This is the first post in a series on the securities litigation likely to arise from the recent market declines.
Since the Global Financial Crisis ("GFC") in 2008-9, the Federal Reserve has keep interest rates at extremely low levels.
Indeed, at the end of 2007, the yield on the 10-year U.S. Treasury note was 4.0232 percent and at the end of 2011 it was 1.8762 percent. As I write this, it is at 0.69 percent.
This has lead brokers and advisors to “reach for yield" for their investors. Of course, they were able to grasp it, primarily by reducing high quality equity and fixed income investments and increasing:
- Equity allocations;
- Equity “bond proxy” allocations, and;
- Low-quality fixed income allocations.
Over time, these combined shifts have led to an increasing amount of risk in investor's portfolios, even if the equity allocation did not increase (or even decreased). Indeed, many investors have seen their portfolios become predominately equity exposed, greatly increasing their risk. Table 1, below offers a comparison.
Table 1: Typical Pre- and Post-GFC Portfolio Composition
Table 1, above, compares typical investor portfolios from the pre- and post-GFC periods. The yellow banded rows highlight investments with equity or equity-like exposure (even if they are bonds).
The pre-GFC portfolio has a 55/35/10 (stocks/bonds/cash) asset allocation, and is heavily skewed to quality on both the equity and fixed income sides. The post-GFC portfolio has a 65/30/5 asset allocation, but has added 15 percent of equity “bond proxies” and lower quality fixed income. (Equity bond proxies include equity investments such as traditional infrastructure, utilities, REITs, MLPs, and other higher yielding equities.)
Importantly, the direct equity exposure only increased from 55 to 65 percent, however, the total equity and equity-like investments increased from 60 to 85 percent. From a risk perspective, the post-GFC portfolio is 85 percent in equities.
This is a significant increase. And a bad trade.
In the 10-year rolling periods from January 2001 through June 2018, a traditional 60/40 portfolio returned an average annual 6.56 percent, whereas an 85/15 portfolio returned an average annual 7.13 percent, or 57 basis points higher.
However, the increase in risk is dramatic. Over the same period, the 60/40 portfolio had a standard deviation of 9.19 percent compared to 12.84 for an 85/15 portfolio.
In percentage change terms, by shifting the equity (and equity-like) allocation from 60 to 85 percent, an investor gets an approximate nine percent increase in expected return, but a 40 percent increase in expected risk. This is what made it a bad trade.
Worse still is the max drawdown risk of the two portfolios. The 85/15 portfolio has significantly more drawdown risk. Those risks are now being felt as the typical post-GFC portfolio proves to be much more highly correlated (i.e. where almost all the assets decline simultaneously) than most investors thought.
Hidden Fixed Income Risks
The litigations arising from the recent declines will likely have a common theme that was not present in those arising in post-GFC litigations: hidden risks in investor’s fixed income investments. All the risky fixed income investments that investors have been put into as part of the reach for yield are declining similar to equities, and in some cases more than equities.
These risky fixed income investments include those investing in the following underlying investments and/or strategies:
- Corporate bonds (which were typically around 50 percent in BBB rated bonds);
- High yield “junk” bonds;
- High yield municipal bonds;
- Leveraged closed-end funds;
- Convertible bonds;
- Preferred stocks (almost all preferred stocks are issued through trusts which buy a note from the issuer and then sell interests in the trust);
- Commercial mortgages;
- Asset-backed securities;
- Leveraged loans;
- Collateralized loan obligations, and;
- Emerging market bonds;
Table 2: Bottom Decile One-Month Fixed-Income Mutual Fund Returns through March 20, 2020
The full list can be downloaded here.
Table 2, above, shows that the fixed income funds with the worst one-month performance through March 20, 2020, also generally had high, double-digit total returns in 2019. These funds have fallen in-line with the S&P 500, which was down about 29 percent over the same period.
When reaching for yield, the handhold is risk. The 2019 returns were the yield part, the previous months performance is the risk part.
In my experience, when bonds decline like equities, litigation ensues.
In subsequent posts, I will examine other aspects of increased risk-taking over the past 11 years.
 Source: Bloomberg.
 Goldman Sachs; Diversified Investment Allocation Tool. Available at: https://www.gsam.com/content/gsam/us/en/advisors/resources/diversified-allocation-tool.html; Accessed March 20, 2020. Dataset is the 91 10-year rolling periods from January 01, 2001 to June 30, 2018.
 This list is by no means exhaustive. All kinds of risky fixed income products have been invented over the past 11 years.
 Source: Bloomberg. Performance data for U.S. domiciled fixed income mutual funds with $500 million or more in assets, through March 20, 2020.
To learn more about suitability and fiduciary expert Jack Duval, click here.