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Personal finance

Squeezing out yield in a climate of low rates

For many years, the rule of thumb for most long-term investors was 60 percent to stocks and 40 percent to bonds.

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For many years, the rule of thumb for most long-term investors was 60 percent to stocks and 40 percent to bonds.

Squeezed by historically low interest rates, a wide range of investors — from retirees living on fixed incomes to huge endowments and pension funds trying to meet budgets — are trying to figure out how to generate income.

Some Duke University undergraduates think they have the answer.

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Business and economics programs at US colleges and universities have long sponsored stock- and other asset-picking contests for their students. But last semester, faced with the current ultralow interest rate environment, Duke’s undergraduate economics department ran a competition in asset allocation for the first time. Students had to decide what percentage of assets to put in fixed-income investments and what percentage to invest in other categories. The asset management firm BlackRock was a cosponsor of the contest, which was open to any Duke sophomore or junior.

‘‘Where is someone supposed to get yield these days?’’ said Emma B. Rasiel, an associate professor of economics. ‘‘That’s what got us thinking.’’

It’s a pressing question for nearly every investor and has left even professional financial advisers scratching their heads. The United States is now in the fifth year of a low interest rate environment. Ten-year Treasurys, the benchmark US interest rate, yielded 5 percent in July 2007, just before the recession began. This week, the rate was less than 2 percent, and in July, 10-year rates were the lowest ever recorded. This week, the one-month Treasury bill, the lowest-risk bond investment because of its short duration, was yielding practically nothing: 0.04 percent.

For many years, the rule of thumb for most long-term investors was ‘‘60/40,’’ a 60 percent allocation to stocks and 40 percent to bonds. Besides having the virtue of simplicity, less volatile and lower-return bonds were meant to smooth out the riskier stock market while giving investors some of the greater possible gains of stocks. Vanguard estimates that an investor with a 60/40 allocation can expect an average annual return of 8.6 percent.

By comparison, a 100 percent allocation to stocks produced an average annual gain of 9.9 percent. A 100 percent allocation to bonds resulted in an average gain of 5.6 percent.

Given this, should investors abandon the tried-and-true 60/40 approach and move more aggressively into stocks?

“The traditional 60/40 approach to building a portfolio is on the way out,’’ said Michael Fredericks, head of retail asset allocation for BlackRock. It is being replaced, he said, by ‘‘tactical’’ asset allocation, a strategy in which investors change their allocation based on the current pricing of asset classes.

For the Duke contest, the students were asked to design a portfolio for an investor expecting to retire or begin withdrawing assets around 2020.

Alex Kim, a Duke junior from New Zealand majoring in economics, told me that he and his teammates faced the same quandary as most investors: how to generate income while minimizing risk and preserving assets. They examined model portfolios from Fidelity, Vanguard, and BlackRock.

The team’s contest entry called for allocating 43 percent to US stocks — 30.3 percent to a Russell 2000 index fund and 12.7 percent to a Russell 2000 fund that invests in midsize companies. They made no allocation to international stocks. Like more traditional models, they maintained a large allocation to fixed income but weighted it heavily toward Treasury inflation-protected securities,whose yields rise with inflation.

The result was a 9.7 percent projected annual return, with less volatility than the model funds they examined. The team ran projected returns for cases including both bull and bear markets, and their allocation outperformed the BlackRock model ‘‘in all scenarios,’’ Kim said. His team won the contest.

Financial advisers stress that all asset allocation plans need to be tailored to each investor’s circumstances and risk tolerance. Faced with the same low interest rate environment, professional asset allocators with the same time horizon as the Duke contestants have emphasized stocks over bonds.

After all the models and projections, they’ve ended up pretty close to the old 60/40 approach.

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