Five steps to get your clients out of bonds and into alternative, low-volatility investments

Elizabeth’s note: RIABiz is happy to say that Rob Isbitts will be joining us as a regular twice-monthly contributor, writing on market conditions and alternative investments, alternatively. Some of his previous columns, The top 10 alternatives to alternative investments and What the alternative is to ill-conceived Target Date Funds have been some of our most popular investment-strategies columns. Look for his first column based on Morningstar mutual fund data in the first week of November. In the meantime, here are some particularly timely thoughts about how coax your clients out of bonds and into low-volatility alternatives.

To look at the trends in mutual fund investing this year is like watching an old Sean Connery/Roger Moore movie: bonds … high quality bonds.

Bond funds, too. Bond funds, particularly those that invest in US Treasuries and other types of bonds at the low end of the risk spectrum, saw piles of new cash in 2010, according to data through July 31. Bond funds saw cash inflows of $185.6 billion between January and July.

If you want the full detail, go to the website for the Investment Company Institute, the mutual fund trade group that compiles this (www.ici.org). A lot of those bond buyers apparently moved cash out of money market funds to buy the bond funds, so there is likely a strong element of “reaching for yield” occurring there.

And what about 2010 flows into Equity mutual funds? Well, to put it nicely, they delivered “negative gains” – that is, net-net, investors pulled a bit more out of equities than they put in. Even Municipal bond inflows have been modest, perhaps due to concerns about the health of state economies. It appears that in the aftermath of 2008’s stock market debacle, when it comes to anything but the safest bonds, investors’ are “shaken, not stirred.”

It’s clear now that investors’ portfolios are WAY too heavily allocated to high quality bond funds.

If bond rates rise, based on real-world concerns (inflation, excessive decline of the U.S. Dollar), high-quality bond funds will fall in value. Clients will be shocked because, even after some nice returns in those funds, they could see negative numbers. With interest rates so low in these funds, it won’t take much of a rate boost for this to happen.

The other scenario is that stocks and other growth investing styles will rally hard again, and those with bond-laden portfolios will get jealous, causing the advisor to scramble to “catch up.” I suspect many advisors will say this is nearly as difficult as counseling clients during market declines.

A prescription for change.

In this column, I’m offering a prescription for how advisors can get themselves and their clients out of this precarious position. It is guaranteed to work out for all involved? No way. But does it have the potential to move advisor-client relationships forward at a time when, on a national level, the strains between consumers and “Wall Street” are high? Absolutely!

1. Start the education process NOW. This simply means spelling out the possibilities, as outlined above. You might even try to handicap the potential outcomes, making an educated guess about what the likelihood of each scenario is, in your opinion. Clients may not agree with you, but they will like that you are taking a stand in defense of their assets.

2. Use history as your guide. The fact is, this generation of investors has not seen a secular decline in bond prices. Since the early 1980s, rates on U.S. Treasuries and other High-Quality bonds have generally moved downward. This has created a false sense of comfort for investors who, from their actions, are believers that bonds are “safe” in all circumstances. Do them a favor and look back at the history of interest rates, bond prices and bond fund prices. If you don’t have that info nearby or don’t know where to find it, email or call us and we will direct you to it.

3. Once you have made the case for thinking beyond current market conditions, start looking for ways to “thread the needle.” What do I mean by that? As noted earlier, you need to develop a strategy that accounts for both possibilities: falling bond prices AND rising stock prices. Both are going to prompt an emotional reaction from investors, and both are environments where that allegedly safe bond fund, with its puny current income return will not inspire much confidence.

4. If bond assets are being used as a way to “enhance” returns available on money funds, warn investors about the danger of “reaching for yield.” History is littered with investors who grabbed a closed-end high yield fund, a basket of high-dividend stocks, or a short-term bond fund to earn a little more on their money, only to see their principal get slaughtered. Leave the “enhancement” activities to scores of companies that flood our email boxes with spam (if you know what I mean).

5. Make the case for low-volatility total return strategies as part of a bond replacement approach. In football, there is an old saw about running the ball instead of passing it. Fans of the running game like to say that when you pass, three things can happen, and two of them are bad. That is, either the pass is incomplete and you gain nothing, or it is intercepted by the other team. Only a completed pass (one out of three possibilities) is a favorable outcome.

I will not debate the merits of passing versus running but I will analogize it to the matter at hand. If you own high-quality bonds or bond funds, there are three things that can happen:

a. Rates rise and your income return is uncompetitive
b. Stocks rise and your total return is uncompetitive
c. Rates stay low and stocks meander, while inflation stays tame, so your hunker-down investment is the safest and best-returning alternative

It seems obvious to me that this is not an era in which most investors should be thinking about income from high-quality bonds as a major source of their investment return. Note that I did not say that the objective of funding one’s lifestyle should be ignored. Of course the main objective of many investors is to fund their current lifestyle. That is what retirement investing is all about.

I am simply saying that the way to go about funding that “income” should be quite different from what the investor is used to. Specifically, they should be replacing the term “income” with the phrase “low-volatility total return.” There are numerous asset classes that, when mixed properly, can aim for returns that rival or exceed the interest rate on high-quality bonds, and may accomplish that with volatility well below that of equities.

Equaling bond returns

This area has finally received the attention it has long deserved, likely a result of so much hedged and alternative product hitting the retail investor marketplace the last few years. Mutual funds now perform many acts once limited to hedge funds. Whether its long-short funds, arbitrage, multi-strategy or “equity surrogates” like Convertibles and REITs, it is possible to create a portfolio with a low standard deviation (such that the expected best and worst case returns are in a comfortable range), without having to be trapped by a low fixed rate and the threat of rising bond prices.

These strategies may not keep up with stocks over time. There is, however, increasing evidence that when mixed properly, their long-term return in skittish markets can rival that of an all-stock portfolio, with favorable tax rates compared to a portfolio whose returns are generated primarily from income. That is, if you create the same return as a bond fund, in a taxable account you are better off net of taxes with a low-volatility growth approach.

For those investors who intend to use a portion of their money within a year or so, I can see the rationale for holding cash-like instruments. However, understand that, as in a passing game in football, only one of the three results above is in your favor.

The short-term investor should be fine with the tradeoff. But most investors should have medium or long-term time horizons, and for them, a strategy that relies on bonds is a mismatch – one that their advisors should be helping them avoid.

Robert A. Isbitts, a 25-year industry veteran, is a newsletter writer, published author, and investment strategist. He is also the lead-manager of asset allocation mutual fund and a global equity mutual fund. For more information on those mutual funds, visit www.easfunds.com. His second book, “The Flexible Investing Playbook” – Asset Allocation Strategies for Long-Term Success” was published by John Wiley & Sons in August, 2010.

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