Burton Malkiel, Princeton professor and author of A Random Walk Down Wall Street, had an Op Ed piece in the Wall Street Journal on December 7th that advocates rethinking simple indexed portfolios. While Vanguard has recently published research asserting the superiority of a simple asset allocation made up of 50% allocation in a stock index and 50% allocation in an aggregate bond index, Malkiel proposes that investors need to look at a range of asset classes that are less familiar to most investors.
To begin, Dr. Malkiel asserts that long-term Treasury bonds (10 years and longer) have such low yield that they are likely to have negative real long-term return (return net of inflation). Rather than invest in Treasuries, he advocates putting your money into municipal bonds. In addition, he likes the opportunities afforded by closed-end municipal bond funds that employ leverage to increase their yields. He notes that these funds are currently yielding 6% to 7%.
The second alternative for achieving higher income is foreign bonds. In particular, he highlights Australia’s an example of a country with robust economic fundamentals and high yields. He states that it is possible to purchase high-quality bonds from Australia at a yield of 8%.
The most controversial statement in this piece, in my opinion, is the following:
Another strategy would be to substitute a portfolio of blue-chip stocks with generous dividends for an equivalent high-quality U.S. bond portfolio. Many excellent U.S. common stocks have dividend yields that compare very favorably with the bonds issued by the same companies.
The idea that Malkiel raised here may seem very odd to investors who have been taught that stocks are the ‘risk asset class’ and bonds are the ‘safety asset class.’ There are, however, good reasons to consider Malkiel’s suggestion here. It is possible to create a portfolio of low-volatility dividend-paying stocks plus a modest allocation to bonds that will generate more income with less risk than a more traditional equity portfolio with a higher allocation to bonds. Ben Stein and Phil DeMuth discussed this idea in their 2008 book, Yes, You Can Supercharge Your Portfolio (see the chapter titled: Special Topics: A Farewell to Bonds). For income-oriented investors, it is quite possible that a higher exposure to dividend stocks will make more sense than a bond-heavy portfolio.
While it is always risky to make a market call, Malkiel’s point that interest rates have nowhere to go but up is not a bad one. When any market is at an extreme in terms of values, reversion to the mean is a decent bet. It is possible, however, that the U.S.economy will continue to stagnate and interest rates will stay low for quite a long time. This is where I think that some nuance is required in terms of avoiding long-term government bonds. In May 2011, I published an article in Advisor Perspectives titled How to Build a Low-Risk High-Income Portfolio. In this article, I noted that both Warren Buffett and Bill Gross had recently very publicly announced that long-term government bonds had yields that were too low to justify their risk levels. In my analysis presented in the article, I came to the same conclusion as Malkiel. When I looked at yield vs. risk, long-term government bonds looked really unattractive. My analysis suggested that you could build a portfolio with higher yield and less risk than long-term government bonds by allocating a substantial portion of your portfolio to high-dividend stocks and other ‘risky’ asset classes. These portfolios all included allocations to long-term government bonds, however, with allocations ranging from 3.3% to 7.5% of the total portfolio. Why, when long bonds looked unattractive on a standalone basis, did these portfolios maintain positions in these bonds? In a word: diversification. Long-term government bonds provide powerful diversification benefits relative to many other asset classes.
How about muni bonds?
Munis are an intriguing asset class that many investors do not understand. Analyst Meredith Whitney’s widely-publicized prediction in late 2010 for a large number of defaults on munis certainly gave investors reason to steer clear of muni bonds. An April 2011 analysis by two professors at Harvard Business School came to quite a different conclusion. This research suggests that while munis certainly have some risk associated with them, the market is currently pricing munis with the assumption of too pessimistic a projection of future defaults. From my perspective, the main reason to consider munis is because of their low correlations to other major asset classes. The returns from the PowerShares Insured National Muni Bond Fund (PZA) are negatively correlated to major equity classes and also have a modest 38% correlation to aggregate bond indexes (e.g. BND, AGG).
The final sentence of Malkiel’s Op Ed piece makes the key point:
The traditional diversification advice of a simple stock-bond mix needs to be fine-tuned.
The core idea of diversification is to combine assets in a portfolio which tend to have different drivers. When part of the portfolio is declining, other parts are likely to be gaining. The simple stock-bond portfolio that combines a broad market stock index with an aggregate bond index is not ideal in this regard, particularly given the extremely low yields on government bonds. There are other asset classes that can be added to a portfolio that can reasonably be expected to increase return and yield as compared to a simple stock-bond mix at the same risk level.
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