It’s the standard conventional wisdom offered regarding modern portfolio theory, or even regarding investing itself: Strike an acceptable balance between risk and reward. (See "The History of the Modern Portfolio.")
For most investors, that acceptable balance means placing oneself somewhere in the comfortable middle. Invest in securities of intermediate risk and intermediate return, and no one will ever decry you for squandering your life’s savings, nor for taking too modest a return. The median is the socially prudent place to be. But is it the most financially rewarding one?
Enter the Barbell Investment Strategy
The barbell strategy is a method that attempts to secure the best of both worlds. It’s possible, the thinking goes, to garner substantial payouts without taking on undue risk. The strategy’s prime directive is interesting in that it’s not only counterintuitive to a populace weaned on the benefits of tempering risk and reward, it’s unambiguous: Stay as far from the middle as possible.
Nassim Nicholas Taleb, the renowned derivatives trader and arbitrageur whose unorthodox methods enabled him to profit stupendously in 2007 and 2008 when some of Wall Street’s ostensibly sharpest cookies were getting burned, explains the barbell strategy’s underlying principle as follows:
"If you know that you are vulnerable to prediction errors, and … accept that most “risk measures” are flawed, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative."
The Long and Short of the Barbell Strategy
In practice, the barbell strategy is frequently applied to bond portfolios. Instead of risk per se, the defining criterion here is maturity. Invest in short-term bonds and long-term ones, while steering clear of maturities of intermediate length.
“Short-term” typically means under three years, while “long-term” means more than 10. The long-term side of the equation should be straightforward: investments that require an enduring commitment on the part of the investor ought to pay high interest, therefore at least one half of an optimally balanced barbell portfolio should pay a decent return. To receive an appreciable return from the other half – the short-term half – the key (and the requirement) is to constantly trade out maturing bonds for new ones.
It’s easier to understand how the barbell strategy works by contrasting it with its opposite, the bullet strategy. That’s a method in which an investor chooses a date (e.g., bonds set to mature seven years from now) and sticks exclusively with it. The major advantage to this method is that it is largely immune from interest rate movements. Also, once a bullet investor sets their maturity criteria, they can mostly forget about the investment.
Unlike the bullet strategy, the barbell strategy is not for the passive investor. By investing heavily in short-term (or ultra-short-term, or less than one year) bonds, the rapidly approaching maturity dates mean that the investor must always reinvest the proceeds. Short-term bonds need to be found, assessed, and bought once the last series of short-term bonds matures.
Also, success while administering the barbell strategy is conditional on interest rates. As the short-term components of the bond portfolio are always being traded out as they reach maturity, when rates are rising (at least over the life of the short-term bonds), the new bonds will pay higher interest than their predecessors did. And if interest rates fall, your long-term bonds save your portfolio because they’re locked in at the older, higher rates.
For example, assume an investor implements a barbell strategy for their portfolio because they think the yield curve will flatten. The investor buys five 30-year bonds, while simultaneously buying five three-year bonds. With this strategy, the investor mitigates the risk associated with an adverse move in interest rates. If interest rates fall, the investor may not have to reinvest funds at the lower prevailing interest rate because they has long-term bonds with higher interest rates.
However, if interest rates rise, the investor has an opportunity to sell their short-term bonds and reinvest the proceeds in longer-term bonds. Assume interest rates rise by 1% and the short-term bonds are maturing next month. The investor could hold on to her short-term bonds until maturity and reinvest her gains into longer-term bonds at the higher prevailing interest rate.
Stay Alert, Not Inert When Utilizing a Barbell Strategy
With a barbell strategy in place, at any given moment an investor has a) a portion of his/her money about to churn over into a new series of short-term bonds once the current ones reach maturity, and b) the remainder of the money set to pay out at a specific time in the future.
A common misconception about the barbell strategy is that like a literal barbell, the portfolio’s two sides need to balance to avoid disaster. They don’t, necessarily. Some bond portfolios optimized under the barbell strategy will have much of their value concentrated in short-term bonds, others in long-term bonds. Granted, “much” isn’t much of a quantifier, but once you get too far past a 2-1 or 1-2 split, your strategy starts to look less like a barbell and more like a bullet.
As a barbell strategy is designed to take advantage of increasing interest rates, the best time to adopt such a strategy is when there’s a large gap between short- and long-term bond yields. The theory is that the gap will eventually close and reach historical norms.
If an investment strategy exists, someone’s created a mutual fund or exchange-traded fund to track it. The first ETF designed to replicate the barbell bond strategy was developed by a Canadian investment firm in 2012 (comprised of Canadian government bonds, naturally), and more are likely to follow on either side of the 49th parallel.
Build Your Own Barbell Strategy
The beauty of being an independent investor is that you don’t have to wait for the professionals to create a fund that suits your objectives. You can apply the barbell strategy on your own, and without hesitation. One way is by purchasing separate short-term bond exchange-traded funds and long-term bond exchange-traded funds from a brokerage. The bonds in the short-term ETFs will roll over automatically.
To buy government bonds directly – specifically U.S. Treasuries – the easiest method is to go right to the source. TreasuryDirect.gov sells bonds at auction to anyone who can open up an account and isn’t legally prohibited from buying U.S. government debt. From the website, find the gamut of maturities and their current prices.
For starters, at any rate, a bond portfolio that incorporates the barbell strategy should be placed half in maturities of, say, one to three years; and the remainder in 10-20 year bonds. The U.S. Treasury sells its bonds quarterly, and at “auction,” which is slightly misleading. Large institutional investors are the ones that do the actual bidding. Once they’ve agreed on a price, the little fish purchase the bonds at the interest rate that was just agreed upon.
The Bottom Line
The barbell strategy requires a modest level of sophistication regarding the bond market, but not an overwhelming one. By investing in short-term bonds and long-term ones while staying out of the middle, you can leave yourself open for admirable returns (contingent on interest rates) while not being unduly beholden to the rate-setting whims of the Federal Reserve.