Diversify beyond the AGG - McElhenny Sheffield Capital Management

Diversify beyond the AGG with MSCM's Tactical ETF Strategies

Finding Portfolio Safety in a Rising Rate Environment

With inflation hitting 8.5%, the U.S. economy is entering a new reality of tight monetary policy. The Federal Reserve Board has signaled that in addition to prescribed rate increases, they will be aggressively reducing their balance sheet. This dual approach aims to increase interest rates across the yield curve to reign in the 40-year high inflation.

Of course, rising rates mean bonds prices are falling. While the past 40 years have been great for bonds, this paradigm shift could be ushering in a new era of bond underperformance. In the 1^st quarter of 2022, the US Aggregate Bond Index was down more than the S&P 500 by nearly 1%. It is very rare for bonds to lose more than stocks. This creates a direct impact to stock and bond portfolios with increased losses registered on account statements.

The failure of bonds to provide adequate diversification to equities, while also causing a drag on returns, is why we use portfolio strategies that offer an alternative risk management strategy to dampen volatility. We use tactical ETF strategies, like our TPSR, that seek to capture equity market gains without the drag of long-term bond exposure.

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Quantitive Easing

The Federal Reserve Bank added $4.5 Trillion to its balance sheet since the Covid-19 economic shutdowns. The $9 Trillion in current holdings is the result of the asset buying programs dubbed quantitative easing (QE). The mechanics of QE are relatively straightforward. The Fed buys bonds (generally Treasuries and Mortgages) which increases the demand on the bonds available for sale in the market and thus increases liquidity in the financial system. With higher demand, bond prices increase and yields decrease. QE has been successful in reducing yields on the longer end of the yield curve (10-Yr Treasuries) while rate cuts have reduced yields on the short end.

https://www.marketwatch.com/story/what-happens-to-money-when-the-fed-starts-shrinking-its-balance-sheet-11647433132

Unwinding QE

Reducing the balance sheet, also called quantitative tightening (QT), operates in reverse. Beginning in May, the Fed plans to start allowing $95 Billion per month in bonds to mature or “run off” without replacing them. In theory, quantitative tightening will increase rates on the longer end of the curve as demand is decreased and there is an increased supply of bonds available for investors to purchase. Rising rates result in falling bonds prices.

QT + Rate Hikes = Bond Problems

Over the past 40 years, bonds have had a strong bull market. In 1981, corporate Aaa bonds reached their 100-year peak at 15.5%. They have fallen ever since and rest today near 100-year lows. As interest rates decreased over these years, bond prices continued to climb.

However, it wasn’t always this rosy. During the rising-rate cycles that preceded 1981, Aaa corporate bonds had drawdowns that could be severe and last multiple years.

Months of Rate Increases	Rate Increase	Approximate Drawdown	Drawdown Years
48 Months	7.6%	-25%	1977-1985 (5 Years)
87 Months	4.3%	-24%	1965-1972 (6.5 Years)
69 Months	1.8%	-15%	1954-1963 (8.66 Years)
7 Months	2.2%	-13%	1987-1988 (1.5 Years)

SOURCE: CME Group - https://www.cmegroup.com/education/files/when-bonds-fall-how-risky-are-bonds-if-interest-rates-rise.pdf

An extra word of caution about rising rate environments; when the starting rates are very low, bondholders are subject to a higher amount of risk. As rates rise, bonds experience capital losses. Coupon payments generally help buffer those losses, but when starting at low interest rates the amount of buffer is significantly reduced, e.g., a bond with 5% interest can withstand a 2% interest rate hike better than a bond currently yielding only 2%.

Inflation

Additionally, high inflation doesn’t just make your coffee or gas more expensive. It also shows up in your portfolio. When you view the returns from the 1970s, a notoriously high inflation period, you might think that a 60/40 portfolio performed well. That is until you adjust your returns for inflation using real instead of nominal returns.

A portfolio that looks like it returned 50% in nominal terms would have actually lost almost 30% in real terms.

Since early 2020, real yields on longer term Treasuries have been negative. This means that your purchasing power is eroding faster than your investment is returning money to you. As inflation continues to outpace rates, you can count on this trend continuing.

Maintaining Performance in the Coming Years

Many major financial institutions recognized the impending tight monetary policy and economic slowdown when they made their 2022 Capital Market Assumptions. The surprising figures below could be an indication that your portfolios will need a new approach through the next decade. For context, the S&P 500 has averaged 16.34% since 2009.

Capital Market Assumptions by Institution - Forward-looking 10 Year Average Return

Institution	U.S. Equities	U.S. Aggregate Bonds
Vanguard¹	2.3%-4.3%	1.4%-2.4%
Blackrock²	6.7%	1.6%
BNY Mellon³	5.9%	1.2%
JP Morgan⁴	4.1%	2.8%
Research Affiliates⁵	4.3%	2.1%
Invesco⁶	7.0%	1.9%
Average	5.21%	1.92%

If these projections are remotely correct, helping clients reach their goals with a 60/40 portfolio will become significantly harder if not impossible. Couple these low returns with a high inflation rate, and you could be looking at a devastating investment road ahead for most investors.

Again, this is why we suggest that all clients add our tactical ETF strategies to their portfolios. Our tactical strategies allocate capital to equity markets when we detect rising markets. When markets sell off, our risk management measures activate giving us the flexibility to shift quickly into defensive holdings. Our primary goal is to minimize material losses in portfolios. Compared to common strategic allocations, we have a low correlation to the S&P 500, lower annualized volatility, lower value at risk, and lower drawdowns. We use large, highly liquid ETFs to minimize costs, move quickly when needed, and make sure we are not capacity constrained.

We want to make sure they are constantly positioned correctly for the future. Our evidence suggests that using TPSR should enhance the risk-return profile of a portfolio, especially with the grim outlook for a traditional 60/40 portfolio over the next decade.

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If you think TSPR or any of our tactical ETF strategies could be beneficial for your clients, we would love to connect.

TPSR is a low-fee and tactical ETF strategy that uses a rules-based investment approach to either be offensive or defensive depending on market conditions. This strategy has more than five-years of audited track record and has produced strong returns with proven risk management measures by adjusting to changing markets.

¹ Market perspectives: December 2021 (vanguard.com)
² Capital Market Assumptions | BlackRock
³ Our 2022 Capital Market Assumptions | BNY Mellon Wealth Management
⁴ Long-Term Capital Market Assumptions | J.P. Morgan Asset Management (jpmorgan.com)
⁵ Asset Allocation Interactive (researchaffiliates.com)
⁶ invesco-capital-market-assumption-2022-usd.pdf

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This information is presented for illustrative purposes only. Past performance is not necessarily indicative of future performance. Investing involves risk and principal loss is possible.

McElhenny Sheffield Capital Management (MSCM) is a Registered Investment Adviser with the U.S. Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training. Important information pertaining to MSCM’s advisory operation, services, risks, and fees is set forth in MSCM’s current Form ADV Part 2A brochure, a copy of which is available upon request or at www.adviserinfo.sec.gov or www.mscm.net.

MSCM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. MSCM has been independently verified for the period January 1, 2017 through December 31, 2024. The MSCM Trend Plus and Sector Rotation Composites have each had a performance examination for the periods January 1, 2017 through December 31, 2024. The Trend X Composite has had a performance examination for the period May 1, 2017 through December 31, 2024. The TPSR Composite has had a performance examination for the period April 1, 2018 through December 31, 2024. The verification and performance examination reports are available upon request by contacting info@mscm.net.

All strategy performance results, including investment characteristics, shown in the presentation are net of the MSCM Trend Plus, Sector Rotation, and TPSR strategies’ highest model fee of a 1% annual management fee, applied 1/12th of 1% (0.0833%) each month and net of the MSCM Trend X strategy’s highest model fee of a 2% annual management fee, applied 1/12th of 2% (0.1667%) each month, and for the Trend X strategy a 20% performance fee, applied quarterly to the net profits in the account and subject to a “high water mark.” The net of fee strategy performance results are calculated by MSCM by deducting the strategy’s highest model fee from the gross of fee performance returns. Index and strategy returns are inclusive of dividends and reflect total return (TR). Index returns are not net of advisory fees, the indices are not actively managed, and it is not possible to invest directly in the index. Fees and expenses vary based on custodial relationships, trading costs, management fees, and other factors. Individual client results could significantly differ from the performance results being presented. The performance of client accounts can be more volatile at times and may not be comparable to the performance of any index. The charts, graphs, and index information shown are presented for illustrative purposes and should not be relied on to predict future movements of the market or for guidance on when to invest. Nothing in this presentation is intended to be relied on as investment, legal, or tax advice. Investors should consult their tax advisor or legal counsel for advice and information concerning their particular situation.

There can be no assurance that the strategy will be implemented as designed, or profitable, or that clients will not lose money. The tactical strategies use a variety of market indicators and stop levels that seek to identify upward or downward trends in the U.S. equity markets. If an indicator or stop level fails to detect significant downturns in the market, the strategy will continue to be exposed to underlying positions that could lose value during such downward periods. Similarly, if the indicators fail to timely identify a reversal of a downward trending market, the strategies will continue to be exposed to defensive exchange traded funds (“ETFs”) at a time when there is significant appreciation in the equity markets. Either scenario could result in the strategies underperforming other strategies that do not employ these strategies. There can be no guarantee the tactical strategies will correctly or timely identify the industries, sectors, or asset classes that will outperform during a given quarter or that the strategies will correctly or timely identify market trends. The tactical strategies invest in other investment companies and ETFs which result in higher and duplicative expenses. Investing in ETFs are subject to risks that the market price of the shares will trade at a discount to its net asset value (“NAV”), an active secondary trading market will not develop or be maintained, or trading will be halted by the exchange in which they trade. Brokerage commissions will reduce returns.

The Standard & Poor’s 500® Index (S&P 500 Index) includes 500 leading companies listed on U.S. stock exchanges. The Nasdaq Composite Index (Nasdaq Comp.) includes more than 3,000 stocks listed on the Nasdaq Stock Market and, along with the S&P 500 Index, is one of the most followed broad-based stock market indices in the U.S. The Benchmark 60/40 Index (Benchmark 60/40) is a blended index calculated by YCHARTS with a 60% allocation to the S&P 500 Index and a 40% allocation to the Bloomberg Aggregate U.S. Bond Index, a broad-based fixed income index considered to be representative of the U.S. fixed income market. The Benchmark 60/40 represents a traditional “balanced” investment allocation for a U.S. investor of 60% stocks and 40% bonds. Annualized volatility, a common measure of risk, is the standard deviation of monthly returns. Maximum Drawdown reflects maximum peak-to-trough decline in an investment, security, or index over a specific time period, as measured by the difference in the highest value during the time period and the subsequent lowest value during the time period. Alpha is the excess return of an investment relative to the return of a benchmark index. Beta is a measure of a security's or portfolio's systematic risk, indicating its volatility relative to the overall market (e.g., S&P 500 Index). R-squared is the proportion of a strategy’s price movements that can be explained by movements in a benchmark index. Sharpe Ratio measures the average return in excess of the risk-free rate per unit of volatility or total risk. Sortino Ratio is like Sharpe but focuses on downside risk. Treynor Ratio measures the return earned in excess of the risk-free rate per unit of systemic or market risk. Calmar Ratio evaluates the return of an investment over the risk of its maximum drawdown. A Chartered Financial Analyst (CFA®) charter is a designation given to those who have completed the CFA® Program and completed acceptable work experience requirements. The CFA Program is a three-part exam that tests the fundamentals of investment tools, valuing assets, portfolio management, and wealth planning. The Certified Financial Planner (CFP®) certification is a professional certification for financial planners conferred by the Certified Financial Planner Board of Standards. To receive authorization to use the designation, a candidate must meet education, examination, experience, and ethics requirements and pay an ongoing certification fee.

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Diversify beyond the AGG with MSCM's Tactical ETF Strategies

Finding Portfolio Safety in a Rising Rate Environment

Interested in learning more?

Schedule a call with our experts

Quantitive Easing

Unwinding QE

QT + Rate Hikes = Bond Problems

Inflation

Maintaining Performance in the Coming Years

Capital Market Assumptions by Institution - Forward-looking 10 Year Average Return

Interested in learning more?

Schedule a call with our experts

There is much more to learn

Our strategies are unique!

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