Armstrong: Invest for Total Return

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

Big market swings are unnerving to everyone, but especially to retirees who are looking to their portfolios for current living expenses. Here to discuss some coping strategies for retirees is Frank Armstrong. He is president and founder of Investor Solutions LLC, which is a registered investment advisor based in Florida.

Frank, thank so much for joining me.

Frank Armstrong: It's always my pleasure.

Benz: So, Frank, you have been one of the pioneers of the bucketing approach to retirement income. Let's talk about what that is exactly, and why you think having separate buckets in retirement can help retirees manage volatility a little bit better?

Armstrong: Well, first, if you have an income bucket of fixed-income today, at least, it's going to produce next to nothing, but its purpose is to serve as a store of value and to moderate the risk in the portfolio as a whole. You're not going to be able to accomplish your objectives using that unless you're so incredibly wealthy that you don't need to bother about planning.

However, the other half of the portfolio needs to grow to counter inflation and meet your growth objectives. So, your total return is enough to support a reasonably liberal withdrawal program.

So, on one hand you've got a bucket of safe, safe assets that you can use to withdraw your fixed income for some period of time in the future. We recommend eight to 10 years. That allows you to sleep well at night, have the intestinal fortitude to ride out the ups and downs, and also have the financial ability to ride the ups and downs with the market, because you know that all your bills are going to be paid for some very long time out into the future, and the overwhelming probability is that the market is going to self-correct whatever disaster we have today, and go on to all-time highs during that 10-year period.

So, we use two buckets, one for safe, safe assets to meet your needs off into the future and moderate the risk of the total portfolio, and the other bucket to grow to meet your long-term needs to hedge inflation and have real growth of the portfolio.

Benz: So, eight to 10 years, Frank, you're not saying sink eight to 10 years' worth of living expenses in cash though, right?

Armstrong: ... In a short-term, high-quality portfolio that doesn't vary a lot, and it's a near-cash, one- to two-year durations. It doesn't vary a lot in capital values as interest rates go up and down.

Should you go longer or lower quality, at some point, interest rates have to go up, which means capital value is going to fall like the rock, and you don't want to be there.

So, short-term portfolio protects your downside in a rising interest rate environment. Very few of us would like to bet the farm today that interest rates can't go up.

Benz: Right. I want to talk to you specifically about how you're thinking about client portfolios. It seems like a very vexing environment for fixed-income investors, people are concerned about, as you said, rising interest rates, but also, if the economy weakens, about going to junky. So, how should people manage in such an environment? Do you have any tips for what a diversified fixed-income portfolio should look like right now?

Armstrong: Well, there is no income left in fixed income. ... Yesterday we just saw 30-year mortgage rates fall below 4% for the first time in history. The 10-year Treasury is hovering around 2% or less. There is no income in fixed income. And the downside risk of either going long or lower quality is just not worth whatever little tiny incremental yield you could get.

So, you have to invest for a total return of the portfolio, and give up on the idea that you might have inherited from your grandfather of: live on the dividends, live off the interest, and preserve principal--whatever that means to you--for the rest of your life.

So, the total return portfolio is demonstrably safer than an income portfolio would be, and right now in this current environment, it's going to have a lot of upside--with, obviously, also downside--but as opposed to an income portfolio, I only see downside in it.

<TRANSCRIPT>

Benz: So what role would TIPS play in such a portfolio, because it seems to me that if you are staying short and you're sticking with the high-quality stuff, a risk is that inflation could gobble up every bit of return that you have right there. So, would you add TIPS as some insulation against rising prices?

Armstrong: TIPS aren't crazy, but they haven't worked out as well as you might expect. They're taking the inflation risk off the table, but you still have an interest rate risk. It's still a long-term bond, and if you buy into it and interest rates change, your capital value is going to go up and down. You've got some interesting tax issues with TIPS that you don't have with anything else. Economists seem to love them, but in the real world they haven't worked out as the panacea that you might have thought.

Benz: So do you use them in client portfolios?

Armstrong: I am not presently using them. We might use them in the case of a portfolio design for, say, a pension portfolio where we need to match assets to liabilities, and we could take a little bit of a capital risk, but we're not using them currently. And we fight this out in the office, it seems like every other week, but the long-term returns haven't been wonderful, and there is some downside which most people don't understand.

Benz: The interest rate sensitivity.

So, let's shift gears and talk about the growth component of this total return portfolio. I'm wondering, in the wake of some of the scary news coming out of Europe, as well as concerns that growth here in the U.S. might not materialize as many of us hoped it would, are you making any changes to client equity portfolios?

Armstrong: No, actually not Christine. I'm a pretty simplistic guy. I look at the world, and I say, if something has never worked before, it's unlikely it's going to work for me just because I try it. Shifting back and forth within the equity portfolio doesn't work very well for most people, and that's an attempt to market-time or do some kind of a sector rotation.

We believe that, first of all, the problems out here are real, and we can't pooh-pooh them, but on the other hand, a lot of the problems are really political rather than economic. The Europeans have the economic ability to solve their problems, but right now a couple of very tiny little countries have got a stranglehold on resolving the problem. And, of course, the Germans don't want to roll over and pay for everybody else's mistakes. I sort of understand that. On the other hand, the Germans have to come to grips with the idea that if they let everybody else sink, their markets disappear with them.

So, I would hope that there's going to be a political settlement, because it's more of a political problem than it is an economic problem, which is not to say that there isn't some economics attached to it. There are some serious economic issues attached to it, but it just means that I can't forecast how it's going to turn out, and nobody else can, either, because it's political and who knows what goes on in those meetings, the G20?

Benz: So, within client portfolios is it your sense that it makes sense to just stay sort of geographically neutral relative to the world's market-cap or how do you approach that question?

Armstrong: We actually split it 50-50, foreign and domestic, because we think it gives us pretty good dollar hedge. In academic terms, we probably should be 35% U.S. and 65% foreign, because that's close to the world market cap weights, but the 50-50 makes us pretty comfortable, and we can demonstrate that that's added a lot of value over a domestic-only portfolio in the long haul.

Benz: Now how about things that fall under that "other" heading? I have a feeling I know what you're going to say, but in terms of alternatives and other things like that, are they a component of client portfolios or do you steer clear?

Armstrong: Well, it depends on what you say an alternative is. We think real estate is a very valuable diversification alternative. We invest in it through listed securities, ETFs and index funds, but we think that's an alternative investment that makes sense. The other alternative investment that makes sense that we also use through index funds and exchange-traded funds is the commodities futures funds. They have reasonably low correlation and have proved to be a very valuable diversifier over the longer term, but that's as far as we will go.

Our guidelines here are that it's got to be totally transparent. It's got to be completely liquid. I got to be able to sell it tomorrow if I feel like it, and it's got to be regulated, and there's not a lot of alternative investments which would meet all those three criteria.

Benz: So, Frank, do you have any last bits of advice for retirees or any other investor who is attempting to navigate this kind of market volatility that we've recently had?

Armstrong: Well, I think you've got to keep your head. This kind of volatility is bound to make people nervous, and it's no fun. I don't want to pretend that I am having fun.

Let me tell you a story about when I used to be an airline pilot back and in another life. Before 9/11, we could get up and wander back in the cabin and talk to passengers and stretch our legs and stuff, and occasionally the airplane would hit a little turbulence, and the passengers, many of them, would react with a white-knuckle death grip. "Oh my God! This thing is going down." Whereas, up in the cockpit, the guys are grabbing for their coffee because they don't want to spill it, and they are absolutely not concerned at all.

Well, the difference is, they've got a lot of experience. They understand the airplane is built like a tank, and it's nothing to worry about for them, but for the passengers, it's not natural, and we all know it's not natural to be in a sealed tube more than five miles high, more than 500 miles an hour, while you are bouncing around back there.

So, we try to keep people focused on the idea that this is not an unexpected turbulence. We don't know when it's going to happen, but we know it's going to happen, and the odds are that we're going to muddle our way through this, because it's much more political than it is economic, in both our instance here in the U.S. and foreign.

To reach your objectives, you've got to stay on board. One good thing about the airplane was people couldn't bail out, and our job as a financial advisor is to keep people locked in to where they are so that they don't make a mistake that they may never be able to recover from, because what we've seen in the past is when people bailed out at market bottoms they never recovered from that, and it was a disaster for them and their family. So, we want to keep them locked on to, we want to get to the destination all of us together, and this isn't really so bad. And we've gone through a lot of trouble to make a portfolio that immunizes them against the short-term bounces.

Benz: Okay. Well, thank you, Frank. That's great advice. It's always terrific to hear your insights.

Armstrong: Always a pleasure, Christine.

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