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Thursday, September 30, 2010

Active Bond Fund Investors Beware :Your Fund May Be More Risky Than You Think

 That actively managed bond fund you own may be more risky than you think The wsj reports

my bolds my comments in blue

How Safe Is Your Bond Fund?

A Change in How Portfolios Are Rated Gives More Weight to Risky Holdings

Your bond fund may be riskier than you think.
For years, the fund industry and research firms such as Morningstar Inc. have assessed the safety of bond funds by analyzing their holdings' underlying credit quality. Now, amid concerns that the measurement could understate the risk that the bonds will blow up, Morningstar has changed its methodology to count lower-rated bonds more heavily.
The move—which took effect Sept. 1—means that more than half of the domestic taxable bond funds tracked by Morningstar saw their so-called average credit-quality ratings fall under the new methodology.
In some cases, people who thought they were investing in an investment-grade bond fund may find themselves in a portfolio whose credit risk is more like a junk-bond fund, says John Rekenthaler, Morningstar's vice president of research.
About 43% of bond funds fell by one credit grade and about 13% dropped by two credit grades, according to Morningstar. A few funds—including Federated Real Return Bond Fund, Cavanal Hill Intermediate Bond Fund, Neuberger Berman Short Duration Bond Fund and TCW Short Term Bond Fund—dropped by more, in some cases to non-investment-grade ratings, such as BB, from investment-grade ratings, such as AA. (See table.)

Of course it's the lower credit quality of the assets not the manager's skill that likely accounted for the higher returns of thse funds compared to those short term bond funds that held higher qusality assets such as a short term treasury fund.. That has worked well recently as credit spreads ahve narrowed. But of course when a crisis hits the lower credit quality bonds will suffer. And given that many investors view short duration bond funds as the stable core of their portfolio...that could lead to some unpleasant surprises.

 ....the percentage of domestic taxable bond funds that had average credit ratings of "AA"—or investment-grade status—fell to 13.85% under the new methodology from 36.38%. Funds with average credit ratings of "BB"—or junk-bond status—more than doubled to 13.36% under the new system from 5.49%. "If the credit rating moved down more than one notch, I'd look closely in making sure you understand the strategy of the fund," says Morningstar's Mr. Rekenthaler. "If it only moved down a notch, I wouldn't worry about it at all."
Bond funds that invest mainly in corporate bonds and private mortgages were generally the most affected, he says. Funds that employ a "barbell" investing strategy—investing in extremely safe investments at one end and higher-risk investments at the other—also tended to see big drops in their average credit-quality ratings.

I doubt many individuals investors have the time or the skill to drill down on the strategy of their active bond fund manager and even if they did the data they would be using would be quarterly in arrears so it would not give a real time view of the fund holdings and strategy.

My solution: invest in a bond index fund or etf you will have total transparency and know exactly the characteristics of your portfolio in terms of duration, maturity, and credit quality.

Wednesday, September 29, 2010

Active Equity Fund Investors Beware The End of Quarter Window Dressing !

Just caught an analyst explaining how the end of the quarter always features active mutual fund managers engaging in "window dressing". What does that mean ? These managers increase their holdings in stocks that have best performed during the quarter. "Even though they haven't owned the stocks during the period when they went up" the CNBC reporter noted "correct" responded the money manager being interviewed.

In other, words that quarterly report from the active fund manager listing his holdings tells you nothing about what he held over the course of the quarter. And you really never know what the fund owns,

Of course non of the above holds for index funds and etfs Although the index fund investors will doubtless benefit from the window dressing particularly a shift from cash to equities. That only holds forever for investors that are not engaging to activity simiilar to the window dressing by purchasing what has gone up in the previous quarter.

Wednesday, September 22, 2010

About Those Performance Chasing Individul Investors Moving from Stocks to Bonds...

Here are total  returns for three months through yesterday:

 3 Months

Total Bond Index etf (AGG) 2.7%
Total Stock Index (VTI) 4.6%
Emerging Mkts (EEM) 10.1%
Small Cap Value (VBR) 3.2%
SP 500 (SPY) 9.2%

 12 Months (chart below)

Total Bond Index etf (AGG) 7.9%
Total Stock Index (VTI) 9.7%
Emerging Mkts (EEM) 14.3%
Small Cap Value (VBR) 10.4%
SP 500 (SPY) 9.2%

Tuesday, September 21, 2010

Think You Know What You Own When You Own An Actively Managed Bond Fund ? Think Again

Bonds form an important part of one's asset allocation. That allocation can include bonds of varying credit quality and maturity. But it is important to know the composition of one's bond allocation with regard to these characteristics. The best way to do this is to purchase bond etfs which are designated to match the characteristics of a particular bond index.

Yet many bond investors purchase actively managed bond funds often it seems engaging in performance chasing. Yet because these funds can often engage in purchases any time of bonds and sometimes can even short bonds, invest in credit derivatives or even hold equities the investor never knows exactly what he owns, As a consequence he never knows the risk parameters of his portfolio . Rather than having his bond holding as a stable counterweight to his equity holdings the investor is simply betting on the skill of the fund manager. In addition to the equity risk and fixed income market risk in a portfolio composed of bond and stock index instruments the holder of actively managed "go anywhere' bond funds has added "manager risk".

Today's wsj gives evidence (my bolds and comments in blue)

After rushing to the safety of Treasurys this year, Bill Gross of bond-fund company Pacific Investment Management, or Pimco, and Jeffrey Gundlach of DoubleLine Capital in recent months have pared back their holdings of U.S. government debt.

 This one is particularly shocking that bond alliocation in your protfolio which is invested in a major actively traded bond fund might actually be short treasury bonds:

Meanwhile, for the first time ever, fund firm Dodge & Cox is shorting Treasurys futures in some of its bond portfolios, betting they will fall in value, mainly as a way to manage interest-rate risk, said Daniel Culloton, associate director of fund analysis at research firm Morningstar. Dodge & Cox declined to comment.

If you are invested in the world's largest bond fund it would be difficult for you to know where your bond exposure is since it changes so drastically

In Pimco Total Return Fund, the world's biggest bond portfolio with about $248 billion in assets, U.S. government-related holdings fell to 36% at the end of August from 63% in June, according to Pimco's website. The holdings include Treasurys, Treasury inflation-protected securities and agency securities, among other things. A Pimco spokesman declined to comment.

The same would be the case for holders of the fund of one of the mutual fund world's "hot" bond fund managers:

DoubleLine's chief executive and co-founder, Mr. Gundlach, who predicted in June that the 10-year Treasury yield would fall to 2.5% or lower, reduced his positions in government-backed securities in DoubleLine Core Fixed Income Fund to 36% in August from 52% in July. The changes weren't prompted by a bearish view on Treasurys, Mr. Gundlach told investors in a conference call last week, as much as by the alternative opportunities available.

and if you hold the core bond fund from another fund company you now own a health chunk of non US bonds:

Meanwhile, managers of the Loomis Sayles Bond Fund, which is up 7.7% year to date through August, have been buying longer-term, investment-grade corporate bonds, as well as bonds from other countries, such as Canada, which the team believes to be in better fiscal shape and will benefit from growth in emerging markets, said Matt Eagan, one of the portfolio managers of the fund.
It seems pretty clear that holding actively traded bond funds to a portfolio can add plenty of extra risks there is only one sure way to avoid this: own exchanged traded funds tied to an index that are tied to a particular sector of the market. That is the only way to clearly know at all times the composition of one's bond holdings in terms of duration, issuer, and credit quality.

I caught a commentator on the morningstar website who observed that while there is a trend of funds flowing out of actively managed equity funds into etfs but no such trend in fixed income indicating perhaps that investors feel that active management works better in fixed income than in equities. Perhaps what s actually happening is that investors are chasing performance. Their money is flowing to actively managed funds with high returns,. And we know that the actively managed bond funds with the highest returns have been those that have been rewarded for taking the biggest risks in terms of long duration and high credit risk.

So far the strategy has paid off. But do the investors know the risks inside those actively managed bond portfolios ?

And how many of those managers will be as skillful in a bear market for bonds as they were in this great bull market ?

How many active bond fund investors will find out that they were "fooled by randomness" after all everyone is a genius in a bull market.

Who Is Benefitting Most From All Those Purchases and Issuance of Corporate Bonds...

....seems it may turn out to be the stockholders not the bondholders. Bloomberg reports that stock buybacks funded by the proceeds from those bonds are booming:

my bolds my comments in blue
Record-low interest rates are stoking the biggest increase in U.S. share buybacks ever.
American companies announced $55.9 billion in repurchases since June, data compiled by Birinyi Associates Inc. show. That adds to $93.5 billion in the second quarter and $108.3 billion during the first three months of the year, compared with $125 billion in all of 2009. Corporations are using debt to pay for buybacks after the average yield on U.S. investment grade bonds fell to an all-time low of 3.70 percent last month, data from London-based Barclays Plc show.
Companies from Microsoft Corp. to PepsiCo Inc. and Hewlett- Packard Co. are taking advantage of low-cost financing, purchasing their stock to boost per-share earnings at a time when the Standard & Poor’s 500 Index trades at a 24 percent discount to its average valuation since 1954......
“It’s so cheap to do it now in the bond market: issue debt, fix their cost of capital, then shrink the number of shares outstanding,” said James Swanson, chief investment strategist at Boston-based MFS Investment Management, which oversees about $197 billion. “The markets are almost calling for them to do it.”
Fivefold Rise
It seems the corporate cfos still remember what they learned in corporate finance class with regards to cost of capital even if individual investors don't quite understand risk and reward on bond investments,

Buybacks let firms boost per-share profits by reducing their equity base and may indicate executives find their stock undervalued. .....

....“Oftentimes, you’ll see a debt issuance almost simultaneously with a share buyback announcement,” said Guy Lebas, chief fixed-income strategist and economist at Janney Montgomery Scott LLC in Philadelphia. “Even though there’s no explicit connection, it only takes a little bit of common sense to realize the relationship.”....

In fact this pattern of cheap debt issuance paired with stock buybacks may be the explanation of the stock market's recent rally without any real improvement in the overall economic outlooks:

Announced buybacks this year are about 70 percent below the record $863 billion pledged in 2007, Birinyi data show. While the S&P 500 trades at 12.4 times forecast earnings for the next 12 months, compared with a 56-year average of 16.4 times reported profit, low valuations haven’t been enough to spur an equity rally.
The S&P 500 rose 1.5 percent to 1,142.71 today, the highest level since May 13. It’s up 2.5 percent in 2010 and down 6.1 percent from its April high. The index gained 1.5 percent last week amid speculation Microsoft will sell debt for share buybacks and after Oracle Corp. beat earnings estimates.

corporate finance 101: when raising capital through debt is cheaper than raising it through equity...issue more bonds. :

Decreasing price-earnings ratios and record low interest rates are spurring executives to raise money in credit markets. U.S. companies have sold $83.4 billion in new stock in 2010, the lowest level for the first nine months of any year since 2005, based on data compiled by Bloomberg. At the same time, companies sold $786 billion in both high-yield and investment-grade U.S.- dollar denominated debt after $1.23 trillion last year.

“Corporations are finally feeling a little bit more comfortable and realizing that their own shares are cheap and financing is very cheap, so why not issue some debt and buy back stock?” said David Kelly, who helps oversee about $445 billion as chief market strategist for JPMorgan Funds in New York. “That’s a great way of distributing cash to shareholders and boosting stock prices.”

meanwhile over in the bond market the wsj reports that bond buyers are showing a willingness to take on more and more risk:

...The demand for bonds has allowed some of the riskiest borrowers to sell bonds with fewer protections for investors. These provisions, or covenants, prevent companies from taking actions that would hurt bondholders and would protect investors if companies are sold.

Friday, September 17, 2010

fund flows for august:: eyes on the rearview mirror

 from Morningstar

Fund Spy

Long-term open-end fund flows increased by more than 11% in August, and once again the lion's share went to fixed-income funds. Taxable-bond funds attracted $24.6 billion in new money for the month, and municipal-bond funds absorbed another $5.2 billion. Taxable-bond funds have now taken in $168.4 billion for the year to date. Alternative strategies also took in a robust $3.1 billion in August.
Intermediate-term bond funds dominated once again, taking in nearly $18.5 billion for the month....

Meanwhile, the relentless outflows continued for U.S. stock funds, as another $14.3 billion headed for the exits. This continues the renewed aversion to domestic-equity funds that began with May's flash crash. During the past four months alone, these funds have shed a combined $48.9 billion.

Aggregate bond etf (AGG) vs S+P 500 chart for the last two months

Those that moved from bonds into stocks in august, missed the 5.5% sp 500 rally  since sep 1 which has pushed the S+P 500 into positive territory for the year

gmar tov


Who Do You Think Is On The Wrong Side of THIS Trade ?

from the wsj

A Risky-Loan Market Is Back in Gear

Leveraged Debt, Part of the Credit Bubble, Attracts Yield-Hunting Investors; Not as Frothy as '07

One of the markets at the heart of the credit bubble has surged back with surprising speed as investors chasing yield are increasingly willing to finance riskier companies.
Poster children of the mid-2000s credit bubble, leveraged loans are set to have their busiest year since 2008, thanks to a rush of money into the market from investors looking for high-yielding alternatives to stocks and junk bonds. It is a boon for speculative-grade companies looking to refinance and for private-equity firms hoping to start a buyout wave.
But just as the market has sprung back from its depths, so too has the relative riskiness of many loans. Investors are letting companies take on more debt relative to their cash flows and use the proceeds for creditor-unfriendly activities like paying dividends to stockholders.
Though the market is nowhere near as frothy as in 2007, some of these loans could suggest investors will make riskier bets to attain higher-yielding assets, despite the economy's wobbles.

Tuesday, September 14, 2010

That Corporate Debt "Trade"

some interesting info from the wsj : my comment in the blue box

Corporate-Bond Market Heats Up

Companies eagerly tapped the corporate-bond market Monday, offering more than $13 billion in new high-grade debt as they try to lock in interest rates that have been hovering near multidecade lows but may be moving higher.
Investment-grade borrowers, including General Electric Capital Corp. and Amgen Inc., acted as yields on 10-year Treasury notes, the benchmark for investment-grade corporate interest rates, rose to 2.753% Monday from 2.418% in late August.
"This recent move up in yields has people that were waiting on the sideline willing to jump into the pool," said Tom Murphy, portfolio manager at Columbia Management in Minneapolis, which has $169 billion in fixed-income assets under management.
Issuance was active in other sectors as well. After a pause of about three weeks, the consumer loan-backed securities market came roaring back Monday as companies announced more than $3.5 billion of new asset-backed bonds. In the speculative-grade, or junk-bond, market, companies sold $1.3 billion in longer-dated notes.
What is interesting is that some investors realize what this debt is doing for future prospects for many of these companies locking in low rates. Even cash rich microsoft may be joining the crowd and the stock market reached the logical conclusion: that's good for future earnings, dividends and stock buybacks: from the wsj sotck report on sep 13 trading:

The Nasdaq Composite gained 43.23, or 1.9%, to 2285.71. The measure's four-day up streak is its longest winning stretch since the seven-day period that ended July 14. Microsoft led a charge among technology stocks. The software giant jumped 1.26, or 5.3%, to 25.11, following a report that the company is planning to sell some of its debt in order to pay dividends to shareholders and finance a buyback of its own stock, according to Bloomberg Television.

Monday, September 13, 2010

Who Do You Think Is On The Right Side of This Trade

The financial markets are experiencing a massive exchange of funds between two groups:

Corporate treasurers eyeing the historically low rates for borrowing are issuing debts in record amounts, lowering their cost of capital and building up cash for future business expansion, stock buybacks, paying down higher cost debt or dividends. These corporations are effectively selling massive amounts of bonds into the market

as the wsj notes

Blue-Chip Borrowers Issue Debt in Droves

Companies are jamming the bond market with fresh debt this week, and yield-hungry investors show no sign of blanching—though with each new shovelful the day of saturation grows nearer.
Mark Gongloff discusses the recent eagerness of blue-chip companies to issue fresh debt, and the eagerness of investors to buy it.
An estimated $51 billion in fresh corporate bonds and leveraged loans have hit the market in the past two days, according to estimates by Dealogic and Standard & Poor's Leveraged Commentary & Data Group. Wednesday alone was the busiest issuance day for high-grade bonds this year, with more than $19 billion in new debt, according to Dealogic. This week is on pace to be one of the busiest of the year for corporate debt, despite the number of possible buyers in the market being curtailed by both the Labor Day and Rosh Hashanah holidays.
Corporate borrowers are enjoying a golden moment of super-low interest rates combined with a scramble by global investors for higher-yielding assets, given that cash is yielding nothing and the stock market stalled. Allergan Inc. this week borrowed $650 million at 3.375%, the lowest 10-year yield for a large U.S. corporate bond issue since at least 1995.
The trend has extended to high yield (junk ) debt as well and with the large build up of cash, many companies have actually moved from junk to investment grade status pictured here are the trends in high yield bond spreads and issuance (from the ft)

And who is buying this debt with the record low interest rates effectively on the other side of this trade ? It seems to include masses of individual investors disillusioned with equity returns and anxious to pick up yield above that of treasury bonds. The 2wsj gives the evidence from money flows in the mutual fund world:

Long-term mutual funds had an estimated $4.31 billion of outflows in the latest week, ending a 13-week streak of inflows, as investors pulled money from stock and hybrid funds, according to the Investment Company Institute. Bond funds have thrived, as they typically do in a lower-interest-rate environment, while stock funds have failed to consistently attract new investment for over a year despite 2009's sharp rally. Before the latest outflows, ICI had reported inflows for 13 consecutive weeks, totaling about $50 billion on an unrevised basis and almost entirely due to money going into bond funds.
For the week ended Sept. 1, ICI reported that stock funds had outflows of $9.54 billion, up from $4.6 billion a week earlier. U.S. equities had $7.6 billion pulled from them, while $1.94 billion was withdrawn from foreign funds. Overall, stock funds that ICI tracks last reported weekly inflows in early May.

At the same time, bond funds took in $6.66 billion, up from $5.9 billion the previous week, ICI said. Taxable funds had inflows of $5.66 billion, and municipal funds added $1 billion.
Individual investors plowing money into bond funds with near record low yields or the world's largest corporations making use of that demand to issue long term bonds at those same low interest rates, who do you think is on the right side of the trade ?

I would advise individual investors that instead of following the crowd in the mutual fund flows and  filling the asset side of their balance sheet with low yielding bonds, they follow the lead of the corporate treasurers and look at the liability side of the balance sheet. If there is an opportunity to refinance high interest rate debt  (fixed rate mortgages) or floating rate debt (arms0 with  long term fixed rate debt now is the time to do so. As the corporate treasurers know this is the surest way to improve the balance sheet, improve cash flow and to be well positioned for future opportunities.

a pretty strong case against long term bonds appeared in the ft( my bolds) seems the only reason to hold them is as a momentum trade not an investment

By the standards of the 20th century these are extraordinary figures which, if taken at face value, imply that inflation is not only dead but more or less permanently buried. In the short term they seem to point not just to a double dip recession, but to outright deflation continuing for several years. To purchase and hold to maturity a long-dated US Treasury or UK gilt at today’s yields is a remarkable act of faith in an unproven thesis.
There are of course reasons why owning government bonds today at record low yields can be rationalised. Some investors, we know, are required to own long-dated bonds, whatever the price. With the economic data so uncertain, it is by no means impossible that bond yields could go lower from here, creating the potential for trading gains. Bonds still have a certain amount of diversification value, though how much is open to question, since diversifying assets are only sure to diversify effectively when they are the right side of fair value. Probably the simplest reason though can be summed up as “don’t fight the Fed”....

Yet in the short term, despite the bond market trading at artificially depressed yields, many investors continue to buy the deflation story. There is comfort in numbers. But it is not hard to predict that this trend, however long it still has to run, is not going to end well. Professor Jeremy Siegel of Wharton says that investors who pay 100 times the yield to own a US government bond are participating in a bubble that is every bit as extreme as that involving internet stocks in 2000. Nassim Nicholas Taleb, author of the Black Swan and Fooled By Randomness, says that “every single human being” ought to bet against US Treasuries. It is a “no brainer” of a bet.
It is the nature of climactic moments in markets that warnings tend to count for little when momentum is running strongly in the opposite direction. The Queen was puzzled enough by the global financial crisis to demand to know why nobody apparently saw it coming. Mr Obama won’t be able to say the same about the coming fallout in the bond markets. 

The Endowment Model Disappoints Again

WSJ reports on the Harvard Endowment's performance

Harvard Endowment Gets a Middling Grade

Harvard University's endowment fund posted a 11% return for the 12 months ended June 30, underperforming the broader markets but reversing a big decline in the year-ago period.The largest college endowment by assets in the U.S. is now valued at $27.4 billion, up from $26 billion a year earlier. That still is a far cry from the fund's precrisis value of $36.9 billion in 2008. The median return for large endowments for the year ended June 30 was 12.3%, according to Wilshire Associates, an investment consulting firm. The Dow Jones Industrial Average had a total return of 18.9% in the same period....
Perhaps this is even more interesting a "naive" balanced allocation would have outperformed as well

According to the report, a portfolio of 60% stocks and 40% bonds would have outperformed Harvard's endowment, with a return of 12.6%
This is due not only to the stock performance but to the fact that bonds, an asset class shunned by the harvard endowment (and yale as well) turned in a performance of 9.3% over the period. Seems this sophisticated endowment model missed the large bond rally of the last ten years. Looked at in terms of risk and return the decision appears even more flawed

10 years through aug 2010

s+ p 500   return -1.81%  annualized standard deviation. 19.19

 aggregate bond index 6.47%  s.d 5.70

Lost Decade for Investors ? Some More Data

While it is true US stocks turned in a negative performance for the past 10 years, a balanced portfolio would have shown better results and few investors that paid attention to their asset allocation would in fact hold 100% s+p 500

here is a relatively straightforward global portfolio

us total stock market russell 3000  30%
us small value russell 2000 value 10%
emerging markets msci 10%
developed intl msci  10%
aggregate bonds      40%

$ 1000 invested in this portfolio for the last ten years would have grown to $1630 vs $880 for 100% s+p 500

the 20 year numbers  are close;
4920 for the 60/40 and 4,500 for the 100% sp 500

missing out on emerging markets would have cut performance drastically

$1000 in emerging markets grew to $3,000 in the last 10 years  $17,280 in the last 20 years

Wednesday, September 8, 2010

Old Wine In New Bottles ? Probably Yes But Those Bottles Look Better

Fortune has a gushing article about Robert Arnott and his  RAFI fundamental indexes available as large cap etf PRF and small cap etf Prfz

The article writes

Arnott's Big Idea is a concept he calls "fundamental indexing." It's a system that allocates money to stocks based on the economic footprint of the underlying companies rather than by the more common method of market capitalization. As we'll see, it's a near-revolutionary challenge to the accepted wisdom about passive investing. And it has already won over a range of large institutional clients, from the national pension fund of France to CalPERS, the $200 billion retirement fund for California's public employees. "Rob is one of a handful of guys on the cutting edge of investment thinking," says Dan Bienvenue, a senior portfolio manager at CalPERS. "In conventional indexing you're always average. Rob's method has historically beaten the average."

Arnott quickly concluded that companies weighted by size, using almost any criteria, consistently outperformed capweighted indexes.

The above is hardly a new discovery Eugene Fama has written about the size and value premium (using only book value) for decades and built the indexing firm Dimensional Financial Advisors (DFA) on index products using this methodology. Arnott just seems to have refined the technique by adding other factors.

For his index he settled on a formula that takes the average of four yardsticks: sales, cash flow, book value, and dividends. When companies pay no dividends, RAFI simply averages the other three. Over a 42-year span he found that a hypothetical index weighted by those four measures returned 2.1% more per year than cap-weighted funds.
The reasoning is well known: cap weighted indexes become concentrated in a small number of stocks with large market cap and usually high p/e values. In other words they are skewed to large growth stocks and in periods of high flying markets like the late 1990s are particularly prone to "bibble risk" In other words over the long run value beats growth (as both indexers and many many active managers have both found As the article explains:  The explanation in my view and that of many others far brighter than me is behavioral: investors become enamored of glamour stocks and pay too much for them:


Why do fundamental indexes fare far better? The principal reason is that they are regularly rebalancing their holdings by selling expensive stocks and buying cheap ones, relentlessly exploiting what's known as the "value effect." It's well established, both in academic studies and through decades of fund performance, that "value stocks," companies with low price/earnings multiples and low price/book ratios, perform better over time than expensive growth stocks that boast high P/Es. "The market does a good job choosing which companies will grow and which will shrink," says Arnott. "The problem is that investors pay too much for hot, glamorous growth stocks and set the bar too high." In the fundamental index, the rebalancing goes strictly by formula: When a company's market cap jumps faster than its sales or profits, the fund sells just enough of it so that its investment once again reflects not its price but its scale in the economy.
But as far as a revolutionary discovery in market behavior ...I'm with the view expressed here:

Arnott's critics claim that he's simply repackaging the value effect and calling it something revolutionary. "This is just old wine in new bottles," charges Cliff Asness, chief of hedge fund AQR Capital. "But I like the product." Arnott agrees that the value factor accounts for a lot of his outperformance but maintains his formula for systematically rebalancing into cheap stocks makes his fund far different, and far more original, than a cap-weighted value fund. "We're constantly trading against the market's most extreme bets," says Arnott
And in fact as others have noted the correlation between arnotts large cap and small cap indexes is extremely high (see below for the russell indices  it is close if not equal to 1.0 = 100% correleation) with the corresponding indexes from russell as well as with the the index funds from DFA. However correlation is not the whole story 3 funds can have high correlation but far different returns and on this count the Rafi index performances are quite impressive. Below are PRF (large cap)  and PRZ(small cap) compared to the corresponding etfs representing indices from S+P (spdrs), Russell (ishares) and MSCI (vanguard), The outperformance is impressive and consistent enough for me to make these two my choice for the large value and small value allocation in my portfolios.

Three Year  tables of total return:

Large Value

Correlation PRF and IWD Russell Large Value 3yrs of 60 day correlation

Small Value

Correlation PRFZ and IWN Russell Small Value 3yrs of 60 day corrwlation

No This is Not an Asset Class

The WSJ reported  on the exodus of investors ((looking firmly into that rear view mirror) from managed futures funds in ligfht of their disapoinint performance. As the article notes some other factors contribute to that sentiment as well, although I am sure they were overlooked when performance looked goods:

A slew of new "managed futures" mutual funds purport to offer small investors a sophisticated strategy that held up well during the financial crisis.
But the approach, previously limited mostly to institutions and wealthy individuals, has proved an awkward fit for the mom-and-pop mutual-fund world.
The new funds' complex structure, which can leave investors in the dark about fees and portfolio holdings, already has prompted regulators to push for stricter oversight of the products. And so far, performance has been lackluster.
Managed-futures funds aim to profit from both positive and negative trends in commodities, currencies, bonds and other markets. The funds trade futures contracts tied to these investments, sometimes taking "short" positions to bet on price declines.
The idea (or precisely product) of a managed futures account for individual investors is not new previously they had been done as managed futures accounts run by commodity trading advisors regulated by the CFTC.
These products were/are sold with the argument that these managed futures are an "asset class". Apparently simply because they trade currency, bond and commodity futures they constitute and asset class. Of course nothing of the kind is the case, since they can be long or short and uninvested at times they share no characteristics of those asset classes. They are simply a bet on manager skill something which is by its very nature inconsistent and an unreliable basis to invest.

If these funds correlate to anything it is the existence or non existence of trends in markets (and the managers skill in timing and identifying these). The article notes:

The new funds are arriving amid market conditions that are generally unfavorable to the managed-futures approach. While strong positive or negative market trends tend to benefit these funds, markets lately have generally been choppy with many shorter-term reversals. "If you're trying to invest based on a trend-following strategy and there is no trend, that is not a helpful environment," says Lasse Pedersen, principal at AQR.
And the fees on these funds are massive. If the inestor of actively managed stock  fund with an average fee of over 1%  is analogou to starting out 10 yards behind in a hundred yard dash compared to an index investor with fees of .20% or less, then the investor in these funds starts at least 30 yards behind:

Equinox's MutualHedge Frontier Legends Fund, launched at the end of last year. The fund's website and prospectus fee table list an expense ratio of 2.2% for A shares, fairly typical for a hedge-like mutual fund. But that doesn't tell the whole fee story. A fund prospectus filed in early January said the fund may invest as much as a quarter of assets in a subsidiary, which could in turn invest in various private investment vehicles or commodity pools. In a lengthy section on "principal risks," the prospectus said the vehicles "are typically subject to relatively high management fees and often include performance-based fees" that can reduce fund returns.
Equinox divulged more details in a prospectus supplement filed in late April, after the fund had been on the market for nearly four months. That document said the pools would be subject to anticipated management fees of up to 2% of assets and performance-based fees ranging from 15% to 30% of new-high net trading profits—fees far more typical of hedge funds than mutual funds.
And the often rapid fire short term trading in these funds means the after tax returns will look even worse.

But I have no doubt the industry will be back marketing these funds hard and that investors will return if there is a short period of strong performance.

Tuesday, September 7, 2010

I Have Never Operated My Practice Any Other Way...

..but according to the wsj today it is a new concept to many of my colleagues:

Adviser Shift Expected To Boost ETF Sales

Exchange-traded funds have been embraced by fee-based financial advisers, something that will help fuel their growing popularity.
As regulators tighten up on potential conflicts of interest in the brokerage and advisory industry, more advisers are expected to move toward business models based on fees from clients rather than sales commissions on products.
“When brokers move to a fee-based advisory, we see a significant increase in the use of ETFs,” says Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock Inc. Advisers who depend on commissions “typically do not embrace ETFs,” she says.

Saturday, September 4, 2010

Lost Decade for Investors ? (Bonds for the Long Run Going Forward ?)

I just took a glance at data for 10 years ending july 31,2010. Given the stampede of investors to bonds and the prevailing sentiment that stock investing doesn't work it may merit paying to attention to these numbers. After all the conventional wisdom is that it has been a "lost decade" for investors. Clearly that is not the case for investors with a globally diversified portfolio balanced between stocks and bonds.

Returns for some major indices 10 years through July 31, 2010

S+P 500 -1.81%
US Small Value Stocks (russell 2000 value) 6.56%
International Developed Markets 1.53%
Emerging Market Stocks 11.53%

Inflation Protected Bonds 7.49%
Aggregate US Bond Index 6.47%
3 Month TBills                   2.60%

Given that US long term interest rates are near record lows it is a mathematical impossibility that future returns on bonds will match those of the past decades. 10 Year treasury rates have fallen from 6 %  to their current level of 2.63% (see chart above ) creating the large capital gains on bonds (yields down = price up). Clearly we will not get a repeat of interest rate declines of 3.4%- interest rates on ten year bonds won't go negative.Neither would I see a hgh likelihood of long term interest rates declining by over 50% again although of course anything is possible.

Certainly given the rush of bond issuance by corporations, corporate treasurers see the low rates as a great borrowing opportunity even as indivdual investors see it as a great time to lend to money to them (by buying bonds ) at rock bottom rates. And of course a low cost of capital flows through to help corporate earnings.

So while I would be loathe to forecast future returns on stocks and bonds it seems quite questionable to argue that the massive move from stocks to bonds by individual investors is a prudent move.

Thursday, September 2, 2010

More Evidence Of How Hard it Is to Beat The Market

The WSJs monthly review of investing in funds has a few interesting articles on just how difficult it is to beat the market...

A review of the record on quantitative funds (much the rage over the last decade or more) finds that quantitative managers have discovered that they need to supplement their computer models with the "human touch":

Quant managers need to understand "that financial markets are better understood through the lenses of a biologist rather than a physicist," says Andrew Lo, a finance professor at the Massachusetts Institute of Technology who also manages quant funds. That is, they need to focus on the adaptation to changing environments that characterizes the biological realm, rather than the sort of immutable laws that form the foundation of physics. While quant managers might like to think that three laws govern 99% of investor behavior and thereby drive securities prices, he says, "we're lucky" if 99 laws explain even 3% of investor behavior.
A second article in the section reviews the dismal performance of 130/30 funds a hot product which was to combine long and short positions leverage purportedly to provide higher return without increased risk. Ironically, the above cited Professor Lo is involved with the management of an etf employing this strategy. I have written in the past questioning this claim and calling these funds a "product not a strategy",  The article begins:

A Hot Fund Design Turns Cold

So-called 130/30 funds aim to boost performance with borrowed money and bets against overpriced securities

There are good ideas that are badly implemented, and there are bad ideas that are, well, bad ideas.
It's a matter of debate which construct—if either—best describes 130/30 mutual funds, a leveraging strategy that seemed to be the next hot thing just a few years ago.

I am firmly in the camp of this harsh critic of the funds quoted in the article

Investors "are fooling themselves if they really think they're getting anything but a jacked-up, more volatile S&P 500 proxy that's expensive and doesn't work and can hurt you in the long run," says Lee Munson, chief investment officer for Portfolio Asset Management, Albuquerque, N.M.

In a familiar story in the money management industry the fad gathered momentum under a barrage of marketing as the new new thing and money flowed into these funds. Following a relatively short period of poor performance (which in fairness was probably too short to make any conclusive judgements) the money flowed out.

What is particularly disconcerting is that the money that flowed in came from institutional investors --in other words supposedly sophisticated investors often fiduciary responsibility in managing investments for others. Since the funds were new the money went in based on hypothetical "backtested results" and then went out based on a short period of actual performance. Not exactly the sort of actions one would expect of a fiduciary responsible for $100s of millions in investment dollars. The article reports:

Interest in 130/30 funds and portfolios that employ a similar leveraging strategy but in different ratios (such as 110/10, 120/20 and so forth) boomed around 2006 and 2007, particularly in non-fund vehicles for institutional investors. In 2007, the number of U.S. mutual funds with "130/30" or "120/20" in the name surged to 21 from four, according to Morningstar Inc., and their assets more than doubled to $373 million. In the following years, launches dried up and several funds closed, leaving only 12 with some variation of 130/30 or 120/20 in their name. Combined assets are a little over $1 billion.
Morningstar says a broader universe of 130/30-like institutional accounts and mutual funds has grown to about $30 billion in total assets—a far cry from the $1 trillion that some market watchers predicted a few years ago.
A third article in the section outlined the virtues of a super simple index investing strategy of 50/50 stock /bonds making use of only 3 etfs or mutual funds: one for bonds one for us stocks and one for international stocks. While I would favor a more sophisticated approach particularly one that had a higher weighting towards emerging makets in the international allocation and small caps in the domestic allocation the virtues of the strategy are undeniable. Such a strategy with annual rebalancing is low cost, tax efficient, keeps the investor disciplined away from market timing and chasing hot (and expensive ) actively managed funds. I have little doubt that investors pursuing a variant of this strategy would do far better over the long term than most individual investors. Simply sticking to the discipline of the strategy will account for much of the relative success.

TIPS As I Was Saying.....

on August 12 in my blog entry the emergence of a conventional wisdom that deflation is in the offing doesn't necessarity argue against TIPS.
The WSJ picks up on this today

Despite Deflation Fears, TIPS Still a Good Deal

A Medical Researcher with Good Advice for Investors

The NYT  had an interesting article on internist/researcher Dr. Ronald A. Medelmeier whose research is informed by the insights of behavioral economics. I found this quote quite useful

“Life is a marathon, not a sprint,” he read, adding, “A great deal of mischief occurs when people are in a rush.”
To that end, he studied the psychology around changing lanes in traffic. In an article published in Nature in 1999, Dr. Redelmeier and Professor Tibshirani found that while cars in the other lane sometimes appear to be moving faster, they are not.
“Every driver on average thinks he’s in the wrong lane,” Dr. Redelmeier said. “You think more cars are passing you when you’re actually passing them just as quickly. Still, you make a lane change where the benefits are illusory and not real.” Meanwhile, changing lanes increases the chances of collision about threefold.
The above is particularly striking when read in conjunction with Roger Lowenstein's excellent sunday nyt magazine article The Way We Live Now: Taking Stock

which concludes with the following

So far, ordinary consumers remain too in hock or too frightened to do either. What money they have is going into bond funds. “The individual investor is saying no más to equities,” notes Robert Barbera, the chief economist for Mount Lucas, a private investment firm. It is hardly a stretch to say that the recovery of companies like I.B.M. is being fueled by the willingness of small investors to lend to them on the cheap.
Most of the people buying bond funds do not use a calculator in making investment decisions. They are captives, understandably, of their experience. But gloom and doom also has its price. It would be a sad twist if people were to mirror their recent excessive risk-taking with excessive caution now