Going Contrarian for Conservative Investors
A little while back I decided it time to go contrarian for Solyco Wealth’s Conservative Model Portfolio. I dropped its Cash allocation to 10% from 15%, added that 5% to its Equity weighting, and reallocated its long-term domestic bond exposure to floating rate senior loans. With the already low-yielding iShares 20+ Year Treasury Bond ETF (TLT) down a double-digit percentage to start the year amidst the Fed just commencing its interest rate hiking cycle in response to escalating inflation, it felt right go at least a little bit on the offensive.
For investors with a risk-averse, conservative style I see three factors on the horizon potentially causing them disproportionate harm:
- Exiting risk assets altogether and going to cash,
- Holding this massive cash balance as inflation significantly erodes the future purchasing power of the cash, and
- Failing to re-enter the stock and bond markets until they recover and, thereby, missing the most attractive opportunities to recoup their early 2022 losses.
I addressed Point #1 by deploying more cash and not falling victim to a perceived “flight to safety.” High quality equities with strong balance sheets and pricing power define excellent opportunities foe conservative investors to benefit from inflationary environments. I don’t think upping Solyco Wealth’s Equity allocation to 25% from 20% places the portfolio at an outsized level of risk. In fact, thus far in 2022 the Conservative Model Portfolio’s Equity allocation is only down 5.2%, 230 basis points ahead of the S&P 500 and 330 basis points ahead of the 8.5% loss for the supposed-to-be-conservative iShares Core US Aggregate Bond ETF (AGG). As always, however, past performance is no guarantee of future results…
Not only did I choose to put more cash to work for the Conservative Model Portfolio in my efforts to battle the deleterious impacts of rising rates on bond prices and purchasing power but also, I rejiggered the fixed income allocation for the portfolio to take advantage of highly likely future interest rate increases. This action firmly addresses, in my mind, both points #1, and #2 above. In anticipation of higher interest rates, I initiated the Model Portfolio on 9/8/21 holding 5% allocations to private capital providers Ares Capital Corp. (ARCC) and Hercules Capital (HTGC), which trade like equities but manage multi-billion dollar portfolios of primarily adjustable rate loans to smaller private companies. Year-to-date ARCC and HTGC generated total returns of +5.4% and +15.1%, respectively, including dividend yields of 7.9% and 10.4%. In the current environment of low loan default rates, these companies should enjoy relatively smooth operations. As defaults rise – an all-to-frequent response to rising rates and marginalizing economic growth – the attraction of companies like ARCC and HTGC drops dramatically, however. We also pivoted out of the long-end of yield markets, selling the Model Portfolio’ 5.1% holding in TLT in exchange for a 5% position in the SPDR Blackrock Senior Loan ETF (SRLN), which offers floating-rate loan exposure to companies that, generally, maintain higher credit profiles than those services by ARCC or HTGC. Thus far in 2022, SRLN is down 0.4%.
Two primary risks I incurred in taking the above-detailed actions several days ago: 1) I miss – at some indeterminate point in the future – outperformance from TLT equal to or greater than the 11.5% loss the portfolio took while holding it and 2) The 5% increased allocation to Equities and the swap to SRLN fail to compensate for the missed opportunity presented by not retaining TLT through its recovery. Notably, the Conservative Model Portfolio, however, already, avoided an additional 700 basis points of losses from TLT while gaining 70 basis points of gains from holding SRLN. Better late than never…