Are Equities the Best Option for Investors? – Part 1

Fixed income, alternative assets, and cash are discussed

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Ryan Modesto | October 4, 2016 | 5i ResearchWith equities at all-time highs and fixed income offering unattractive yields, we are often hearing that equities are the only place to go. While we actually agree with this idea, we wanted to break down the options that investors have and see what the alternatives to equity are.

Fixed income:

fixed incomeBelow is the historical chart for 10-year (US) Treasury yields. Yields are hitting 63-year lows in the US and most countries around the world are following suit. Remember, record low yields mean record high bond prices. Even if we try to correct for higher yields in the past that may have been an anomaly, and exclude all yields at and above
6%, the average 10-year yield is still 3.93% with the median being 4%.

UntitledGiven that yields are currently at 1.5%, if we assume a modified duration of 8.9, Treasuries could fall by 22% if yields were to adjust to this longer-term average. Turning from capital gains/losses to the actual interest, even if a 1.5% yield is enough for an investor, if we consider any bit of inflation and taxes, this 1.5% income yield becomes quite meager. This is all to say that, yes while yields could remain low or still go lower, when you consider the above, it is hard to consider fixed income as an overly attractive investment, unless it is out of necessity for some semblance of certainty and stability behind future returns. The biggest selling point behind fixed income we see is that while you may lose money on it, at least you have a better idea of what you will lose, compared to say equities where there is more uncertainty any given year.

Regardless, this is hardly a ringing endorsement for fixed income. *

Alternative assets:

16719567_lWe are including commodities and real estate in this category but regardless of the long-term characteristics, it is just not an asset class investors should or should want to have a large allocation to. Depending on the asset, it can be higher risk, volatile and movements are at the mercy of supply and demand factors that are out of any individual or company’s control. Gold has had a great run for the last year but has not done a whole lot for investors over two and five-year periods, while oil is a great example of how fickle these sectors can be. Commodities, in most cases, are really viewed as a diversifier and more for a store of value and protection against inflation. Real estate is an interesting option as well but given North American culture, a great deal of assets are already held in real-estate through houses that individuals own. So again, ratcheting up a real-estate allocation in a portfolio may not make a whole lot of sense for a lot of individuals. For Canadians in particular, this asset class may be even less attractive (or out of reach) due to the trajectory of housing prices. Finally, an investor may need to store these hard assets somewhere or pay for storage costs, so

these assets just do not fit reality for most investors as a reliable asset class to move funds into.

Cash:

banner-imgThere is a level of solace that can be had with a cash balance, as investors don’t feel like they are losing anything. This is a mistake. Holding loads of cash not only ensures you lose money to inflationary pressures but it has a very real opportunity cost. Every dollar that could be made in any other investment is a dollar lost by holding cash. The typical arguments here are that it is great in a deflationary environment or something that, in fewer words, equates to trying to time the markets. For the deflation argument, bonds should still be preferred over cash and on the market timing; studies have shown time and again that investors of any ilk are not good at this. Finally, similar to alternative assets, we just do not view cash as a realistic option for investors to hold 40% to 80% of their portfolio in (like you would in fixed income or equity). If you do hold that large of a cash balance, the portfolio has an enormous cash drag in an up-trending market. If markets are falling, investors are now faced with some big psychological barriers. It can be very hard to buy during some type of crash event (which is what most investors with such a high cash balance would be looking for) and even harder to put a large portion of your portfolio into a falling market.

At the end of the day, cash is less of an investment and more of a tactical, market-timing decision, which is again why we feel ,

Cash is not an overly feasible alternative either.

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Stay tuned for Part 2! 

About the author: Ryan Modesto, CFA is a Managing Partner at 5i Research and has worked in high-net-worth portfolio management at one of Canada’s largest banks.

*It is important to remember that while fixed income may not be the most attractive asset class in terms of return, there is real value in the stability and relative certainty of the cash flows it offers to those who rely upon them. Fixed income still plays an important part in a diversified portfolio.