Navigating Asset Allocation in a Low-Yield Landscape

Ronen Schwartzman joined the Cooper Family Office as Chief Investment Officer with 20 years of investment and capital markets experience. He started his career as an equity analyst with Oppenheimer where he covered small cap technology stocks. After receiving his MBA from the Wharton School – University of Pennsylvania, Ronen joined Bear Stearns, where he managed equity and fixed income portfolios for individuals and corporations, and also advised institutional investors on various capital markets investments. Ronen specialized in investing in alternative assets such as hedge funds, private credit, private equity, and real estate. A former Special Operations Intelligence Officer in the Israeli Air Force, Ronen is fluent in Spanish and Hebrew. Ronen is often quoted in The Economist, Reuters and Bloomberg News. A guest lecturer at The Wharton School and NYU Stern School of Business and a frequent speaker at industry conferences, Ronen is a noted thought leader in the hedge fund and family office communities.

 Kirby Rosplock

Welcome to the Tamarind Learning Podcast. My name is Dr. Kirby Rosplock and I'll be your host today. I'm thrilled to have Ronen Schwartzman with me here today. We're going to be talking about asset allocation and implications for your 2021 goals as we think about your asset allocation. Ronen is founder of Ten Capital Advisors. We're so lucky to have him here today. He works with various families and family offices on investing, and he's also the CIO for the Cooper Family Office with over 20 years of experience with capital markets and investing. We're thrilled to dig in today, Ronen, with you and talk a little bit more about asset allocation. So Ronen, let's talk about that 40/60 portfolio that is sort of the bedrock of portfolio construction. And I'm just going to pop open a slide as we talk about it.

Kirby Rosplock

What are your thoughts?

Ronen Schwartzman

Absolutely. Yeah. So first, Kirby, thanks for having me and I'm excited to be speaking with you today. So let's talk about the asset allocation model. So traditionally, we had a model which was what's called the 60/40. The 60/40 means 60% of the assets are allocated to equities and 40% into fixed income. And over the last two or three decades, this pretty much have worked well. But the challenge today where we're standing, I think things might be a little bit different. And let me explain that 60/40 model for the most part, tries to solve for an annual return of about 8% for most people. And for that, we need both the equity markets to work well and also the fixed income portion to work well and generate the returns. The problem is that we live in a world of very low interest rate environment. So for example, the yield on the ten year US. Treasury bond stands today at about 90 basis points less than 1%. And that's actually pretty good and exciting compared to other parts of the world. If you think about countries like Germany or Switzerland where their ten year yields are in negative of about 50 basis, half a percent negative.

Ronen Schwartzman

So think about that for a moment. You're willing to lend, people are willing to lend money to the government in order to get less money ten years from now. It continues also with other asset classes within fixed income. So think about investment grade bonds. Those are yielding today about 3% high yield where some investors thought they can find higher returns is trading at about 4% yield. So you can even ask yourself on a risk adjusted basis, am I compensated enough to take this risk?

Kirby Rosplock

So why would anyone want to invest in a bond? To say a government like Germany, if they're going to make less money in ten years, doesn't seem very logical to tie up that capital for a negative return.

Kirby Rosplock

Maybe talk to us what you think are some of the other allocation options that you see people going into to mirror that fixed income component.

Ronen Schwartzman

Sure. The first part of your question is why would anybody invest in negative yield bonds? And the answer is to hedge. Typically, when in times of higher uncertainty and increased volatility in the markets, investors rush to what's called the safe haven, the most safest asset classes, which are the government bonds. Because the theory is the government can always print more money and pay back its debt. In Europe these days, it may be a little bit more complicated because they're in euros and it's not Deutsche marks. But in Switzerland, they still have the Swiss francs and they can print money. Same thing here in the United States. So that's why people would still continue and buy these bonds.

Ronen Schwartzman

Back to the question and the challenges of that 60/40 model, so that we started talking about before, that 60% equity needs to continue and compound at higher returns to compensate for the low interest rate, for the low yields that we get in our fixed income portfolio. But fixed income allocation, as I kind of mentioned before, traditionally has been allocating to investment grade bonds, high yield bonds, some municipal bonds. People always like to get municipal bonds where they don't have to pay taxes, and some government bonds for safety.

Ronen Schwartzman

The problem with all of them is that the yields are so low. So if we take even a blended approach, a blended portfolio, and kind of do an average for all these yields, you will probably get a portfolio that has a yield of maybe two and a half to 3%. And that's without us wanting to take too much duration. That's like a five year type of portfolio, which we can argue is a little bit long. So we have two problems with this today. One, the yield that this portfolio generates is just not enough, some may even argue is not attractive enough to even invest with. Can you argue - for me to invest in a municipal bond that generates a one and a half or 2% return? It's just not attractive enough. It doesn't make sense. You can even add to that the potential risk because of the amount of money that we're printing in this country and where some cities or states are carrying large deficits and probably going to have less income from taxes because of all the COVID situation we're in. Then there's even a higher risk that we don't know. If you'll get paid for owning those municipal bonds.

Ronen Schwartzman

Now, again, if you want to achieve, our goal is to get to that 8% total return for a portfolio. And we know that our bond is going to do 3% or even 4%. That means our equity portion needs to do 12% or even higher. Probably we need to get to 14 or 16% annualized returns. So when we combine the two, you can get to that 8% on average. Basically, I think that this traditional fixed income allocation model is just not going to work going forward. And investors, you really have to be creative and try to think about new ways we can generate returns or increased yield, higher yields from our fixed income allocation. So what are we doing about this? So there are different ways to think and places to allocate capital to generate higher yields. One is preferred. So preferred is kind of hybrid between equities and bonds. And in preferred today we can probably get something around 5% or 6% type of yield. So clearly that these five or 6% is a little bit more attractive than the 3% that we get in investment grade bonds. Another place that we're allocating capital these days is into REITs (Real Estate Investment Trusts).

Ronen Schwartzman

Think REITs are attractive? There are some private REITs where they are providing loans, construction loans to developers. These are all short term type of loans. So think of it of twelve to 18 months. So we're not taking what's called too much of duration risk, meaning the risk that interest rates will actually move higher from where they are today. And that can hurt the value of the bonds that we own or fixed income instruments. So private REITs is another place. Private credit is an area that's been growing a lot in the last few years exactly because of the situation we're in where the traditional fixed income generates low returns. So in private credit we like to invest in managers that do a few things. But what we like is that they have tax credits attached to them. So for example, we're invested in a fund that specializes in film tax credits. We've invested in another fund where we know they're providing loans to entities where we have the government as the backstop. So the government is the one who's responsible for paying back our money in the end. So we feel the counterparty risk is low because it's either a state or a government entity that's supposed to pay it back.

Ronen Schwartzman

And we can get more into that soon. And in these type of funds we can get about 8% to 10% type of type of returns. Another part where we like to invest and we think we can solve for this type of returns is traditional, is what's called long short credit hedge funds. So these are hedge funds that go both long and short bonds. And overall they have low volatility and they can create between six to 10% annual returns, which we think is better. This is what we do. The only downside to all these, or most of these, is that we give up the daily liquidity. So the advantage of those traditional municipal bonds or government bonds or corporate bonds is that we have daily liquidity in them. Meaning if we own the bonds or the mutual fund or the ETF, we can sell it every day and get our money back. Whereas if we're investing a private credit fund, we probably have to lock our money for a year. So we still think that within the overall fixed income allocation, there should be some allocation to those more traditional fixed income, maybe a government bond or even an investment grade bond, but at a much smaller amount.

Ronen Schwartzman

And these can give the families their daily liquidity in case they need them.

Kirby Rosplock

So this is a great way to diversify, basically, your fixed income portion of your pie and probably increase to some degree, or have the opportunity to enhance your return on that fixed income, but also maybe spread the risk around a little bit more. As you're thinking about different fixed income strategies, talk to us a little bit about the equity portion. What are some of the things that you're seeing and anticipating going into 2021 that look attractive to your families, to you? What are you most excited about?

Ronen Schwartzman

Yeah, absolutely. Overall, we're fairly constructive about equity markets for the coming year. We think that we had the vaccine news coming last month, and that's definitely something we've all been waiting for. And it will help to reaccelerate the opening of our economy next year here and around the world. So what we've started to see, and what we're excited about is our small cap stocks in the United States, for example. These have lagged the market so far this year. And now with the reopening, we start to see money flow into them, and the valuations there are attractive within that. We like the financial sectors, the regional banks, for example. So until a month ago, nobody wanted to touch them. Everybody was so scared. What's on their balance sheet? How much loan loss provisions have they taken? And how much worse can it get? Now, when we know, yes, there's a valley in front of us, the next three months until everybody will get the vaccine. We see a spike now in COVID cases in the United States, but if we can look after that, let's look three, six, nine months from today, then clearly situation will be better.

Ronen Schwartzman

And now the banks that are trading at maybe 70% of their tangible book value, which historically is very attractive levels are looking as pretty compelling for us as a sector to be invested in. We also like Asia these days. We like China and we like Japan. Two areas that certainly can help both from diversification perspective and also can generate good, attractive, absolute returns. I think China for one. China was the first to start with COVID and experience that. But if you look at their data, they're past that. The numbers there are pretty much back to where they were before the pandemic. So their economy is strong, it's accelerating. China did not print so much money as we are, as we have, and we continue to do, and probably will continue to do next year. So that's a positive thing in my mind for their economy, and it's continuing to grow its influence in the region and in the world. So we like China. We like Japan as well. Japan is interesting because it's kind of been a dead place for the last 20 years or so. But what COVID did, COVID brought to Japan, they kind of forced them to accept certain things that they were not able to do so before.

Ronen Schwartzman

So think of it, things such as even signing documents or contracts where historically we have to meet in person. You have every contract, 100 pages. You got to sit there and sign and sign and sign for hours. Now, companies such as DocuSign is the new normal, and once you start with that, there's no going back. That's one area. Another area, for example, of them accepting this kind of new world we're in is food delivery. So where in the past they used to cook more at home and go to supermarket, food deliveries is becoming more of a norm over there, just like any other parts of the world. So where historically the adoption rate has been very low, we're seeing acceleration there. And Japan is still a market that's predominantly dominated by retail investors. Does that mean there is a lot of alpha to be created by professional money managers that are experts in the country? So these are some of the things we're excited for next year.

Kirby Rosplock

And if you had just one or two takeaways on asset allocation as it relates to that traditional 40/60 portfolio, what are some takeaways that we can leave the listeners today with about 2021 and how to think about it?

Ronen Schwartzman

Yeah, so 60/40 can continue to exist, but we really have to rethink that 40%.

Kirby Rosplock

So Ronen, when we think about the 60/40 portfolio allocation going into 2021, what are one or two takeaways about what you would advise or think about your construction? What's going to work better or not so well in 2021?

Ronen Schwartzman

Yeah, I think 60/40 can continue and exist, but in a little bit of a different way. So let's start with the 60 of the equities. So obviously it's okay. We need to be diversified, I think, not just where until maybe this year, people more overweight into nasdaq large cap growth. So people maybe start thinking maybe adding to small cap, their small cap exposure, perhaps in value stocks really have lagged the market significantly in the last decade or so. So the spreads between growth and value kind of really going back today to where we were in the year 2000. So value is more interesting. Definitely if you do not have international exposure or exposure to Asian markets, that's certainly the time to do that. And the 40% fixed income, I really think that traditional investment grade high yield is just not the right place to be going forward. And you really have to diversify and go into those private credits style of managers, look into those REITs areas that you can really get higher yield and that will help you both from an income generation perspective and to meet your goal in the end of the day, to generate an income in return.

Kirby Rosplock

Excellent. Well, it's delightful to have you here today, Ronen. Thank you so much for sharing your wisdom on the Tamarind Learning podcast, where we got to cover some investment allocation considerations and thinking about 2021. I'm your host, Kirby Rosplock. It's been a pleasure having you tune in. Thanks so much, Ronen.

Ronen Schwartzman

Thank you very much, Kirby.