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Saturday, April 30, 2016

Is This Really How You Want Your Money Managed ?

I have written many times about the perils of "go anywhere (also known as unconstrained) bond funds. As is (or should be) clear from the label the funds can invest in assets well beyond those that would make up the stable assets that most investors seek in the bond allcation of their  portfolio. Rather than investing in an asset class the investor is really betting on the future success of the "star manager".

The prime example of this was the Pimco Total Return bond fund managed by "bond king" Bill Gross. While Pimco marketed the fund as a "core holding" for investors it was in fact far closer to a risky hedge fund than the time of fund that would be a good choice for a core bond holding.. After many years of strong performance and investment chasing investors which made it one of the largest mutual funds in the world, the fund began to turn in sub par performance and the assets came rushing out. Gross was ousted in a much publicized controversial episode still the subject of a lawsuit with  over $100 million in dispute.

Gross has moved to Janus Capital where he manages the Janus Unconstrained bond fund. But to say he has moved on would hardly be correct. As described in this NYT article Gross is nothing short of obsessed at his new funds perfrmance vs. Pimco Total Return...and he measures that performance on a daily basis:

Mr. Gross, 71, is not tethered to his phone, so when Bloomberg publishes the daily result of his fund at 3 p.m. California time, he will drop his golf clubs and rush to the office to get the news.
The first thing he says he does when arriving home (after kissing his wife, Sue, of course): Check the Bloomberg. At night he will wake up as many as three times to check on global markets, he says....“My whole evening is dependent on whether I beat them,” Mr. Gross said. “You see, I have to prove it all over again. Every day.”
In his obsessive quest for short term performance Mr. Gross is prepared to take some huge bets on what are far from conventional assets a long term investor might seek as parts of his bond allocation:
Mr. Gross has made some big bets that Brazil and Mexico will not default by selling investors credit-default swaps, derivative instruments that would force him to disburse large sums if these countries go belly up.
Such derivative-fueled bets on financial stability can backfire when markets go haywire. Last year, his Janus fund experienced several sharp drops in price, which preceded Mr. Soros’s decision to withdraw his funds.
“This is not a riskless strategy,” Mr. Gross acknowledged.
He is also under no illusion that his good run is permanent.
So he is enjoying its fruits while they last. And if he has become fanatical about beating the guys across the street, so what? He is convinced that fealty to the screen, not to mention daily yoga stretches, is what keeps him feeling youthful.

Latin American credit default swaps (yes credit swaps the intrument so well explained by Selena Gomez and Prof Richard Thaler in the movie the Big Short)

Gross, never one to hide from the media spotlight appeared recently on CNBC to tout two other holdings in his unconstrained bond fund: the stock of brewer SAB Miller s and a preferred stock ETF !
At  present around half of the $1.3 billion in the fund are Gross' own assets. But I have little doubt a period of strong short term perfrmance will attract more assets...into an extremely high risk portfolio,...certainly not the kind f stable instrument that should make up the bond allocation for a long term investor.
The Janus fund may be seem an extreme example but the new hot "unconstrained bond fund" run by the recently crowned bond king Jeffrey Gundlach: The Doubleline Total Return Bond Fund  takes some large concentrated riks as well. Gundlach  does not have large holdings in emerging market credit swaps but it has far from a conventional bond fund. The top holdings are in agency mortgage back securites (48% of the portfolio vs 15% for the intermediate bond category) and 17% in non agency mortage backed securities (1.3% average for the category) . As viewers of :"The Big Short" movie and other market observers doubtless know such securities were at ground zero of the 2008 financial crisis. 
The big bets of Gross and Gundlach may well produce spectacular short term returns or major losses even when the overall bond market experiences little fluctuation.. Is this the way you want your long term money invested..especially as part f your bond allocation?

Thursday, April 28, 2016

High Yield Bonds..Only for the Long Term and Not for the Faint of Heart

High yield bonds have had a major recovery since the ugly 2014 (measured  in total return HYG the largest high yield ETF is up over 8% in the past 3 months) showing that they are an asset class that only works for long term investors. Further complicating matters  is the fact that changes in the bond market with dealers holding last inventory and less willing to take risks after market makers have reduced liquidity in this market. Less liquidity means more volatility and of course the liquidity dries up just when performance chasing investors want to sell creating a vicious cycle.

Unlike Treasury bonds or even investment grade high yield bonds won’t form a buffer to a portfolio in times of crisis.  But they may offer an attractive addition to a portfolio as an asset with risk between those of stocks and those of treasury bonds and investment grade bonds. The NY Times recently presented a good overview of the high yield bonds' role in a portfolio,

With US stock valuations high based on historical measures and yields on junk bonds—despite the recent rally—well above long term averages it may still be a good opportunity to add high yield bonds to a portfolio. In the long term asset classes show a reversion to the mean in valuations with US stocks at high historic valuations and high yield bonds – even after their recent rally— are still at relatively low valuations it may be a time to consider incorporating high yield bonds in a portfolio allocation…but only for those who consider it as part of a long term investment strategy.

As is the case in most asset classes investors tend to chase performance and thus miss out in the long term returns. This is certainly the case with high yield bonds. Below are graphs of fund flows and below that changes in yield spreads –the differential between high yield and investment grade vs treasury bonds, lower spreads mean higher prices.

Nor surprisingly the flow of investor money chases performance with outflows at the bottom in price (high in spreads) and vice versa.


And here is a chart of the high yield bond ETF HYG as can been seen high yield bonds are not for the faint of heart. Matching this chart against the flow of funds chart above shows the outflows matched price declines and the inflows chased the advances in price. One can observe here a spikes up in volume (bottom scale)at the lowest price levels..indicated large scale selling..

On the other hand, disciplined investors who allocate a portion of their assets and use a disciplined rebalancing strategy can reap the benefits of an allocation to high yield.  Perhaps more than other asset class, high yield bonds have a very clear pattern of reversion to the mean: when yield spreads move to extreme levels they return back closer to long term averages. This makes them a particularly good asset to benefit from those that use discipline in rebalancing.  Selling part of the allocation after large increases in price (spreads well above the mean) and vice versa gives excellent opportunity for a “rebalancing premium” in this asset class…as well as reducing risk.

Here is a longer term chart of credit spreads.

So where do High Yield bonds belong in a portfolio. A recent NYT article discusses this. High yield bonds fall somewhere between stocks in terms of risk and return. Given the attractive cash flows from such investments and lower volatility than stocks they might be seen as an attractive alternative to dividend and dividend growth stocks in generating cash flow from a portfolio. For example, at present HYG currently carries a yield of 5.77% vs 3.57% for HDV the high dividend ETF and has consistently carries a yield well above that of HDV. Below is a three-year graph of the yields for HYG and HDV

A few more graphs of interest.

Long term chart of total return (growth of $1) high yield index vs US stocks (Russell 3000 index), US investment grade bonds and US treasury bonds

And the risk return graph used to show the “efficient frontier” how asset classes line up in terms of risk and return.

 The graph shows that in fact high yield investors are compensated for the risk they take relative to treasury bonds. And that the risk/return is between that of US stocks (Russell 3000) and the US treasury bonds. In fact, the risk return tradeoff (added risk vs increased return) high yield bonds look attractive compared to credit bonds indices which include investment grade and high yield. That is logical since in times of financial crisis spreads between both investment grade and high yield bonds both widen considerably (decline in price) during periods of financial stress. As many have observed the only thing that goes up in such markets is correlation among risk assets. Only treasury securities and cash offer a shelter in those conditions.

The long term disciplined investor can benefit from a long term allocation to high yield bonds…but only for those with the fortitude to hold on to their allocation during periods of share declines. And disciplined enough to sell high and buy low in rebalancing.

Current high historic valuations for US stocks and low historic valuations for high yield bonds may make it an opportune to consider initiating such an allocation.

Tuesday, April 12, 2016

A Few Tax Notes for US -Israel Dual Citizens

As April 15 approaches it is a good time to note some tax related matters specific to US Israeli Dual Citizens and their taxes.
·         New immigrants are exempt from Israeli taxes on investment income for the first 10 years after Aliya. Of course the investments are still subject to US taxes. But because of the provisions of tax law which allow the deduction of Israeli tax paid from US taxes, many dual citizens find themselves in the 10% or 15% tax bracket in the US. That means that their capital gains and dividend income are not subject to tax in the US.
·         The dreaded PFIC issue. US law categorizes most foreign mutual funds including those in Israel as Passive Foreign Investment Companies. This means that the tax on those funds is far higher than on US mutual funds and exchange traded funds. The PFIC rules mean that even if one buys an Israeli S+P 500 Index fund it is a PFIC while the US fund with the identical strategy is not and would be taxed at far lower rates. The tax on PFICs can reach as high as 50% while for many US citizens none of their capital gains would be subject to tax.
·         The PFIC solution: the solution to the PFIC issue is relatively straightforward purchase of US ETFs either through a US brokerage accounts (clearly the preferred solution for those in the exemption period or in an Israeli brokerage account)

·         US Mutual Funds and Brokerage Firms and Foreign Residents: It is true that because of potential reporting requirements many US brokerage firms no longer will hold accounts for US citizens with foreign addresses many will. Many US mutual fund companies no longer accept investments in their funds from firms with foreign addresses. The solution to that is very straightforward and in most cases the preferred choice for all investors. A portfolio of low cost US exchange traded funds (ETFs)

Thursday, April 7, 2016

Are You Getting the Right Kind of Investment Advice ? the US Government Indicates That Very Likely is Not the Case

After a long period of discussion…and despite the opposition of the lobbyists for much of the financial services industry. the US Department of Labor will be announcing new regulations for financial advice. The new rules will require all advisors including stockbrokers and insurance agents to give advice based on a fiduciary standard as opposed to the current requirement of suitability:
The fiduciary standard is already the required standard for Registered Investment Advisors (like us) As the WSJ notes
…. the rule, which requires stockbrokers providing retirement advice to act as “fiduciaries” who will serve their clients’ “best interest.” That is stricter than the current standard, which only says they need to offer “suitable” recommendations, a standard that critics say has encouraged some advisers to charge excessive fees or favor investments that offer hidden commissions.
Of course this a welcome development and will no doubt improve the level of advice given to many investors. Nevertheless, several points merit pointing out:
·         The requirements only apply to IRA accounts not to all investment accounts. Those with non IRA accounts will find that their broker is still held only to the lower “suitability “standard. It is unclear to me what happens to a client that has both IRA and taxable accounts. The reason the new rules don’t apply to all investment accounts is because the rules are from the Department of Labor which only has responsibility for retirement accounts. Other investment accounts would come under the purview of the SEC which is tied up in a partisan divide and unable to agree on new rules 
·         The new rules don’t “grandfather in” existing investments. This would leave things in the strange situation where advisors are held to the new fiduciary standard for new investments are under no obligation to explain to clients that their existing investments while “suitable” (the current standard) don’t meet their best interests (the fiduciary interest). I’m not quite sure how that would work in practice but clearly it is not the optimal situation for investors.

·         The rules won’t take effect until spring of 2017 at the earliest.
Never underestimate the lobbying power of the financial services industry. The WSJ reported they were able to get some last minute watering down of the new rules...with a puzzling explanation of he changes by Secretary of Labor Perez: (my bold)

Wall Street breathed a sigh of relief Wednesday when the industry finally got a look at the Obama administration’s new retirement-advice regulation, discovering some onerous requirements floated earlier had been scaled back.
A broad coalition of financial firms, trade groups, and Republican politicians, joined by a handful of Democrats, spent the past year mounting a fierce counterattack to the Labor Department rule promising to shake up the $14 trillion in assets parked in 401(k)s and individual retirement accounts….
The Labor Department also retreated from language that would have explicitly favored low-cost investments and declared instead that an adviser isn’t required to recommend the lowest-fee option if another product might be better for a client. “The Yugo may be the lowest priced car, but it isn’t a very good car,” Mr. Perez told reporters in explaining one of the changes

I think any objective person looking at the choice of an index fund or ETF with fees as low as .05% as analogous to a Yugo…seems Yugo’s no longer exist because they truly “weren’t a very good car” and investors voted with their wallets and walked away from them/. On the other hand, trillions have flowed into index funds and ETFs from both institutional and individual investors (including some of those proprietary mutual funds). It’s difficult to believe they have all invested in the equivalent of a Yugo (and continue to pour money into these funds) bypassing proprietary funds which would have better met their needs.

It’s hard to believe that the changes that were made based on the lobbying of the financial services industry are to the benefit of investors.

All of this begs the question: Why work with a broker who will only be held to the fiduciary standard (with the exceptions listed above) on their IRA accounts, may still work with a firm with proprietary funds(and the potential conflicts of interest involved in those), and who will only be held to those standards at the earliest a year from now…..instead of working now with an independent Registered Investment Advisor already held to a fiduciary standard for all his client accounts that has no proprietary products connected with his firm ? our firm.