As Markets Face Rising Rates, Rebalancing Gets Tougher

US News

Portfolio rebalancing is the "tire rotation" of personal finance, a good practice for people of any age who are investing for retirement. It's supposed to be a simple check a few times a year to see how the bumps and turns of the financial markets might have put your assets out of alignment. At times like this, when markets stutter after a long run up, it's also a tool to help investors recognize what's changed in the investing environment.

That's because the current volatility in both stocks and bonds that has hit the market at the halfway point this year could be a red flag warning that it's time for some less-than-routine portfolio maintenance now that the Federal Reserves gave some unusually clear guidance about what's facing investors around the next curve.

[Read: 12 Surprising Facts About Boomer Retirement.]

"People have to think more strategically now and use these short term episodes of volatility to help lock in to their strategic goals," says Ernie Cecilia, chief investment officer at Bryn Mawr Trust.

The way forward is actually clearer now than it has been in some time: Interest rates are heading higher. Everyone knows it now. The Fed in its June meeting showed an unusual level of openness about its plans. It will start scaling back its support for an economy that's on the mend. Wall Street investing gurus, who like to be the ones bringing clarity to the obscure workings of the Fed, actually seem to be complaining about that.

For example, billionaire hedge fund manager Stanley Druckenmiller says he's lost his "competitive advantage" when everyone knows what will happen next. Pimco chief investment officer Mohamed El-Erian told CNBC this week that "too much guidance" has given investors a road map that's too clear. "They don't even wait for the journey. They go immediately to the destination, and the re-price," he said.

Some of their disappointment might be related to their own fund disappointments. Pimco's Total Return Fund, the world's largest mutual fund, managed by El-Erian's colleague Bill Gross, trailed 94 percent of its peers in the latest month, according to Bloomberg data. Druckenmiller vented his frustration in a recent Goldman Sachs client note, explaining why he closed his fund rather than suffer with the bad returns he expected.

[Read: How to Chase Value During a Bull Market.]

But the bad news for the investing insiders points to something not so bad for individuals. Even if the outlook is not pretty - rising rates always cause declines for stocks as well as bonds - it's at least a chance for investors to do some repairs and lessen their exposure to risk.

So how do you allocate your savings while facing such stiff headwinds?

Start by understanding that the investing environment really has changed.

Nothing in the financial word is as simple as it once was, even if it seems so. Just as the auto repair shop uses computer diagnostic scans to do simple tune-ups, there are things you just can't do at home.

For starters, there have been big changes to many basic allocation models once offered to most individual investors. Investment managers say it's not as easy as the standard old 60/40 split between bonds and stocks, followed by a measured shift toward more fixed income the closer you get to age 65. (Even the age is no longer a sure thing. The official Social Security retirement age rises by small increments to 67 over the next few years based on your year of birth, and to 70 for maximum benefits using a system of credits added each year beyond the retirement age.)

The bonds-and-stocks equation has changed partly because bonds now are seen as less safe than before after enjoying huge inflows since the financial crisis began.

"Bonds are the new risk investment," says Anton Bayer, CEO and founder of Up Capital Management, a fee-based financial planning and investments firm that focuses on risk-balanced investing. Bayer says the old equation has been turned on its head. Financial planners see equities taking a bigger share of portfolios. High quality, dividend paying stocks are replacing fixed income in model portfolios that planners recommend. The toughest problem now facing individual investors is how to manage the income side of their portfolios with rates rising.

[Read: In Search for Yield Interest Rises for Floating Rate Funds.]

People who like to put cash into set-it-and-forget-it funds, such as target-date or balanced funds, could also be facing tough times. Bond funds are especially challenged in times of rising rates because they are not set up as "hold-to-maturity" investments. With an individual bond, holding it and getting interest payments until it matures is the only guarantee in the volatile debt market. Bond funds, meanwhile, need to be active, buying and selling to meet redemptions and remain fully invested, so their net asset value reflects all the market volatility.

There will be disappointment for anyone looking for guaranteed yield that will rise with interest rate increases and also protect your initial investment. Some debt investments, like floating rate notes, cover those needs but come with increased credit risk. And most individual investors simply don't have the tools to navigate that environment.

"There is no security that does that," says Aaron Izenstark, co-founder of Iron Financial, an investment firm specializing in alternative investments. "It's something you need help with. The strategy of a manager with a history of managing bonds is what you need in this market if you want income that avoids credit risk. But it is not possible for the individual investor to do that."

Another part of the rebalancing act is resetting expectations. In a rising rate environment the temptation to "chase yield" will lead some astray. For those who never equated bonds with risk, it's time to consider the downside. That corporate bond maturing in five years might be paying reasonable 3 percent yield - but is there credit risk or chance of an untimely recall? Are you set to hold it to maturity even if its market value plunges as rates rise.

"Americans are challenged at building wealth not because they are not making money," says Bayer, of Up Capital Management, "but because they are not good at assessing their risk tolerance and their expectations when they invest."



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