Investment managers tend to group themselves into either the active or passive camp. Active managers think they have an edge, so they typically allocate 100% of client assets to active strategies. Passive managers do the opposite and buy and hold index funds.
I’ve never personally agreed with going all in on either active or passive. For that reason, Movement Capital’s strategy is 50% active and 50% passive. This page details the passive stock and bond allocations.
Investing 100% in the S&P 500 is not a passive approach. It’s both concentrated in one country and concentrated in large-cap stocks. Passive equity exposure needs to be global and avoid market-cap tilts. U.S. stocks currently represent approximately 50% of the global stock market.
The average U.S. investor has 79% of their stock exposure in U.S. stocks. People tend to invest more in their own local markets because it’s the comfortable thing to do. This is called home country bias. Staying close to home and ignoring the rest of the world is the wrong decision to make in today’s globalized markets.
Research shows that portfolio volatility is most reduced when a U.S. investor’s allocation to international stocks is 40-50%. Another benefit of owning international stocks is that they’ve historically been a better inflation hedge than domestic stocks.
Movement’s passive stock exposure comes from VTI and VXUS, the same U.S. and international total market-cap index funds used in the trend and macro models. A 50/50 split achieves truly passive global stock exposure.
Movement’s passive bond allocations are built with intermediate-term Treasuries, municipal bonds, and inflation-protected Treasuries (TIPS). TIPS are used in both tax deferred and taxable accounts. Treasuries are only used in tax deferred accounts, and municipal bonds are only used in taxable accounts.
Intermediate-term bonds are the most passive way to get bond exposure. A tilt to either short-term or long-term bonds is an implicit bet on which way interest rates will go. You feel like a genius if you shift to short-term bonds (which are less sensitive to rising rates) right before rates spike and bond prices fall. Then you’ll get frustrated if you tilt to short-term bonds before the economy enters a recession, when interest rates typically fall and bond values rise.
The graph below shows that economist and investor forecasts (dashed lines) for the 10-year Treasury yield have consistently been off the mark. Nobody can predict where interest rates are going, and this is why Movement allocates to intermediate-term bonds. Additionally, intermediate-term bonds have historically provided the highest return for their level of interest rate risk (The Bond Book, page 407).
Movement does not use bond funds that track the popular Bloomberg Barclays Aggregate Bond index. The purpose of bonds in growth-oriented portfolios is to diversify equity risk and to (hopefully) not go down as much in a recession. Corporate bonds represent a quarter of the Bloomberg Barclays Aggregate Bond index. U.S. Treasury, municipal, and TIPS bonds are less correlated to the ebbs and flows of the business cycle, hence why they’ve historically been better portfolio diversifiers during periods of stock market volatility.
The chart below shows the drawdown during 2008 of two example allocations: one 50% in U.S. stocks and 50% in a blended bond fund, and another 50% in U.S. stocks and 50% in a fund that only invests in intermediate-term U.S. Treasuries.
There are two main types of Treasury bonds: regular bonds that pay a nominal rate of interest and TIPS that pay an inflation-adjusted rate of interest. TIPS were introduced in 1997 as a way for U.S. bond investors to protect against inflation. Twice a year, the U.S. Treasury raises the face value of a TIPS bond by the realized inflation over the prior six months. So if you buy a $1000 TIPS bond on January 1, and inflation during the entire year rises 3%, the face value of that bond will be adjusted higher to $1030. TIPS also have a rarely discussed deflation floor, preventing their face value from dropping below $1000 at maturity.
Movement’s passive bond allocation uses a 50/50 split between intermediate-term regular bonds and TIPS. Anything other than a 50/50 split is an implicit bet on whether current market inflation expectations are high or low. The graph below shows a measure of inflation expectations called the breakeven rate. The 10-year breakeven rate is the difference in yield between a regular 10-year U.S. Treasury and a 10-year TIPS bond.
For example, if a regular 10-year Treasury yielded 3.0% and a 10-year TIPS yielded 1.0%, the 10-year breakeven rate would be 2.0%. This is the level of average inflation over the next ten years that would result in identical total returns between regular Treasuries and TIPS.
If an investor were to only use regular bonds, they’d be vulnerable to future inflation that’s higher than what the market currently expects. On the other hand, an investor that were to only use TIPS would lose out if we were to enter a deflationary environment and future inflation ends up being less than current expectations.