In part two of AB’s “Build a Better Path” Disruptor SeriesTM, we shifted from diagnosing the challenge of long-term investing to a potential approach for solving it. With practical, actionable steps, investors have the potential to translate the concept of improving up/down capture into strategies aimed at improving portfolio design. Here’s a summary of the discussion.
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A Third Investing Dimension: The Sequence of Returns
As we discussed in part one of “Build a Better Path,” enhanced up/down capture offers a potential avenue for improving the path of portfolio returns. But to do that, investors must take a broader perspective to assessing risk and return.
Think of a typical scatter plot that arranges investments by their average volatility and average return along X and Y axes, respectively. In looking to improve the path of returns, we think it makes sense to add a third dimension—let’s call it “Z.” This variable describes the order of investment returns over time. If we think about it this way, improving portfolio design becomes about more than return and volatility—it also involves seeking to improve the sequence of portfolio returns.
Two portfolios could have the same average return and similar volatility but deliver very different outcomes if one has a more favorable return path—for example, a less severe downturn if a bear market happens early on. As we see it, a key element in that better sequence is designing a strategy with better up/down capture. The good news is that there are concrete steps to take: identify better betas, assemble them efficiently and incorporate sources of alpha.
Better Betas: Improving on Basic Building Blocks
At their simplest level, betas are the fundamental market exposures in a portfolio. They could be a combination of large-cap equities, emerging-market stocks, government bonds and other investments. But not all betas are alike, and we believe that some of them have attributes and behaviors that could deliver better up/down capture over time.
In the equity world, for instance, many investors seek quality companies for their potential staying power. In our view, quality is a better beta. While it has lagged the S&P 500’s narrow market leadership lately, its longer history is more compelling, and quality stocks have rebounded effectively after downturns. Of course, quality has different definitions, and as with all better betas, we think the distinctions make a difference.
Then there are dividend growth stocks, with their regular income streams. Companies that can sustain and grow dividends, in our view, offer a better opportunity. Defensively oriented low-volatility equities may also help mitigate market downside. Value stocks have struggled since the global financial crisis but have rebounded lately as the supply chain of AI creates new opportunities. Value is arguably the original better beta, dating back to Graham and Dodd security analysis and the Fama-French value factor.
High-yield bonds are an interesting case. They live in the bond world but have historically acted equity-like because they’re similarly driven by economic growth and corporate profits. High yield also provides income payments that are contractually obligated. These provide not only return potential but also a possible cushion in equity downturns. Short-duration high yield, typically less volatile than the broad high-yield market, may refine that upside/downside profile.
Enhancing Portfolio Assembly with Efficient Structures
Better beta building blocks offer potential individually, but they also have different return drivers, so they haven’t historically moved in lockstep. This, from our perspective, gives them the potential to help diversify the return path—what we refer to as the “Z dimension.”
In part one, we discussed how a poor return sequence with a sizable market downturn early in retirement could hurt a retiree’s ability to make income last. A more efficient portfolio structure with better up/down capture than a traditional 60/40 stock/bond portfolio might have enabled assets to last through 30 years in retirement instead of running out at age 90 (Display).
Finding Alpha in Investing Skill…and Other Sources
Beyond better betas and efficient structures, the financial world offers opportunities to further improve the return path through outperformance, or alpha.
One well-known source of alpha potential is the skill of active managers—selecting specific securities, managing portfolio exposures and adapting those exposures to changing market conditions. Historically, the chances of generating alpha have tended to be more favorable in parts of the market that are less efficient, such as high-yield bonds and small-cap stocks.
But alpha can come from noninvestment sources, too, and that’s important. They include seeking to improve after-tax returns by managing when capital gains are realized, harvesting tax losses and being deliberate about asset “location.” For example, putting less tax-efficient assets into tax-advantaged accounts and more tax-efficient assets into taxable accounts may preserve more of a portfolio’s after-tax return. Because these sources tend to be structural, we think they could be more persistent.
In our view, alpha doesn’t have to be heroic—in fact, that goes for the other techniques aimed at building a better path. Even modest enhancements from better betas, efficient structure and targeted alpha might add up if they can be delivered consistently. We believe that over the long haul, this approach has the potential to deliver better outcomes.
AB's Disruptor Series is designed to provide distinctive perspectives on critical issues facing capital markets today.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.
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