How the Merriman research team evaluates potential investment opportunities

Value and blend vs. value and growth – which is better?

You have previously suggested a mix of value and blend funds. However, Burton Malkiel states in his book “A Random Walk Down Wall Street” that value and growth are equal over time. His argument suggests that a mix of value and growth – not blend – with annual re-balancing would be a better strategy. Both you and Malkiel cite historical figures. Can you explain the difference in your point of view?


Great question. I cannot speak to the context of how it was stated but I would argue the premise that value and growth are equal over time.

Consider the following return figures from Dimensional Fund Advisors over the period of 1927-2011:

US Large Cap Value 10.03%
US Large Cap Growth 9.75%
US Small Cap Value 13.50%
US Small Cap Growth 8.8

As you can see, value has historically outperformed growth.

The use of value and blend funds enables us to take advantage of the value premium illustrated by the preceding figures. Of course, blend is a combination of the two so the same result could be accomplished with a mixture of roughly 3 parts value to 1 part growth. However you slice it up our recommendation is to tilt to value.

 

Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Compound returns have an assumed rate of return, are hypothetical, and are not representative of any specific type of investment. Standard deviation is one method of measuring risk and performance and is presented as an approximation. Past performance is not a guarantee of future results.

Convertible bonds as an asset class?


Please share your view of convertible bonds as an asset class for folks entering retirement.


Convertible bonds are a unique asset class in that they have features of both stocks and bonds. They are often referred to as “hybrid” securities. This, along with their typically sub-par credit rating, is why they do not fit into our bond portfolio.

We prefer to keep the stock and bond components of our portfolios separate. Our bond portfolio is designed to buoy the allocation in times of stock market stress. The potential for convertible bonds to act like stocks does not jive with this logic. If convertibles – due to their hybrid nature – were showing stock-like tendencies when stocks were declining, your portfolio would have much less downside protection. As we have seen in the recent past, it is extremely important that investors maintain some level of protection in their portfolio. We do not believe convertible bonds are the solution. (more…)

Adding bonds in preparation for retirement


At 61 years old, what is the best way to transition from an all stock portfolio to a 60% stock 40% bond portfolio?

 

This is a difficult question to answer without knowing your specific set of circumstances. To narrow the scope I will assume the following: 1) you will retire at 65, 2) you will take a 4% annual distribution from the portfolio upon retirement, and 3) you are using a globally-diversified portfolio like the one we outline in The Ultimate Buy-and-Hold Strategy.

Regarding the third assumption, it is extremely important to understand that different portfolios have different risk characteristics. A 60% stock 40% bond (60/40) portfolio allocated to the S&P 500 and high-yield junk bonds is entirely different and much riskier than the one discussed in the aforementioned article.

That said, I would make the switch immediately. With four years until retirement you cannot afford to subject the entirety of your portfolio to the risks associated with stocks.

For perspective, consider that the financial crisis cut the average stock portfolio value in half. Taking distributions from an all-stock portfolio during such a time period has disastrous consequences on the longevity of your assets. This is why, as investors near retirement (the distribution phase of a portfolio), they should – as you’ve indicated – consider adding a preservation component (bonds) to their portfolio.

If the goal is to achieve a 60/40 allocation by retirement, many people will initiate the transition process around the time they reach age 50. This longer time frame for transition allows the use of ordinary cash flows and rebalancing opportunities to make it a cost-effective and natural process. Your situation calls for a less subtle shift. Nonetheless, it is a shift in the right direction and, as mentioned above, I would proceed.

How can I get hurt holding bonds?

I am considering buying bond funds and would welcome your recommendations. I recently read in Time magazine that you could get hurt if you’re invested in a bond fund. How can I get hurt holding bonds?


Many people think bonds are risk free, but that is not actually true. There are multiple risks associated with bonds, but they can be an extremely important component of a portfolio despite those risks. And, if properly allocated, they can provide a level of security above and beyond the equity markets. Of course there is no free lunch, and the added stability of bonds requires a tradeoff. Namely, you are foregoing the equity premium associated with stocks.

We recommend using a mix of high quality short- and intermediate-term government and Treasury issues. For tax-deferred accounts we include Treasury Inflation Protected Securities (TIPS). This allocation is purposefully designed to be very conservative. Nonetheless, it is still subject to certain risks. Interest rate and inflation risk make the top of the list. You can alleviate the risk of inflation through the use of TIPS. Interest rate risk is somewhat of a different story.

There is an inverse relationship between bond prices and interest rates. As rates rise, bond prices fall and as rates fall, bond prices rise. Longer-term bonds are hit hardest in a rising rate environment; short-term issues are hurt the least. Of course shorter-term issues generally pay less interest. If you want an appreciable return – especially in today’s low rate environment – you need to extend beyond extremely short-term debt. Our solution is to limit risk exposure and also gain some additional yield by using high quality short- and intermediate-term US government and Treasury debt.