Broker Check

Quarterly Update - October 7, 2015

| October 20, 2015

We are going to mix things up a bit in this quarter's update.  For one, some clients have expressed that our previous content had become a bit too "technical".  That is probably an understatement, as one reader actually commented that "while I appreciate the updates, my eyes start rolling into the back of my head after about the second paragraph....".  Point taken.  More important is our concern that many investors remain confused with the current investment landscape (join the club), and more specifically about how their monies are being managed as a result.

So, we are going to skip the traditional summary of the last quarter's events.  For the sake of simplicity, let's just say that it was not a good one for most asset classes.  Instead, we want to offer some thoughts as to what we believe investors need to know concerning the current environment.  (WARNING - this will be longer than usual, but we hope will also prove more informative.)

The "Zero Interest Rate" Environment and Your Portfolio

In our opinion, recent interest rates and their effect on portfolio performance (both good and bad) remains largely misunderstood and too often ignored.  While wonderful if you are buying a house or car, zero percent interest is hardly helpful is you are heading into retirement and need income from your savings.  Nor is it helpful when you are trying to reduce volatility in your investment portfolio while still leaving room for potential return.  Here are some thoughts that we believe every investor must at least consider regarding the current interest rate environment....

#1 - The lower the interest rate, the lower the cash flow being generated from your investments

Yes, we know that this is not rocket science - but investors are accustomed to generating at least some level of cash flow from the "safer" parts of their portfolio.  This is no longer the case.  And because of this, more and more investors are found "chasing" income by moving into riskier or longer-dated fixed income instruments - which brings us to our second must-know fact...

#2 - Bonds are less volatile.....except when they are not

For reasons I cannot quite explain, our society seems to have remarkably short-term memories.  I mention this because it has been THIRTY+ YEARS since we have experienced a significant and sustained rise in interest rates.  Please remember that when interest rates rise, bond prices fall (and vice versa).  We are at or near HISTORICAL lows in terms of interest rates across all maturity lengths.  It is also important to understand that while long-term bonds pay out higher interest - their values will also drop substantially more in reaction to rising interest rates than bonds paying less interest but with shorter maturities.

#3 - Yield (income) does NOT = return

It is a must that every investor understand this concept.  If an investment pays you 7% interest - but proceeds to lose 20% in value - the holder of that investment just LOST 13%.  Generally speaking, investments generating greater income levels have either longer maturities or are "less safe"....or many times both.

#4 - A LOT of money has flowed into fixed income investments

We have an aging population in need of income.  The stock market "bubbles" of the past 15-20 years have scared a lot of investors out of the stock market and into bonds.  The Fed has ensured that returns on cash holdings are minimal at best, and so a lot of that money has flowed into bonds with higher interest.  Yields (income) in the U.S. are still substantially more attractive (and often deemed to have less risk) than in other parts of the world.  For all of these reasons, an enormous amount of money has flowed into bond investments in the U.S.  Why is this important?  Read below....

#5 - Bond prices (and rates) are determined by the "market" - NOT by the Fed

Yes, it is true that the shortest of interest rates (and indirectly the rate on your savings account) are controlled by the Fed.  But prices and yields of all other fixed income investments are market-driven.  Just like stocks, buying will cause prices to rise and selling will cause prices to fall.  Remember what we just discussed about all of the money that has flowed into (buying) bonds in the U.S.?  What do you think happens if a substantial portion of that money then flows out (selling) because of rising rates or other reasons?  It is irresponsible not to consider in our opinion.

#6 - Fed action since "the great recession" is unprecedented

This can get technical quick, so we will try to keep things basic.  The Fed brings interest rates to zero, and ultimately begins printing money to buy bonds in an attempt to manipulate long-term rates along with the short-term rates that they already control.  This forces many investors in need of income away from cash and into bonds or stocks.  People start borrowing money that they don't have (again) since it is so cheap to do so.  The economy starts "humming" - although that statement is certainly debatable.  The stock market reaches and then makes new all-time highs in a relatively short period of time.  Sound familiar?  I hope so, because that is the last 7 years in a nutshell....

It is at the very least plausible (and likely in our view) that the "recovery" of the past several years is due mainly to unprecedented manipulation of markets (both bonds and indirectly stocks) by the Fed.  What happens when the punch bowl ("zero percent interest") gets taken away?  Anyone who tells you they have a concrete answer to that question is something less than honest...

The moral of the story is that - if for no other reason than the Fed action alone - current valuations of asset prices (both stocks and bonds) cannot be trusted in a historical context.  The current investment environment is nothing if not uncertain - and one definition of "risk" is "uncertainty".  We believe in managing risk.

So, What is One to Do?

We are hopeful that the above discussion will help put this into better context.  At Round Hill Wealth Management, we employ "tactical asset allocation strategies" for our clients.  Simply put, "tactical" means that your allocation to the different asset classes will change based on our perceptions of the investment landscape.  Conversely, a "static" allocation would maintain a constant allocation across asset classes regardless of the environment.  Each of our clients have a "target allocation" across asset classes (bonds, stocks, etc.).  This target allocation is derived from the financial planning process and includes clients' goals, resources, tolerance for risk, etc.  The "target allocation" is then tactically adjusted periodically based on our perceptions of the different asset classes and the overall investment environment.

For simplicity, let's pretend that the only two asset classes are stocks and bonds.  In reality of course, there are many subsectors to each of those and many other asset classes as well.  Furthermore, we are going to skip what drives our "tactical" decision making as that is the mother of all technical discussions - and we promised to try and not put you to sleep this time....

 Traditionally, stocks are the most volatile part of an investor's portfolio.  They will be the main driver of long-term gains, but also the main cause of short-term losses when markets are performing poorly.  And since we view stocks as having elevated valuations in the current landscape (in other words, we do not view them as overly "attractive"), we are reducing (NOT removing) exposure to stocks in client portfolios.

What makes the current environment so frustrating is that we perceive bonds to be as (if not more) unattractive as stocks in terms of their current valuations.  As a result, we want to minimize both interest rate and default risk as much as possible, while still leaving some room for potential return in the event interest rates continue to fall (which is entirely possible). So, we have increased credit quality (perceived "safety" of issuers) and also shortened maturities in client portfolios - both in an attempt to minimize volatility due to rising rates or an overall disruption in fixed income markets due to reasons discussed above.

While many reading this welcome our attention to risk, it is also important to understand that this strategy also reduces potential return.  Yes, you will have much less downside risk with shorter-dated bonds vs. longer maturities - but you will also receive less income.  Gone are the days where we could sit back and collect 5% on our fixed income positions in a safe fashion.  Yes, a substantial drop in stock prices will likely affect you less when you own fewer stocks - but it also means that you will not participate as much when stocks are rising.

As we have mentioned many times before, one thing about risk management is that it cannot effectively be done after the fact.  We believe that managing risk should always be viewed at least on equal footing with potential for return - with even greater emphasis put on risk management during periods of elevated uncertainty.  We believe the current environment to be one of those times, for all of the reasons discussed and more.

A Final Note on "Tactical Allocation"

Investors should remember that fees and taxes are two of the biggest detractors from overall portfolio performance.  Please note that tactical allocation often involves more frequent buying and selling of assets and will tend to generate higher transaction costs as a result.  Investors should also always consider the tax consequences of moving assets more frequently.

It is for these reasons that we typically prefer "fee-based" platforms for our clients.  Under this type of platform, clients pay a set percentage of their assets under management with us - regardless of the number of transactions occurring in their accounts.  This gives us the flexibility to react to changing investment environments without incurring additional costs for clients.  Furthermore, fee-based accounts give us flexibility to execute "tax-loss selling" for clients, again without having to worry about creating additional costs.  It is for these reasons that we prefer fee-based vs. commission-based accounts for our clients and other investors considering tactical allocation strategies.

Finally and always most important - to all of our clients, we thank you for the trust and confidence you have placed in Round Hill Wealth Management.


Douglas Brymer                                                David Swanson

President - Wealth Advisor                                Principal - Wealth Advisor

The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Statements of forecast are for informational purposes and are not guaranteed in any way to occur.  Trends discussed are not guaranteed to continue in the future.

All performance referenced is historical and no guarantee of future results.  Investments mentioned may not be suitable for all investors.

Investing involves risk including loss of principal.  No strategy assures success or protects against loss.

Bonds are subject to market and interest rate risk if sold prior to maturity.  Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Securities offered through LPL Financial - member FINRA/SIPC.  Investment advice offered through HighPoint Advisor Group, LLC - a registered investment advisor.  HighPoint Advisor Group, LLC and Round Hill Wealth Management are separate entities from LPL Financial.