“We don’t know when quantitative easing will end, but it’ll likely end badly.”

The preceding isn’t an actual quote but an amalgam of opinions recently expressed by a number of well-known Wall Street types about the ultimate outcome of the Federal Reserve’s unprecedented monetary stimulus programs of the past four-plus years. Folks ranging from hedge fund manager Stanley Druckenmiller to commodities guru Jim Rogers and CNBC personality Jim Cramer are warning that the Fed’s expansive asset-buying program (roughly $3 trillion and counting) is creating a bubble that’ll eventually burst and create a big financial mess.

Others aren’t so sure. Either way, most observers agree that Fed Chairman Ben Bernanke’s monetary manhandling has put the U.S. economy in unchartered territory and has investors peering into the unknown.

The Fed has kept the federal funds target rate close to 0% since late 2008, with promises to keep it at historically low levels until the unemployment rate falls to 6.5% and as long as inflation remains under 2.5%. Then came three rounds of quantitative easing where the Fed has printed money to buy large amounts of assets from the market––mainly mortgage-backed securities and longer-term Treasurys––to boost their prices and reduce their interest rates to help prime the economic pump through increased lending and liquidity.

During the current third round of QE, the Fed each month is buying $85 billion in mortgage securities and Treasurys, though it says it could taper those purchases going forward depending on economic conditions.

The questions concerning what will happen in the post-QE world are many: How far and how fast will interest rates rise when the central bank boosts the federal funds rate and stops acting as the bond market’s sugar daddy? Will equities take a breather––or worse––without the Fed pushing investors into risk assets? When will the Fed stop buying assets?

“The Fed won’t start reducing its purchases until the economy shows signs of expansion because it doesn’t want to derail the recovery,” says Jennifer Vail, head of fixed-income research for U.S. Bank Wealth Management. Some Fed officials have hinted it might start curtailing purchases later this year, but disappointing March employment numbers put that time frame in doubt.

One of the biggest questions of the QE era is how will the Fed divest of these holdings. “I’d find it hard to believe the Fed is confident it’ll be able to completely unwind a $3 trillion balance sheet,” Vail says. “It’s hard to say I’m confident about something I’ve never seen in my lifetime, let alone been able to read about in books.”

Wealth managers and investment strategists alike are trying to figure out how to play ball in a game where the playbook, to some degree, is being rewritten on the fly. “Everyone is trying to gauge the risks and unintended consequences of when these programs are going to stop,” says Mark Balasa, co-CEO and chief investment officer at Balasa Dinverno Foltz LLC, a wealth management firm in Itasca, Ill.

Abyss Or Opportunity?
Proponents of QE say the Fed has done a masterful job of keeping the economy afloat and inflation in check. Critics of the Fed’s program––and they are legion––say QE has lost its effectiveness. To keep printing money and purchasing assets, they say, unnecessarily pumps more liquidity into the economy, which perpetuates a misallocation of resources and sets the stage for currency devaluation and hefty inflation.

Not everyone agrees with those arguments, but most concur that historically low interest rates have nowhere to go but up, which will negatively impact certain fixed-income securities. “With bonds, for much of the past 30 years you’ve been playing offense because in the U.S. there’s been this beautiful tailwind of falling interest rates,” Balasa says. “Now with interest rates set to rise at some point, you’ll have to switch from playing offense to defense. Most people on the fixed-income side aren’t accustomed to that mind-set.”

To prepare for the unknown, Balasa says his firm is trying to play both offense and defense. In fixed-income investments, the firm is minimizing bond duration to about four years, paying close attention to credit quality, looking at overseas opportunities and employing unconstrained bond funds that have flexibility to invest in any part of the bond market and can do so at any maturity point, average duration or average rating. These funds can also bet against individual bonds.

On the equity side, Balasa says investors are seemingly addicted to the easy money that’s pushing people into stocks and will likely react negatively when the Fed pulls the plug on QE. That said, he notes there aren’t a lot of viable alternatives.

“We’re not running from equities now,” he says. “We think valuations and available alternatives are such that there’s no better place to go for the lion’s share of the risk part of the portfolio.”

Don’t Try To Outguess The Fed
Lee Partridge, chief investment officer at Salient Partners, a money management firm in Houston, posits that trying to time the end of QE is a fool’s game. “You have to be in the market, but you need to be truly diversified to offset a variety of potential market conditions that can negatively impact certain asset classes,” he says.

For now, Partridge says, Salient continues to ride the tailwind to stocks provided by continuing monetary stimulus. To protect against the downside if the Fed overplays its hand with too much stimulus, the company is hedging its bet with positions in fixed income, commodities, energy infrastructure and real estate.

For its fixed-income sleeve, Salient favors the sovereign debt of Australia, Japan, the U.K., Germany and Canada. The firm also likes emerging-market debt. “Much like with natural resources, we think local-denominated debt will hold up well,” Partridge says.

Brad Thompson, chief investment officer of Stadion Money Management in Watkinsville, Ga., believes QE so far has been a friend to both investors and to the economy, even if weakness still remains in the latter. “For investors, it has made risk assets the only place to get any kind of return,” he says. Even so he acknowledges that if QE continues, the country’s balance sheet will become even more unbalanced than it already is.

Indeed, the Fed’s balance sheet has grown from total assets of $869 billion in August 2007 to $3.2 trillion as of early April 2013. According to the Federal Reserve’s Web site, the volume of securities held outright declined at the end of 2007 into 2008 as the Fed sold Treasury securities in order to increase the amount of credit it extended through liquidity facilities during the heart of the financial crisis. But the volume of securities holdings has jumped greatly since 2009 through its purchases of Treasury, agency and agency-guaranteed mortgage-backed securities during the three stages of QE.

“That type of situation is creating a bubble,” Thompson says. “But if you structure your portfolio in anticipation of the Fed ending QE and they keep extending it, you could be wrong a long time and be underinvested. That’s why we feel a risk-controlled investment strategy that’s designed to react quickly rather than predict what will happen is the most prudent way to approach this market.”

Thompson says Stadion constantly tracks price actions, market breadth and other internals to gauge market risk. When signals are bullish, it remains fully invested and adds beta to its portfolios. When those trends turn negative, the firm will remove risk and move to safer havens or cash.

“No one knows for sure when QE will end, but it will end eventually, and when it does there will most likely be some shakeout in risk assets,” Thompson says. “Cash might be the best place to go. I think there may be a flight to quality regarding U.S. fixed-income securities. That might be the best place to go, but you’d want to be on the shorter end of the duration curve in a rising interest-rate environment.”

Musical Chairs
Likewise, Scott Colyer, CEO and chief investment officer at Advisors Asset Management in Monument, Colo., says he’s not trying to time the Fed. “I don’t view this as a time to change your asset allocation model in anticipation of some unknown point in the future when the Fed will change its mind,” he says. “We’re continuing with the idea of ‘Don’t fight the Fed.’”

But that doesn’t mean his firm is simply riding the equity tailwind created by Fed policies. “You have to change your portfolio to play defense along the way. It’s like a game of musical chairs––you want to make sure you have a chair behind you when the music stops.”

Colyer believes the end of QE could herald economic growth because the Fed won’t stop the show until the economy is on firmer footing. And that would favor equities. “Even if interest rates rise––assuming they’re rising due to economic recovery and growth––risk assets tend to do well in that environment,” he says.

But Colyer notes that the inevitability of rising rates requires flexibility with his bond portfolio. “You don’t sell them,” he explains. “You just move them to another part of the bond market. We’re shortening duration and taking more credit risk. That’s what the playbook calls for when you expect economic expansion.”

Jennifer Vail at U.S. Bank Wealth Management says she expects interest rates to gradually rise and she’s advising clients with fixed-income exposure to avoid adding positions in interest-rate-sensitive sectors such as mortgage-backed securities and Treasurys. “We encourage them to favor more moderate maturities in steeper parts of the curve where they’re actually being compensated for the risks they’re taking,” she says. “They should also focus on higher coupons within all sectors and all credit qualities of the fixed-income market because that helps reduce duration risk.”

No Easy Choices
Thomas Meyer, CEO of Meyer Capital Group in Marlton, N.J., doesn’t believe the end of QE and the inevitable rise in interest rates will be the end of the world. That is, unless you own long-term Treasurys. “It will end badly and in tears on the higher-duration, long-term fixed-income side,” he says. “No ifs, ands or buts about it. A lot of people will get hurt because they won’t get out in time.”

But he thinks it’ll be a different story on the equity side. “There will probably be a negative knee-jerk reaction across the board [when the Fed stops QE], but equities will eventually have less correlation as interest rates rise and bonds fall,” Meyer posits.

To buffer against the unforeseen, Meyer says his firm’s portfolios comprise 25% alternative investments––20% on the equity side and 5% in fixed income. “We’re going with managers with the ability to go anywhere, do anything or go to cash so we can protect ourselves when the inevitable happens,” he says. “The way we approach the markets and our portfolio allocations is risk first, returns second.”

Wealth manager Mark Balasa says some of his clients have expressed concerns about the end of QE and the markets in general. “Emotionally speaking, 2008 and 2009 are still just beneath the surface for a lot of people,” he notes. “An element of fear still exists, and they’re looking over their shoulders.”

And what they’re seeing probably isn’t too comforting. “Think about the four major asset classes,” Balasa says. “There’s no return in cash and their equivalents. Real estate is recovering but still seems scary. Bonds have [an interest rate] headwind. And stocks are still scary. So pick your poison.”