Portfolio Rebalancing at Market Highs
After a year of climbing stock prices, your portfolio might be a bit too heavy on equities. How do you rebalance at a time when bonds are also pricey? For some answers and insights, we turned to David Baker, Director, Investment Research at LNWM.
Dave, what are the key considerations when structuring/rebalancing portfolios in 2021?
DB: It’s always important to reconcile long-term positioning with near-term expectations, a practice made more complicated by today’s markets. Longer term, we are concerned about the impact of deficit spending, the consequences of which are likely to be inflation, rising interest rates, a weaker US dollar and a reduction in future growth. In the meantime, however, changes in US fiscal and regulatory policy are likely to provide both obstacles and opportunities for investment portfolios.
The greatest headache asset allocators have is that most financial assets look expensive in the near term. Of course, there are opportunities in areas that haven’t seen strong rebounds since the March 2020 market plunge. But after back-to-back years of strong returns and Covid-19 remaining the dominant market factor in 2021, investors will have to be more selective, even if a full rebalance isn’t necessary.
From a long-term perspective, returns over the next 10 years are likely to be less robust – certainly compared with the last decade – due to current valuations, lower forecast growth, lower yields (even if they do eventually trend higher) and perhaps also inflation. When you put these things together, there will likely be a pull to make portfolios riskier to meet long-term return objectives in a market that looks expensive.
The bottom line is that asset allocators will probably need to: (1) think strategically about what impact any additional risk will have on the portfolio during a full market cycle; (2) accept some measure of increased portfolio risk and volatility to meet long-term objectives; and (3) ensure that diversifying asset classes, including fixed income and private market investments, have the right types of exposures required to buffer volatility when it arises.
Which asset classes, if any, do you find particularly appealing at this point?
DB: One area we’re looking at closely is real assets, on both a near-term and long-term basis. In our view, this includes commodities, natural resource stocks, REITs, and infrastructure equities. Most of these areas lagged both the stock and bond markets in 2020. Infrastructure equities in particular – power plants, water utilities, toll roads, telecom towers, airports, hospitals, etc. — absorbed a good deal of punishment in 2020. These assets seem to us to be uniquely positioned to do well in 2021 and 2022 as cyclical plays. Longer term, real assets should benefit from increasing demand for infrastructure repair and development, political support across party lines and, should inflation get away from us, some built-in protection from that shock, as the majority of infrastructure companies are able to pass price increases through to customers.
Another asset class that deserves attention is core [high-quality] fixed income. Bond yields are still low, although they have been creeping up in the past few months. With the yield on 10-year Treasuries recently at 1.3%, it isn’t surprising that asset allocators continue to look for yield outside of bonds, especially if they’re willing to accept more volatility.
That said, I would not lose sight of the fact that the primary role fixed income has in a portfolio is to reduce risk, not generate return. Consider the investor making greater allocations to high-yield credit at the expense of core fixed income. Yes, they’re boosting the portfolio’s expected yield. But, at the same time, they’re deteriorating the contribution of quality fixed income as a diversifier.
High-quality fixed income is likely to provide the simplest and cheapest diversification to portfolios that are in aggregate driven by equity risk, even during a period of low yields. Portfolios may hold less fixed income than they did in the past, but there needs to be a focus on increasing the quality of what remains to ensure it provides value when it’s needed.
What role should cash play?
DB: What we’ve seen during the past year is similar to what we’d see in any stressful market environment. There’s always a push to increase cash during market downturns, but this often ends up as a drag on portfolios as conditions invariably improve. Our perspective has always been to focus on adequate liquidity for each client, protecting them from having to raise cash during market downturns and taking a discount when the asset being sold isn’t truly impaired. Typically, we recommend holding at least three to six months worth of cash outside an investment portfolio, and 12 months or more in certain cases. The range varies greatly depending on client needs, goals and finances.
Some argue that cash is a superior alternative to fixed income in a portfolio. That may be the case in the short-term if you expect interest rates to rise. But, with limited exception, quality fixed income has outperformed cash in significant market selloffs as investors revise their growth and inflation expectations downward and long-term interest rates follow suit. Even with interest rates at near record lows, maintaining an allocation to high-quality bonds is a smart strategy.