Morningstar - Q1 2021 - 12

Dispatches

Can We Build a
Better Balanced Fund?
Slim Treasury
yields prompt a search
for alternatives.

IVORY TOWERS

John Rekenthaler

Should bonds continue to be a part of the
traditional 60/40 balanced portfolio? As of late
November, 10-year Treasuries yielded 0.87%.
With the 10-year break-even inflation rate
at 1.7%, the note's miserly payout implies that if
inflation meets investor expectations, the
receipts from 10-year Treasuries will trail inflation
by almost 1 percentage point per year. (The
break-even expectation seems credible, given that
inflation over the past 10 years has been
1.9% annualized.)
To be sure, that payout will look relatively attractive if yields fall further. In such a case, the
Treasury note would increase in price, thereby
boosting its total return. The math, though,
remains unfriendly. For example, if Treasury yields
were to hit zero in 2025, the 10-year Treasury's total
return over that five-year period would be
1.4%-still below the level of expected inflation.

Other Bond Options

Are there better fixed-income choices than U.S.
government bonds? Not really.
Most domestic bond-fund categories yield
more than do Treasuries and thus likely
have better long-term return prospects. However,
as bond credit spreads are relatively tight,
with the option-adjusted yields for BBB corporate
bonds a moderate 1.5 percentage points
higher than those of Treasuries, the reward for
assuming credit risk isn't great. In addition,
swapping government bonds for corporate bonds
reduces diversification, because lowerquality securities move more in tandem with
the stock market.
Heading overseas is no solution, as U.S.
government yields exceed those of most other
developed markets. For example, Japan's
10-year government bonds yield a piddling 0.01%,
while those of Germany, France, and the
Netherlands have negative payouts. Unless the
dollar weakens, thereby providing the
international-bond investor with capital gains, the
mattress would be an investment improvement!
(Assuming that the bedroom doesn't burn.)
One possibility, which I mention tentatively,
is emerging-market government bonds,
which yield about 4% and which for the major
markets are very likely to be money-good.
(China won't default anytime soon.) Unfortunately,
they tend to lose value when the global
stock market dives, so they aren't particularly
good diversifiers.
Alternative Assets

As the goal of investing is to at the very least
preserve purchasing power, if not to outright
increase it, then one could legitimately wonder if
Treasuries at today's prices are " investments. "
Perhaps they should instead be regarded as an
electronic version of mattress stuffing.
The question as to whether the traditional 60/40
allocation still applies is reasonable. The
underlying assumption of balanced portfolios
is that the bond allocation, although conservative, will also be profitable. That assumption
faces serious doubt.

Morningstar Q1 2021

Can alternative investments replace bonds?
Perhaps they can. I have long been skeptical
of alternative investments, such as managedfutures, currency, or market-neutral funds,
because their performance hasn't justified their
additional risk. For example, the managedfutures and multicurrency mutual fund categories
show an annualized loss over the past
decade through November, while market-neutral
funds barely appreciated by 1% per year.
Meanwhile, intermediate-term core bond funds
gained 3.4% per year.

That math may change. True, it's unclear whether
alternative investments will beat bonds in
the future, as opposed to joining them by treading
water in nominal terms while losing money
in real terms. It could be, as has occurred over the
past decade, that the profitable alternatives
will be cushioned versions of the stock market-
long-short equity and options-based funds-while
the alternatives that actually offer diversification
go nowhere. That would be no help.
Nonetheless, in contrast with my earlier views,
I would now consider using alternatives with
balanced funds. Not as complete substitutes for
bonds, but instead as partial replacements,
along with other investments. For example, rather
than the conventional blend of 60% equities/
40% bonds, I might hold 60% equities, 16% bonds,
8% alternatives, 8% gold futures, and 8%
cash. (This is purely hypothetical, as I neither own
a balanced portfolio nor advise clients.)
Hybrid Securities

Readers of my column on Morningstar.com have
proposed two other investments that currently
generate higher income than government
bonds: preferred stocks and utilities stocks. These
assets are largely similar. Each can be considered
hybrid securities, offering higher income
than conventional stocks while retaining equitylike
characteristics. Preferred stocks accomplish
that task by being, effectively, a flavor of junk bond,
while utilities stocks do so by being full-blown
equities but issued from a sedate sector.
(My favorite explanation of preferred stocks: " They
are neither preferred nor stocks. " The securities
are called preferred because they outrank common
stocks when standing in the creditors' line, but
their claims nevertheless are subordinate to those
of the company's bonds. And while they
technically are stocks, they have fixed par values
and thus do not share in stock market gains.)
Let's see how these investments have performed
over several decades. EXHIB IT 1 shows the
real (that is, after inflation) performance of four
assets: (1) the overall stock market, as represented
by the S&P 500; (2) bonds, via the Bloomberg
Barclays US Aggregate Bond Index; (3) preferred
stocks, depicted by the record of now-expired fund

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Morningstar - Q1 2021

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