(Dynamic / Lucas Felbel, CIMA®, Director, Portfolio Services) Investors in short-term “safe money” instruments have enjoyed strong returns over the past year, thanks to the Fed’s aggressive stance on interest rates to curb inflation. Since the Spring of 2023, investors seeking refuge in money market mutual funds, CDs, Treasury bills, and other short-term instruments have celebrated annual yields exceeding 4.8%, and over 5% since late July 2023, a rarity in recent decades. This yield advantage not only protected investors from the erosive effects of inflation but has also facilitated prudent wealth preservation strategies for advisors and their clients.
Compounding this situation, stubborn inflation prints and other economic data point to interest rates remaining elevated for the time being, prolonging the riskless bliss that conservative investors have experienced. Trillions in money market assets are poised to extend their favorable run in a “higher for longer” rate environment. So, what’s the catch?
In the last 12 months the S&P 500 was up over 20%, 4-times the elevated risk-free rate. While leveraging liquid money market instruments may be beneficial to clients in the right situation such as emergency funds or short-term cash needs, broader market returns have eclipsed traditionally safe investments by a factor of four. This stark contrast underscores a critical dilemma facing advisors and risk-averse clients: the allure of current yields must be weighed against the potential future gains of investing in equities.
As the Federal Reserve inevitably pivots towards easing monetary policy, the era of elevated money market returns will end. Historically, downward-moving Fed rates prompt a migration of assets from bonds to equities, driven by the appeal of greater appreciation potential and reduced corporate borrowing costs further stimulating market growth.
This iteration of Portfolio Perspectives will examine a few strategies advisors may use to extend the benefits conservative-minded clients are currently realizing with money market investments, and to gradually get clients back into equities in anticipation of future interest rate cuts to maximize opportunities for potential benefits.
Keep the High Yields Rolling
Advisors should strive to improve client experiences in every interaction, taking them from good to better. Receiving 5% on a money market mutual fund is good, especially if clients are looking to maximize returns with safety of principle. However, fund yields are immediately reactive to Fed interest rate adjustments which indicate cuts later this year. Advisors have an opportunity to raise their clients’ experience from good to better by purchasing treasury securities directly and extending the duration at which clients will receive yields at 5%+.
By cutting out the intermediary money market fund and purchasing treasuries, clients benefit from reduced costs of ownership, increased after-tax returns as T-bills are only taxed federally, and the ability to lock in favorable yields for longer periods of time. A bonus to this method is that when interest rates are reduced, the inverse relationship between interest rates and bond valuations increases the value of the individual bonds yielding the previously higher rate level. We have just transformed a good 5% yield into a better 5%+ yield, for longer, with greater tax efficiency, and appreciation in a cutting rate environment. Good to better.
Diversify With Equity
Modern Portfolio Theory underscores the importance of diversified portfolios in maximizing returns for a given level of risk. With interest rates poised to decline, advisors could begin strategically allocating a portion of clients’ assets from money markets to equities, thereby capitalizing on potential market shifts while mitigating volatility. By carefully rebalancing portfolios and maintaining a well-diversified approach, advisors can help clients navigate changing market dynamics while optimizing risk-adjusted returns.
In fact, an allocation to 30% equities and 70% bonds only marginally increases standard deviation vs. a 100% fixed income portfolio, while over tripling the potential for returns over both the short and long-term. All-bond portfolios are subject to the same overconcentration risk as all-stock portfolios: being exposed to only one segment of the market. Deploying a broader, more diversified portfolio in the shorter term can significantly boost return potential while marginally increasing risk less than assumed.
Protect Client Portfolios, Get Buff(ered)
ETFs continue to serve as an attractive investment vehicle in the industry and fund issuers are continually launching products that cause investors to reevaluate the status quo. Buffered and “defined outcome” ETF products offer a compelling solution for clients seeking downside protection without sacrificing appreciation potential. These innovative products utilize options and futures hedging strategies to provide security in turbulent markets, making them an attractive option for risk-averse investors transitioning away from stable shorter-term investments. Buffered ETF products may also offer downside protection with a capped upside appreciation potential.
Predecessor securities offering similar functions include fixed indexed annuities and structured notes, both of which come with a measure of downside protection for investors with a form of upside participation in an underlying index. These products are usually quite expensive to buy, own, maintain, and difficult to transact in a secondary market – all concerns that buffered ETF providers have solved for without sacrificing benefits.
Buffered and defined outcome ETFs can be a great fit for clients who may be reticent to fully jump back into the equity pool after experiencing the safety of products with high short-term yields. Buffered ETF products are often positioned as a transitioning tool for clients who may be feeling market FOMO and wanting to get waist-height into the pool while maintaining a measure of principle safety.
Final Thoughts
As advisors navigate the complexities of shifting market dynamics, they have the responsibility to guide clients towards sustainable solutions aligning with a process-driven approach to investing. While the allure of high money market yields may be enticing, the potential gains offered by equities cannot be ignored. Through reasonable anticipation of market shifts and embracing innovative approaches, advisors steer clients towards continued success in achieving their long-term investment goals.
In the immortal words of Wayne Gretzky, “Skate to where the puck is going to be, not where it is.” By embracing change and remaining vigilant in their pursuit of optimal investment outcomes, advisors can help clients navigate uncertain times with confidence and resilience.
Invest with Intention.
This article is not exhaustive, and specific advice should be sought from qualified tax professionals before implementation.
For more information, contact Dynamic’s Investment Management team at (877) 257-3840, ext. 4 or investmentmanagement@dynamicadvisorsolutions.com.
As Director, Portfolio Services, Lucas Felbel, CIMA®, leads the implementation, monitoring and evaluation of trading activities at Dynamic Advisor Solutions.
Disclosures
This commentary is provided for informational and educational purposes only. The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. This is not intended to be used as a general guide to investing, or as a source of any specific recommendation, and it makes no implied or expressed recommendations concerning the manner in which clients’ accounts should or would be handled, as appropriate strategies depend on the client’s specific objectives.
This commentary is not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investors should not assume that investments in any security, asset class, sector, market, or strategy discussed herein will be profitable and no representations are made that clients will be able to achieve a certain level of performance, or avoid loss.
All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed as to its accuracy or reliability. These materials do not purport to contain all the relevant information that investors may wish to consider in making investment decisions and is not intended to be a substitute for exercising independent judgment. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements or assumptions are now or will prove to be accurate or complete in any way.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the markets is subject to certain risks including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed.
Investment advisory services are offered through Dynamic Advisor Solutions, LLC, dba Dynamic Wealth Advisors, an SEC registered investment advisor.
