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Tuesday, May 27, 2008

Inflation and Bond Investing

Food for Thought

Bill Gross of Pimco the world’s largest fixed income manager issues periodic analysis of the markets and the economies. The newly released newsletter is a particularly good one and is highly recommended.

Gross has been in the high inflation camp for several years and in the current piece he levels a high degree of skepticism about official government inflation numbers. He points to data for a representative group of countries developed and emerging which shows an average inflation rate of 7% for both the last 10 years and the past 12 months. Official US government inflation rate for those 2 periods: 2.6% for the last 10 years, 4% for the last 12 months. Gross (and I would agree) find that gap not credible.
Two graphs from his newsletter are at the top of this post.

Gross’ conclusions for investors make sense. Since we are not traders we have integrated emerging market foreign securities and commodities into our portfolios for quite a long time. While Gross’s caveats with regards to TIPS are valid they still make sense in a portfolio and as he notes are far superior to conventional treasuries.

A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate…..

What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.
As for his positioning in his bond fund, Gross (see below as reported in the Financial Times) is implementing his view that US treasuries are extremely unattractive given their negative real yield. Instead he has moved into mortgage backed debt based on the yield spread over treasuries and what he perceives as a strengthened implied government guarantee for Fannie Mae and Freddie Mac. Our portfolios have moved into mortgage backed securities in a more cautious manner by investing in a GNMA bond fund. GNMAs are mortgages which carry the full faith and credit of the US treasury (unlike fannie and freddy) yet it seems the mere word “mortgage has scared away investors and pushed up yields. The Vanguard GNMA fund currently yields 4.76 vs 3.20 for their equivalent maturity treasury bond fund

Pimco's Gross makes big mortgage debt bet
By Deborah Brewster in New York
Published: May 23 2008 03:00

Bill Gross, the manager of the world's biggest bond fund, has switched gears to make a big bet on mortgage debt, almost tripling his holding of it to more than 60 per cent of the fund…..
Mr Gross said his decision to raise exposure to mortgage debt in recent months was based on the US government's implicit guarantee of Freddie Mac and Fannie Mae, the government-sponsored mortgage agencies.
"Government policy is moving to sanctify the status of the government-sponsored agencies . . . it became a question of which institutions would be sheltered by the government umbrella," he said…..
Mr Gross said Pimco was buying primarily mortgage agency debt and "not the subprime garbage"…..
Mr Gross was heavily overweight US Treasury bonds in the early 2000s but is now scornful of them and the fund is using derivatives to gain from any downturn in Treasuries.
He called Treasuries "the most overvalued asset".
"If there was a bubble, the -popping has produced a counter-bubble in quality securities. The safe haven has been way overdone. Treasuries are yielding 2 to 3 per cent, there is no real return on that at all," he said.
"This is an asset class that is held by sovereign wealth funds and central banks . . . but that is not any reason to follow them

Wednesday, May 21, 2008

Advice on Inflation Protecting Your Portfolio in the NYT: Proceed With Caution

An article in the May 18 NYT reviewed investors’ options for insulating a portfolio from the effects of inflation but it contained a number of inaccuracies, some of which I will review below

May 18, 2008
How to Stop Inflation From Devouring a Portfolio

Is inflation roaring back with a vengeance? It depends on whom you ask.
“The experience we have had in recent years harks back to the 1970s,” when commodities prices surged, said Zvi Bodie, a professor of finance and economics at the Boston University School of Management. He recommends that investors reposition their bond portfolios, in particular, to try to minimize the ravages of inflation.
The above contains some good and some not so good advice. First off, making changes in a bond portfolio based on a forecast for inflation, just like any other type of market timing is usually a poor move. On the other hand, Prof. Bodie’s suggestion that bond portfolios be positioned to protect against inflation is good advice indeed. And it makes sense in a long term allocation regardless of one’s current economic forecast.
But some strategists say the weak economy may help moderate inflation later this year. “What is holding inflation down, even to this elevated level, is the sluggish economy,” said Stuart A. Schweitzer, the global markets strategist at JPMorgan Private Bank. “And I think growth is likely to stay quite sluggish all this year, in which case inflation should come back down.”

The above is simply an economic forecast, a thin reed to hang an investment strategy on.

In either case, many strategists say that there are few attractive options for investors who may worry most about inflation, like retirees and others who rely on their portfolios to supplement their incomes.

I would label the above statement extremely imprecise if not just plain wrong. In fact there is an investment that would shield retirees from inflation’s ravages. Certainly it provides protection that is even better than the inflation adjustment to social security or most private pensions.

The instrument is TIPS: Treasury Inflation Protected Bonds. These bonds pay a fixed rate (the real return) in addition to an inflation adjustment based on the govts consumer price index (CPI U) thus the bonds return is guaranteed to keep up with the CPI plus pay an addition real return. So an investor holding these bonds would receive a current return based on the CPI (3.9%) + the real return of (currently 1.5% for the ten year bond) That is attractive relative to social security which adjusts to the CPI and most inflation protected pensions which are similarly adjusted. By comparison the current conventional 10 year Treasury bond pays 3.84% with of course, no inflation adjustment. On this bond your interest does not even cover inflation. In economist’s lingo there is “negative real return”.

For bond investors the great enemy is inflation particularly when it creates a situation such as we have presently for treasury bonds: a negative real return. In many ways TIPS are the “perfect” fixed income investment. Even if they do not completely replace conventional bonds in a portfolio they certainly merit a significant allocation. The bonds can easily be bought in low cost mutual funds or etfs.

In my view Professor Bodie is quite right later in the article:

…. Professor Bodie is still a big fan of Treasury inflation-protected securities, or TIPS, as well as municipal and corporate bonds that also adjust for inflation. These bonds are often regarded as an alternative way to protect a portfolio from inflation, because of regular adjustments in the bonds’ principal based on changes in the Consumer Price Index.

In fact, he said he would not personally own any bonds now that did not adjust for inflation. “I don’t have to guess with TIPS,” he said. “I can lock that inflation-adjusted return in today.”

Professor Bodie is a major advocate for very large holdings of TIPS in investors’ portfolios in a recent book Worry Free Investing.

As noted below, TIPs have recently had a large runup in price pushing the real yield to historically low levels. While this may not be the best instant to buy TIPs it doesn’t do much to diminish their long term attractiveness.

Compared to the long term argument in favor of TIPs based on the structure of the instrument the comments of JP Morgan’s Mr. Schweitzer seem relatively flimsy

Schweitzer pointed out that inflation-protected bonds have already had a very good run. The Morningstar category for inflation-protected bond funds shows that they have returned 11.5 percent, on average, in the last 12 months. Although these bonds may be good for capital preservation, Mr. Schweitzer said that their current rich prices might mean that they will generate disappointing returns in the coming years — unless, of course, the economy is entering a long period of high inflation.

Mr. Schweitzer definitely shows his colors as a two handed economist as he argues inflation protected bonds (tips) may not be a good investment going forward…..or maybe they will.

Another often touted strategy to protect a portfolio is to invest in commodities, particularly gold. The growth of efts and etns (exchange traded notes) tied to individual commodities such as gold,silver and oil or commodity indices has made it far easier to invest in commodities. While it is true that commodities generally rise with inflation. This hedge is certainly not perfect.

Several fund companies have begun offering “real return” strategies in mutual funds that invest in TIPs. Commodities and real estate in with the goal of beating inflation. One major fund company (Fidelity) has a full page ad in the same Sunday issue of the NYT (could that be mere coincidence) for a “strategic real return fund…”that’s designed to outpace inflation”. The fund has only been in existence since September 2005 but the results do not seem particularly encouraging: a return of 4.83 through the end of the first quarter vs. 11.54% for the vanguard inflation protected bond fund. There is a longer track record for another real return fund: The PIMCO Real Return Asset fund. Its one year return is 12.83. The fund ’s 5 year return is 8.14% vs. the vanguard inflation protected bond fund’s 6.27%. But that return comes at considerably more risk: the volatility (as measured by standard deviation ) of the Pimco fund is 8.43 vs. Vanguard’s 5.03.

While it is true that the two asset classes that consistently are positively correlated with inflation are TIPs and commodities, it would probably serve and investor to purchase these two asset classes directly and at lower cost than by purchasing the active managed “real return fund. As is usually the case with an actively managed fund one the investor is paying a higher management fee and is counting on the active manager who will be actively switching between holdings of commodities, tips, real estate and conventional bonds. The PIMCO fund must be altering its strategy at a rapid rate, its portfolio turnover is 489% (!)

Current market conditions for those trying to add inflation protection to their portfolios are difficult. They are a bit late to the party as commodities have increased sharply in value and have been particularly volatile. The real yields on TIPS are at historically low yields a consequence of high inflation expectations and low yields on conventional treasuries. Nonetheless the TIPs are surely more attractive than the conventional treasuries.

Prof Bodie is not far from the mark in stating:
“The bottom line is there is no free lunch,” he said. “If you try to protect yourself against inflation with either or both of these approaches, then you have to either give up return,” by accepting the lower yields that are now available on TIPS, “or take on more risk” in the commodity markets.

His advice certainly makes more sense than this:

“If you are looking to outpace inflation, you should be investing in stocks,” said Sam Stovall, the chief investment strategist at Standard & Poor’s.
For the moment, Mr. Stovall recommends underweighting bonds while maintaining a neutral position on stocks.

The above strategy points out the difference between a long term strategy and a trading orientation. Only 2 asset classes: TIPs and commodities have a long term positive correlation with inflation (i.e. they move up with inflation). US stocks have a negative correlation.

Here’s more of Stovall’s advice :, if an investor keeps 60 percent of her total portfolio in stocks, he might advise that she keep 25 percent of the total in bonds and 15 percent in cash. His usual recommendation would have been to put 30 percent of the portfolio in bonds and just 10 percent in cash.

This”strategy" has nothing to do with a structured strategy to offset inflation as can be seen by the lack of any mention of TIPs in the bond portion of the portfolio.
Moreover, Mr. Stovall said that once investors felt comfortable enough to put more money into the markets, they should buy stocks rather than bonds.
And here is another market guru, ostensibly an expert on inflation and investing who makes a market call rather than recommending a strategy for limiting inflation’s hit on a portfolio.

Jim Floyd, a senior analyst …, who edits Inflation Watch, a monthly newsletter for Leuthold, said he was most concerned about sky-high commodity prices.
Mr. Floyd recommended taking a fresh look at some stocks that have suffered recently. He said that there might be opportunities in consumer products, utilities and financials, including insurance companies, banks and real estate investment trusts. “You want to buy the companies that are beaten down before the good news comes out,” he said.

Another analyst who I generally hold in high regard reaches a conclusion which I find puzzling

Ed Yardeni, the president of Yardeni Research, based in Great Neck, N.Y., said he thought that commodity prices could have further to run. He cited rising demand in developing nations like China and India, combined with dwindling discoveries of raw materials that are relatively easy to extract.
But he warned individual investors against buying commodities, for example, through one of the scores of commodity exchange-traded funds that have sprouted in recent years. Commodity prices are so volatile, he said, that individual investors who bought them would probably not sleep too well at night.
Instead, he advised investors to take a page from the San Francisco gold rush.
If you are an investor who thinks that the commodity boom is far from over, he said, “don’t get yourself dirty digging for gold; open up a shop that sells picks and shovels.”

He said that such “pick-and-shovel” stocks include shares of oil-field services companies, specialty chemical manufacturers, fertilizer makers and other companies that provide the materials or services on which the mining and agricultural industries rely.

I’m not sure I understand all the logic here. Yes commodities can be volatile, but Mr. Yardeni thinks they are likely to go higher. That would seem to me to argue to hold a relatively small allocation in commodities and to rebalance on an ongoing basis, reducing the position and consequently reducing risk on big increases in price and adding on price drops.

The pick and shovel companies he describes might be interesting for stock pickers, but there certainly is more risk that they will disappoint as inflation hedges compared with directly buying an etf based on a basket of commodities. Any number of factors independent of commodity prices could affect the returns of these stocks.
In sum, it seems the best strategy to add some inflation protection to a portfolio is the same as it is for most asset classes: keep the portfolio balanced and invest in instruments that have low costs and transparency and are invested directly in the asset class. In the this case it would be a low cost inflation protected securities fund or etf and a low cost commodity index exchange traded fund or note.

Wednesday, May 7, 2008

Wisdom From the Oracle of Omaha

When presenting the arguments for indexing to clients or prospects I often encounter the objection “what about Warren Buffett”. In fact Buffett has often advised prospective investors to invest in index funds. Such was the case at last week’s annual meeting of Berkshire Hataway. Where Jason Zweig of Money magazine reports, the following exchange took place.

Asked what's in store for the economy, Buffett said he doesn't have a clue and doesn't care.

"I haven't the faintest idea," he said. "We never talk about it, it never comes up in our board meetings or other discussions. We're not in that business [of economic forecasting], we don't know how to be in that business. If we knew where the economy was going, we'd do nothing but play the S&P futures market."

His simple point: As an investor, you don't need to predict the economic cycle (or even pay much attention to it). Instead, you should focus on evaluating individual businesses if you pick your own stocks -- or, simply buy the entire market in the form of an index fund. When a shareholder asked for the single best specific investment idea Buffett could recommend to an individual in his 30s, Buffett said: "I would just have it all in a very low-cost index fund from a reputable firm, maybe Vanguard. Unless I bought during a strong bull market, I would feel confident that I would outperform...and I could just go back and get on with my work."

Buffett also downplayed expectations that he would outperform the overall market going forward. It is also important to note that Berkshire Hathaway’s low funding costs (it basically takes in insurance premiums and invests them), attractive tax status for his insurance entity, heavy investment in privately held companies (which are not marked to market on a daily basis like a mutual fund’s holdings) make a direct comparison between Buffet’s results and those of an open end mutual fund impossible.

One more puzzling thing came out of this year’s annual report . Many indeed have called the Oracle of Omaha incredibly perceptive when he wrote this well before the current financial crisis.

I view derivatives as time bombs, both for the parties that deal in them and the economic system.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multimillion-dollar bonus or the CEO who wanted to report impressive 'earnings' (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade and eliminate bumps for individual participants. On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
-- Warren Buffett's Letter to Investors, Berkshire Hathaway 2002 Annual Report

Yet here’s what came out of this year’s financial results:

May 3, 2008
Derivatives Hurt Profit at Berkshire Hathaway
OMAHA (Reuters) — Berkshire Hathaway, Warren E. Buffett’s investment company, said on Friday that first-quarter profit tumbled 64 percent, hurt by $1.6 billion of pretax losses tied to derivatives contracts….
Net income fell to $940 million, or $607 a Class A share, from $2.6 billion, or $1,682, a year earlier….
The derivative losses stemmed from Berkshire’s exposure to contracts aimed at making money if junk bonds stayed out of default and stock indexes rose.
In February, Mr. Buffett revealed that Berkshire ended 2007 with $40 billion of exposure to 94 of these contracts.
Berkshire said it had a $1.2 billion unrealized loss on put options it wrote on the Standard & Poor’s 500-stock index and three foreign stock indexes. It also reported a $490 million unrealized loss on contracts that require payouts if some high-yield bonds default from now to 2013. Other contracts brought the net loss in derivatives down to $1.6 billion.
Accounting rules require the company to report unrealized gains and losses in earnings regularly, Berkshire said.
The exposure may at first seem odd given that, in his shareholder letter in 2003, Mr. Buffett called derivatives “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
But in his letter this year, Mr. Buffett said Berkshire had already been paid for its derivatives contracts, giving it cash to invest, and that “there is no counterparty risk.”
He also said shareholders should be prepared for gains and losses that could “easily” top $1 billion in a given quarter.
Curious, to put it mildly, it seems even the "rock solid" portfolios contain ticking time bombs