree with $1 million will, therefore, get only $3,000-&7,000 of income a year, while also having the asymmetric potential to lose money on a total return view if interest rates were to rise.
“There’s no cushion for air in the bond side of that portfolio,” Azous said. “At the same token, if the other sides of the portfolio were to do terribly, because of a volatility shock or the equity markets were to fall back, it’s also not acting as the proper shock absorber that they've historically been.”
On the bond side, if a nominal security or fixed-income instrument is no longer a diversifier, it doesn’t offer the required total return potential and, if rates were to rise quickly, also has the risk of money loss. Add in the potential for inflation and investors are now faced with decisions regarding that 40% slice.
Azous said reducing nominal securities and increasing exposure to inflation sensitive bonds or inflation-linked bonds is one method. The other move is to add an element of commodities to help with managing purchasing power risk if inflation were to materialize.
He added: “The big challenge is the weightings, knowing that these markets are not as large as the nominal bond markets. Also, what if that inflation never actually comes? Did you do the right thing?”
The equity 60% is more nuanced but Azous said there are two inputs that help value that side of the portfolio. One is the risk-free rate - the theoretical rate of return of an investment with zero risk – which is now zero, and the second is cash flow.
If investors are reliant on the risk-free rate coming down to help their equity portfolio, they may not have that benefit any longer, with most countries near the zero bound or below. There is, therefore, much greater emphasis on company cash flows and seeking out firms around the world that are generating large amounts of cash. Compared to the past three or four years, which have been dominated by U.S. centric secular growers like the large-cap tech names, some degree of global rotation could well be under way.
Then there is the overarching question of how you get that income. Azous said the simplest answer to that is to find non-traditional product. This could be through a taxable municipal bond as opposed to a tax-free municipal bond, short duration high-yield bonds, structured credit, REITS or closed-end funds.
For the CIO, the latter is where his expertise steers him, and what the two ETFs focus on. Azous said that choosing a manager with the requisite knowledge and track record is paramount, and investors must match this with the right strategy.
He said: “That's where our differentiator comes in, and why these products exist. If you were to just buy a closed-end fund in isolation, you would be exposed to some of the negative concerns around these funds. However, if you were to buy it through a specialist that knows how to create a portfolio and knows the nature of those markets, they are also in a position to help potentially mitigate drawdown risk if volatility were to increase significantly. That’s where we fit in.”
Targeting a 4% after-tax distribution yield to help maintain income, Rareview hopes to address the needs of the millions of baby boomers who are heading towards retirement.
He added: “Closed-end fund products exist; some in the ETF world, some in the mutual fund world and some in the separate account worlds. But I would say that these are distinct, and that our municipal [ETF] is the first time it's in an ETF wrapper with active management. We believe we're also the first distinct dynamic fixed income product wrapped in an ETF.
“We're trying to be at the forefront of that innovation of marrying non-traditional ETFs or non-traditional closed end fund strategies with traditional fixed income.”