What will portfolio construction look like when the threat of the coronavirus has diminished? While investment fundamentals such as asset allocation, diversification, rebalancing and risk management will remain pillars of financial advice, other areas of building portfolios are set to be reassessed in a changed economic landscape, according to financial advisors and investment professionals.
One asset class in particular is set to receive the most intense scrutiny, says Jason Blackwell, chief investment strategist for The Colony Group. “The coronavirus crisis is likely to be most impactful on fixed income,” Blackwell says. “People will be rethinking how the fixed income portion of a portfolio is positioned. Investors will need to be paid more for risk.”
Before the precipitous market decline began in mid-March, he points out, spreads between Treasury bills and high-yield bonds were less than 5%; by the end of March, the spread had more than doubled. The bull market of the past decade resulted in a market that was “priced for perfection,” according to Blackwell. “It assumed there would be no defaults. That won’t be the case anymore.”
Gabe Lembeck, director of research for Atlanta-based wealth management firm Balentine, agrees.
“Investors will not invest in fixed income securities that promise higher yield but end up not being reliable when things go badly in the economy,” Lembeck says.
Yield for liquidity
But in an environment of ultralow interest rates, yield will clearly be a priority for portfolio construction.
In a market where the yield on a 10-year Treasury note is less than 1%, advisors and clients will “really need to figure out the income puzzle” says Jeff DeMaso, director of research for Adviser Investments.
The coronavirus jolt to the market saw high-yield bonds “behave a lot more like equities,” DeMaso notes. Some alternative sources of yield for investors may be master limited partnerships, REITs and preferred stock, he says.
Other alternative sources of yield in a post-coronavirus market may be closed-end investment grade bond funds, private credit and loans to middle-market companies, says Michael Dow, chief investment officer for Beacon Pointe Advisors.
“There is an excellent opportunity to gain additional yield if investors are willing to give up liquidity,” Dow says.
Rude awakening
Risk is also going to be reevaluated after the shock of the current crisis subsides, say advisors and investment professionals.
For example, the high-yield bond index was down 13% from February 19 to March 27 while the S&P was down 25%, notes Buckingham Strategic Wealth CIO Jared Kizer. “Investors that thought the risk [for high-yield debt] was more similar to investment-grade bonds, which were up 0.8% [in that same period] had a rude awakening,” Kizer says.
“Reassessment of risk will be the number one change” in the post-coronavirus era, predicts Jim Maher, CEO of Archford Capital Strategies in St. Louis. “Investors got comfortable with a 10-year bull market run. What’s coming next will be different.”
The era of investor complacency is over, Morningstar portfolio strategist Amy Arnott agrees.
“When everything goes so well for so long, it’s tempting to think equity values can only go up,” Arnott says. “There will now be more awareness of the importance of risk and the potential for unexpected Black Swan events. And there will be more emphasis on quality and liquidity.”
The value of cash
Cash, of course, is arguably the least risky component of a portfolio, measured by protection against losses — the impact of inflation notwithstanding.
“Investors will keep more cash on hand so they won’t have to sell in a down market to meet spending needs,” says Lembeck.
More than ever, advisors need to determine a client’s risk tolerance before allocating cash to a portfolio, says Maher. Even though practically no yield is expected on cash in the immediate future, concerns about market volatility will nonetheless spur investors to add cash to their portfolios, he says.
The pandemic highlights the importance of having a well-funded emergency fund, says DeMaso. “Being able to tap your rainy day fund ought to allow investors to be patient with their investment portfolio.”
But Kizer says cash won’t be any more important than it was before the coronavirus crisis.
“The only need to specifically allocate to cash is to target a certain number of months of living expenses,” he says. Some investors, however, may include their emergency cash as part of their overall portfolio allocation, Kizer points out.
As advisors and clients prepare for a post-coronavirus world, they need to remember that despite the disruptions, the “basic principles of portfolio construction have worked well,” Arnott says.
“But we are likely to see the aftershocks of the crisis last for quite a while,” she adds. “Investors will need to remain vigilant.”
