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Portfolios Look Stock-Heavy

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Have investors grown complacent in the extended bull market? Joining me to discuss that topic is Fran Kinniry. He is a principal in Vanguard's Investment Strategy Group.

Fran, thank you so much for being here.

Fran Kinniry: Thank you, Christine.

Benz: Fran, let's talk about investors' appetite for risk. When we look at fund flows, we've seen flows into equity funds ebb and flow, but it does appear that some investors might be getting a little bit complacent about the equity market--returns have been so strong for so long. Is that something you're seeing when you look at flows into Vanguard products?

Kinniry: What we're really seeing is that the giant bull market of the last five years has pushed equity allocations up. So, whereas the cash flow, as you mentioned, has been volatile in and out, when you have such a bull market, equity allocations are near peak. When we look at all mutual fund assets, there have only been two times where investors have had this much in equity--that is 1998 through 2000 and then in 2007.

Equity allocations are at their extreme, and that is a reason to have some caution or pause or at least think about rebalancing.

Benz: And those two time periods that you mentioned, things weren't so great in the period right after 2000 and 2007?

Kinniry: Right. And this is not a prediction of a bear market or a bubble, but what we do see is investors' flows with the market. It is very difficult for investors to rebalance, which is selling their winners and buying their losers. We don't know how long this bull market is going to last, but it has certainly elevated all investors' equity risk, and that's something they need to think about: Are they prepared if trouble hits?

Benz: When you think about bonds, as well, in terms of the bond preferences that investors seem to be expressing--they are buying some of the higher-risk stuff there, too, correct?

Kinniry: That would be the bigger concern, because the equity markets have lifted the equity allocations, but cash flows into bonds look much different than they did in the late '90s and even 2007. I always say, the bond market today, or what people are buying, is not your father's bond market. It's been high-yield corporates, it's been bank-loan notes, emerging-markets bonds.

So, they have "bonds" in the name, but they are actually out on the risk spectrum, which means if equities ever do fall into some trouble, the correlation, or the downside risk of the total portfolio, may be significantly worse than in past periods.

Benz: Let's talk about what investors should do. Say you're a well-meaning investor and you're trying to figure out the current market environment. You've got stocks--they're certainly not as cheap as they once were--as well as bonds, which aren't all that attractive in and of themselves given how low yields are, given that yields have a lot more room to move up than they do down. What should investors do? You mentioned rebalancing--is that still the prescription?

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Kinniry: Rebalancing, number one; and number two, understand each asset or each fund's role in the portfolio.

It's hard to get excited about traditional bonds or even money markets, money markets at 0% or traditional bonds at 1%, 2% and 3%. So, I do empathize with the audience. It is very hard to get excited. But the role of those assets is to preserve principal and actually hold up well if your equities are coming down. You don't want all of your assets performing similarly. I worry about the bond component having equity-like characteristics.

Benz: Which is what you get with high yield and bank loan and some of those other categories?

Kinniry: That's right.

Benz: You think investors should be rebalancing, but they should be focusing on higher-quality bonds because they will be better balanced for their portfolios?

Kinniry: That's exactly right. Stick to high-quality fixed income. Total market fixed income, high quality, tax-exempt municipal bonds make a lot of sense as opposed to stretching out on the credit spectrum of fixed income.

Benz: There is this issue, though, of principal losses. Some investors are concerned about that, concerned that, if indeed we see a substantial interest rate increase, that those bonds and bond funds could be subject to losses. What do you say to investors who are concerned about that?

Kinniry: We've been talking about rising rates almost since 2000, and it just hasn't happened. I would say just like timing the stock market, timing the bond market is very difficult. Clearly, yields are low. I try to tell everyone, do not confuse the level, meaning the level of interest rates, with the direction. We are at a low level, so low yields, low return, but that hasn't been a great indicator of the next direction. So, just because we're low, low interest rates doesn't mean that interest rates have to rise.

Benz: When I'm thinking about my fixed-income position, should I think about keeping the majority of it in some sort of intermediate-term product? How do I decide how much interest rate sensitivity to take on?

Kinniry: If you're broadly diversified and let's say you have a duration of five and a yield of two, even if interest rates go up 1%, and they did that a year ago, and here we are, bonds have a positive 12-month return of 5%.

Let's look at a bear market in bonds. If we go from 2% to 3% and the duration is five, your downside risk is negative 3%, negative 4%. That's a lot different than equity bear market losses of negative 30%, negative 40%. And the good news is, now if interest rates do go up, that's your new floor of forward-looking returns; it would be 3% instead of 2%. So, if we actually have gradually rising interest rates that may not be bad for the average investor.

Benz: OK, Fran, thank you so much for being here to share your insights.

Kinniry: Thanks Christine. Appreciate it.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.