August 22, 2016: Inflation Protected Securities TIPS For Current Overvalued Markets

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For regular SAA and TAA portfolios, the next re-balance will be on Monday, September 19, 2016. You can also find the re-balance calendar for 2016 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Inflation protected securities (TIPS) for current overvalued markets

Amid a buoyant financial market that sees everything is rising, prudent investors are actually facing an increasingly tougher market condition: on the fixed income/bond side, zero or even negative interest rate is unprecedented. Eventually, one way or the other, interest rate will rise and as a result, bond prices will decline. It’s a matter of when, not if. It’s also a matter of how much decline. On the risk asset side, stocks and REITs have risen to a level where their valuation is also historically high. For these risk assets, investors are more familiar with their behavior: they will eventually suffer from a violent correction, as much as a 30%-50% loss. Again, this is just a matter of when and how much decline, not if.

One of the most important goals in investing is to preserve your purchasing power, before even considering a real wealth increase. Inflation is a real threat even for the most conservative investors: those who keep cash under mattress. Unless they are willing to suffer from the loss of purchasing power, they are forced to participate (or invest) in other assets. The much harder question is what to invest. In old times, these most conservative investor can earn reasonable interests from their bank accounts or from bonds purchased. Even when bad inflation indeed happens, the interests earned along the way can still make up some of the loss. However, with rates being so low at the moment, these investors are forced to venture into other areas, both for the purpose of preserving purchasing power and earning a little along the way.

One way to combat such a potential loss is to subscribe to a tactical or dynamic investing strategy, such as MyPlanIQ’s Tactical Asset Allocation(TAA). Such a strategy is often coined as a timing strategy that has been usually labeled as ‘bad’ by status quo financial professionals. However, numerous articles we have published on this subject and our 6 year and on going live record have illustrated its effectiveness. Admittedly, there are issues in such a strategy (see, for example, July 22, 2013: Tactical Asset Allocation: The Good, The Bad And The Ugly). However, with enough patience and disciplined implementation, this can work.

The other way is to find some safer investments that might help to combat inflation. Gold has had an on and off favor. The problem with gold is that it is extremely volatile and can be very hard to comprehend its real value. It could have a place in an overall asset allocation portfolio such as the famous Harry Browne Permanent Portfolio. But having a sizable exposure to it can make your portfolio/investments way too much volatile for most investors.

Enter inflation protected securities (TIPS). TIPS were first introduced in 1997 as a way for government (and later on, some corporations) to help investors such as insurance companies and retirees to preserve their purchasing power. Here is what’s stated on Treasury Direct website (a place you can purchase TIPS directly):

Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.

TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

In essence, TIPS will deliver, through both interests and principal appreciation (depreciation in the case of deflation), inflation adjusted constant monetary value.

TIPS have been touted as ‘worry-free investments’ by Zvi Bodie in his popular book Risk Less and Prosper. He suggests ultra conservative investors to purchase maturity matched individual I-bonds (Series I savings bonds). Such an approach at least can guarantee you not to lose your purchasing power.

However, for most investors, putting the entire savings to TIPS is too conservative. Some investors might expect to have higher spending that can not be exactly matched by individual TIPS bonds. Furthermore, many would like to grow their assets in order to make them last for a longer retirement period. Finally, some might even want to leave some of their wealth to their heirs or charitable organizations.

Aside from buying individual TIPS to match your short term needs, we prefer constructing a diversified portfolio that can employ various assets, including TIPS. A good example is David Swensen’s lazy portfolio that was discussed in a recent newsletter May 30, 2016: Swensen Portfolio And Permanent Portfolios. In the following, we will discuss in some details TIPS in a portfolio.

PIMCO’s recent studies on long duration TIPS

PIMCO recently published a study The Role of Long-Maturity TIPS in Retirement Portfolios. We find its studies interesting as we are a fan of using both intermediate term TIPS and long term TIPS (more later on this) in a portfolio. The paper shows the following table:

This table illustrates a hypothetical scenario for a worker who was 55 in 2005 and expected to retire in 10 years. As it turns out, investing in equities in that 10 year period yields the best return. However, in the TE vs. Liab (Tracking Error vs. Liability) row, it shows that stocks can have 24.4% variations. What this means is that in this 10 year period, there are many times (24.4%) when the worker would have faced a short fall (liability not matched, using PIMCO’s jargon) in his retirement income if he would retire at that point of time. Times like beginning of 2009 till 2013 are the examples. In fact, if he would retire in 2011, he would have faced 60% short fall in his retirement income.

On the other hand, long TIPS not only delivered a satisfactory return that matches the expectation (liability), it did it with very low TE vs. Liab, just 2.2%. That means in this period, there are only 2% of times when this worker would lose sleep and worry about his retirement income.

The paper further points out that long term TIPS are the least sensitive to current valuation level, compared with equities and core (traditional) bonds. This is a very important property to understand, especially in the current overvalued situation for both bonds and stocks!

Long term TIPS in Permanent Income Portfolio

In May 30, 2016: Swensen Portfolio And Permanent Portfolio, we brought up Permanent Income Portfolio with Long TIPS that replaces intermediate term TIPS with long term TIPS. Let’s look at its performance again:

Portfolio Performance Comparison (as of 8/22/2016):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	5Yr Sharpe	From 9/9/2009
Permanent Income Portfolio with Long TIPS	12.2%	11.6%	9.4%	7.4%	1.19	8.8%
Permanent Income Portfolio	9.5%	9.7%	8.0%	6.8%	1.45	8%
Harry Browne Permanent Portfolio	12.7%	10.6%	6.5%	4.4%	0.72	7.3%
VWINX (Vanguard Wellesley Income Inv)	9.3%	11.5%	8.2%	8.8%	1.92	8.9%

Detailed year by year >>

This portfolio has about a similar return as VWINX. Unfortunately, because the ETF LTPZ (PIMCO 15+ Year U.S. TIPS ETF) only started on 9/9/2009, after the financial crisis, we can’t compare the portfolio’s drawdown during the crisis. However, we expect this portfolio had a similar or less drawdown than the 17.5% maximum drawdown of Permanent Income Portfolio. VWINX (Vanguard Wellesley Income Inv), on the other hand, had about 21.8% maximum drawdown.

To summarize, TIPS can be effective in a portfolio. Long term TIPS are especially interesting and can be smartly used to hedge the potential inflation. We plan to add long term TIPS to some of our investment plans to combat the current tough (over)valuation problem.

Market Overview

Markets are showing some fatigue after the flurry of earnings reports was finally over. REITs have shown some sign of weakness: several mall operators and retailers are closing their physical stores because online retailers have been making inroads in the retail market. Emerging market economies are stable but are not showing strong momentum. The overhang of low interest rates has strained global economy. At the moment, markets are in a breathing wait and see mode. As stated before, investors are pinning their hope on an earning recovery, after five consecutive quarters’ decline.

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that since the financial crisis in 2008-2009, we have not seen substantial structural change in the U.S., European and emerging market economies. Economies have heavily relied on low interest debts. Capital might be misallocated to unproductive investments and consumption. U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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