Sponsored by Westwood Holdings Group, Inc.
Harvey Steele, Senior Vice President, Head of Intermediary Distribution, Westwood
Can you describe Income Opportunity’s investment philosophy and where it might be used in a multi-asset portfolio?
Income Opportunity lives in a very popular category, which consists of 30% to 50% equity allocation, categorized by Morningstar. If you look at Westwood’s investment philosophy, we’re quite a bit different. Many of the products in this category tend to be static portfolios with median investments in stocks, bonds and cash, often a relatively static 40% allocation to stocks. Westwood invests across the capital structure. That means that we can look across the investment spectrum at preferred stocks, convertible debt, traditional debt, traditional equities, MLPs and ETFs. We are a bottom-up, multi-asset manager looking for the best value across the capital structure. We tend to be highly tactical in our multi-asset allocation strategies.
We look for the best relative value across the sectors that we invest in. Although the securities that go into our portfolio have a yield component, we’re not buying for maximum yield. There are some investors out there who have a yield bogey of 4% to 5%. What we’re really looking for is the best total return potential with some level of income.
Westwood seeks to provide equity-like returns with substantially less volatility, and that’s what we’ve been able to do over the last decade or more. Income Opportunity has provided about three-quarters of S&P 500 returns with a volatility profile similar to that of a 10-year Treasury bill. This has been an interesting year for the portfolio. We’re above the median by about 100 basis points compared to our peer group as ranked by Morningstar.
What do you recommend for advisors who heavily use ETFs for their U.S. equity exposure? How should they employ a multi-asset approach?
I think ETFs have worked incredibly well over the last decade. I don’t think that’s going to come as much of a surprise to anybody. What I would emphasize, particularly this year, is that the market has become incredibly bifurcated in that you have a small number of winners that have driven the majority of the returns. I think over the last three years now, roughly 60% of the S&P 500 returns have come from six stocks. Most ETFs are cap weighted, so in essence, in times like these as they rebalance, you’re going to be buying much more of what’s gotten more expensive and much less of what’s gotten cheaper.
If you look at a multi-asset portfolio today, you’re really giving the portfolio manager the flexibility to go find the assets that maybe haven’t participated in this relief rally that we’ve had or are still undervalued given the context of what’s going on in the broader market, whereas it’s very difficult to do that with ETFs.
We have seen in times of crisis such as in 2008 and now with COVID-19, that rising correlation between bond and equity returns has challenged the common rule of 60/40 diversification within a traditional portfolio. How can Income Opportunity help an advisor build a more effective diversified portfolio?
This one is pretty simple — it’s having access to more asset classes. We employ eight asset classes within this portfolio. Traditional products in this category might have access to three or four.
Although there has been an increasing correlation among all asset classes, whenever you have a liquidity squeeze, like we did in the first quarter this year, having access to deeper markets is a bit of a damper.
For example, if you’re looking to shift your stock allocation and you want to keep your equity exposure, you could look at a preferred, which is senior in the capital structure and has a greater yield component. Those typically have a lower correlation than going into, say non-investment grade debt or something along those lines. Having more tools in the toolbox leads to better diversification. I would also say that not having a yield return target where you’re essentially looking for similar types of securities to meet an objective gives you an opportunity to focus more on total return.
Westwood uses the word “tactical” to describe its Income Opportunity strategy. Can you elaborate on what that means and why not every manager can truly be tactical?
Since the early ’80s, you have had over 35 years of falling rates and we have seen almost constant PE expansion on the equity side. For example, if you had a 40% equity, 60% bond portfolio, it helps you on both sides without having to take a lot of active risk. There hasn’t really been a need for managers to make their clients money by rotating among sectors.
Today, we have a 10-year Treasury bill yielding under 70 basis points. Depending on which earnings estimates you’re following for the S&P 500, we’re somewhere between 22 and 23 times forward earnings, which is as high as we’ve been in a decade and a half. Our approach is tactical, meaning that we don’t have to have exposure to any of the eight asset classes if we don’t feel it is appropriate to achieve our investment goals. We really look for the best perceived opportunity in the market.
A great example of that is back in March where we were able to find dislocations predominantly in the preferred and convertibles market. We were looking at either preferred stocks that are senior in the capital structure, trading at a discount to common equity, or we looked at convertible bonds with put features that provided uncommon value. We were able to make those changes without having any meaningful limitation.
There are about a half a dozen managers that dominate this space. They have roughly $300 billion in assets under management in those six funds. Some of these funds have $50, $60 or $70 billion under management. If you think about making a large-scale shift of 10%, 15% or 20% of a $75 billion strategy, that’s too much money to move too quickly to access some of the markets we’re talking about. If you try to place $10 or $15 billion into preferreds, convertibles or the REIT market today, you would end up being one of the larger managers, making it harder to find liquidity. That is something that can move markets; we don’t have that problem.
What do you think will be the biggest challenge for investors over the next two to five years?
The largest challenge, we see over the next few years, is that the average age-weighted investment dollar in the country has been increasing over the last decade. Because of this, folks have been delaying retirement. Traditional products are yielding very low income — as we already mentioned, the 10-Year Treasury bill is yielding south of 70 basis points. We know corporate bond yields have come down dramatically as well.
As investors are approaching or looking to retire, they are having a difficult time replacing their income. And on the other side of that, we have equity valuations at the highest level we’ve seen in many years. If you look at that traditional formula for retirement that includes a mix of stocks, bonds and cash, it is harder to arrive at an agreeable outcome. What investors are really going to have to do is look to other asset classes where there is still relative value to change the traditional allocation mix of stocks, bonds and cash.
What is Westwood doing to help address those potential hurdles?
Westwood has a few products that fit this scenario. Across our multi-asset framework, we are looking for other asset classes that offer better relative values to meet investor goals. If you’re looking at income, you might want to invest in preferred securities and convertible bonds over traditional corporate bonds. When the opportunity comes, you could consider incorporating REITs in your portfolio if you are looking for inflation-adjusted income. At the moment, just for context, we are dramatically underweight REITs and we feel opportunity will come in the future.
At Westwood, we’re looking to manage for the best outcome for clients irrespective of capital outlook. We are hired to give folks exposure to the markets. If you survey the institutional market, and read the reports coming out of the largest U.S. broker/dealers, which are the majority of our clients, they have muted expectations for equity markets and fixed income markets for the next five years or more. I think if you survey the average firm on Wall Street today, they’re talking about mid-single-digit returns on equities at best, and very low single-digit returns on fixed income. In that environment, we do not think that having a significant amount of risk is going to be rewarded.
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