A prize winning plan for investing when interest rates are low - ny times

February 1, 2013

Conceived by Students, a Portfolio ThatPaysBy JAMES B. STEWART

Squeezed by historically low interest rates, a wide range of investors — from retirees living on

fixed incomes to huge endowments and pension funds trying to meet budgets — are trying to

figure out how to generate income.

Some Duke University undergraduates think they have the answer.

Business and economics programs at American colleges and universities have long sponsored

stock- and other asset-picking contests for their students. But last semester, faced with the

current ultralow interest rate environment, Duke’s undergraduate economics department ran a

competition in asset allocation for the first time. Students had to decide what percentage of

assets to put in fixed-income investments and what percentage to invest in other categories.

The asset management firm BlackRock was a co-sponsor of the contest, which was open to any

Duke sophomore or junior.

“Where is someone supposed to get yield these days?” said Emma B. Rasiel, an associate

professor of economics. “That’s what got us thinking.”

It’s a pressing question for nearly every investor, and has left even professional financial

advisers scratching their heads. The United States is now in the fifth year of a low interest rate

environment. Ten-year Treasuries, the benchmark United States interest rate, yielded 5 percent

in July 2007, just before the recession began. This week, the rate was below 2 percent, and last

July, 10-year rates were the lowest ever recorded. This week, the one-month Treasury bill, the

lowest-risk bond investment because of its short duration, was yielding practically nothing:

0.04 percent.

How much of their assets to allocate to bonds and other categories may well be the most

important decision investors make. The mutual fund giant Vanguard advises, “Research shows

that your asset mix — how you spread your money across stocks, bonds and cash — has a far

greater impact on long-term returns than your individual investments.”

For many years, the rule of thumb for most long-term investors was “60/40,” a 60 percent

allocation to stocks and 40 percent to bonds. Besides having the virtue of simplicity, less

volatile and lower-return bonds were meant to smooth out the ups and downs of the riskier

stock market while giving investors some of the greater possible gains of stocks. Vanguard

estimates that an investor with a 60/40 allocation can expect an average annual return of 8.6

percent, based on data going back to 1926. That allocation resulted in a decline in 21 of the next

86 years. In the worst year, 1931, it resulted in a drop of 26.6 percent, while in the best year,

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1933, it produced a gain of 36.7 percent.

By comparison, a 100 percent allocation to stocks produced an average annual gain of 9.9

percent, with a decline in 25 of the 86 years and much greater volatility. A 100 percent

allocation to bonds resulted in an average gain of 5.6 percent, with a decline in just 13 of the 86

years.

But those are long-term averages. The results can vary substantially depending on the starting

point. In the decade ending in 2009, stocks had average annualized returns of negative 3

percent and lagged bond returns by more than 9 percent, a record disparity, according to T.

Rowe Price.

Hardly anyone expects those high bond returns now. Despite the paltry yields, fixed-income

investors have been cushioned for the last few years by falling interest rates, which allowed the

value of their bonds to increase as yields declined. (Bond prices move inversely to interest

rates.) But with short-term rates now near zero and longer-term rates still at historical lows, it’s

almost impossible for rates to decline any further. Indeed, they have been creeping up in recent

months. And if and when rates rise more substantially, bond investors will be stuck with not

only slim yields, but also losses on their principal.

Given this, should investors abandon the tried-and-true 60/40 approach and move more

aggressively into stocks?

“The traditional 60/40 approach to building a portfolio is on the way out,” said Michael

Fredericks, head of retail asset allocation for BlackRock and lead portfolio manager for the

BlackRock Multi-Asset Income Fund. It is being replaced, he said, by “tactical” asset allocation,

a strategy in which investors change their allocation based on the current pricing of asset

classes.

If bonds are overpriced, as many now believe, and stocks are underpriced, at least relative to

other assets, then the allocation should shift toward stocks. “We’re not telling clients to sell all

their bonds,” Mr. Fredericks said. “They do balance out the riskier assets in a portfolio. But

most investors need to consider putting more in stocks.”

In his own Multi-Asset Income Fund, which has traditionally focused on fixed-income assets,

Mr. Fredericks said he had reduced the amount invested in high-yield bonds and moved into

stocks that pay high dividends, using an options strategy to lock in gains and protect against

market drops. The fund had more than 25 percent of its assets in equities at the end of the year,

with the remainder in various forms of fixed income. Last year, it returned just over 13 percent.

For the Duke contest, the students were asked to design a portfolio for an investor who was

expecting to retire or begin withdrawing assets around 2020, just seven years away. That time

frame ordinarily calls for a conservative — that is, bond- and cash-oriented — allocation to

minimize volatility and the potential for loss. A traditional rule of thumb for older investors is

that the percentage of assets in bonds should equal their age. So, 70-year-olds should have 70


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percent of their assets in bonds.

Alex Kim, a Duke junior from New Zealand majoring in economics, told me that he and his

teammates — Yuefeng Du and Yuci Zhang — faced the same quandary as most investors: how to

generate income while minimizing risk and preserving assets for retirement. They examined

model portfolios from Fidelity, Vanguard and BlackRock. “We looked at historical returns for

each asset class and then adjusted those for current market conditions,” Mr. Kim said.

As the members of the team formulated their strategy last fall, they shared the concerns of

many experts that bonds were overvalued. But they saw little risk in the short term to principal,

given the Federal Reserve’s public commitment to keep interest rates low until the economy

improves. At the same time, they worried that the Fed’s easy money policy would lead to

inflation, which has traditionally eroded fixed-income returns.

They were bullish on United States stocks, especially those of large companies, based on their

predictions of a continuing recovery in housing, rising consumer confidence, strong retail sales

and the continuing impact of the Fed’s quantitative easing program. They were also optimistic

that Congress would avoid the so-called fiscal cliff and other threatened political calamities. But

they were pessimistic about Europe and emerging markets, given the euro zone crisis and what

they saw as slowing growth in countries like China and Brazil.

The team’s contest entry called for allocating 43 percent to United States stocks — 30.3 percent

to a Russell 2000 index fund and 12.7 percent to a Russell 2000 fund that invests in midsize

companies. They made no allocation to international stocks. Like more traditional models, they

maintained a large allocation to fixed income, but weighted it heavily toward Treasury

inflation-protected securities, or TIPS, whose yields rise with inflation. They allocated 32.1

percent to TIPS and 24.9 percent to an aggregate bond fund.

The result was a 9.7 percent projected annual return, with less volatility than the model funds

they examined. The team ran projected returns for cases including both bull and bear markets,

and their allocation outperformed the BlackRock model “in all scenarios,” Mr. Kim said.

Professor Rasiel winnowed the field of more than 30 entrants to 10 finalists, who presented

their strategies to BlackRock executives in late November. The executives announced the

winner a few weeks later: Mr. Kim’s team. BlackRock praised the team’s research, its modeling

in bull and bear market assumptions and its “strong understanding of macroeconomic drivers.”

The prize was an interview and a shot at an internship at BlackRock this summer. Mr. Kim is

waiting to hear if he got one, and said he was aiming for a career in investment banking.

The runner-up team embraced a similar strategy to Mr. Kim’s team, but was even more

concerned about inflation. It put 68.2 percent of its assets into TIPS. It was also bullish on

riskier equities from emerging markets, with a 16 percent allocation. The remainder was in

United States equities. The projected annualized rate of return was 10 percent, with slightly

lower projected volatility than the winning entry.


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Before investors rush to replicate either approach in their own portfolios, they might want to

consider that these are college undergraduates, however talented and motivated they may be.

It’s much too early to assess the winning team’s results, but so far they have been right about

United States stocks: the market has rallied strongly since they made their submission.

But projections and models are only as good as the underlying assumptions. Given the heavy

allocation to currently low-yielding TIPS, the students are likely to outperform more traditional

portfolios only if inflation picks up in the next seven years. Mr. Kim conceded that his team’s

projected return for TIPS (5.66 percent) and bonds (5.91 percent) “may be optimistic, given

current market conditions.”

Financial advisers stress that all asset allocation plans need to be tailored to each investor’s

circumstances and risk tolerance. Faced with the same low interest rate environment,

professional asset allocators with the same time horizon as the Duke contestants have

emphasized stocks over bonds.

The Fidelity Freedom 2020 Fund, for example, had almost 56 percent of its assets in stocks at

the end of last year, including more than 15 percent in international equities. Only 8 percent

was in TIPS. Vanguard’s Target Retirement 2020 Fund was even more weighted toward stocks,

with an allocation of just under 64 percent, nearly 20 percent of which was in international

equities.

After all the models and projections, they’ve ended up pretty close to the old 60/40 approach.


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A prize winning plan for investing when interest rates are low - ny times

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