Stress-Testing Some Vanguard and T. Rowe Allocation Funds

In the early throes of the recent global pandemic, the Federal Reserve lowered interest rates twice, resulting in a 0-0.25% federal-funds rate that hasn’t budged. But with coronavirus vaccinations in progress and the U.S. economy showing signs of recovery, many expect interest rates to rise, though few agree on when this will happen. Rising rates have a negative impact on strategies with long duration (a measure of interest-rate risk), and recent rising-rate anticipation has led many investors to take a closer look at the durations of their funds. But duration alone won’t make or break performance for thoughtfully curated allocation strategies. Other characteristics of the portfolio’s profile, such as the size of the equity sleeve relative to that of the bond sleeve, geographic and sector diversification, and tilts to lower credit risk, can offset the effects of a longer duration relative to peers. Let’s consider a few Morningstar Medalist allocation strategies during two recent stress periods for rates: August-December 2016 and January-October 2018.

- Source: Morningstar.

- Source: Morningstar.

With an average effective duration of 7.8 years, Vanguard Wellesley Income VWINX, which has a Morningstar Analyst Rating of Gold, bears more duration risk than its typical allocation - 30% to 50% equity peer (the Morningstar Category's average duration is 4.7 years). The 65% bond allocation is benchmarked to the Bloomberg Barclays U.S. Credit A or Better Index, which tilts toward high-quality corporate bonds and has a longer duration than the Bloomberg Barclays U.S. Aggregate Bond Index. The managers structured the bond sleeve in this way as they believe they can provide more upside potential, with little default risk, than the Aggregate Index. From August to December 2016, as the price of long-dated bonds fell, Vanguard Wellesley Income lagged its average category peer by 1.2 percentage points. But over the more recent January- October 2018 interest-rate climb, when many of its multi-asset income-focused peers courted greater credit risk than this offering, the strategy modestly outpaced the average of that group by 0.5 percentage points. Even with its longer duration, the strategy’s lower exposure to weaker-performing non-U.S. equities gave it a bump.

Gold-rated Vanguard Wellington VWELX shares the same risk-aware bond process as the previous strategy but with a higher allocation to equities; it lands in the allocation - 50% to 70% equity category. This category’s average effective duration of 5.2 years is lower than the fund’s 7.9 years. Given this strategy’s lower allocation to bonds, which stays close to 35% over time, its above-average duration hasn’t hurt so much during periods of rising rates. In fact, in either of the interest-rate stress periods considered here, that profile helped it outperform the average of its peer cohort, by 1.8 percentage points from August to December 2016 and by 1.6 percentage points from January to October 2018.

Silver-rated T. Rowe Price Spectrum Moderate Growth Allocation TRSGX has a neutral allocation to equity of 80%, and it stashes the remainder of assets in bonds (16%) and alternatives (4%). At 7.5 years, its duration is longer than the allocation - 70% to 85% equity category average of 5.2 years. Since early 2018, management has maintained a relatively long duration through increased exposure to T. Rowe Price’s global bond and U.S. Treasury long-term funds in order to increase this fund of funds’ diversification. This might give an investor expecting a rate rise some pause, but even as interest rates climbed from January through October 2018, the strategy’s shrewd sector rotation and security selection, as well as a portfolio primarily commandeered by equities, helped it lose 0.3 percentage points less than the average of its category.

Gold-rated Vanguard LifeStrategy Income VASIX is part of Vanguard’s target-risk series; it uses a straightforward, static allocation approach and holds broadly diversified, low-cost index funds. It has a duration close to 7.1 years, about 2.2 years longer than its allocation - 15% to 30% category. From August to December 2016, it trailed its average peer by 1.7 percentage points. But from January to October 2018, it benefited from high-quality and diversified holdings that offset some of the duration risk; this helped it lose 0.5 percentage points less than the average of its peer cohort over the period.