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Duke University juniors Mike Du, left, Jenny Zhang, center, and Alex Kim won an asset allocation contest sponsored by BlackRock.
Squeezed by historically low interest rates, a wide range of investors — from retirees living on fixed incomes to huge endowments and pension funds trying to meet budgets — are trying to figure out how to generate income.
Business and economics programs at American colleges and universities have long sponsored stock- and other asset-picking contests for their students. But last semester, faced with the current ultralow interest rate environment, Duke’s undergraduate economics department ran a competition in asset allocation for the first time. Students had to decide what percentage of assets to put in fixed-income investments and what percentage to invest in other categories. The asset management firm BlackRock was a co-sponsor of the contest, which was open to any Duke sophomore or junior.
“Where is someone supposed to get yield these days?” said Emma B. Rasiel, an associate professor of economics. “That’s what got us thinking.”
It’s a pressing question for nearly every investor, and has left even professional financial advisers scratching their heads. The United States is now in the fifth year of a low interest rate environment. Ten-year Treasuries, the benchmark United States interest rate, yielded 5 percent in July 2007, just before the recession began. This week, the rate was below 2 percent, and last July, 10-year rates were the lowest ever recorded. This week, the one-month Treasury bill, the lowest-risk bond investment because of its short duration, was yielding practically nothing: 0.04 percent.
How much of their assets to allocate to bonds and other categories may well be the most important decision investors make. The mutual fund giant Vanguard advises, “Research shows that your asset mix — how you spread your money across stocks, bonds and cash — has a far greater impact on long-term returns than your individual investments.”
For many years, the rule of thumb for most long-term investors was “60/40,” a 60 percent allocation to stocks and 40 percent to bonds. Besides having the virtue of simplicity, less volatile and lower-return bonds were meant to smooth out the ups and downs of the riskier stock market while giving investors some of the greater possible gains of stocks. Vanguard estimates that an investor with a 60/40 allocation can expect an average annual return of 8.6 percent, based on data going back to 1926.
That allocation resulted in a decline in 21 of the next 86 years. In the worst year, 1931, it resulted in a drop of 26.6 percent, while in the best year, 1933, it produced a gain of 36.7 percent.
That allocation resulted in a decline in 21 of the next 86 years. In the worst year, 1931, it resulted in a drop of 26.6 percent, while in the best year, 1933, it produced a gain of 36.7 percent.
By comparison, a 100 percent allocation to stocks produced an average annual gain of 9.9 percent, with a decline in 25 of the 86 years and much greater volatility. A 100 percent allocation to bonds resulted in an average gain of 5.6 percent, with a decline in just 13 of the 86 years.
But those are long-term averages. The results can vary substantially depending on the starting point. In the decade ending in 2009, stocks had average annualized returns of negative 3 percent and lagged bond returns by more than 9 percent, a record disparity, according to T. Rowe Price.
Hardly anyone expects those high bond returns now. Despite the paltry yields, fixed-income investors have been cushioned for the last few years by falling interest rates, which allowed the value of their bonds to increase as yields declined. (Bond prices move inversely to interest rates.) But with short-term rates now near zero and longer-term rates still at historical lows, it’s almost impossible for rates to decline any further. Indeed, they have been creeping up in recent months. And if and when rates rise more substantially, bond investors will be stuck with not only slim yields, but also losses on their principal.
Given this, should investors abandon the tried-and-true 60/40 approach and move more aggressively into stocks?
“The traditional 60/40 approach to building a portfolio is on the way out,” said Michael Fredericks, head of retail asset allocation for BlackRock and lead portfolio manager for the BlackRock Multi-Asset Income Fund. It is being replaced, he said, by “tactical” asset allocation, a strategy in which investors change their allocation based on the current pricing of asset classes.
If bonds are overpriced, as many now believe, and stocks are underpriced, at least relative to other assets, then the allocation should shift toward stocks. “We’re not telling clients to sell all their bonds,” Mr. Fredericks said. “They do balance out the riskier assets in a portfolio. But most investors need to consider putting more in stocks.”
In his own Multi-Asset Income Fund, which has traditionally focused on fixed-income assets, Mr. Fredericks said he had reduced the amount invested in high-yield bonds and moved into stocks that pay high dividends, using an options strategy to lock in gains and protect against market drops. The fund had more than 25 percent of its assets in equities at the end of the year, with the remainder in various forms of fixed income. Last year, it returned just over 13 percent.
For the Duke contest, the students were asked to design a portfolio for an investor who was expecting to retire or begin withdrawing assets around 2020, just seven years away. That time frame ordinarily calls for a conservative — that is, bond- and cash-oriented — allocation to minimize volatility and the potential for loss. A traditional rule of thumb for older investors is that the percentage of assets in bonds should equal their age. So, 70-year-olds should have 70 percent of their assets in bonds.
Alex Kim, a Duke junior from New Zealand majoring in economics, told me that he and his teammates — Yuefeng Du and Yuci Zhang — faced the same quandary as most investors: how to generate income while minimizing risk and preserving assets for retirement. They examined model portfolios from Fidelity, Vanguard and BlackRock. “We looked at historical returns for each asset class and then adjusted those for current market conditions,” Mr. Kim said.
As the members of the team formulated their strategy last fall, they shared the concerns of many experts that bonds were overvalued. But they saw little risk in the short term to principal, given the Federal Reserve’s public commitment to keep interest rates low until the economy improves. At the same time, they worried that the Fed’s easy money policy would lead to inflation, which has traditionally eroded fixed-income returns.
They were bullish on United States stocks, especially those of large companies, based on their predictions of a continuing recovery in housing, rising consumer confidence, strong retail sales and the continuing impact of the Fed’s quantitative easing program. They were also optimistic that Congress would avoid the so-called fiscal cliff and other threatened political calamities. But they were pessimistic about Europe and emerging markets, given the euro zone crisis and what they saw as slowing growth in countries like China and Brazil.
The team’s contest entry called for allocating 43 percent to United States stocks — 30.3 percent to a Russell 2000 index fund and 12.7 percent to a Russell 2000 fund that invests in midsize companies. They made no allocation to international stocks. Like more traditional models, they maintained a large allocation to fixed income, but weighted it heavily toward Treasury inflation-protected securities, or TIPS, whose yields rise with inflation. They allocated 32.1 percent to TIPS and 24.9 percent to an aggregate bond fund.
The result was a 9.7 percent projected annual return, with less volatility than the model funds they examined. The team ran projected returns for cases including both bull and bear markets, and their allocation outperformed the BlackRock model “in all scenarios,” Mr. Kim said.
Professor Rasiel winnowed the field of more than 30 entrants to 10 finalists, who presented their strategies to BlackRock executives in late November. The executives announced the winner a few weeks later: Mr. Kim’s team. BlackRock praised the team’s research, its modeling in bull and bear market assumptions and its “strong understanding of macroeconomic drivers.”
The prize was an interview and a shot at an internship at BlackRock this summer. Mr. Kim is waiting to hear if he got one, and said he was aiming for a career in investment banking.
The runner-up team embraced a similar strategy to Mr. Kim’s team, but was even more concerned about inflation. It put 68.2 percent of its assets into TIPS. It was also bullish on riskier equities from emerging markets, with a 16 percent allocation. The remainder was in United States equities. The projected annualized rate of return was 10 percent, with slightly lower projected volatility than the winning entry.
Before investors rush to replicate either approach in their own portfolios, they might want to consider that these are college undergraduates, however talented and motivated they may be. It’s much too early to assess the winning team’s results, but so far they have been right about United States stocks: the market has rallied strongly since they made their submission.
But projections and models are only as good as the underlying assumptions. Given the heavy allocation to currently low-yielding TIPS, the students are likely to outperform more traditional portfolios only if inflation picks up in the next seven years. Mr. Kim conceded that his team’s projected return for TIPS (5.66 percent) and bonds (5.91 percent) “may be optimistic, given current market conditions.”
Financial advisers stress that all asset allocation plans need to be tailored to each investor’s circumstances and risk tolerance. Faced with the same low interest rate environment, professional asset allocators with the same time horizon as the Duke contestants have emphasized stocks over bonds.
The Fidelity Freedom 2020 Fund, for example, had almost 56 percent of its assets in stocks at the end of last year, including more than 15 percent in international equities. Only 8 percent was in TIPS. Vanguard’s Target Retirement 2020 Fund was even more weighted toward stocks, with an allocation of just under 64 percent, nearly 20 percent of which was in international equities.
After all the models and projections, they’ve ended up pretty close to the old 60/40 approach.
http://www.nytimes.com/2013/02/02/bu...=business&_r=0
http://www.nytimes.com/2013/02/02/bu...=business&_r=0
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