Planner Mark Balasa of Balasa Dinverno Foltz has been shortening fixed-income durations, increasing allocations to TIPS, and employing flexible bond funds to fend off inflation.
Jason Stipp: I’d like to turn the conversation a little bit and talk about the portfolio construction. So you had mentioned earlier how you’re taking a close look at the fixed-income allocations of your client portfolios given the cloudy environment in bonds right now.
What sort of adjustments are you making, given that we could see rates go higher in the intermediate term?
Mark Balasa: Again, this is a difficult question--that’s why everyone struggles with it. When you look at the bond side of a portfolio, one of the first things you would do to help protect against rising inflation and rising rates would be to essentially shorten the bond maturities. But right now, of course, that means a lower return.
So, if you look at protecting against short-term inflation and long-term inflation, again, you think about interest rates. Rising interest rate helps dampen inflation, but it also hurts the value of bonds. So, when you’re constructing a portfolio, many times, from our perspective, you’re trying to strike a balance between those two competing risks.
So, for us to do that, we in general have shortened the maturities of our bond portfolio, we’ve increased our allocation to TIPS, some people are using global TIPS, we tend to use domestic TIPS to do that. And we’ve also started to use products that have a lot more flexibility in terms of their mandate and how they are constructed to give the manager the ability to be more flexible, to help protect the portfolio against not only rising interest rates, but potentially inflation as well.
Stipp: On the side of the more flexible bond funds, we’ve done some coverage on those. It seems that the management of those funds is extremely important given the latitude that they have. How do you go about selecting investments for that particular sleeve of the bond portfolio?
Balasa: It’s so true. Actually that advice, of course, is good for everything, but especially here. And because the products tend to be newer, their track records are not that long to look at and analyze the products. So, to your point, we have to place probably a little bit extra emphasis on the track record of the manager themselves: So, when they've done a good job elsewhere, they’ll do it here as well.
So, for us, trying to look at the manager and their track record in other products and paying close attention to the people actually running these flexible products and their track record, and taking the data that’s at hand, which is again it’s fairly short--three or four or five years--and to place almost equal importance on the management’s overall track record with other products.
Stipp: At this point are you limiting exposure to a smaller sleeve for those unconstrained funds?
Balasa: We are. For us on the bonds side of our portfolio, for a typical portfolio, we’re using two different products, and we’re using 5% in each right now, with the expectation that as things get more difficult in six months or a year out, that could potentially increase.
Stipp: Would you mind sharing with us the products that you use?
Balasa: Sure. We use PIMCO Unconstrained, and we use JPMorgan Strategic Income.
Stipp: Two other funds that our analysts have also taken a very close look at as well.
Mark I want to ask you a little bit about a trend that we’ve been seeing: investors putting more money into floating rate funds and high-yield funds hoping to keep ahead of inflation and also combat the current low interest rate environment. It’s a trend that worries us a little bit. Are you looking at these instruments at all?
Balasa: We certainly are looking at them, but we share your concerns. On the high-yield front, as long as we're talking specific products, we’ve tended to use Loomis Sayles. We think they do a really nice job of balancing the risks for the high-yield along with foreign and domestic bonds.
So, we don’t use a dedicated high-yield player currently, although we have in the past. The reason we don’t right now is because we’re concerned with the credit risk and just the strength of the underlying economies in markets that high-yield represents. So, for us that’s been an important addition to the portfolio.
As far as the floating-rate securities instruments goes, we typically have not used those. Our concern there is the credit quality, the liquidity, again some of the short track records, fees. So, although we spend time looking at them, we typically haven’t used them.
Stipp: What about commodities? Do you employ a commodities exposure?
Balasa: Currently, we don’t. I know we are in many cases an odd man out in this regard. We spent a lot of time looking at commodities, and for us, we get the idea that it provides a leveler, if you will, or a dampening of the volatility of the portfolio, but in our view, that comes at the cost of return. Commodities in and of themselves, as everyone knows, don’t provide an income, and so, it’s all based upon the next person paying more for it than we did.
That combined with the volatility of commodities--and if you go back to ’08, when you really needed protection--everything, including commodities, really didn’t help. So, we spent a lot of time looking at it, Jason, but to-date in this environment, and again, based on some valuations as well, we currently do not have it in the portfolio.
Stipp: Okay, last question for you, Mark, has to do with younger investors. So, you alluded to this a bit before when you were trying to strike a balance [between] wanting to be shorter duration, for example, but also knowing that there is very little return there right now.
Younger investors, though, will tend to have bigger portions of their portfolios in stock. For folks like that, do you need to layer on any additional explicit inflation protection? Or how do you think about protecting inflation over the very, very long-term for these folks?
Balasa: In some ways it’s an easier answer than the short-term inflation concerns, and part of the reason it’s easier is because of what you brought up--which is that stocks over the very long-term have provided a real return over inflation of about 6%.
So, when you have a long enough time horizon, by putting equities in the portfolio--again for a younger person, of course, the higher allocation is easier to justify--and you look at the total return for the portfolio, instead of just looking at instruments to help hedge against short-term and intermediate inflation, and again focused on the long-term, you can say, that’s an easier problem to solve by using a total return perspective and using domestic and, in our opinion, a pretty healthy allocation of international equities.
Stipp: Mark Balasa of Balasa Dinverno Foltz, it was a pleasure speaking with you today. Thanks for calling in.
Balasa: Absolutely. Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.