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Monday, March 30, 2015

Don't Blink, the Conventional Wisdom Just Changed

Not a good argument for market timing.

WSJ March 30

Morning MoneyBeat: Why Stocks Could Keep Rising as Recovery Matures

Stocks Revisit Last Spring’s Selloff — With a Difference

The latest pullback in technology and biotechnology stocks echoes a temporary selloff last spring. But this time around, some investors are warning that the broader market’s problems could run deeper.

Thursday, March 26, 2015

Index Investor or Hedge Fund Investor...Who is Smarter ?

Seems a better simpler strategy is available tot the little guy is better than the complicated one available to big hitter "qualified investors" and their genius managers

Two headlines recently at the WSJ

Are Index-Fund Investors Smarter?

One of the keys to running a hedge fund is learning how to say you don’t.
Grappling with years of uneven performance, image problems and deep-pocketed clients who have publicly distanced themselves from the industry, hedge-fund managers are taking pains to avoid the moniker.

Asset Allocation in Two Minutes

I wrote in an earlier post how "Robo Advisors" come up short by not sufficiently getting to understand a clients circumstances before recommending an asset allocation.

Over at future advisor...they promise: asset allocation in two minutes. Plug in your age and retirement age and it triggers a detailed portfolio allocation.

Seems to prove my point.

Wednesday, March 25, 2015

Do You Think You Know How to Pick Actively Managed Mutual Funds ?,,,The "Experts" Don't

From the economist Buttonwood blog

Nobody knows anything

WHENEVER one writes about the failure of active managers to beat the index, someone is bound to pop up online and argue that people don't pick fund managers at random. Select the right fund managers and all will be well. But how? Relying on past performance does not seem to work. Logic would also suggest that it cannot be easy to identify the best performers in advance; if it were, then why would anyone give money to the underperformers?
Many pension funds and endowments hire investment consultants to help them choose fund managers (one estimate is that 82% of US pension plans use such services, and consultants advise on $25 trillion of assets). The consultants employ highly-educated workforces, have decades of experience and charge hefty fees. But an award (the 2015 Commonfund prize) has just been granted to an academic paper that concludes
we find no evidence that these (the consultants') recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless...
 , while one can be willing to accept that there are smart fund managers who can outperform the market, the trick is identifying such managers in advance. This process seems as difficult as identifying hit films in advance; in that business, as William Goldman wrote once "Nobody knows anything". 

The Economist also had a recent article specifically on large cap actively manged funds

BETTING on red gives the punter an 18-in-37 chance (in Europe) or 18-in-38 chance (in America) of success in roulette. Parcel out your money carefully and you might have a diverting 20 minutes or so until it's all gone, with a few wins along the way. If the odds were just one-in-four, then the whole game would be much more discouraging.
But those have been the chances, over the last 20 years, of largecap US mutual funds beating the market. It has happened in just five calendar years..... investors buy a US largecap fund to get exposure to largecaps, not the other stuff. To the extent that managers go off piste, that can only be justified if they reliably outperform. They clearly don't.
This explanation only makes the lesson clearer; if you want an exposure to US large caps, buy a US largecap index fund with low fees.
Of course, many people will ignore this advice. They see an index fund as a boring commodity product; they want the best in class, a manager that can outperform. And no active manager will admit that he (or she) is likely to underperform. But it is remarkable how few will put their money where their mouth is.

Do You Know What Your Mutual Fund Owns..And What it is Really Worth ?

The NYT reports on the growing number of mutual funds that own stakes in non public tech statrt ups. 
The retirement accounts of millions of Americans have long contained shares of stalwart companies like General Electric, Ford and Coca-Cola. Today, they are likely to include riskier private stocks from Silicon Valley start-ups like Uber, Airbnb and Pinterest.
Big money managers including Fidelity Investments, T. Rowe Price and BlackRock have all struck deals worth billions of dollars to acquire shares of these private companies that are then pooled into mutual funds that go into the 401(k)’s and individual retirement accounts of many Americans. With private tech companies growing faster than companies on the stock market, the money managers are aiming to get a piece of the action.
Fidelity’s Contrafund includes $204 million in Pinterest shares, $162 million in Uber shares, and $24 million in Airbnb shares. Over all, there were 29 deals last year in which a mutual fund bought into a private company, and they were worth a collective $4.7 billion, according to CB Insights. That was up from six such deals, worth a combined $296 million, in 2012. T. Rowe Price was the most active

These non public companies are illiquid, difficult to value and the investor can actually only realize profits when the company goes public. In other words, at least parts of major mutual funds have left the world of publicly traded stocks into the far different investment marketplace of venture capital. I doubt too many investors are aware of the difference.

 Since these start up companies are not public the requirements for publicly available financial disclosures don’t exist. And based on the type of measures used in the public equity markets the valuations are astronomical, This means any disappointments in performance of the business or surprises in any of the financial metrics could lead to a large rapid decline in value. And of course even those valuations are based only on the data voluntarily provided by the company. For example Uber owned by these funds has encountered regulatory issues and other controversies in various part of the world. 

As a group small cap growth publicly traded stocks(growth meaning high p/e or other valuation measure) are the worst performing category of the stocks.  They are often referred to as “lottery tickers”..since a few wind up generating high returns but many many more disappoint.

A strong case could be made that these non public small companies with high valuation are even riskier.

Barrons gives some more specific information about this trend  here   

 As of the Boston fund(Fidelity) giant’s latest filing, its $113 billion Fidelity Contrafund (ticker: FCNTX) alone owned $162 million worth of Uber and $142 million of file-hosting company Dropbox. T. Rowe Price Group (TROW) had about a dozen funds on the list, including the $46 billion T. Rowe Price Growth Stockfund (PRGFX), which recently had a $63 million stake in rental marketplace Airbnb and $74 million in Dropbox. Rounding out the list were funds from BlackRock (BLK), Franklin Resources (BEN), and Vanguard Group, among others.

I looked at the information on the Fidelity and T Rowe Price websites at information on the funds losted above. 

The following appears for the contrafund on the Fidelity website
Investing in securities of companies whose value FMR believes is not fully recognized by the public. Investing in either 'growth' stocks or 'value' stocks or both. Normally investing primarily in common stocks.

The TROWE Price Growth Stock fund has the following on the TROWE website hard to see how Dropbox and Airbnb match this description::
This fund provides long-term capital appreciation potential by focusing on established growth companies with proven performance records. These companies are typically financially sound and represent a wide variety of industries. To enhance return potential, the fund also has the ability to invest in foreign companies.

Bottom line: 

Unless you check carefully your mutual fund may own types of securities you didn’t expect it to hold.

And since some of the securities you fund may own are not traded securities with open market prices you may not really know what your fund shares are worth.

Strong Dollar Winners and Losers

Although we have had a pause, the US dollar has strengthened over 20% against the Euro in the past 12 months

Who wins and who losses from the move ?

Losers: Large cap multinational coroporations

Worst hit from the strong US dollar are US multinational corporations. Their large sales overseas means large declines in the US dollar value of their earnings.

As the WSJ reports:

Analysts have sharply reduced earnings estimates; smaller, domestically focused firms gain allure

Analysts, citing the dollar’s strength as a key factor, are predicting that profits at S&P 500 firms for the first quarter will show their biggest annual decline since the third quarter of 2009.
As a result, investors are keeping a continued bias toward U.S.-based stocks that do less business abroad, such as shares of small companies that tend to be more domestically focused, and on companies outside the U.S. that stand to benefit from a weakening of their home currency as the dollar strengthens, particularly European manufacturers

The speed of the move means that these corporations have been caught by surprise not implementing the currency hedges they often put in place.
. It is the large cap multinationals that take the biggest hit, Many of these are in the S+P 500 others in both the S+P 500 and large cap indices such as the Russell 1000.

Winners are European multinationals. They benefit in two ways: their foreign earnings in dollars are worth more in Euros and their prices are they charge for therio goods and services can be more competitive in selling to foreign markets as their goods are priced in Euros/their costs are in Euros. After a long period of underperformance European stocks have outperformed US stocks as the Euro has weakened. Year to date Eurozone stocks (ETF ticker FEZ) have outperformed the S+P 500 by 7.7% vs 2% the hedged European ETF (ticker HEDJ) is up 19.6%.

Large Cap vs Small Cap US Stocks. Small cap companies tend to be more domestically oriented and thus less affected by the lower Euro. After underperforming  with a return of 5% (etf vtwo) for small cap vs 13.1% for large cap (IWB) in 2014, the trend has reversed year to date with small cap at 5.2% year to date and large cap 2.6%.

Wednesday, March 11, 2015

The "Gurus" are Buying European Stocks

I have been writing and investing based on the view that Europe and Germany in particular was undervalued vs the US for over 2 years And have written about adding currency positions to those positions over the last 12 months.

 As the more performance chasers join those that already own European stocks the better fior those "early birds"as they push prices higher.

At some point disciplined investors who got in early  will be rebalance and some of the gains sold off "selling high" as the performance chasers "buy high" I dont know whether the "gurus' are performance chasing or investment geniuses  but they are buying European stocks.

I came across this interesting article from Guru Focus

Which Regions And Sectors Are International Gurus Buying?

March 06, 2015

Warren Buffett said in an interview published on 2/25/2015 in the newspaper Handelsblatt that his holding company Berkshire Hathaway is definitely interested in companies in Germany. “Germany is a terrific market, lots of people, lots of buying power, productive, it’s got a legal system we feel very good with, it’s got a regulatory system we feel very good with, it’s got people we feel very good with - and customers,” Buffett said.
George Soros, one of history’s most successful financiers, has been selling US holdings to buy European stocks. It is said that he has moved about $2 billion into companies in Asia and Europe, according to a person familiar with the strategy.

Robert Shiller, who popularized the cyclically adjusted price-to-earnings ratio (commonly known as Shiller P/E), is also thinking about exiting US stocks and getting into Europe. He said in a television appearance on 2/18/2015 “I'm thinking of getting out of the United States somewhat. Europe is so much cheaper.” Specifically, Shiller has already purchased stock indices in Spain and Italy.
The US stock market was up more than 30% in 2013, the best year since the go-go years of the 1990s. 2014 was another strong year for the market. The S&P 500 index was up more than 13%. Since the market recovery in 2009, the stock market has been up for 6 consecutive years. The US stock market appears to be really high. Maybe it is the time to find some real bargains in the international markets. 

Among the 12 international gurus, 9 funds have their largest holdings in Europe, 2 funds have their top holdings in Asia, and one in UK/Ireland. 3 funds have their second largest holdings in Europe, 4 funds in Asia, and 5 in UK/Ireland. Asia and UK/Ireland divide the third largest holding regions

About that Annual Letter from Warren Buffet for 2015

Many many individual investors think they can "be like Warren". The evidence keeps accumulating that going forward it may be even more difficult if not impossible than it was in the past.

 Berkshire has gradually shifted from being an investment vehicle that owns traded shares to a collection of wholly- or partly-owned businesses, such as Heinz, a food manufacturer. Listed equities now make up only 22% of Berkshire’s assets, down from 72% in 1994. Mr Buffett offers a barnstorming defence of Berkshire as a conglomerate, which he says is sprawling, “and constantly trying to sprawl further.” It buys businesses to hold on to them for ever, avoids getting involved in weak or hard-to-understand companies, gives managers autonomy, ignores the advice of investment bankers and keeps central overheads lower than a limbo stick. Berkshire’s head office employs just 24 people.

One recent example has been his swapping of his shares of Procter and Gamble in exchange for taking direct control of Duracell

Why is this change so important ? Because when you are purchasing businesses you are (legally) doing so based on what would be insider information and illegal in the case of publicly traded companies. The companies that Buffett acquires are under no legal obligation to report their finances to any prospective investor...just those it is interested in looking at to buy/invest in the company. So stock picking skills are irrelevant to 78% of how Berkshire now invests. 

One can speculate on why this is but it would seem that Mr. Buffett is finding it harder and harder for an investor to outperform a broad index of stocks. With the broad access to information and the growth of ETFs it is no longer the day when rolling up your sleeves and kicking the tires one could easily find undiscovered values among publicly traded companies particularly among major blue chip companies. Of course size plays a factor as well Berkshire is so big that it is difficult to build a stock position that would have significant impact on its returns.

Mr. Buffett has also used a bit of sleight of hand in reporting performance:(economist again)

Mr Buffett used to argue that Berkshire’s book value per share, rather than its share price, was a good proxy for its long-term worth. But the group’s book value has stopped outperforming the broader stockmarket—in fact it has underperformed it in five of the past six years So now Mr Buffett has begun to argue that book value is no longer such a good measure, and to give greater prominence to Berkshire’s share price. This sort of goalpost-moving is a habit of lesser conglomerates than Berkshire, and is hardly a promising sign.

With private investments making up the overwhelming part of Berkshires portfolio (and thus not have a verifiable market price) it would seen a strange time to move the goal posts.

Although Berkshire has had phenomenal performance vs the S+P 500 in the past it has underpeformed the index for the last 5 years 11.75% vs 15.12%.

Perhaps there are signs that like his mentor Benjamin Graham towards the end of his career he concluded that outperforming the market was getting harder and least in part due to the easy accessibility of financial information on public companies.

Once again this year Mr. Buffett has written about the virtues of indexing.

He recommended 2 books in his letter this one from John Bogle the pioneer of indexing and sitll itts most influential champion.

and this great classic which an entertaining debunking of Wall Street

Not on the list ..his mentor Ben Graham's classic books The Intelligent Investor or Graham and Dodd's Security Selection geared towards stock picking

Over at the WSJ Bret Arends makes an excellent case on why Buffett and Bogle are wrong not to recommend a global portfolio:

It’s a good question today whether the neutral investor should even have half of a stock portfolio in the U.S. According to the International Monetary Fund, the U.S. accounts for 22% of the world economy when measured in U.S. dollars, and still less when measured in purchasing power terms. The U.S. economy, at $18 trillion, is slightly smaller than that of the European Union. Even when you take account of America’s deeper financial markets and the global nature of its blue-chip companies, it’s hard to get to 50% — let alone 80% or 100%
Today, unlike in 1970, you have an embarrassment of riches when it comes to overseas options. It’s hard to see why an allocation of, say, 1/3 U.S. stocks and 2/3 International stocks is wrong.

But I should note that Arends is not totally correct about Buffett I did find this:

Warren Buffett said in an interview published on 2/25/2015 in the newspaper Handelsblatt that his holding company Berkshire Hathaway is definitely interested in companies in Germany. “Germany is a terrific market, lots of people, lots of buying power, productive, it’s got a legal system we feel very good with, it’s got a regulatory system we feel very good with, it’s got people we feel very good with - and customers,” Buffett said.

Tuesday, March 10, 2015

Robo Advisors..I Won't Back a Recommendation Here

But this illustrates all the complications in robo advisors that investors may not be aware of.

From Investment News:

Wealthfront CEO accuses Schwab of deceiving investors with 'free' new robo

Adam Nash says Schwab is straying from its original values to profit from hidden costs

Monday, March 9, 2015

A Different "Apple Effect"

Apple (AAPL) will be added to the Dow Index initially with a 4.3% weight. The index is price weighted so as the price goes up the weighting goes up so the higher the AAPL price again the higher the index.

But the initial impact is in the opposite direction the inclusion in the index creates large demand for AAPL. Many billions of dollars are indexed to the Dow Index. Any of those portfolios must by AAPL to match the index.

I dont know how large that number is. But just to give a part of that amount of stock that must be bought DIA the dow industrial index ETF alone has $12 billion in assets and apple will be a 4.3% weight so that alone is $516 million in apple stock that must be bought. By my calculation that is roughly ten times AAPLs averrage daily volume of 57.3 million shaes and .07% of the market capitalization of $737.4 billion

Sunday, March 8, 2015

What Mix Of Stocks and Bonds Should You Own ?

In an earlier post I noted how the actual data on risk/return on various mxes of stocks and bonds didn’t line up with the academic presentation of the relationship. Because of this it is useful to reopen the discussion of what is the optimal choice of stock bond allocation

Does standard deviation really matter to investors ?
Warren Buffet noted the following in his annual letter as reported by the wsj

(by currency denominated instruments cds and bonds which offer poor inflation adjusted returns)
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

He concedes that short-term ownership of stocks is more volatile and therefore it makes sense for certain types of investors, …, to tie stock-price movements to risk
Although standard deviation is indeed the measure of the riskiness of a portfolio that seems to be the favorite of virtually every finance professor I would also argue that it is not very relevant to most investors. My view is along the same direction as Buffet’s but my focus is a bit different.

Standard deviation is a measure of the volatility of a portfolio. But most investors don’t or shouldn’t care about price volatility as a measure of risk. In fact most know that short term volatility shouldn’t influence their investment decisions and that for money that they might need in the near term it shouldn’t be invested in stocks….At least they know that intellectually even if they have trouble implementing it in practice. I have never seen a client answer a risk questionnaire that asks what they would do in response to a short term market drop as ‘sell everything” but we all know investors do exactly that. In fact one of the most important things an investment advisor can do is prevent you from trading and investing in stocks with a short time horizon and selling (or buying) in response to short term market movements.

What really concerns investors is how much they might lose on their portfolio. A simple answer of course would be that holding more bonds and less stocks reduces the potential for loss and increases potential returns. And this concern should be over longer time frames…since stocks should never be regarded as a short term holding.

Taking the analysis the next step in approaching the choice of a stock bond allocation the most relevant question ... how much extra risk an investor should take in exchange for potential return. 

Many "risk tolerance questionnaires" include a question like this in which the risk reward ot each alternative is symmetrical the upside and downside are of the same magnitude (the potential gain is equal to the potential loss in each case) In an example like this the choice is very clear..more risk equals more potential loss and more potential gains.

However as will be seen in the rest of this article, in the real world things don't line up the way they do in the above graph. There are times where the potential incremental upside potential may not be the same as the potential downside risk. Knowing that information would be a key input in deciding upon an appropriate stock bond allocation..and it is not as simple as the above hypothetical.

To give a simple example few investors would think it reasonable (or should if they are “rational investors”)to add to their stock allocation if it increased their potential gain from 10% to 15% and increased their potential loss from -10% to -20%.   That is simply a poor risk return tradeoff. In the real world there are points at which adding or reducing the % of stocks relative to bonds will give an asymmetric payoff...the increase in upside is greater than the increase in downside risk when adding to stocks..based on historical data.

It is possible to calculate this using historical data in terms of the range of returns and the best/worst and average returns for a portfolio allocation. I have done this analysis for a mix of total world stock /total us bond market allocations. The data is presented for 1,3, 5 and tenyears. It gives an idea where the what I call the “sweet spot’ is for an allocation the point .. the point beyond which adding stocks makes significantly less additional upside than the downside and a relatively small difference in average returns. It would correspond somewhat to what the risk/standard deviation approach of the finance professors call the 'efficient frontier'

 Of course finance is not physics and this is historical data..but it is something to use as a basis for decision making. It does show the benefit of adding to the stock allocation increases as the time horizon  gets longer but the real world is certainly not the idealized version in the above risk tolerance questionaire.

Below are the results for one year periods. The bar graphs show the range of returns and the numbers give the highest lowest and average. Ideally the investor would want to choose the mix which would offer the highest upside and the lowest downside. Or put another way a portfolio where the part of the bar graph above the zero line was far larger than the part below that line.

Obviously this doesn't exist.  As one increases the upside potential the downside potential moves up as well. But what is important is that the relationship isnt' linear or nearly as that as predicted by the professor's graph shown in the earlier post.

For example one could compare two allocations  be based on the size of the bar graph which represents the range of  returns, the best and worst year and the average return.

One could compare the 80% allocation which has the following

best period +34.78
worst period -34.6%
average return 8.84%

and the 60% allocation

best period 28.03%
worst period -26%

 average return 8.28%

and see that in order to get a higher average return of .56% the investor is trading off a much larger range of returns and a much lower worst one year loss.With the 60% return the historical worst case is leass extreme (smaller absolute value =26%) vs the upside (+28.03%) while in the 80% allocation they are basically identical at a +34.78 and -34.6%

One can review the numbers to see where the incremental return is worth the incremental risk. it seems to "sweet spot" lies somewhere in the 60-65% level adding more stocks beyond that seems to add little in terms of average return in exchange for larger risk.

Below are results  for 3 year periods. Once again the "sweet spot" in terms of risk of loss per unit of gain, average returns and range of returns seems to fall in the 60 to 65% range.  Note that going from 60% to 80% stocks -
  raises the maximum downside form-15.93% to -28.7% but only increases the average return from 27.34% to 29.84%

A risk adverse investor for example one already in or very close to retirement might well choose the 50/50 allocation whose worst period was -9.06% in exchange for a lower average return.

             Here are the 5 year numbers. Particularly interesting is that across all the allocations there is
             not a single 5 year  period with negative returns . Readers can make their own judgements as to the sweet spot it seems around 60 to 65%stocks. but as the time frame increases it does indeed look like the risk return of a large stock allocation does look more attractive. The 60% allocation here has a high upside of 92.95%, downside 14.61% and average return of 43.76%. Increasing the stock allocation to 70% raises the upside by nearly 10% to 102.41 while the worst downside is a bit more than 5% worse at 9.48% and the average return 44.66% vs 43.76% for 60% stocks


Finally, below are the 10 year numbers , in this case as one would expect the benefits of a larger stock allocation even out to 80% show themselves. Warren Buffet's advice to the long term investor seems to hold up well. 

For the real world long term investor this means that if he is willing to align his behavior to what he knows it should be --and mostly like his answers on a risk questionnaire-- he will be rewarded for holding more stocks as his time frame increases. But this will only happen if he --perhaps with the reinforcement of a good advisor--looks past the inevitable short term volatility or more precisely downside volatility, And the risk and return tradeoff based on historical data is not as simple and linear as in the textbook or "risk tolerance survey".

In any event this approach of looking at the range of returns is a much more relevant way for an investor to quantify his risk than looking at the standard deviation measure favored by the professors.

Wednesday, March 4, 2015

The Real World Isn't Always the Way It is in the Textbook...Especially If it is A Finance Textbook

I have been doing some research on updated data and the risk return of various asset allocations starting with a simple mix of the total world stock index and the total US bond index ( I am not a fan of non US bonds)

The textbook picture of what a portfolio risk and return should look like when you change the stock bond mix in a portfolio should be familiar to anyone that has taken a basic finance class or read a finance book. Increasing the stock allocation increases the return of a portfolio and raises the risk (measured as standard deviation)

I doubt there is a finance book published anywhere in the world that doesnt include this graph.

But when I ran various mixes of  the total international stock index and the US aggregate bond index here is what I got. The numbers in the key at the right are the % stocks in the allocation.

Below  is some more data in table form with returns and standard deviation. You can see that almost all time periods as you increase the allocation of stocks the increased return is not nearly as great as the increase in standard deviation. For example looking at ten year returns an 80% stock allocation gives an annual return of 6.58%  a standard deviation of 12.3 reducing the stock allocation to 60% drops the return a very small amount to 6.32% but the standard deviation falls quite a bit down to 9.43.

In other words raising the stock allocation from 60% to 80%  an investor is taking alot more risk (as measured by standard deviation) in exchange for a very small increase in return.

I ran the same exercise using only US stocks the results were a bit closer to the anticipated increase in return per unit of risk but nowhere near as large as shown in that textbook graph. Numbers at right refer to the % of stocks i,e, green is 50% US stocks 50% US total bond

 And once again as you can see in the table..not alot of increase in return relative to the increase in risk as you increase the stock allocation

Not exactly what the Dr. (the one with the Finance PhD ordered)

Obviously this raises some very interesting questions....

What implications does this have for your choice of  stock/bond mix ?...that will be the subject on the next blog entry on this subject .

The Money Flows Back Into High Yield



Demand for high-yield corporate bond ETFs came back with a vengeance in February, with funds like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64) and the SPDR Barclays High Yield Bond ETF (JNK | B-68) gathering a combined $3.5 billion during the month. The strong asset flows suggest appetite for yield is again alive and well among ETF investors. 

In February, the high-yield index underlying JNK, for instance, saw the greatest excess return over Treasurys since October 2011, Clayton Fresk of Stadion Money Management told That performance, as well as the demand for these bonds, can be explained by three factors, he noted:

  • No. 1: Stabilization of crude oil prices
As Fresk sees it, that has taken some of the focus off the large amount of oil-related business companies represented in the High Yield index and related ETFs.

  • No. 2: Value
“High yield spreads stabilized around the +500 basis point level during most of January, which were the widest level since late 2012,” Fresk noted. “A combination of capturing +5 percent to Treasurys with declining volatility in spreads are two factors that could lead investors to see value in the high-yield space.”

  • No. 3: Rates
The rate spike seen in February after January’s decline may have spooked some investors from Treasurys, he says. Based on flows, investors are favoring the less-interest-rate-sensitive aspects of high yield as a way to protect against climbing interest rates.

Tuesday, March 3, 2015

Should You Use a Robo Advisor: Will You Really Understand What is Under the Hood?

In my first article on “robo advisors” I pointed out many shortcomings of the “robo advisor” process. I detailed all the questions which the “advisor” doesn’t ask which are essential to investment planning. I didn’t even discuss the actual allocations proposed by these services and how they are implemented.

Reviewing the allocations of the major robo advisors one finds widely divergent allocations. Investing and asset allocation are at the end of the day a mix of “art” and science. The differences among these portfolios are significant and reflect very different views on investing.

But somewhat ironically, the target market for these robo advisors is individuals who have little interest in getting deeply involved in their investment choices and are looking for a simple inexpensive way to allocate their investments. Yet the assumptions inherent in the allocations are so complex that few if any individuals in this target market” or indeed many non-professionals (and plenty of professionals too) would have difficulty carefully analyzing these portfolios.

Furthermore since there is little explanation that I have seen on the websites of the choices made in the portfolios, when or why they might make changes in the portfolios or specific risks in the portfolios Investors are often buying a portfolio they don’t really understand And since they must buy the entire portfolio they can’t remove from the portfolio any asset classes they are uncomfortable with.

And the costs of these portfolios? The fees on these programs may be low but as will be seen below that does not mean that the portfolios are really low cost

What’s Under the Hood?

Do you know what is under the hood? The various robo advisor portfolios contain some weightings and choices that are certainly subject to debate in the investing... produced a great analysis going under the hood of robo advisors allocation. An in depth analysis is in this article 

I’ll just highlight some of the differences 

Some robo advisors include broad based commodity exposure, some gold, some REITS, some have a long duration bond portfolio some shorter, some include inflation protected bonds, emerging market bonds, developed market international bonds and some don’t. On the equity side the choices of instruments, type of allocation (market weight or value tilt for example) vary widely. There are robo advisors that include allocations to specific industries, 

And the differences in allocations are not a trivial matter, they are extremely significant here is one example

Here are the allocations in the 90% stock allocations for two Robo advisors

Developed International
Emerging International

In fact Betterment’s allocation to emerging markets stock is less than half that of the other major robo advisors.

Obviously this is a huge difference and just of one of dozens across all the major robo advisors

How many individuals could make a judgment among these or find a good explanation (as they should get from a good advisor) as to why the allocation is as it is, how it has performed in the past and even what long term expectations are. And of course in many cases working with an advisor they could individualize the allocation after the details of various pieces of the allocation are explained. None of this will be done by the robo advisor.

Here is the article’s analysis of the Betterment allocation I would doubt many Betterment clients would be able to do this analysis, understand it and evaluate it compared to alternatives. And Betterment says it is thinking of adding more/different ETFs. How will the clients learn about this and when and why?


Betterment has come through on its pledge to deliver marketlike exposure with a value orientation. But its promised small-cap tilt and downside protection are not in evidence. Like Wealthfront, Betterment takes on moderately high duration and credit risk from its muni bonds.
Betterment pulls off the trick of being both marketlike and value-oriented while not tilting small by making value allocations with U.S. equities only. U.S. large-cap value funds emphasize mega-caps, so Betterment’s value tilt increases its portfolio-weighted average market cap.
If, in the future, Betterment ventures into international value funds, as Chief Executive Officer Jon Stein suggested they might if expense ratios fall, its portfolio-weighted average market cap would likely rise further, approaching the global-weighted average, since mega-cap firms dominate value funds globally

Betterment makes use exclusively of Vanguard ETFs certainly in terms of cost they are usually a good choice and the lowest cost in most categories. But there is d an expense ratio price war going on and ETFs from Schwab and Ishares now have ETFs at expense ratios very close to Vanguard’s.
 Methodologies differ, it could certainly be that the fee difference is offset by differences in strategy. To give a significant example several robo advisors use dividend oriented ETFs which have widely different methodologies. It is not transparent why these firms chose one vs another and would they explain their choices to you and if and when they might make a change.
Several robo advisors make use of industry sector funds. What are the criteria for those choices? Do they ever change? If so why? This is another set of “under the hood” issues many investors particularly the type that would use a robo advisor will likely not ask...or even understand. And how would they even ask a robo advisor and of course if the response is not satisfactory to the potential Betterment investor he would have to move to another one since all the Roboadvisors are “packages” that can’t be broken up.
Risks you may not be aware of. In my view emerging market bonds are an asset class that is not worthwhile to own given its risk/return characteristics. Others may differ, but how many of those using Betterment (to give one example) know that it owns an emerging market bond fund as 4% of their model allocation. The emerging markets bond etf from Vanguard which Betterment uses has a 10% allocation to Brazil a 9.4% allocation to Russia and a 6.3% allocation to Turkey. How many Betterment investors will be aware of this or check the holdings of each of the ETFs owned in their portfolio to find this out? Investors buy the Betterment portfolio as a package and don’t have the choices explained in depth. And the investor does not have the option that he would likely have with an advisor to simply eliminate an asset class from your portfolio after the risks are explained.
This is just one example the same could be said to one degree or another about every choice in every robo advisor portfolio. Will the investor know what particular asset class performance affected the portfolio performance and is this explained to you in any quarterly or annual reports…to the best of my knowledge there is no in depth reporting explaining results.
Will Investors Start to Chase Performance Among Robo Advisors?
Since the allocations of robo advisors differ the performances of course will differ. Will investors be tempted to check performance across robo advisors and switch based on short term performance? Certainly as these products grow there will be articles reporting on the performance of the robo advisors. I can predict Morningstar ratings on each of the robo advisors will be coming soon. Investors will doubtless make investment decisons based on the Morningstar analysis. This despite the fact that Morningstar acknowledges (but you can’t find that information very easily) that their “star’ ratings are not predictions of future performance…and they change. Instead of simplifying things for investors the growth of robo advisors will simply lead to a different level of complexity.
Changes in Response to Market Conditions
You probably would not like to work with a “non robo” advisor that make frequent changes to your allocation. But in my view there are some conditions where strategic changes in portfolios are merited.
Here is one important example: It is crystal clear that the next move in US interest rates will be up. It is also a simple fixed relationship that the longer term the bond the more its price is affected increases in interest rates. A “non robo” advisor would often choose to reduce the duration of its bond allocation under current market conditions. The robo advisors have varying durations in their bond allocations…but none of them own only or mostly short term bonds.
Thisarticle presents a very thorough analysis of the impact of rising rates on the bond market. I haven’t seen any indication that Robo advisors make adjustments to their bond portfolio in light of the near certain increase in interest rates (the only question is when…not if it will happen) Some non robo advisors will make adjustments because of this and I am sure that most will explain this decison to their investors.
 An informed consumer looking at putting their life savings with an advisor robo or other should ask how the portfolio is positioned for a rise in interest rate. If they asked a robo advisor who would answer? And of course the response to the answer was unsatisfactory the consumer would have to move on to look at another robo advisor
There are other specific categories of ETFs that are likely to be unfavorably affected by rising rates. Based on historical market performance these would include REITS and dividend stocks. How is the robo advisor positioned now in response to the near certain increase in interest rates? Why? And what changes might the robo advisor make ant why.
There is much more to say about looking “under the hood” of robo advisor portfolios. After doing due diligence an investor would likely find choices in virtually every allocation that it would prefer not to be in its portfolio.  Investors, certainly those in the target market for robo advisors who “want a simple solution to their problem of how to allocate their money may not be getting what they are looking for.
 It is unlikely they would be inclined or have the skills to do thorough analysis and due diligence in reviewing robo advisors. In fact these investors would be the least likely to have the skill or inclination to make such analysis.
To do a thorough review they would likely have to pay a “non robo” advisor to help them. And even after that review of the robo advisors many may find that picking the best solution to meet their needs is a bit like solving a Rubik’s cube in fact it is even harder if not impossible. 
Since you have to buy the “package” with a robo advisor there will almost inevitably not be a robo advisor that perfectly matches an informed client’s preference. But a good “non robo” advisor would be able to customize client portfolios rather than using what is virtually a one size fits all approach.
Trade Execution: There are more costs than just the management free.
It is unclear how the robo advisors execute the trades in their portfolios. Money will be coming in every day. Do they execute all the trades at one fixed time every day? How do they do their rebalancing trades? If the markets are particularly volatile on a particular day do they restrain from trading, do they make sure not to trade on the day or time of major economic events, what controls do they have for something like a “flash crash” or extreme moves in a particular asset class or sector they own.
I am sure the robo advisors don’t all use the same methodology. But how many robo advisor consumers would know to ask or fully understand the implications for the investor. And how many robo advisors will disclose that information?
Why is this important? Because the differences in trade execution can create unnecessary costs to the investor far in excess of the explicit robo advisors fees.
This excellent article from the WSJ explains the importance of trade execution for the individual investor
The article notes that differences in execution “could save you from trading at a price that could eat up a year’s worth of return on a stock”
Now consider the case of the robo advisor who needs to execute millions or tens of millions of dollars of purchases or sales of a particular security. Not only would it be hard to enter the trades with a “marketable limit order” as recommended in the article. The orders themselves could “move the market” making the trading price less attractive than it was when the trade was about to be executed.
Now consider the not likely scenario (in fact it has already existed) that it becomes knowledge in the market that a large robo advisor executes its rebalancing trade the 15th or every month at noon. It is not hard to figure out what the trades will be. The details of the allocation are public and the particular trades are clear. The robo advisor will be selling what has gone up and buying what has gone down. Not only are human traders savvy enough to take advantage of this there are high frequency traders whose entire business is built upon making profits because of short term activity in the market.
Trades like the one described are a big fat pitch down the middle of the plate for human and robot traders to make money at the expense of the robo advisor.
A human advisor would have far little if no “market impact” since their trades will in almost every case be far smaller than the robo advisors. And the human advisor can fine tune his execution.
And this problem will only increase over time if the robo advisors continue to gather assets. Betterment alone has close to $1 billion in assets under management is in very early stages and is just starting to gain awareness among the general public through exposure in the mass market press I am sure that few if any of the issues above are discussed in these articles.
Despite the many issues related to robo advisors virtually all of the articles in the popular press  praise the robo advisors as the “wave of the future” and praise them as the best choice for investors because of their low costs. 
This blog entry and my previous one has reviewed many and far from all of the issues and hidden costs associated with a robo advisor. has published several articles which analyze various issues related to robo advisors. And even though the new blog articles together are fairly lengthy I have covered only a small number of the relevant issues

 Perhaps the apparent savings and utility of using a robo advisor are illusory and a one size fits all stock amd bond allocation is not the best choice. In fact perhaps it makes sense to find “non roboadvisors" to work on a consulting basis or asset management of an ETF portfolio for a reasonable fee…even if it seems higher than the ultra-low cost robo advisor