NAVIGATING VOLATILE MARKETS
FOR RISK-AVERSE INVESTORS
December 2013
DEFRED G. FOLTS
SENIOR MANAGING DIRECTOR
With interest rates potentially beginning to tick higher, some investors may wonder if they’ve missed their opportunity to participate in the
gains the bond market has experienced over much of the past three decades and the outperformance of the equity market over the past
few years. For those who are more averse to risk or have a shorter time horizon, navigating today’s volatile and uncertain investment landscape can be challenging. Many investors are left with questions such as how to manage the risk of rising interest rates when investing in
bonds, the role equities play in a conservative portfolio, and whether or not to stay out of the markets entirely and remain in cash, among
others. Those investors may wish to consider the Windhaven® Diversified Conservative strategy, which we feel addresses many of the concerns of conservative clients.
KEY POINTS
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Interest rates may rise in the near future which could be detrimental to bond holders.
Cash may be a suitable investment only for those with a very short time horizon as inflation can be more harmful than some realize.
A modest allocation to equities is important, but conservative investors should not become over-concentrated or try to time the markets.
Windhaven’s Diversified Conservative strategy attempts to address many challenges and may be suitable for risk-averse clients.
ALLOCATING TO FIXED INCOME
Managing interest rate risk
BURNED BY BONDS
Bond investors experienced a 16.7% decline in the early 1980’s
fueled by rising interest rates
100
0%
16%
Interest Rate
95
-5%
14%
90
-10%
-15%
85
-20%
80
U.S. 10-yr Treasury Bonds 7/1/1980-9/30/1981
Source: Bloomberg
12%
Bond Value
10%
Interest Rate
With such uncertainty, some conservative investors wonder if
bonds are still an appropriate investment. At Windhaven, our Diversified Conservative strategy maintains a considerable allocation to
bonds (though also includes exposure to a wide variety of other
asset classes which we will discuss in greater detail shortly), but
the types of bonds we hold has evolved over the past year or so.
You see, not all bonds are impacted by changes in interest rates to
the same degree. The shorter the duration of a bond, which is a
measure of a bond’s sensitivity to interest rate change, the less a
bond may be harmed in a rising rate environment.
So while we believe bonds should continue to play an important
role in the portfolio of a conservative investor, we feel the types of
bonds held could dramatically impact investment performance and
need to be analyzed closely. Windhaven maintains a dynamic approach to asset allocation and carefully monitors the bonds within
the Diversified Conservative strategy. We strive to expose our clients to bonds which we believe are most appropriate given potential future economic scenarios, and over the past year or so we
have shortened the overall duration of the bonds within the Diversified Conservative strategy. This move to shorter duration bonds is
significant as we believe it may allow the Diversified Conservative
strategy to experience the benefits of a declining interest rate environment, but may reduce the harm caused should rates tick upward.
Bond Value
For many conservative investors, fixed income is the investment
option of choice, and those who have gone this route have been
rewarded with a 30 year bull market in bonds. The strong performance of the bond market is due to a unique relationship between
interest rates and the value of bonds. As interest rates rise, the
value of bonds decreases, and as rates decline the value of bonds
increases. While this inverse relationship may appear to be counterintuitive, it is extremely important to take into consideration. It is
the decline in interest rates over the past three decades which has
led to the strong performance experienced in the bond market. As
a result of this extended period, it can be easy to forget that investors can actually be harmed by bonds. For instance, those who
invested in 10-Year U.S. Treasury bonds in the early 1980’s
watched the value of their holdings decline 16.7% between July
1980 and September 1981 as interest rates ticked higher over that
period. Rates have since declined which has fueled the bull market
in bonds, and have been driven to new lows in recent years by
U.S. Federal Reserve policies intended to encourage investors to
move to riskier asset classes such as stocks. These actions seem
to have been effective, and the Fed has recently announced plans
to begin to taper such stimulative policies. This could cause interest rates to rise, potentially harming bond holders. There is evidence that this may already be beginning to take place as longerterm interest rates have risen as of late.
STAYING ON THE SIDELINE
Investing in cash
The traumatic experiences of the bursting of the housing bubble in
2008 and the tech wreck in the early 2000’s have made it difficult
for some to jump back into the equity market, and many remain
heavily allocated to cash. While cash could certainly be an appropriate investment vehicle for those with a very short time horizon,
for others maintaining a large cash position can be quite harmful.
Cash may not expose investors to the potentially large, newsworthy declines which can be experienced in many other asset classes, but investors can be harmed significantly by losing their purchasing power to inflation, and over time inflation’s impact can be
dramatic. For instance, an annual inflation rate of just 3% could
erode an investor’s purchasing power by over 25% in just 10 years
and by over 45% in just 20 years (see illustration below), making it
more difficult to achieve long-term goals.
The Windhaven® Diversified Conservative strategy could be a good
fit for those concerned about the potential for large equity market
declines, but who don’t want to see their purchasing power eroded
by inflation. Diversified Conservative attempts not only to preserve
investment capital, but also strives to outpace inflation over time.
While it can be tempting to sit in cash to avoid market risk, the risk
of losing purchasing power to inflation is just as real, and one
which Diversified Conservative could help investors mitigate.
In hindsight, it appears that it should be possible to foresee market
peaks and troughs, but in practice it is extremely difficult to buy low
and sell high. Instead, we believe it is important to maintain some
exposure to equities at all times, understanding that there will be
times when equities will perform poorly, yet also understanding that
there will be other times when they will likely be a top performer
and offset losses incurred elsewhere. Diversified Conservative may
provide a modest level of equity exposure and enable clients to
remain invested through even volatile periods to reap the benefits
of long-term equity appreciation. Over-exposure to equities can
certainly be detrimental to conservative investors, and we would
not support an attempt to time when to enter and exit the equity
market, as such behavior can be harmful. However, when used as
part of a more broadly diversified portfolio such as the Diversified
Conservative strategy and held over time, an allocation to equities
may help conservative investors achieve their long-term investment
goals at an acceptable level of risk.
DIVERSIFIED CONSERVATIVE ALLOCATION
CASH INVESTMENTS
U.S. EQUITIES
LOSS OF PURCHASING POWER TO INFLATION
NON-U.S.
EQUITIES
$120K
U.S. FIXED
INCOME
$100K
71.0% Decline
$80K
45.6% Decline
U.S. REITS
COMMODITIES
$60K
$40K
$20K
5
10
Years
Assuming 3% Inflation
15
20
Assuming 6% Inflation
Data Source: Internal Windhaven research.
TIMING THE MARKET
As a result of an increased risk of rising interest rates combined
with outperformance in the equity markets over the past few years,
even the most conservative of investors may stare longingly at the
stock market with envy. With the stock market generating outsized
returns with no material declines over a several year span, what
role, if any, might equities now have in a conservative portfolio? At
Windhaven, we believe equities play a very important role, as do
many other asset classes traditionally thought of as more risky
such as commodities, real estate and currencies. We would never
advocate exclusively holding any one asset class, but we would
also not advocate excluding many asset classes, especially those
as important to diversification as equities. What can be troublesome however, is attempting to time investment entry and exit
points.
Asset classes and the proportional weightings may change at any time without notice,
subject to Windhaven’s discretion. Cash investments are highly liquid, short term securities and may include, but are not limited to, U.S. government Treasury bills, bank certificates of deposit, bankers’ acceptances, corporate commercial paper, and other money
market instruments.
A CASE FOR CONSERVATIVE
Managing the many risks always present across the global capital
markets is a challenge for all investors, but takes on additional
importance for those who are more conservative or who have a
short time horizon as such investors may not have time to recover
from large drawdowns. We understand the concerns of risk-averse
clients and have constructed the Diversified Conservative strategy
to attempt to address these concerns. Diversified Conservative
maintains a large exposure to bonds, including those which could
be less impacted in a rising rate environment. It provides modest
exposure to equities so investors have the opportunity to benefit
from long-term equity appreciation, and may allow those heavily
allocated to cash to get back into the market to potentially offset
the harmful effects of inflation. The end result is a broadly diversified investment strategy designed with the needs of conservative
investors in mind.
LEARN MORE ABOUT WINDHAVEN
If you are interested in learning more about the Windhaven
Diversified Conservative, Diversified Growth, or Diversified
Aggressive strategies, please call 1-877-340-1714, visit
schwab.com/Windhaven, or contact your Schwab Investment
Professional.
Data Source: Bloomberg Please refer to Windhaven’s ADV Part 2 for more information.
Windhaven’s risk management process includes an effort to monitor and manage risk, but should not be confused with, and does not imply, low risk or the ability to control risk.
Opinions expressed are current opinions as of the date this material was published and are subject to change without notice in reaction to shifting market conditions.
Past performance is not indicative of future returns, and the value of investments and the income derived from them can go down as well as up. Future returns and
achievement of stated goals are not guaranteed, and a loss of principal may occur.
Windhaven Diversified strategies are managed by Windhaven Investment Management, Inc. ("Windhaven"), a registered investment adviser, and are available through Schwab’s
Managed Account Connection® and Managed Account Access® programs. Windhaven participates as a separate account manager in those programs, which include other separate
account managers and strategies. Please read Schwab's disclosure brochure for important information and disclosures relating to Schwab's managed account programs.
©2013 Windhaven Investment Management, Inc. All rights reserved (1213-8459).