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How to turn interest-rate hikes into portfolio opportunities

Personalization offers client benefits in turbulent times

The Federal Reserve increased interest rates this month — and we're likely to see multiple 50 bps hikes this year. It's a sign that the Fed no longer sees inflation as transitory, and action was needed to put the brakes on the economy to prevent a price spiral. 

In a rising-rate environment, financial advisors can stay attuned to potential opportunities that can help them differentiate portfolios for their clients.

Here’s a framework for helping clients understand the current environment, and guiding them through it with confidence. 

The effect of rising rates on stock prices

The relationship between rates and bonds is well understood, and not surprisingly fixed income returns have been extremely turbulent — investment grade credit has fallen nearly 15%, while even Treasuries are down 10% YTD, marking the biggest bond selloff in decades.

Equities haven’t been spared in this environment, either. Rates play a significant role in the valuation of equities, and understanding exactly how can help you guide clients and deepen your relationships. 

Here's a primer that can help guide conversations with clients:

The price of every stock is reliant on two inputs:

  • The company’s actual fundamentals

  • The valuation multiples investors are willing to pay for those fundamentals.

Rising rates affect both of these inputs.

On the fundamental side:

  • Higher rates can slow down the economy and reduce demand for goods and services, lowering revenue and growth expectations.

  • At the same time, borrowing costs can go up for corporate debt, leading to higher interest costs.

  • Theoretically, all of this translates into potentially lower earnings and cash flows as rates increase and the economy cools down.

On the valuation side:

  • A basic standard to value companies is as a function of its future cash flows.

  • To get a “present value,” investors discount back all these future cash flows to present day, using, most commonly, the 10-year US Treasury yield plus some “risk premium” to account for the additional risk in stocks.

  • With the 10-year rate more than doubling this year, and risk premiums widening, equity valuations have tumbled.

  • But not all equities are equal. The worst affected stocks have been “long duration” stocks — borrowed from fixed income terminology, it represents a set of unprofitable, cash-burning companies where positive cash flows are expected only in the distant future.

  • On the flipside, companies with strong current cash flows, dividends, and profitability — value stocks — have turned attractive as investors look for the safety associated with stable profits. 

  • As a consequence, value has outperformed growth by over 15% since the start of the year alone, saving those with a value tilt from the harsh effects of the growth drawdown.

Given these drivers of volatility, how can advisors, especially during inflationary periods, find meaningful ways to differentiate portfolios and take advantage of data-driven intelligence?

The answer lies in looking beyond the standard portfolio models.

The downside of legacy models

For a standard “indexed” market portfolio, 2022 has been a grim year so far — without actively tilting toward value stocks, market portfolios tend to have a growth bias given the years-long outperformance of growth and the increased weight of growth stocks in the market indexes. Portfolios that are tied to the overall performance of the market have felt every bit of pain the market experiences. 

However, personalized portfolios — those in which securities are owned individually as part of a Single Managed Account, and can be adjusted amid negative market forces more easily than ETFs and other elements of indexed funds — offer opportunities for advisors and their clients.

These tech-driven models of portfolio creation and management are increasingly in demand by investors used to personalization in other aspects of their lives. They expect it in their financial planning as well.

>> Read more from an RIA incorporating technology into his business.

Increased personalization for client portfolios does more than just bring shiny new tools to portfolio management. The ability to customize portfolios is a key differentiator during periods of broad market volatility.

Here’s why:

Value premiums and loss harvesting

At Vise, our investment philosophy places an emphasis on:

  • Valuation

  • Cash flows

  • Profitability

As a result, we manage custom portfolios to systematically deliver exposure to value and profitability premiums for portfolios of all sizes. 

Ordinary indexed funds don’t offer systematic exposure to these premiums — investors are at the mercy of prepackaged funds, with little ability to change course according to their specific needs or changing conditions.

With ETFs and mutual funds, another downside is the inability to effectively tax-loss harvest. 

Although the index itself is down 15% this year, some major names within it are down anywhere between 30% (Amazon, Meta) to nearly 70% (Netflix, Paypal).

By holding single names and using our automatic daily tax-loss harvesting capabilities, a Vise equity portfolio can sell these names and invest in replacement securities with similar characteristics.

This maintains overall market exposure, while taking advantage of significant loss-harvesting opportunities to offset capital gains for clients.

Customization for each client scenario

On top of the customization at the single-security level, our asset allocation framework provides multiple levers within the fixed income sleeve — an advisor can customize duration, sector, and geographic exposure based on each client’s scenario.

For example, an advisor can exclude high yield exposure for a risk-averse client near retirement age and allocate only to Treasuries, TIPS and IG credit.

For a more yield-oriented client, a portfolio could be created with only intermediate and longer-term credit and international debt, removing Treasuries and shorter-duration positions. 

Rising rate environments are stressful for investors and advisors alike. Having a clear framework, and being able to communicate that framework in order to align with your clients on better alternatives, can go a long way toward reducing that stress.

May 18, 2022