Are Indices Your Best Benchmark?

11/01/2011 7:00 am EST

Focus: MARKETS

Comparing your returns to the S&P 500 is not necessarily the right approach, says Brent Burns, who also explains why individual bonds are a more predictable investment than bond funds.

Kate Stalter: I’m on the phone today with Brent Burns. He’s a co-founder of Asset Dedication.

Brent, your company’s tagline is “engineered income portfolios,” and as I understand it, your company was founded to bring some institutional-style disciplines to retirement accounts in particular. So, for individual investors who are listening to this today, tell us how your strategy works.

Brent Burns: Well, we think about investors in the same way that a pension fund would think about its pool of pensioners.

When you think about it, most folks are saving for a goal. The primary goal is to be able to get to retirement, and then not run out of money in retirement.

There are other things as well: paying for kids’ education and weddings, and taking vacations, and major purchases and things like that. Those function similarly, but it’s easiest to think about our concept in the context of building your own pension.

We started as a research project out of the University of San Francisco School of Business. You mentioned that I was one of the co-founders. The other co-founder is Steven Huxley, who’s a professor at the University of San Francisco there at the School of Business, and he and I started researching this concept back in the mid-1990s.

It really came out of a very interesting discussion that he had. His mother-in-law, who had been widowed, had gone to sort of interview a number of financial planners or advisors.

She asked a very insightful question after getting various asset-allocation recommendations: If this process is so scientific, how come I get so many different answers?

Actually, she called them prescriptions, and the reason she did so is because she said, "If I went to three different optometrists, I would expect to get very similar eyeglass prescriptions." That got us starting to look at investments: Where do asset-allocation recommendations come from, what are they based in?

And it turns out that when you look at the literature, those three advisors were probably technically correct. Depending on the assumptions that they made, they could end up with very different answers.

I think that’s hard from a scientific perspective, because that process doesn’t provide a replicable process and answer. Really, every client should have, depending on what their situation is—but if two clients come in with the same situation, they should expect to see the same kind of answer.

So that got us looking at: How should we think about the problem, first off? Who is thinking about that? Certainly pensions have been thinking about that for a long time, and so that’s ultimately the type of investing that we settled on as an approach that seemed most fitting, and it takes a little bit of a different spin on the world.

A lot of approaches are focused on volatility, which is certainly a concern for people. But really the concern—although volatility makes people nervous—the thing they want to protect against is running out of money too soon. So what we wanted to do is look at a portfolio structure that could help buffer some of that volatility, so people could feel more comfortable investing.

But for most people, they have to take on some level of market risk. If they do that, it’s really not the volatility, it’s the risk. The risk is not having structured the portfolio in the right way to make it sustainable over somebody’s lifetime.

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Kate Stalter: Now, you just led into one of the questions I wanted to ask you, Brent. On your Web site, you list three different solutions or methodologies, and it sounds like you’re heading in that direction in describing your asset allocation. So can you say a few words about each of these methodologies?

Brent Burns: Well, first of all, I would say our approach is only available through other financial advisors. So we don’t take clients directly, and the reason that we don’t do that is that we think that the financial planning process is the key to long-term success.

Both end investors and the people who are advising them about their money really need to have gone through some kind of process about where are we now, where do we want to go, what’s the timing of various things that an investor wants to do…so that you know how much you need to have, when you need to have it, and how you can systematically take risk out of the portfolio in a way that’s aligned with what the portfolio is trying to do.

So we’ve developed a suite of products that are very modular that the core of what we do. What has gotten us a lot of publicity, and one of the things that make us succinct, is the way in which we construct bond portfolios. So that’s generally where conversations start with our firm.

We call that our Defined Income Portfolio, and that’s really where we build a portfolio of individual bonds, which are designed to protect principal, and if the investor is retired, also deliver a predictable income stream that is tied to what they actually need to spend.

So it essentially builds a paycheck portfolio. If the client’s not retired, then it’s all about building to that point, getting the portfolio to the place where they start to need to actually generate a paycheck.

We want to do it in a way that protects the principal, because bonds are kind of tricky. They’re an inverse relationship between yield and price, and that math is completely not intuitive for most people.

What it really boils down to is: For the last 30 years, interests rates have been falling. They sort of peaked in 1981, and they have been falling ever since. They’re now at historic lows.

And when I say historic—I mean, we’re obviously a research shop with a lot of academic background. We have a database of yields going back to 1800, so when I say historic, I mean all-time historic lows back to 1800s.

So that’s a pretty good sign that 30 years of falling interest rates are behind us. And the reason that the falling interest rates are important is, as interest rates fall, the prices of the bonds go up…and that’s just because that’s where that inverse math comes in that as yields fall, prices rise. On the flip side of that, as yields rise, prices fall.

So if we’ve seen kind of the end of that 30 years of declining interest rates, then we’re looking at either flat or rising interest rates, where solutions like a bond fund are either going to flat-out lose money or they’ll underperform what the individual bonds would do.

The reason that’s the case is because if you buy an individual bond, you can simply hold it to maturity and get your principal back, and you’ll get the coupon payments along the way. So the return on that is positive. Even if the values of the bond change over time, it doesn’t matter, because you plan on holding the bond until maturity and then taking the coupon interest.

On the flip side, in a pooled portfolio where it’s a bond fund, a bond fund does not behave the same way as a bond—even though it’s a mutual fund that invests in bonds—and that’s because there is turnover in the portfolio. So the managers are constantly selling the bonds, and that happens in both a rising and falling interest-rate environment.

But in a rising interest rate environment, that means that the bond fund will recognize the loss as rates rise and the prices fall. So that means it actually digs a hole and then it has to try and climb out of that hole, but it digs a hole every time.

Whereas that individual bond, if you hold it until maturity, you already know your worst-case scenario when you buy it, which is when you buy it and then you get the yield to maturity on it.

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Kate Stalter: This is a really good way to think about the buying of individual bonds vs. funds, and something that I’m sure a lot of investors hadn’t really heard before.

Let me ask you this, Brent: Just to put some of this in the context for many of the do-it-yourself investors who are among our listeners and readers today, what investment ideas should they be considering at this juncture?

Brent Burns: Well, I would say that there are a few pieces. And as I mentioned, I’m sort of laying out our framework of thinking about your investments like a pension. Our firm is called Asset Dedication. It’s based off of the concept of dedicated portfolios where specific asset classes, stocks or bonds, are dedicated to specific purposes.

The way that we view the world is that bonds are extremely good at protecting principal and delivering predictability. That’s the beauty of an individual bond, and this is contrasted to a bond fund.

An individual bond or a CD when you buy it, they tell you when they’re going to pay you and how much they’re going to pay you. So you can piece those together in a way that would generate a predictable paycheck. So you get all of the other pieces.

The other reasons why people invest in bonds, which is diversification, to dampen volatility, sure, you get that, when you invest in individual bonds or a bond fund, but the thing about the individual bond that the bond fund lacks is that ability to be predictable.

Because you don’t know what’s in there and it changes all of the time in a bond fund, so that mix of bonds is moving around and there is no predictability around it, and as things get sold and particularly as losses get recognized, you lose that ability to say, “I’ve paid this much and I know it will generate this cash flow that I need, because it may recognize that loss,” and now it no longer can generate the cash flow that you need.

But you sort of take that as: You’ve got bonds that are good at that. What are stocks good at? Well, stocks are not good at delivering predictability. They’re not necessarily good at protecting principal all of the time. But over the long run, and sometimes it could be very long, but certainly if given enough time, they deliver higher long-term growth most of the time.

Sometimes it can take a very long time, and the crossover between the worst case in stocks and the best case in bonds to where you should feel fairly comfortable owning stocks at that point is 20 years.

So that’s a pretty long worse-case scenario for owning stocks vs. bonds, except that most of the time they’re better, and can deliver, on average, quite a bit more return. The investor needs some growth in their portfolio—and for most people that’s the case. Most people aren’t so rich or so frugal that they can afford to live off of an all-bond portfolio.

So they need some of that long-term growth, but they can use the bonds to protect them and sort of provide a buffer of that near-term volatility so that they can ride through the bumpy market so that you don’t have to sell anything. In 2008, you can ride through it so that you can get 2009 and 2010. You get the market recovery.

So as we talk about dedicating assets, sort of dedicating the bonds to predictable income and protecting principal and to dedicate stocks to delivering long-term growth, then you piece them together and then you have to try to figure out how to balance between the two, and that’s where the third piece of what we do, called the Critical Path, comes into play. With the Critical Path, we take someone’s financial plan and we turn it into their own personal benchmark.

And when we do that, then we can drive investment decisions around not how are the investments doing relative to some external benchmark, like the S&P 500, because who cares? If in 2008, I benchmark my portfolio against the S&P 500 and I happen to own the iShares S&P 500 (IVV), then I basically performed with my benchmark.

But how does that relate to what I’m trying to do with my money if I’m an investor? I don’t know. If my financial plan is my benchmark, then I can look and see, based on how much I need to have on my portfolio at any point in time, how am I doing relative to that?

It’s much more relevant in terms of an overarching plan and again taking from a pension fund, because you probably have heard pensions talk about their funded ratio.

And that’s where they say, do they have enough money or not? Is there enough money in the portfolio to deliver what they think they need to deliver or not, and it allows an individual to do the same thing. For the most part, most people now have their 401(k), not a company pension, so they’re kind of on the hook for their own personal pension.

Kate Stalter: Brent, thank you very much. This is some unique perspective that I’m sure many investors haven’t heard, and would certainly help them think about the asset allocation going forward.

Brent Burns: Well, I hope so. Thanks for the time and the opportunity. We do bring a different spin on the challenge of figuring out what the investments ought to be, but I think intuitively, hopefully folks will recognize that tying their investments to what they’re trying to do with their money makes a lot of sense.

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