“While you don’t need as many fixed income choices as you probably want with the equity side, you need to have enough,” Matt Sommer, vice president and director of defined contribution and wealth advisor services with Janus Capital, told ThinkAdvisor on Wednesday.
“There’s so much focus on the equity side and not enough focus given to whether there’s ample choice and availability on the fixed income side so different participants at different stages of their lives can build a portfolio accordingly.”
There are three fixed income “staples” for 401(k) lineups to cover the risk-return spectrum, Sommer said: “U.S. intermediate-term, some sort of international diversified option and if you like high-yield, in addition to your money market or stable value option.”
Sommer said that U.S. intermediate-term bonds are so common that even plans that only have a few fixed income options have them. “It’s sort of like large-cap U.S. equity on the stock side,” he said.
Sommer said Janus has observed that plans adopt a “passive approach to fixed income, in all likelihood they’re using the U.S. Barclay’s Agg as the passive vehicle or the index option.” In those cases, advisors need to make sure plan sponsors understand that the duration for the U.S. Aggregate is 5.6, not three as it was before the crisis in 2008.
That’s important because the longer the duration, the more sensitive investments are to interest rates, he pointed out.
“We’re of the opinion that when interest rates do ultimately begin to creep back up, it’s not going to be a linear trend,” Sommer said. In fact, he added, “over the last several decades, we’ve been in a bull market for bonds when interest rates kept declining, but there were 22 periods since 1970 where interest rates actually picked up substantially.”
That’s what makes an active manager so valuable, Sommer said. “What an active manager is able to do is adjust the way the portfolio is managed relative to duration, to pick spots on the yield curve that offer the best risk-reward ratios, and also to evaluate sector and issue selection. It’s going to be a difficult environment, obviously, if the long trend in rates is upward, but there’s certainly opportunity especially for active managers who know how to exploit that.”
Advisors also need to consider how well the plan sponsor or investment committee actually understands the makeup of the bond funds in the plan and what the risk-return parameters are, Sommer said. “It’s been my experience that when you talk to most plan sponsors and most investment committees about their 401(k)’s U.S. intermediate-term bond fund and what their expectations are, it’s hardly ever yield. It’s not ‘I want the best return.’ It’s more often, ‘I’m really concerned about protecting principal.’”
One of the biggest challenges for advisors is finding the right balance of equities and bonds for clients. “Given people’s life expectancies and the impact of inflation,” Sommer said, and “the fact that people must live on after-tax cash flow, not pretax balances because of long-term capital gains […] it’s really important for advisors to have a balanced approach with those clients who aren’t in retirement. The right portion of equity is going to vary depending on the client and their risk tolerance, obviously, but equities are still a very big piece of the puzzle.”
“Some of the tenets that we believe in relative to the 401(k) world apply to the retail investor as well. Everyone is so hungry for yield,” Sommer said. However, say you have an 8% yield on an investment. “That sounds really good, but if the investment depreciates by let’s say 10%, your net return is negative 2%. We think that one of the best things that advisors can do for their clients, especially in the yield-starved environment that we’re in, is keep their focus on a total return approach.”
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