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The role of bonds in AA, are there substitutes?
Old 05-07-2013, 07:12 AM   #1
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The role of bonds in AA, are there substitutes?

I've been pondering about AA, as I sit today I'm about 30% in cash, 70% in equities having taken some profits during the recent run up. I'd like to understand the role of bonds in AA models better. As I look at bond funds today they're getting killed and rates so low no real contribution to fund growth, can I use inverse index ETFs to accomplish the same counter cyclical movement that bonds provided, or is holding in cash today's best alternative? Can someone explain the role of bonds in AA and which alternatives investments could be considered?
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Old 05-07-2013, 08:29 AM   #2
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The Intelligent Asset Allocator By William J. Bernstein
Max Equity Allocation Exposure Max loss
20% 5%
30% 10%
40% 15%
50% 20%
60% 25%
70% 30%
80% 35%
90% 40%
100% 50%
What the above means is that if you have 70% equity exposure, you might experience a 30% drawdown with 30% in fixed income (Cash or Bonds). It is more complicated, as for a short period where inflation is low, your Cash loses little. Bond funds are very high in NAV, generally speaking. The pundits seem to be pleading with everyone to sell off bonds. However, there is a lot of diversity in bonds. We're comfortable with 40% in cash/lt muni bonds/st muni bonds/VBMFX/VWEHX.
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Old 05-07-2013, 08:31 AM   #3
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I see at least three purposes for bonds in a portfolio using an AA strategy:

(1) Provide some current income;

(2) Provide some noncorrelation with other assets held in the portfolio (i.e. equities), thus reducing overall volatility

(3) Keeping "dry powder" in something less volatile so you can take advantage of rebalancing when equity prices fall.

I'm sure people can come up with more.

In reality, there's little point in holding inverse index ETFs (especially in tax-deferred accounts), and here's why. Let's say you own $5000 in an index fund and $2000 in other assets. You decide to ease your equity exposure so you buy $2000 in the inverse fund. This is functionally equivalent to selling $2000 of the index fund and holding $4000 in cash yielding *zero*. Your net "long position" in the index is $3000; the other $4000 is generating no return at all.

There are other equity asset classes which pay bond-like yields such as REITs, preferreds and high dividend stocks (often including utilities and consumer staples). These are *usually* lower in volatility than most other stocks but if they suspend their dividends, all bets are off. These will provide a *some* noncorrelation (i.e. less than 100%) with standard large cap equities, but not as much as income securities.

I'd also add that dividend stocks are much pricier than they usually are because the Fed's War on Savers has investors desperate for yield chasing it. If it generates a significant income stream, it's expensive now.
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Old 05-07-2013, 10:15 AM   #4
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Quote:
Originally Posted by Rothman View Post
I've been pondering about AA, as I sit today I'm about 30% in cash, 70% in equities having taken some profits during the recent run up. I'd like to understand the role of bonds in AA models better. As I look at bond funds today they're getting killed and rates so low no real contribution to fund growth, can I use inverse index ETFs to accomplish the same counter cyclical movement that bonds provided, or is holding in cash today's best alternative? Can someone explain the role of bonds in AA and which alternatives investments could be considered?
Your premise is wrong. As of today, bond funds are not "getting killed" in the slightest. They are actually performing well, and in general the longer maturities are performing better than shorter maturities (the exception being long term treasuries). Take a look at Vanguard's bond funds. Of the more than two dozen listed, only VIPSX is showing (small) loss YTD, and most of the rest are showing returns that would most likely beat what you've been getting with your 30% cash holding.

I would have to know more details about the yields of your cash holding to be sure, but since you are probably sacrificing return by shunning bonds in favor of cash, I can only infer that you have been unduly swayed by all the articles in the financial press about a looming "bond bubble" and the fear that bonds may suffer catastrophic losses at some unspecified date in the future. I suggest that you do your best to tune out this type of "noise" and stick to your asset allocation, without regard to what the pundits are saying. They mostly have proven that none of their predictions can be taken seriously.

https://personal.vanguard.com/us/fun...ssetclass=bond
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Old 05-07-2013, 10:56 AM   #5
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Seems like the best an inverse EFT could do would be to equal cash. If it acted exactly the opposite as your equities (or bonds for that matter), it would just cancel out any return/loss and essentially 2x your holding in the in the inverse fund would be in "cash" doing nothing. In reality, inverse ETF's are not the exact inverse of indexes at all, and they have plenty of costs. So that would be worse than cash unless you are making successfully timed trades.

With bonds you have the opportunity to move opposite stocks. With cash it's just a stable value, ignoring inflation. So bonds should offer better rebalancing opportunities. In addition to better returns under "normal" conditions. I suspect if you keep bond durations low you won't lose principal but total return will be poor for a while. Not that cash will be any better.

Dr. Wade Pfau, often quoted here, has been suggesting immediate annuities in place of bonds. That may be worth looking into.

Also if you have access to a stable value fund in a 401k plan cash may look pretty competitive.
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Old 05-07-2013, 12:12 PM   #6
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Preferred Stock Issues are an alternative to bonds, but you have to do some research. There are also a couple of preferred share ETF's out there. For some diversification I am holding etf CNPF.
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Old 05-07-2013, 12:23 PM   #7
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Quote:
Originally Posted by Rothman View Post
I've been pondering about AA, as I sit today I'm about 30% in cash, 70% in equities having taken some profits during the recent run up. I'd like to understand the role of bonds in AA models better. As I look at bond funds today they're getting killed and rates so low no real contribution to fund growth, can I use inverse index ETFs to accomplish the same counter cyclical movement that bonds provided, or is holding in cash today's best alternative? Can someone explain the role of bonds in AA and which alternatives investments could be considered?
I include 45% bonds in my portfolio to reduce volatility and to provide income. Right now as income producers they aren't doing very well. But I keep my durations around 5 years so that when rates go up I won't take an enormous hit in NAV and it won't take a decade for new issues to provide me with greater income as a compensation.
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Old 05-07-2013, 01:30 PM   #8
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Thanks all for input, it makes sense that inverse ETFs will give the equivalent of cash,which is what I am doing now. Regarding where the cash is I moved to barclay's 5 year CD with1.8% earlier this year for cash on hand at that point. Now have more cash and would like a place to put it without NAV risk given low returns, this cash money now is in trad and Roth IRAs at Fidelity.
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