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Larry Swedroe (Photo: Tom McKenzie)

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Larry Swedroe: The Best Investments for the New Market Reality

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Clients urgently need to face reality: Expected returns aren’t what they used to be, so investors “have to get exposure to much different risks than they’re used to,” argues Larry Swedroe, chief research officer of Buckingham Strategic Wealth, in an interview with ThinkAdvisor.

Persuading clients to think about the rising risk of equity investing, as well as the increasing risk of a hard landing for the economy means helping them manage those risks by “reducing their exposure to equites and longer bonds” without moving to cash, Swedroe says.

For many clients, the answer is alternative investments. And that’s just what Swedroe has been recommending, as he reveals in the interview.

Such vehicles include private floating-rate debt, long-short factor funds, litigation finance, private credit and reinsurance funds.

Swedroe’s analyses of academic research inform the RIA’s investment strategy recommendations.

Looking at the heightened probability of a hard economic landing, or recession, Swedroe calls the Federal Reserve’s decision not to act promptly to curb inflation at a time of “massive fiscal stimulus and a strong economy” and keeping interests rates down “one of the most incompetent decisions ever made.”

In the interview, the author of “Your Complete Guide to a Successful & Secure Retirement,” co-written with Kevin Grogan, discussed what he considers the ideal investment portfolio — think Harvard and Yale — which uses a strategy where “the risks are more equally distributed.”

Swedroe’s latest book is “Your Essential Guide to Sustainable Investing” [Harriman House], co-written with Samuel C. Adams.

In our conversation, Swedroe names the chief benefits to green stocks set against the background of the “Holy Trinity” of brown stocks, aka “sin stocks,” which for the last 100 years have “outperformed the market by about 3% a year,” he says.

A member of the firm’s investment policy committee, Swedroe was previously vice chairman of Prudential Home Mortgage and senior vice president and regional treasurer of Citicorp.

ThinkAdvisor interviewed Swedroe on June 10. He was speaking from St. Louis, where Buckingham is based.

He said that his recommendation to clients was to invest “in things that aren’t generally available in public markets … We try to buy different risks and do it with as low cost as we can.”

Here are excerpts from our interview:

THINKADVISOR: How should people be investing for retirement right now?

LARRY SWEDROE: We’ve been strongly recommending that investors change the way they think about their portfolios. We’re trying to get people to recognize that they live in a world with much lower expected returns than they’ve been used to.

They have to get exposure to much different risks than they’re [accustomed] to. That means maybe investing in things that aren’t generally available in public markets.

So we’ve been trying to get our clients to add more and more of those assets. We try to buy different risks and do it with as low cost as we can. 

Broadly, what’s your approach?

We want to invest systematically; some call it passively. But it’s about avoiding trying to find alpha, if you will, with individual stock selection or market timing. 

We’re trying to get clients to think about the risks of equities, which have gone up, as has the risk of a hard landing because of policy mistakes — too much fiscal and monetary stimulus.  

The risk of inflation has gone up. So we need to think about how investors can insulate or minimize those risks by reducing their exposure to equities and longer bonds without just going to cash, where you’re doomed to fail because you get no return.

What sorts of alternative investments are you recommending?

A lot of our clients have very significant investments in private floating-rate debt. We use a fund called CliffWater Corporate Lending Fund (CCLFX). It’s all floating-rate debt and currently yielding about 7.5%. 

If rates go up, this [fund] will immediately move up in yield, and you’ll be hedged. 

It does have some economic cycle risk because companies could go bankrupt. But it has so much protection. 

You’re taking some risk, but you’re getting a massive premium. Today, 5-year Treasurys are 3%; [with this fund] you’re getting 7.5%.

CliffWater recently came out with another vehicle, an extended lending fund, called CELFX.

What other alternatives are your clients investing in?

Things like structured life settlements, drug royalties and private real estate, which can have a focus on low-duration assets.

If you have a 10- or 20-year lease on a property, that’s not a good inflation hedge. But if you’re invested in single-family homes for rental, that’s a one-year lease — and every month some of the rents go up. 

So we’re investing in vehicles that invest in things that have shorter-term duration, like single-family homes for rental, warehouses with short-term leases, hotels — things where prices can adjust quickly.

What about commodities?

That’s another example of an asset class that can provide diversification and benefits. 

And then there are long-short factor funds. We invest in one called QSPRX [AQR Style Premia Alternative Fund Class R6]. It’s long value, short growth — and totally uncorrelated to stocks and bonds.

How have these alternatives been performing? 

Every single one is up this year, while both stocks and bonds are getting hammered. 

What others are you investing in?

Litigation finance and private credit. Again, there’s no exposure to interest-rate risk or equity-type risk. It’s a different risk. They all have a liquidity premium.

What do you see as the ideal type of portfolio?

You want to build a portfolio that I think looks much like the portfolios of the Yales and Harvards of the world and like Ray Dalio’s investment portfolio. 

They’re risk parity [strategies], where the risk is more equally distributed rather than being concentrated 85% in stocks and 15% in bonds, which have inflation risk in them. So you’re much more diversified.

What other alternatives do your clients have? 

Reinsurance funds, where the risk of inflation and stocks has nothing to do with their risk of hurricanes and tornadoes. 

For example, we invest in funds like Stone Ridge Trust II Reinsurance Risk Premium Interval Fund (SRRIX).

What do you think of the way the Federal Reserve has been handling inflation?

There’s more risk of a hard landing today because the Fed got behind the curve about inflation rather than acting earlier and preventing it.

The risk of a hard landing is increasing because the Fed is going to have to drive interest rates up much more. I think that next month the inflation number is going to be just as bad or worse [than this month]. 

The Fed made a horrible choice, one of the most incompetent decisions ever made: to get behind the curve on inflation and suppress interest rates while at a time that the economy was booming. 

We had massive fiscal stimulus, and inflation was picking up and we were having negative real interest rates at a time when there was strong economic growth. That is literally insanity.

What have been the ramifications?

Now you are getting high inflation, and it’s likely that it will be for much longer than people think. 

The Fed is likely to have to tighten much more than they would have if they acted properly in the first place.  

What if an investor has a financial plan in place and wants to add some alternative investments? Where do the funds come from? 

You have to logically incorporate them and take into account taxes. Certainly the assets that are in your IRA account can be converted. 

And you can use any new cash you’re generating, any dividends you receive and move them to alternative assets and change your plan, recognizing that you’re now living in a different world.

You have to always think probabilistically and make sure your plan can adapt to whatever the environment is because we don’t know what risks will show up. No forecaster does.

Your new book is “Your Essential Guide to Sustainable Investing” (Harriman House-April 2022). You point out that “investors are confused about what they can expect in returns” from ESG, SRI and impact investing. Please elaborate.

Today, about one-third of U.S. money is invested with sustainable strategies. More individuals, especially younger ones and millennials, are expressing interest. Based upon surveys, I think that trend is certainly going to continue.

The estimates are: In the next 10 or 15 years, that [percentage] might get up to 75% or 80%.

But sustainable investing hasn’t exactly taken off like a rocket, has it?

In the last 15 years, we’ve seen a movement toward sustainable investing. But it’s been very slow to come up, maybe like 1% a year. 

But around 2018, when it became more of an issue in the news, the cash flows spiked. ESG strategies were getting tens of billions of dollars a month flowing in.  

What are the main benefits to sustainable investing?

You should expect [these] things: Green stocks should have much less risk because they don’t have the risk of bad environmental disasters. They have better corporate governance — so you have less fraud risk. 

There’s higher employee satisfaction because [the companies] have a good culture and people want to work with them. They have better accounting standards and better risk control.

What are your thoughts about the way ESG stocks are screened and scored?

Green stocks have high ESG scores. There are two ways to think about that. Negative screening is the bad way: “I don’t want to own any energy companies.”

That’s stupid because when you do that, you won’t buy ExxonMobil or TotalEnergies. Well, guess who’s doing the most advanced transition [to green]? Who has the most green patents? It’s those companies. 

They’re doing everything — spending money — to make this transition. So if you don’t buy their stock and penalize them, they’ll end up with a higher cost of capital and can’t spend that money to make the transition.

What’s the better way of screening, then?

A best-in-class or best-in-sector approach. Look at it by utilities, technology, health care [and so on]. Find the highest-scoring companies in a sector and invest that way.  

As opposed to green stocks, what are so-called brown stocks?

These are also called sin stocks, the old term for them. There was a Holy Trinity of sin stocks:  tobacco, alcohol and gambling stocks. Some people threw in guns or defense or pornography.

In the last 100 years, the Holy Trinity has outperformed the market by about 3% a year. 

Pictured: Larry Swedroe (Photo: Tom McKenzie)


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