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Wednesday, March 20, 2013

Morningstar Agrees With Me on Emerging Markets ETF

I wrote about alternative emerging maarkets ETF strategies emphasizing low volatility strategies here

Morningstar reached similar conclusions here:

Are There Better Emerging-Markets ETF Choices?

Saturday, March 16, 2013

Rethinking A Bond ETF Allocation...The RIght Way and The Wrong Way

The March 11 WSJ features on of the almost endless stream of articles about preparing for the time when interest rates, rise. The articles range from sensible to apocalyptic with some predicting a quick and massive "bursting of the bond bubble".

First off its interesting to me that so many articles worry about the impact of a rise in interest rates on the bond market but seem to ignore it with regards to its impact on stock prices.

Thus the WSJ article starts out as follows:

"Don't fight the Fed" has been a market mantra for the past four years. But some bond investors are starting to lace on their gloves.

Figuring that the Federal Reserve won't be able to keep a lid on interest rates forever, large money managers such as BlackRock Inc., BLK -0.08% TCW Group Inc. and Pacific Investment Management Co. are getting ready for the day when rates take their first turn higher. 
It isn't coming anytime soon, these investors say. But when it does, they worry, the ascent will be swift and steep.
Of course the"don't fight the Fed mantra" is part of stock market lore too. And if there is one thing that pundits endlessly stress in their explanations of the stock markets rise it is the Fed policy of low interest rates which has pushed investors into riskier assets including stocks. In other words there is ample reason to be concerned that a change in interest rate policy will lead to a stock selloff that could be swift and steep as welll. And given that stocks are more volatile than bonds it is the stock market reaction to higher rates that may be more painful.
But back to bond allocations.
  • In establishing a bond portfolio it is easier to pinpoint the risk factors and potential risk return of alternative scenarios. While it may not be possible to predict when interest rates will change it is relatively straightforward to predict how various types of bonds will react to changes in interest rates.
  • Don't forget the total return: many articles on bonds focus solely on price changes ignoring the total return which is a product of price changes and interest earned. 
Despite the many words written on the bond market and the oft repeated warning of a "bond bubble" these same articles are very imprecise in explaining where exactly they see the "bubble" and therefore which bonds are at risk of big losses due to "bubble bursting". I have seen the term applied to high yield bonds, corporate bonds and treasury bonds often with little specificity as to maturity.

So here is an effort at clarity and specificity

Of course bond prices and yields move in opposite directions. And longer term bonds are more sensitive to changes in interest rates than short term bonds. The unprecedented declines in longer term interest rates has led to massive price increases. People have called the rise in prices in long term rates a "bubble" for several years but prices have continued to rise(yields fall). 

Unlike stocks which theoretically have unlimited upside bond prices cannot rise forever (interest rates can not fall forever). Therefore it is a simple mathematical certainty that long term bond investors will not experience the total return gains they have experienced in the last  years when for example 10 year treasury bond yields fell from over 5% to under 2.5%. Looking further back on the long term chart of bond yields below, it is clear that the gains to holders of bonds over the past decades will not be repeated in the future is simply mathematically impossible, interest rates cannot fall below zero.

So from a strictly mathematical point of view the risk/return to holding longer term bonds is skewed negatively. The downside risk is greater than the upside potential for longer term bonds. 

Credit Risk: The other factor affecting bond prices is credit risk i.e. market perception of the potential inability of the issuer to pay back the bond holder. When using ETFs one is investing by asset class therefore diversifying away the individual company risk in the bond portfolio.

Investors can increase their credit risk and increase their yields through moving from treasury bonds to investment grade coporate bonds or even to riskier high yield bonds.

Spreads: the interest rate differential between treasury bonds and coporate bonds of both investment grade and high yield have narrowed at the same time that interest rates have declined. See chart. below.

But are high yield bonds in a  "bubble " ? Here is where I think alot of the analysis gets very sloppy. The Federal Reserve has told the world that it will only raise interest rates when economic conditions improve. But when economic conditions improve so should the fortunes of the financially weaker companies that issue high yield bonds. In other words their ability to repay their debt should improve...lowering the risk of default. Remember that in the beginnings of the economic crisis in 2008 as treasury bond interest rates fell, high yield bond interest rates moved up sharply (the spreads increased). Investors in the intermediate term HYG high yield bond ETF  suffered a loss of over 17% in 2008 while investors in intermediate term treasury ETF (ITE) had a gain of over 11%.

In other words better economic conditions lead to higher interest rates across the board lead to price changes which are greater as the maturity/duration increases. But there is no reason to assume they will affect high yield (junk) bonds more negatively than Treasury bonds.

 Long term bonds may be in a "bubble" or at least have poor risk reward characteristics but it is because of maturity not credit quality. 

In other words its the maturity/duration not the credit quality that should be the most important concern in establishing a bond etf portfolio.

Saturday, March 9, 2013

A Better Way to Index Emerging Markets

A lot has been written about the "south korea issue" created by the largest emerging market ETF  Vanguard's VWO.

Vanguard announced last year that it was switching index benchmarks from MSCI  to FTSE which does not include South Korea as an emerging market. The transition is being made gradually. But for those looking to retain a significant South Korea exposure the search was on for a low cost alternative.MSCI has South Korea as its second largest country exposure at a bit over 15%. VWO is gradually transitioning to the new index and currently has a bit over 11% weighting in South Korea.

Ishares emerging markets ETF (EEM) retains the MSCI benchmark but at a management fee of .69% quite an increase for those previously paying .18% for VWO.

But Ishares has stepped up with a very attractive new emerging markets ETF: IEMG which has a management fee of

IEMG as other attractive aspects as well: it has larger number of holdings and thus more exposure to small and mid cap stocks.

Recently another interesting alternative has debuted among emerging markets ETFs. The low volatility strategy (which I described here) is now offered in an ishares ETF EEMV.

Adding EEMV to an emerging markets allocation is particularly interesting because it is weighted in different industries than IEMG (or VWO or EEM). The low volatility screen reduces the weighting to natural resource based holdings and shifts towards those more linked to the local economies.

Here is a comparison by industry of the emerging market ETFs As can be seen the only significant difference among the ETFs is EEMV (minimum volatility) vs. the others.

Basic Materials           11.63% 12.06% 11.78% 5.39%
Communication Services    6.97% 8.67% 8.00% 12.74%
Consumer Cyclical         9.27% 8.70% 8.57% 6.05%
Consumer Defensive        8.33% 8.20% 8.56% 14.34%
Energy                    9.69% 11.59% 10.84% 6.62%
Financial Services        23.32% 22.84% 24.29% 24.92%
Healthcare                1.65% 1.11% 1.08% 4.77%
Industrial 8.55% 7.58% 7.67% 8.25%
Real Estate               3.15% 1.65% 1.89% 1.69%
Technology                14.42% 14.49% 14.32% 9.08%
Utilities 3.02% 3.11% 2.99% 6.16%

As a consequence the EEMV returns have been strikingly different than other the other ETFs listed above.  Although of course one should not draw too many conclusions from the short trading history of EEMV.

EEMV is below in green EEM in gold  VWO in blue

This chart shows growth of 100,000

And below the top bar chart is returns and the bottom is volatility
So far an impressive performance for EEMV with far higher returns at significantly less volatility. It would be too early to declare an absolute preference for EEMV but the data certainly argues for including it in a portfolio.

( I left out IEMG here because it has been on the market for such a short period of time but at least for now it trades in line with EEM and VWO)

Thursday, March 7, 2013

This Makes Me A Little Nervious

  • The stock market is basically impossible to forecast in the short term 
  •  I am a big advocate of not market timing by going "all in" any single asset class.
  • There is a well known document momentum factor in short term market movements.
  • But in the short term price can deviate from value and there is a reliable pattern of prices reverting to the mean (closer to value)

On the Other Hand... Remember that stock prices can move higher only one of two ways: p/e (or other multiple )expansion ( a higher valued stock market ) or  higher earnings (which keeps the p/e growth minimal, nil or even can push it lower) Right now we are in a p/e expansion mode on historical short and long term earnings measures meaning that the expansion is based on increasing enthusiasm for future earnings (if price is keeping base with value). Or the move up is based on too rosy a forecast for the future=pure momentum and price is deviating from value.

One of the fewer macro indicators with some medium to long term efficacy is the  Schiller p/e ratio based on Long Term Normalized Earnings.(more explanation here). And that indicator is at a minimum flashing a warning signal.

Current Shiller PE Ratio: 23.75 +0.03 (0.11%)
4:35 pm EST, Wed Mar 6
Min:4.78(Dec 1920)
Max:44.20(Dec 1999)
And Here is the P/E most analysts and journalists commonly refer to:price to earnings ratio, based on trailing twelve month “as reported” earnings.
Current PE is estimated from latest reported earnings and current market price.

Current S&P 500 PE Ratio: 17.53 +0.02 (0.11%)
4:35 pm EST, Wed Mar 6
Min:5.31(Dec 1917)
Max:123.79(May 2009)
Price to earnings ratio, based on trailing twelve month “as reported” earnings.
Current PE is estimated from latest reported earnings and current market price.I would regard a third measure of p/e based on forecasted earnings as of little use, considering the unreliability of earnings forecasts 

Looking at this S+P 500 chart above (total return) and especially the pattern of last  3 years with major rallies in the first quarter followed by sharp declines through the middle of the year and strong annual performance one might conclude it is worh looking into some rebalancing to return portfolios to target allocations by selling some stocks.

One the other hand many might look at the 45% total return and conclude that despite the roller coaster ride it was worth simply ignoring the selloff and not making any adjustments.

I tend to favor rebalancing.