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Wednesday, February 21, 2018

If You Think The Stock Market Has Been A One Way Bet..Take a Look at Long Term Bonds

The long term bond market has been in a massive rally (decline in yields) for the past 10+ years.

Yields hit record lows in late 2017 before moving up of late/

  • With yields near record lows
  •  The Federal Reserve in tightening mode for the first time since the unusual measures of easing after the financial crisis, s
  • Some hints of inflation, 
  • And a massive increase in the Federal deficit and government borrowing needs
It's not hard to see that a move up in bond yields could create quite a bit of volatility in the financial markets.

10 year Treasury bond yields...(prices move inversely to yield)

It's also hard to see how any rational long term investor would have accepted yields on long term Treasury bonds locking in a rate of 2.25% or less. Which means many of the buyers of these bonds were buying them as trading positions including leveraged positions.

Price graph of the Ten Year Treasury Bond ETF (TLH) for the past ten years. It has been virtually a one way bet since the Fed reserve started its quanitative easing after the financial crisis. Not hard to see that a reversal of Fed policy would create violent changes in price.

Monday, February 12, 2018

Still Overvalued ?

I argued earlier in a post that the market  was not significantly overvalued based on forecasted earnings and economic growth. I still believe my argument holds and that returns for the year for the SP 500 would be around 7-9%..not bad considering the gains of the last 2 years.

The decline in stocks has led to a huge decline in p/e ratios based on forecasted earnings.Should earnings exceed forecasts or companies increase dividends and buy backs it would be another positive for the market.

Below is S+P 500 P/E ratio via bloomberg 

"It's Going to Be A Stock Picker and Market Timers Market'"

No doubt after the recent fluctuations in the stock market we wil hear again that the conditions are those in which active managers will  outperform their passive benchmark.

Standard and Poors regularly publishes its SPIVA report comparing the results of actively managed funds vs, their index benchmarks.

Based on the numbers seems the odds are against outperformance by those stock pickers and market quite slim.

Sunday, February 11, 2018

Risk Parity and Market Fluctuations Here's What the Creator of the Strategy and a Critic Said in 2015

Rau Dalio head of Bridgewater Associates denies claims tht the risk parity strategy that it pioneered was responsible for large market swings that occurred in August 2015.

FT Sept 16, 2015

In ts paper, Bridgewater said the exact strategy pursued by risk parity funds varied, but indicated that other volatility-targeting strategies and investment vehicles were a more likely culprit for the turmoil than risk parity. It also stressed that its All Weather fund did not adjust allocations according to spurts in volatility. “We also understand that some managers tend to sell assets when prices fall and buy them when prices rise because they believe that changes in volatility will persist, and volatility tends to rise when prices fall,” the paper said. “We do the opposite because we want to rebalance to achieve a constant strategic asset allocation mix.”
 AllianceBernstein wrote in a report before the turmoil that it was concerned at the industry’s potential to fan the flames of a broader downturn. “Should correlations turn positive, with stocks and bonds declining at the same time, the risk contribution of each one would rise. Managers would then have to sell both to maintain their risk targets. In other words, selling begets selling,” the AllianceBernstein report said

5 year chart below..note moves in fall of 2015 and again at the beginning of 2016....and how with a longer term view they were basically "noise"

Automated Tax Loss Harvesting

Both of the largest robo advisors advertises that they use automated tax loss harvesting in which they take short term losses and then buy equivalent securities thus taking short term capital gains losses that can be netted against future gains. Wealthfront says it does this through "direct indexing" i.e. trades of individual stocks. Of course each time you book one of these losses it is not a free lunch. The cost basis is lowered so the potential tax liability is higher.

I have absolutely no idea how well these robo advisors executed their strategy on Feb 5. But with a swing between highs and lows of in excess of 6% it must have been quite complicated. During the rest of the week the swings between high and low were in excess of 4% except for Feb 6.

3 month chart of  S+P 500 ETF:

Wednesday, February 7, 2018

Is a Target Date Fund Really the Best Choice for You ?

Many investors have chose a one fund fits all choice for their retirement savings: a target date fund. In fact they are the default choice for many 401k plans.

These funds contain a mix of a globally diversified index fund and a bond index fund. But a closer look at these funds particularly in a period of rising rates may show that "autopilot" may not be the right choice.

Take for example the Vanguard target retirement 2030 fund. According to Vanguard:

Vanguard Target Retirement Funds offer a diversified portfolio within a single fund that adjusts its underlying asset mix over time. The funds provide broad diversification while incrementally decreasing exposure to stocks and increasing exposure to bonds as each fund’s target retirement date approaches. The funds continue to adjust for approximately seven years after that date until their allocations match that of the Target Retirement Income Fund. Investors in the funds should be able to tolerate the risks that come from the volatility of the stock and bond markets. The 2030 fund invests in 4 Vanguard index funds, holding approximately 75% of assets in stocks and 25% in bonds. You may wish to consider this fund if you’re planning to retire between 2028 and 2032

Here is a one month chart of the fund vs the vanguard S+P 500 index fund (VFINX)
through Feb 5 

charts via bloomberg

And here is a description of the target 2020 fund

Vanguard Target Retirement Funds offer a diversified portfolio within a single fund that adjusts its underlying asset mix over time. The funds provide broad diversification while incrementally decreasing exposure to stocks and increasing exposure to bonds as each fund’s target retirement date approaches. The funds continue to adjust for approximately seven years after that date until their allocations match that of the Target Retirement Income Fund. Investors in the funds should be able to tolerate the risks that come from the volatility of the stock and bond markets. The 2020 fund invests in 5 Vanguard index funds, holding approximately 55% of assets in stocks and 45% in bonds. You may wish to consider this fund if you’re planning to retire between 2018 and 2022.

and a chart.vs the vanguard S+P 500 index fund (VFINX) one month through Feb.5

These funds are performing virtually identically to a portfolio that would be 100% S+P 500 yet they are designed--or investors expect-- that they will be less volatile and perform better in a sharp stock market downturn than an all stock asset allocation.

So what's going on ? The bond allocation in these funds is composed of a single index fund: the Vanguard aggregate bond index fund. That fund is a mix of bonds and has a duration of 6.1 which means that the value of the index will fall 6% when interest rates rise by 1%. That number represents total return (price change +interest earned) Clearly with the current rise in interest rates and an expectation continuation that this will continue the bond part of this portfolio and thus the fund could have some unpleasant returns.

The achilles heel of these funds is that although they reduce the exposure to the stock market in the overall stock/bond allocation of the fund to make it less subject to stock market does not make any adjustments to reduce volatility within the bond holdings of the fund.

How could such a risk reduction be accomplished ? Even using the basic stock/bond allocation of the fund the level of risk in the bond market part of the allocation could be reduced by shortening the duration of the bond allocation either by adding to or replacing the current holding with a short term bond fund. One example might be the Vanguard Short Term Bond Index Fund (VBISX) which has a duration of 2.7 years. Other funds or ETFs could further modify the overall duration of the bond allocation,

Another strategy might be a "ladder of individual CDs or bonds extending over several years.An alternative to that option would be the use of bulletshares ETFs which would give a diversified portfolio within each maturity,

Tuesday, February 6, 2018

Market Volatility is Tough For Robo Advisors to Handle

via Investment News

Robo-adviser websites crashed as market slid

Wealthfront, Betterment websites went down Monday, cutting clients off from accounts

By Bloomberg News   |  February 5, 2018 - 5:47 pm EST
Robo-advisers haven't had much experience with market routs. When confronted with one on Monday, they struggled.
The websites of two of the country's biggest robo-advisers — Wealthfront Inc. and Betterment — crashed as the S&P 500 Index sank 4.1%.
Complaints quickly spread across Reddit and other internet sites from people who had trouble logging onto their accounts. "Really?" wrote @jlpatel23 after he received a message from Wealthfront saying its site was down.
The glitches represent a setback for a niche of the financial market industry that has been booming of late as people have become more comfortable making investment decisions without speaking to human advisers.
Wealthfront acknowledged in a statement that its clients lost access to their accounts for "a short period of time today" and said it's working to ensure that "clients don't experience this again."
Betterment didn't immediately respond to requests for comment. Back in June 2016, during the Brexit fallout, Betterment had told users that it instituted a "short delay in trading" to protect its users from a "potentially erratic market." No such statement was issued by the company in this case.
This is particularly worrisome not only because a similar glitch occurred during a the last major one daymarket move (7 months ago). But also because it calls into question the actual structure and implementation of the activities of these providers.
These robo advisors are neither platforms for individuals to conduct trading nor are they regulated mutual funds. Thus they don't follow under the same scrutiny. They are registered investment advisors who almost  never implement strategies that involve short term trading. Yet they manage assets in a manner at times potentially more akin to a  a hedge fund with short term trading based on an algorithm..but don't have the same transparency.
They have also grown extremely quickly to assets under management in the area of $10 billion but have minimal experience in executing their market strategies in the financial markets.
The Perils of Tax Loss Harvesting
A key selling point of the robo advisors is that constantly review accounts for "tax loss harvesting opportunities' done on an ongoing even in some cases intraday basis. In order to do this a firm would need to have extremely sophisticated monitoring and trading capabilities Each account would need to be examined for individually (since there would be virtually endless permutations of cost basis and purchase date) and then thousands of buys and sells.
Given that these companies' systems were overwhelmed in simply keeping the client interface up and running it seems doubtful the necessary computer firepower to do that tax loss harvesting would be in place.
Furthermore the tax loss harvesting on a day like yesterday would have likely had little real economic benefit. Over the course of the day for instance there would have been "opportunities" to sell to harvest short term losses in accounts that made purchases in periods since the beginning of 2018, Upon the sale a new purchase of an "equivalent security" would need to be made. 
Later in the trading day security would have dropped furhter with a new "opportunity to tax harvest" with another paired trade. This would have to be executed across a range of ETFs that cover the same asset classes, At the end of the day there could have been 10s if not hundreds of trades across a portfolio composed of 10 or more ETFs in a portfolio from Betterment. 
At the end of all trade trading an investor could be left with a large number of short term capital losses, or a simply a large number of transactions which had the end of the day accomplished nothing as gains offset losses. 
If there were net losses on the accounts it is possible that for a larger investor  the losses would be larger than the $3,000 that is deductible each year. Those losses would be carried over to the next year and based on Betterment's explanation of its strategy it would be equipped to manage harvesting of the losses carried forward to maximize.
Furthermore if the market recovers from the levels at which some of the purchases were made the accounts now hold shares at a lower cost basis and higher potential tax liability than if nothing was done at all.
And then there is the issue of transaction costs. Each time a tax loss harvesting trade is made there is a buy and a sell and thus a spread paid on each trade. These costs on dozens if not hundreds of trades in an account could easily eat into whatever tax benefit might theoretically exist for the strategy. 
There is an additional unseen cost of slippage. The tax loss harvesting strategy is based on executing the two trades without a discrepancy in movement in the market. For example to be done correctly and seamlessly the sale of one total market etf that is down 1% should be offset by another total market etf when it is also down 1% if not there is what is called "slippage" and the strategy has not been optimized.
For Wealthfront the trading challenge is even greater. Their strategy of "direct indexing" means that in place of ETFs in several asset classes it owns individual stocks. And in their "tax loss harvesting" they will execute hundreds is not thousands of trades in an individual portfolio on a day like yesterday. And of course the issues of spreads and slippage are far greater than in the case of Betterment.
The challenges outlined above would be massive for a large well established investment firm with decades of experience creating portfolio management systems and large staffs of professionals with technical and market experience. And even in the case of those firms we have seen major "glitches".
Both Betterment and Wealthfront have grown to around $10 billion each in assets under management in a very short period of time. Their staffing comes almost exclusively from people with not experience in the financial markets and asset management.

Wealthfront and Betterment addressed the outages although Wealthfront did not address issues related to their complex "direct indexing strategy". And of course it is impossible to know what transactions costs or slippage were encountered.
Wealthfront admits in a statement that its clients couldn’t access their accounts, but only for a brief period of time Monday, and that the firm is working on a fix to prevent this sort of outage from happening again, Bloomberg writes.
A Betterment spokesman, meanwhile, tells the news service that the robo’s clients had trouble logging in for around 30 minutes yesterday afternoon, but that account activities such as rebalancing and tax loss harvesting went on uninterrupted. Vanguard’s spokeswoman tells Bloomberg that only “some” of its clients “may have” run into “sporadic difficulty” getting into their accounts online and over the phone. And a Schwab spokeswoman tells the news service its clients had delays logging in for just a few minutes, due to increased demand.