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.”