As seen on Global Banking and Finance Review
Written by Jeff Mount
FAIRFIELD, CONN. (PRWEB) APRIL 27, 2020
The world seemed to be so much simpler just a few months ago. Nobody wore masks to protect themselves and others from a potentially lethal virus. There were no shortages in the aisles of grocery stores. Unemployment was at historic lows. Investing seemed relatively easy.
This financial crisis is different than just about every other we have faced due to the complete reversal of the simple life we enjoyed just a couple months ago. The stock market has recovered somewhat due to the “hope” that our lives will return to normal in the coming days. Investors have been so optimistic that they have clearly ignored the catastrophic unemployment claims of the last few weeks and are overlooking what are expected to be dismal earnings reports for the second quarter. In the last six weeks, investors have driven the S&P 500 up 30% from the bottom in late March. This rapid rise—driven by hope and optimism—could be at risk should the pandemic spike again as people around the world attempt to restart their lives. So, what is an investor expected to do to manage risk and create liquidity for upcoming life events (college tuition, weddings, etc.)?
Traditional financial planning is based on an institutional method. It asks the investor questions that assess their risk profile and creates an allocation from which growth occurs during the accumulation phase and distributions occur when income is needed. This allocation is reset on a systematic basis (semi-annually or annually) to take advantage of selling securities that are overvalued and buying ones that are undervalued. Here is the problem with this—institutions do not get sick or hurt. They do not get laid off. They do not pay for their children’s tuition or weddings. All of these real-life challenges require liquidity. The most liquid security is cash. However, cash pays the investor nothing and, therefore, creates a drag on a portfolio. Bonds function as an instrument that offers less volatility than stocks (which makes them a great instrument to lower overall risk) and they generate income. However, bonds endure two risks that should be addressed in this environment: credit risk and interest rate risk. It is unlikely that we will see the Federal Reserve tighten interest rates for a while, however, rates could potentially rise naturally if inflation becomes a concern due to lack of supply and/or continued supply chain disruptions. Credit risk, however, is a very real risk moving forward. We just exited the strongest economy we have ever seen in the United States and the consequence of that is there are a lot of outstanding loans that were made to entities that will probably not survive this downturn. These entities were probably in financial trouble before the downturn but were kept afloat by the strong market and easy access to more capital. As the tide rolls out, it will be revealing to see who is wearing a bathing suit and who is not! As sophisticated bond investors evaluate these bonds, they have to try to identify which companies have that healthy mix of strong revenues, a strong cash position, and enough of a dividend to justify the risk for the investor. All of these challenges highlight why the traditional “institutional” method of financial planning cannot be trusted moving forward.
A new, more human-centered, financial planning method is taking shape. It is called Dynamic Mapping, and it creates liquidity for the investor by applying a process called “aging of portfolios.” Rather than putting the investor through the risk profile questionnaire experience (imagine how different the answers to these questions would be when asked last year versus today) and rebalancing back to an allocation that was probably flawed to begin with, Dynamic Mapping suggests creating purpose-based portfolios that each have their own unique distribution date. Assets would be allocated very highly towards risky asset classes (like stocks) when the distribution date is far into the future (like 15 years or more). As the distribution date nears, these portfolios gradually move to bonds, and then to short-term US Treasuries at the point nearest the distribution date. Some compare this process to target-date management, but it is very different in that Dynamic Mapping assigns no downside risk management benefit to diversification of sub-asset classes. Periods like a dotcom collapse, a global credit crisis or a global pandemic cause these sub-asset classes to correlate to “1”, thus eliminating the risk management benefit at the worst possible time. Dynamic Mapping also strongly encourages the creation of a bear market reserve, a contingency reserve, and an inflation reserve. Each is funded with different types of securities that provide liquidity for each purpose. The bear market reserve and contingency reserve are invested in short-term U.S. Treasuries and the inflation reserve is invested in asset classes like TIPS (Treasury Inflation Protected Securities), commodities and dividend paying stocks. Under all circumstances, investors who use this process will always have liquidity for those purpose-based accounts at the time they need it.
Once a financial planning method has been chosen and crafted, the investment management challenges begin! It is a given that managing stocks for the short-term will be very tough. The stock market makes enormous moves up when hopeful information is disseminated to the general public about the possible end to this crisis and equally powerful moves downward when the public is disappointed about economic data or a potential resurgence of the pandemic in the future. Interest rate cuts and demand for safe assets have driven yields to near “0.” If an investor wants to own a bond with a higher yield, they take on potentially devastating credit risk with companies who might default on their debt. This dynamic certainly suggests a need for professional management of both stocks and bonds over passive strategies like indexing. However, there is a risk of illiquidity in bonds when the bonds are inside of a mutual fund or exchange traded fund. Here’s how this plays out:
- The bond fund manager builds a portfolio that meets the objective of generating income while managing credit risk through the diversification of investment grade and high yield bonds. (Without the high yield bonds, there is very little yield available to make the return performance compelling at this moment in time.)
- A cash position is created that is larger than the normal 3% in order to distribute to potentially exiting investors in the next downturn. However, it is almost never large enough to meet this objective because a large cash position creates an enormous drag on performance. (Portfolio managers often receive performance-based compensation relative to their peers which serves as a conflict of interest).
- When the liquidity crisis hits, exiting investors burn through the cash and the portfolio manager is forced to sell bonds. The sale of these bonds in a crisis means the bonds will be sold at a discount and may take a while to clear (bonds do not trade on an exchange like stocks do).
- Since there will be no appetite for risk in the crisis, the portfolio manager will only be able to sell the highest quality bonds. Nobody will want to buy the high yield bonds that carry enormous default risk.
- The end result is that the exiting investors get their cash while the investors who were asked to “remain calm, all is well” (visualize Kevin Bacon in Animal House here)are left with a lower quality bond mutual fund than the one they initially bought and feel the pain of those bonds that were sold at large discounts. The risk of default in their portfolio would be higher than ever before.
Ideally, an investor would be better off hiring a portfolio manager to manage individual bonds they would own outright. This would relieve the portfolio of any pressure from exiting investors and allow the investor and manager to remain patient during a liquidity crisis.
Another important risk management tool that is implemented in the Dynamic Mapping method is the calculation of purpose-based liabilities. When saving for our children’s college tuition plan in the future, we often calculate the four-year tuition into the future with an assumed rate of inflation. We rarely do that with retirement or other funding needs. Dynamic Mapping calculates the personal liability for each of life’s purposes so that the investor knows exactly what amount they need. These liabilities are graphed alongside their corresponding assets. The output of the calculations is easy to read due to the graphical nature of the method. No boring spreadsheets and no old school bar charts. For those who like to “do it themselves,” a free app called Dynamic Map is a calculator that can show these graphs.
The COVID-19 crisis has changed the world in many ways forever. One of these changes needs to be the elimination of risk management methods that have nothing to do with the challenges faced by real people. The old school method of financial planning is fine for foundations, endowments, and pensions. No amount of “Monte Carlo analysis,” or other such gimmicks, will justify a “set it and forget it” asset allocation program designed to cover a family’s entire life.