Tue, 6 Sep 2016
Morningstar's Lifetime Allocation Indexes are shifting toward emerging-markets and high-yield fixed income where valuations are more attractive.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. In setting up model portfolios for Morningstar.com, I've piggybacked on some of the work being done in Morningstar Investment Management. Joining me to discuss some recent changes to the asset allocations at Morningstar's Lifetime Allocation Indexes is Brian Huckstep. He's a senior portfolio manager in Morningstar Investment Management.
Brian, thank you so much for being here.
Brian Huckstep: Thanks for having me.
Benz: Brian, as I said in the intro, I've been using the lifetime allocations to kind of help guide how I position my model portfolios on Morningstar.com. So I want to talk about some recent changes that you and the team have made. But before we get into that I would like to just kind of go over your overall philosophy on asset allocation and how it makes its way into these target-date and target-risk indexes that you help oversee.
Huckstep: OK. Morningstar Investment Management--we have seven overarching principles that we follow in everything we do, whether it's asset allocation, building indexes, target-risk, target-date fund selection. Those seven principles are: We put investors first; we are independent-minded; we invest for the long term; we're valuation-driven; we use a fundamental approach; we always seek to minimize costs; and we invest holistically. So we think about the whole package and how it goes together.
Benz: OK. So, in thinking about these indexes and thinking about your overall approach to asset allocation, I think one of the big questions for investors attempting to asset allocate their own portfolios is how hands on should I be with this, or should I just be a strategic hands-off investor or should I be one who gets in there and does a little more active management? Where do you come down on that question?
Huckstep: So I think, in general, there are two extremes. There's somebody who invests strategically, and we would consider that maybe updating once a year, not doing updates too often, maybe just resetting back to a target. And then there are tactical investors who invest often and are really looking at asset classes to make a lot of moves. We think both approaches are valid. We maybe are somewhere in the middle. We use what we call a valuation-driven approach where we once a month are forecasting returns and volatilities for the next 10 years for 166 different asset classes. And we will invest in asset classes where we see good opportunities. So based on their valuations, even avoid ones where we don't. So we're looking at these asset classes once a month but we're moving much less frequently. We want to hit as much as we can fat pitches. So, we will wait until a valuation really does look attractive. The indexes themselves that we're talking about today are updated once a year, and that's on the kind of the longer cycle for a lot of the models we manage and we think that's fine. But then we do do some shorter-term investing in other places, nothing less than once a year.
Benz: OK. So, I'd like to discuss these recent annual changes, and I'd like to focus on fixed income and what you've been doing there. One thing I'd like to start with is your exposure in these indexes to non-U.S. developed-market bonds, so whether bonds issued by the U.K. or Japan, you have taken exposures to zero. It appears to be an asset class that you and the team don't like at all. Let's talk about that.
Huckstep: We don't like negative yields. Not all countries, not all developed countries have negative yields but a lot a lot do. And so, it's very likely in our opinion that those countries and those bonds are going to have negative returns over the next 10 years. So we've taken those out of the portfolio. We are invested in emerging-market bonds where we're finding valuations much more attractive. Those yields were punished recently by a couple of different things. A few years back Greece's default really scared people, and valuations got a little more attractive and prices went down and additionally, energy. A lot of those countries produce energy, not all of them do, but a lot do and there is some concern that some countries may have higher defaults than normal. So some of those prices have been pretty attractive and when we evaluate and forecast defaults relative to current yields and where we think interest rates are going, we triangulate then on the expected return for the next 10 years, and we're finding those emerging-market bonds are relatively attractive today.
Benz: OK. And high-yield as well?
Huckstep: High-yield U.S. and non-U.S. is attractive also based on credit spreads. So credit spreads are a function of the current yield relative to a government bond. And when those credit spreads get wider and those yields are paying more than normal or more than other options, they become more attractive to us, and we are finding high-yield as pretty attractive today.
Benz: OK. But you don't use high-yield to fully supplant high-quality bond exposure?
Huckstep: No. When we build portfolios, we consider how all the asset classes work together and the expected returns and correlations, and we take as much of that free lunch from diversification as we can for the volatility. So we have not taken any very focused positions. We have moved all the money to emerging bonds or high-yield but a little bit more than normal, a little more than peers today.
Benz: OK. I'd Like to talk about the high-quality fixed-income piece and specifically, what you're thinking about in terms of duration for fixed-income portfolios, how much interest-rate sensitivity should investors be taking at this juncture. Let's get your thoughts there.
Huckstep: That's one of the hardest questions for asset allocators and multiasset bond managers to answer. And it's been a hard question for a long time. In my opinion, one of the largest consensus tactical tilts that bond investors have taken since 2009 has been to underweight duration relative to benchmarks. So if our benchmarks have a duration maybe in the 4.5, 5 or 5.5 range and that would probably be Bar Cap Ag or another well-diversified index, the majority of asset allocation funds and indexes and institutional managers are below that. And so it's been like that since at least 2009. People have been very concerned about rates rising and they've been wrong. Rates have not gone up. So we've left some money on the table. So returns are still positive, just not as positive as maybe they could have been.
So today when we look at that same decision, it's 2016, where do we think rates are going. We think rates are going to go up again. When you set that duration to decide how far below benchmark to be, we want to think about the risk that prices might go down in those bonds, but we also want to consider the risks that we're wrong. So, we're maximizing total return for each unit of risk but we're also trying to produce good outcomes for investors. So, in the target-date series when I forecast out maybe a 2035 investor, that's the vintage I'd be in, has two or three or four market cycles left until they retire, I don't want to get rid of all my duration. I don't want to go to cash or short-term bonds with all of my investments because I think rates are going to go up. There's a chance I'm wrong there, and so I don't want to leave too much money on a table. But also, if I'm in cash and short-term bonds today, we expect those returns are lower than inflation and that's a problem. If we think inflation is going to be 2%, maybe a little more than 2%, and we see those that cash is paying zero almost today and that short-term bonds are often less than 2%, that's not an attractive place to invest because it's behind duration. So you're getting stuck on both ends; there's risk of the longer-term bonds and there's risk from the shorter-term.
Benz: Right. So, if I'm a very short-term investor though, say, I have a time horizon of just a couple of years, it does make sense for me to be short or maybe even in cash with that portion of my portfolio?
Huckstep: Absolutely. Once you start talking about investors with less than maybe a seven-year market cycle left to invest, absolutely, they need to be more--we think they need to be more defensive. But if you have more than one market cycle, you can justify durations between 4 and 5 still today. We don't have any portfolios, anything above 5 any diversified core portfolios. But I think only a retirement income series is below 4 today. So between 4 and 5 is kind of that sweet spot today is what we're forecasting.
Benz: So the basic idea is that even if interest rates go and that crunches your intermediate-term bond fund's price in the short term that you, kind of, will get that back over time in the form of a higher return than the short-term bond investor would earn?
Huckstep: Yeah and that's the one comfort is that if you are leaving some of that money on the table, at least by holding those bonds and after the yields go up and the prices go down, you're getting a higher relative yield for the current price. So, I mean, you get that back. And in a perfect world where you have a crystal ball that would tell you the date when these things are going to happen but we just don't have that. So we feel it's more prudent to not go fully to cash or short-term bonds but to have some skin in the game there.
Benz: OK. Brian, thank you so much for being here to share your insights.
Huckstep: Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.