Thu, 25 Jul 2013
Given that markets are operating in uncharted territory today, allocating to asset classes that probably weren't traditionally found in retirement portfolios may be appropriate, says Windham Capital Management CIO Lucas Turton.
Andrew Gogerty: Morningstar is celebrating its 25th Morningstar Investment Conference this year, and while the investment environment has certainly been volatile over that time, there has been a somewhat consistent trend of falling to steady interest rates.
Joining me today for perspective on that, and also what risk this places in the current market environment, is Lucas Turton, Chief Investment Officer of Windham Capital Management. Lucas, thank for joining me.
Lucas Turton: Thank you.
Gogerty: So your firm's investment process starts with looking at market cycles of risk and trying to identify them. It's very institutional, and I can see where it can sound somewhat complicated, bringing that to an intermediary market and building a portfolio of ETFs around it.
How are you crafting that message and what are you looking to provide advisors in those portfolios for use with their clients?
Turton: Well, let me begin by describing to you the process, because it is fairly straightforward, and I think it applies in many markets today. So, the first step of our process is to analyze risk in the markets, and determine what sort of environment we're in and try to anticipate how assets will behave from a risk perspective in the future. So this first step, when we think about a multiasset income strategy, is to determine whether or not we will be pursuing income with capital appreciation or income with capital preservation. So, a calm market will lead us to try to grow principle, whereas a risky market will cause us to preserve principle.
Now, the second stage is then to come up with forecasts that reflect the current environment for those income-producing tools that we have--in this case, they're exchange-traded funds--ranging from fixed-income instruments to alternatives such as real estate or master limited partnerships, and then some of the more esoteric preferred and convertible bonds become that opportunity set.
We then, based on our view of the environment, create efficient frontiers, and we identify the income optimal portfolio that's either capital preservation or capital growth. We then implement using the exchange-traded funds, and we continuously monitor the markets, and this gives us the ability to dynamically manage risk, while producing a steady income.
Gogerty: Let's talk about that. On your panel here at the Conference, you talked about opportunities and areas of concern building a global multiasset ETF portfolio. What are some of the changes and exposures that Windham has made over the last six months, either to asset classes or specific risk exposures given what's going on in the market?
Turton: So, this year has been interesting, a bit of noise, but also some information. We began to detect, and actually began during the decision to ease in Japan, that real estate investments--international in particular the Asian markets--were behaving strangely. They started to act more like fixed-income instruments and began decoupling from the equity markets. While that may sound favorable--decoupling lower correlation to equity markets--it is a signal that the markets are behaving unusually. So, when we see that type of behavior, we adjust back our risk. So in April, we went from what was actually our most favorable environment for investing to one that was, let's say, more moderately favorable.
More recently, in May, we began to see the same behavior in the United States. So, this was now beginning to transfer from one asset to another asset to another market, and that's another negative sign. So, we actually began reducing our exposure to that asset class, increasing our exposure to fixed income, while simultaneously reducing our duration risk.
Gogerty: Let's talk about rates--and you mentioned duration; rates are obviously tied to that--over the last decade or so, which we've talked about it's been one environment of either rates steadily declining or even just remaining steady. Obviously, that's going to change going forward. In terms of longer-term financial planning, what does that do to either capital-growth assumptions or even retirement planning, given that we're going to be in a different environment five to 10 years from now? What are some of the most substantial changes that advisors are going to need to look at?
Turton: Well, first and foremost, we're going to need to come up with realistic expectations for the growth rates of certain asset classes. While I can't predict when--or arguably even if; we could maintain low interest rates for a long period of time--that doesn't necessarily do a retiree any good, other than their principal is going to be protected. But earning a below inflation rate on their bonds, unless you are fabulously wealthy, that's insufficient to support your liabilities in retirement.
So, the first step is coming up with realistic expectations, and then managing the within-horizon experience. From our perspective, given that these markets are unpredictable, we believe that maintaining a high level of diversification, allocating to asset classes that probably weren't traditionally found in retirement portfolios are appropriate. Managing that duration risk. OK, best-case scenario rates don't rise really rapidly. There are some scenarios where rates do rise rapidly. I think the fixed-income investor may experience returns that we haven't seen from fixed income in 30 or 35 years, but we should be prepared for that, and we should be managing that throughout time, but it's also a matter of managing the expectation of the investor.
Gogerty: One of the things you talked about on the panel was not only expanding REITS and other asset classes, but even diversifying within fixed income, looking at different fixed-income asset classes sounds like that's something that's going to be important too, as opposed to just lumping everything into a Treasury or a core index portfolio in the United States. Making that portfolio more global as well seems like is going to be something that's going to be important, if the advisor is going to help their client meet that goal.
Turton: Right. So, I think as you begin to look at asset allocations going forward, that single line item that is fixed income that's benchmarked to the Barclays Aggregate is going to need to broaden much like the S&P 500 used to be the equity markets. Now, it's actually a smaller portion of the equity markets, if you add up the foreign.
So, I think fixed income is going to evolve, where you still will have your core fixed income. When the markets get fearful, rates will fall, people will flee to the appearance of risk-less assets. So, it still is a stabilizer for your portfolio. But there are opportunities to invest in different parts of the capital structure; there are bank loans, short-term high-yield credit, floating rate investment-grade corporate bonds could be attractive and also helpful in managing duration, because the Barclays Aggregate has been pretty stable around 5 to 5.5 years. You do the math on that, a 2% rise in rates leads to a 10% fall in a bond portfolio. It doesn't happen often. We've got a lot of history on 10-year rates. But we're in uncharted territories at least in many people's professional careers, uncharted territory.
Gogerty: Thank you for your perspective today. Always appreciate it. This has been Andrew Gogerty with Lucas Turton from Windham Capital Management at the Morningstar Investment Conference. Thank you for joining us.