Below is a section from the most recent WhiteTree quarterly client letter.
What’s Conservative Got To Do With It?
Echoing the famous poll in which 80 percent of people rated themselves above average drivers, most investors consider themselves more conservative than their peers. Unfortunately the term “conservative” has little descriptive power in context of portfolio construction, except as short-hand for the investor’s desire for low volatility and consequently more bonds. This common psychological orientation, combined with the obliging nature of investment professionals, the desire for yield, and demographic trends, has resulted in an increasing number of investors with portfolios heavily if not totally allocated to the bond market. Recent market events indicate that such portfolios may exhibit surprising and undesirable characteristics.
As food for thought, consider the performance of a hypothetical U.S. bond portfolio in the second quarter of 2015. The table below includes the returns of various bond market ETF’s, their prospective yields and a hypothetical portfolio allocation.
The value of this portfolio declined by 4.08% in the second quarter. This is of course, not likely a ruinous outcome for the owner. However, consider these losses in the context of the portfolios weighted average yield of 3.18%. If the portfolio owner is a pensioner, he or she has seen the entire year’s earnings and more wiped out in a single quarter – probably not an outcome that was deemed likely if the portfolio was constructed using historical simulation. Indeed, when a substantially similar portfolio is backtested over the period of 1972 – 2014, the worst drawdown over the entire 40+ year period was 4.62%. Students of history may note that the retrospective period includes the 1973 oil crisis and its resulting inflation.
Equal to or perhaps more important than the exact magnitude of the quarter’s decline is the economic environment in which it transpired. That is, that the drawdown occurred without a meaningful increase in US inflation, or hike in interest rates by the Federal Reserve. And while no rigorous conclusions can be deduced from a single quarters data, I do think the events portend an increased sensitivity in what is popularly assumed to be among the most robust asset classes.
To be clear, none of this is meant to be a predication about the future of the bond market or inflation. What I am attempting to convey by way of anecdote is that investors should be aware that what common-knowledge regards as conservative, may be revealed to be otherwise. Intelligent investing requires a more nuanced communication than is commonly employed, with the consequence that many investors get the portfolio they ask for but not what they were expecting.
Disclosures / Disclaimer
All WhiteTree Investment Management Strategies are subject to market risk, including the risk of permanent losses. Before investing, clients should carefully evaluate their financial situation and their ability to tolerate volatility.
This information should not be used as a general guide to investing or as a source of any specific investment recommendations, and makes no implied or expressed recommendations concerning the manner in which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives. This is not an offer to sell or a solicitation to invest.
This information is intended solely to report on investment strategies implemented by WhiteTree Investment Management, LLC and its investment managers. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. Under no circumstances does the information contained within represent a recommendation to buy, hold or sell any security, and it should not be assumed that the securities transactions or holdings discussed were or will prove to be profitable. There are risks associated with purchasing and selling securities and options thereon, including the risk that you could lose money.