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Have you ever been camping, and you didn’t really take the packing part seriously? Maybe the trip was only for a few days, and you said, “what’s the worst that could happen?”
Then you arrived and realized you didn’t have enough warm clothes and blankets and you’re sleeping in a tent, and it’s supposed to be colder than you anticipated because you only looked at the high temperature of the day and missed the part where it was going to be 40 degrees at night. You’re surprised with how dark it gets when the sun goes down, and you didn’t bring a flashlight or bug spray and you thought you took the utility knife, but you left it in the garage. Now it has started to rain, and there’s no umbrella. You walk to the communal bathroom but it’s “bring your own toilet paper,” and you don’t have that either, so the best you can do is paper towels. Rough, literally.
You look over at the family at the camp next to you and they have space heaters and a nice fire going. Their lanterns provide light to the campsite, and you see their awesome Yeti gear (this is not an advertisement), a coffee press, and a speaker playing music. They are having a great time.
That family’s planning paid off and if there’s rain or a storm or an animal that comes out of the woods, they are likely ready for it.
If you just wing it, maybe you’ll be pleasantly surprised in good conditions but in the face of adversity you aren’t prepared.
There is adversity in the market these days, and if you prepared for it, then your game plan won’t be derailed.
I think the economic headwinds are pretty obvious. Persistent inflation has left the rate cuts promised by the Fed on hold for now. Higher rates don’t bode well for growth equities and existing bond prices. The boiling pot in the Middle East is getting hotter and hotter. Israel and Iran sending missiles back and forth is unsettling. We’ve seen the impact in US markets over the last month. The tension brings uncertainty, which is what markets hate. The volatility index is at 2024 highs and approaching 1-year highs. In 4 weeks, bond prices are down -3%, and the S&P 500 is down about -6%. The tech sector is down almost -8% in two weeks. A potential reduction in oil supply keeps inflation elevated and has investors reaching for safety, like the US dollar and gold. The dollar has strengthened against every major currency, (so much for de-dollarization), and gold is up 16% in 2024. There’s also a US election with all sorts of uncharted waters and it’s not being talked about nearly as much as it should be or will be soon.
Direct Indexing
If you have a taxable account and you own the S&P 500 Index ETF or mutual fund, you essentially have no tax efficiency. If you held the S&P 500 ETF/MF for any length of time, then it’s likely carrying a capital gain. Therefore, even though the index pulled back 6% in a month, you can’t do any tax loss harvesting. However, if you were in a direct index where you owned all 500 stocks in your account, there was a big opportunity to harvest losses over the last month. Losses that you will be able to tap when the market bounces back - however long it takes is irrelevant, as realized losses do not expire.
Own the Actual Bonds (Munis/Corps/Treasuries) and use Active Management
Passive bond ETFs have been a bad place to invest for several years. First of all, the passive bond ETFs & mutual funds are not actively managed. Meaning there is no credit oversight. Active management in fixed income has outperformed their passive counterpart by roughly 0.25% per year over 10 years. These passive ETFs/MFs are meant for retail clients, usually in the early innings of their investing journey, and aren’t customized for the individual investor. They also become very correlated to stocks when markets go south. The Barclays US Aggregate Bond Index is down -3% on the year, and if you invested in it over the last 3 years then you are down about -3.5% annually. Over 5 years? Flat! You haven’t made a cent.
Passive ETFs/MFs are like a football team that only runs the ball. They stick to the strategy no matter what defense they are up against. Even in the midst of the most telegraphed and aggressive rate hike in history.
That’s why, in nearly all situations, you’re better off owning the individual bonds because you can customize so many features of the portfolio – duration, hedging, cash flow, credit quality, etc. Active management gives us the ability to be nimble versus going down with the ship like a passive ETF/MF.
Most investors think of US Treasuries, and “risk-free” springs to mind, but they aren’t risk-free if you are looking at daily fluctuations. If you hold to maturity, there is no problem, but if you need to access funds ahead of plan, you are exposed to paper losses. Therefore, you must be careful about the duration of the ETF/MF because even the smallest interest rate move could cause prices to fly higher or lower. Buying the actual treasury bond allows you to customize the duration (and other features) to avoid being so exposed. In fact, changing duration can be both an offensive and defensive measure.
Have an Allocation to Alternatives & Uncorrelated Assets
We often hear from clients and prospects that they believe hedge funds and private investments are too risky, and the fees are too high. Yes, they have higher expenses than public investments but in many occasions, they’ve outperformed their public market equivalent (net of fees) and with less risk. They also have less, and sometimes negative, correlation. Meaning if the broader equity market is down, these investments are typically down less or even up.
The Morningstar long-short index is up about 4% on the year. The Morningstar systematic trend following index (mostly comprised of managed futures strategies) is up over 9% in 2024. Managed futures strategies can bet for or against equities, fixed income, currencies and commodities. This gives them a leg up on long only strategies during periods with spikes in volatility.
US Agriculture and Farmland has done tremendously this year. The population is growing, and the amount of farmland is generally staying the same so we will rely on more production from the same resources.
Public real estate has been getting crushed in 2024, down -11%, but private real estate has had positive returns. They are far less correlated to public equity markets and private real estate managers believe that real estate values have bottomed. They are putting money to work and not just in multi-family homes, but they are buying data centers, last-mile warehouses, and student housing.
Global infrastructure provides a complement to real assets, equities, and private equity as investments in airports, toll roads, railroads, power, and light have had far less risk than the S&P 500 due to their reliable cash flow. The ability to grow in the long run with less downside than broader equities is attractive.
Like proper packing for a camping trip, make sure you build an allocation that can hold up in any weather. Diversification is obvious, but are your investments tax efficient, did you wing it and just invest in bond ETFs and mutual funds and did you leave out the alternative investments because you figured you’d be ok without them?
Disclosures:
The information contained in this presentation is provided for informational purposes only and should not be construed as investment advice or a recommendation to purchase or sell a security. Investing involves the risk of loss that clients must be prepared to bear. This document contains forward-looking statements of opinion, belief, and expectation about the future. Actual results could differ materially from such statements and our opinions are subject to change without notice. Connectus Wealth, LLC d/b/a Connectus Private is an SEC-registered investment adviser. Investment does not imply government endorsement or that the adviser has attained a level of skill or training.