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by Jerry Miccolis, CFP®, CFA, FCAS, MAAA, CERA​

Jerry Miccolis, CFP®, CFA, FCAS, MAAA, CERA, has over 40 years’ experience in the wealth management, investment management, and risk management fields. While he draws heavily from this experience for this column, he is writing as a knowledgeable industry observer, not as a representative of any employer, past or present.

People entering the latter, “distribution,” phase of their lives today are often faced with more than the normal amount of trepidation that accompanies that life transition. These individuals now find themselves in an environment unseen in a generation. Unfortunately for them, that span of time probably exceeds the professional careers of their financial advisers. It is understandable if these clients are anxious about being advised by professionals lacking hands-on experience with this kind of environment.

I have heard this anxiety expressed—by clients, friends, and family—in several ways in recent years. In this column, I will try to convey their concerns through a fictional amalgam whom I'll call Angela.

Introducing Angela—and Her Issues

Angela, who is 65, is a year into a well-deserved retirement. She and her same-age husband Arnold, an artist, are healthy and enjoying their lives. Angela is happily involved in a number of volunteer activities, and Arnold continues to paint, although his work has never been a significant source of income. Their children are successful, self-sufficient adults, and have produced five children of their own on whom Angela and Arnold dote and with whom they are very generous (funding a robust 529 plan for each, for example). The nest egg that Angela and Arnold have accumulated for themselves is sufficient to finance their lifestyle indefinitely, according to their wealth adviser, if invested in a moderately aggressive manner (60/40, more or less).

Angela, always the more financially astute of the couple (and to whom Arnold fully delegates the couple’s financial decision-making), has left the last few quarterly meetings with their adviser with a growing sense of unease. At various times over the course of these sessions, their adviser has touched on the following themes:

  • The bull market in equities has gotten quite long by historical standards;
  • The accommodative stance of the Federal Reserve is unprecedented and inordinately long-lasting, and the fallout from its eventual unwinding is unknown;
  • China has been a large consumer of resources in the last two decades and, as such, has been a major contributor to global economic growth, but that growth engine has been sputtering, and the global economy may continue to be sluggish, at best, for some time;
  • The European Union is in a state of flux, and is entering uncharted territory;
  • Inflation has been inordinately low for some time, and most knowledgeable observers are forecasting significant increases over the next decade or more;
  • The threat of global and domestic terrorism, including financial cyberterrorism, seems never to have been higher;
  • Deep disaffection among the American electorate has led to alarming possibilities regarding future political leadership and unpredictable repercussions;
  • While a healthy dose of equities is necessary in their portfolio to make their financial plan work, the downside risk of those equities is very real (and perhaps overdue), and might be difficult to recover from over their remaining lifetimes;
  • The changing mix of “alternative investments” in their portfolio has shown consistently disappointing performance;
  • Bond yields have never been lower and have nowhere to go but up, making bond investments a “ticking time bomb” according to some experts (this issue alone makes the current investment environment unique in the last 30 years or so).

What to Do?

Against this disturbing backdrop, Angela and her adviser have discussed a number of things they might do to mitigate the risks to her and Arnold’s financial future and position their portfolio for the performance needed to make their financial plan work. They have covered a wide range of possibilities, including:

Reaching for more yield in fixed income. Given the dismal return prospects for traditional high-quality fixed-income investments, long a staple of the family portfolio, the adviser discussed tilting those investments more toward lower-quality, higher-risk, higher-yielding bonds. Angela had some discomfort increasing the risk in the very part of the portfolio whose primary purpose was to provide stability. What really clinched her decision not to go this route, though, was when her adviser pointed out that the higher-yielding the bonds, the more they tend to behave like equities—particularly in stressed markets. The thought that she would be compromising both the stability and the diversification of the portfolio led her to conclude that this approach would be imprudent for her and Arnold.

Reaching for more return in alternatives. The mediocre performance of the liquid alternative portion of the portfolio for several years now could be the result, the adviser opined, of these alternative strategies becoming too popular (in other words, a case of too many dollars chasing too few good ideas). They discussed two possible remedies: looking for more esoteric alternative strategies, and/or looking into illiquid varieties. Angela felt that going more esoteric was simply another iteration of the approach they had been taking all along, adopting new ideas as they came to market only to continue to be disappointed when they didn’t deliver on their promise. And she was leery about sacrificing liquidity—or, in her words, control over her funds—in return for merely the prospect of loftier returns with no guarantee of such. But here, just as with high-yield bonds, the nail in the coffin, as far as Angela was concerned, was when the adviser showed her that the correlation of alternatives in general with equities had steadily risen over the years to very high levels. She concluded that alternatives simply could not be counted on to provide much of any diversification benefit to the portfolio—and this, she always had believed, was their key reason for being.

Going more overseas in equities. The risks facing domestic equities steered Angela and the adviser to discuss the value of becoming more global with the portfolio’s equity exposure. The upshot was that the situations in Europe, Asia, and emerging and frontier markets were even less attractive than the prospects in the U.S. for the foreseeable future, and that whatever diversification international equities used to provide had long since substantially diminished. Furthermore, as active as Angela and Arnold remain, their travels outside the country are not likely to be extensive, so the preponderance of their retirement expenses will be in U.S. dollars. That being the case, Angela saw no real risk/return benefit to increasing currency risk, or the implicit cost of hedging it, beyond what already existed in the modest global exposure they already had in their portfolio.

Doubling down on non-traditional asset classes. Angela and Arnold had done well in following their adviser’s counsel to allocate a moderate portion of their portfolio to select, out-of-the-mainstream assets such as master limited partnerships (via liquid mutual funds) and so-called insurance-linked securities (“catastrophe bond” funds, mostly). These investments were clearly doing their job, but were never intended to play a greater role than they currently do. The adviser himself cautioned against a higher allocation, because these instruments were not designed to do the heavy lifting in a portfolio, and their present allocation seemed, in his expert opinion, to be the most prudent one. The adviser and Angela also considered adding fixed and/or variable annuities to the mix. They decided against this for several reasons, including high and hidden expenses, convoluted structures, exposure to the financial risk of the underwriting insurance company, no real need for additional tax deferrals, and the fact that— specific product expenses aside—historically low interest rates made annuities, in general, less cost-effective than they had ever been.

Considering non-traditional portfolio construction. Given the lack of promise in the previous ideas, the adviser suggested thinking a bit more unconventionally about asset allocation. Specifically, the recent rise in availability of liquid equity investments with built-in downside risk management afforded the opportunity to actually increase the percentage of equities in the portfolio and thereby reduce the reliance on the customary, but now problematic, diversifying asset classes Angela and her adviser had thus far discussed. She had heard about this approach and read some media accounts touting “80/20 as the new 60/40.” But she had deep concerns about these risk-managed equity investments. The popular “low-volatility” funds, for example, had an incredible two-year run beating all equity indexes, but their two-year track record immediately prior was dismal, making their longer-term track record mediocre. Angela therefore concluded that the possibility of these investments being very overvalued, and the risk of getting into them at precisely the wrong time, were too great.

On the other hand, the so-called “hedged equity” funds, which had explicit downside protection embedded via derivatives, had all come to market since the 2008–2009 financial crisis and their cost-effectiveness had not yet been tested in real time to Angela’s satisfaction.

Going more tactical. Angela’s adviser had one more approach to propose. While he had always been a dedicated asset allocator and, to the extent possible, a user of low-cost passive index funds, he offered to delegate some of his portfolio management and some of the portfolio’s individual investments to third-party asset management firms that had some sustained success in tactical investing. Angela appreciated the offer, but did not believe it feasible that her adviser’s mid-sized firm had the capacity to perform the due diligence required of those asset managers.

What Would You Do?

Her substantial fears unabated by these recent exchanges with her adviser—whom, it should be said, Angela continues to trust implicitly and with whom she has had a very beneficial long-term relationship—she is now, reluctantly, considering seeking second opinions.

Readers of my prior contributions to the Journal over the years will probably know how I would respond if Angela came to me. Suppose Angela came to you. What advice would you give her? 

This column is for informational use only and is not intended to constitute legal, tax, or investment advice.

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