Inflation and Bond Investing

Food for Thought

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

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


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

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

What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.


http://www.ft.com/cms/s/0/37f7e034-2878-11dd-8f1e-000077b07658.html
As for his positioning in his bond fund, Gross (see below as reported in the Financial Times) is implementing his view that US treasuries are extremely unattractive given their negative real yield. Instead he has moved into mortgage backed debt based on the yield spread over treasuries and what he perceives as a strengthened implied government guarantee for Fannie Mae and Freddie Mac. Our portfolios have moved into mortgage backed securities in a more cautious manner by investing in a GNMA bond fund. GNMAs are mortgages which carry the full faith and credit of the US treasury (unlike fannie and freddy) yet it seems the mere word “mortgage has scared away investors and pushed up yields. The Vanguard GNMA fund currently yields 4.76 vs 3.20 for their equivalent maturity treasury bond fund

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

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

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

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

May 18, 2008
How to Stop Inflation From Devouring a Portfolio
By J. ALEX TARQUINIO

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

His advice certainly makes more sense than this:

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

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

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

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

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

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

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

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

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

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

Wisdom From the Oracle of Omaha

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

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

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

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

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

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

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

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

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

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

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

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

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

There Are No Geniuses Department

I have noted many times that the past records of fund managers, or a top rating from Morningstar or any other financial publication is of little use in picking mutual funds. There is little persistence of returns and even impressive track records for funds seldom give a full picture of the risk adjusted return.

A recent case in point, highlighted in the March 21 WSJ is Bill Miller and his Legg Mason Value Trust (LMVTX). For years this fund had been the darling of the financial press as the manager stacked up 15 consecutive years of beating the S+P 500.

But we were really not surprised to read this in the WSJ:

Bear Is Bill Miller's Latest Setback

Legg Mason Star
'Was Surprised'
By Stock's Plunge
By DIYA GULLAPALLI

March 21, 2008; Page C1

At an investment conference last Friday, legendary stock picker Bill Miller of Legg Mason Inc. was caught off guard by a simple question.

Mr. Miller was speaking at a conference titled "Credit Cycle-What's Next?" in the auditorium of Deutsche Bank in New York. During a 40-minute session, Mr. Miller along with other experts spoke to more than 200 top-tier Deutsche Bank clients about the markets. In particular, he talked at length about why this is a great time to buy financial stocks -- including Bear Stearns Cos.

Burned by Bear Stearns: Bill Miller of Legg Mason
After the presentation, an audience member raised his hand and asked Mr. Miller if he was aware that Bear was collapsing and its stock was down 15% that morning. Mr. Miller looked shocked, according to observers…..

Bear Stearns is emerging as the latest disaster for Mr. Miller, who has also taken a bath on home builders like Pulte Homes Inc. and other financial companies like Countrywide Financial Corp., while missing out on big gains in energy in recent years.

Seems Mr. Miller is not alone among the fallen investment stars
The sudden decline illustrates how quickly the credit crisis is transforming celebrity investors into laggards, as their traditional down-market playbooks are failing. The setback is particularly stinging for Mr. Miller, who has thrived in the past by assembling a portfolio that is very different from other value investors.
Actually, for years Miller’s portfolios had little in common with what is generally considered a value investing strategy as he has loaded up on high p/e stocks like Amazon.

In fact Miller’s decline wasn’t particularly sudden and gives rise once again to the reliability of a strategy of picking funds run by investment “superstars”
Mr. Miller was similarly ahead of the index over the past 15 years on average. His streak concluded in 2005, however, and his fund was down 6.7% last year while the S&P 500 was up 5.5%, including reinvested dividends. Over the past five years, his fund has averaged just 6% annually, little more than half the return for the S&P 500, says Morningstar.

Even when investors were seeing strong performance from Miller’s fund they were taking quite a bit of risk. Miller’s portfolios are marked by large positions in a small number of stocks and often a high concentration in a particular industry
Reviewing statistics for Mr. Miller’s fund (LMVTX) one finds that his fund has a 5 year standard deviation of 14.6 and a return of 8.02%. The Vanguard Total US Stock Market Index (VTSMX) had 9.63 and 11.5% respectively. This means that the Miller fund was s more than1.5 x more volatile than the market index yet produced less return. For ten years the lmvtx beats the vtsmx in return by a small amount 4.83 vs. 4.46 but with considerably more risk. The ten year standard deviation for the Miller fund is 19.8 vs. 15.23 for the total stock market index.

As noted, Miller’s fund has consistently held concentrated positions making it far less diversified than a market index fund. The top ten holdings of the total stock market index fund comprise 16.1% of its assets. Here are the numbers for the Legg Mason Value Trust:

TOP 10 HOLDINGS ( 47.05% OF TOTAL ASSETS)

Company Symbol % Assets YTD Return %
AMAZON.COM INC AMZN
6.91 -30.41
AES CORPORATION AES
6.20 -15.94
UNITEDHEALTH GROUP UNH
5.93 -20.14
AETNA INC. NEW AET
5.20 -14.08
JP MORGAN CHASE CO JPM
4.73 -6.03
QWEST COMM INTL INC Q
4.10 -21.89
SPRINT NXTEL CP S
3.91 -45.85
EBAY INC EBAY
3.46 -20.58
YAHOO INC YHOO
3.43 19.43
GOOGLE GOOG
3.18 -31.87


.
Whatever Miller’s future performance it is clear that it will be the result of taking on quite a bit of risk:

Regarding recent missteps, Mr. Miller is essentially re-employing his strategy from the early 1990s -- an important reference point that's informed some of his boldest buys.
Back then, a similar crisis was unfolding in financial markets and Mr. Miller eventually swooped in to buy money-center banks like Chase Manhattan and Citicorp that he thought were underpriced, as well as insurance companies and mortgage lenders. Financials made up as much as 45% of Mr. Miller's portfolio by the mid-1990s, and helped drive his 15-year winning streak as they rallied over the years…..

Mr. Miller bought financials like Washington Mutual Inc., Wachovia Corp., Merrill Lynch & Co. and Freddie Mac in recent months. He added Bear, Goldman Sachs Group Inc. and NYSE Euronext in the third quarter. Despite gains in recent days, the financial sector of the S&P 500 is down 15% this year.

Mr. Miller is sticking to his guns. Legg Mason Capital Management was the largest holder of Countrywide through December, holding about 12% of company shares. While the stock was the worst performer for the fund last quarter, down 53%, Mr. Miller is betting it is a great buy for Bank of America Corp. in the long run. Mr. Miller was so eager to keep buying the stock, in fact, he petitioned the Office of Thrift Supervision so he could increase the stake to up to 25% of shares outstanding. The permission was granted in mid-January, and he increased its holding.


My conclusion from all this is that once again it is clears that:
1. There are no geniuses: even investment superstars inevitably run into the reality of how difficult it is to beat the market.

2. Even when it seems like a superstar is “crushing the market” he or she is almost surely doing so by taking on far more risk than the overall market.

3. Which means that eventually we will see the consequences in #1 above.

4. Hope springs eternal and articles will soon appear about the new superstar with a track record of crushing the market indices.

2007 Markets Review and Some Thoughts on 2008

2007 Financial Markets Review

Equity Markets

Needless to say 2007, particularly the second half, was a difficult one in the financial markets. The S+P 500 (total return) ended 2007 +5.49%. The mortgage crisis, first evident in the credit markets, spread to the equity markets as stocks of financial institutions were decimated by massive writeoffs of mortgage related securities on the balance sheets of those companies. The S+P financials index fell 20.84% for the year. Housing stocks suffered severe declines as well.
While the housing market seems far from recovery, the large capital infusions from foreigners into major financial institutions indicates that at least some investors see values in the financial sector. We remain skeptical; the “known unknowns” of more writedowns due to mortgage losses, credit problems in the corporate debt markets, losses in derivatives, or other areas makes us remain cautious.
The impact of the financial stocks’ losses in the equity markets hit value stocks particularly hard as that group carried higher weighting in those sectors. The Russell 1000 large cap value index was -.17% , small cap value was -9.78% for 2007 In contrast export oriented technology stocks led the large cap growth to strong outperformance, posting a gain of 11.81% .

Among other sectors the global growth theme particularly in India and China made materials and commodity stocks a top performing sector. For 2007 Energy stocks (S+P index) rose 32.38% rose materials stocks + 19.98%. Commodities themselves rose as well: oil reaching close to $100, gold rising and agricultural commodities hitting multi year highs.

Internationally, developed and emerging markets diverged. The EAFE (Europe and Far East) index (etf EFA) 9.97 %. Here again the crisis in the credit markets and the large writedowns for financial institutions hit that sector. As a consequence the EAFE growth index (etf efg) was up 15.03% while value (efv) was up only 5.56%. Emerging markets were the star performer investors expressed their confidence in the BRIC countries (Brazil, Russia, India and China) and the MSCI emerging market index (etf seem) rose.33.08%.

Credit Markets

In the credit markets the impact of the mortgage crisis and the threat of recession led to three easing moves by the Fed since September, reducing short term interest rates by 1%. This had little impact on the core of the crisis, which was the availability of credit and level of spreads between treasury bonds and other securities. As a consequence the Fed and other central banks established credit facilities to inject liquidity to limited success. As the year ends limited availability and high costs of credit remain a feature of the markets, and prices of the riskiest credit instruments trade at large spreads over treasuries.

Portfolio Review

Our portfolios shifted a bit from their overweighting in value stocks towards growth stocks in domestic and EAFE markets in response to the first signs of the crisis in financial institutions. Nonetheless, we maintained a core position in value stocks based on their long term record of strong performance. Significant weightings internationally both in developed and emerging international markets helped our performance. We also maintained positions in energy and basic materials throughout the year which was clearly a positive contribution. The REIT positions which we view as core diversifiers suffered along with the rest of real estate.

2008 Outlook

Looking into 2008 US markets continue to face the cloud of recession and the ongoing problems in the financial services and housing/construction industries. These factors are likely to limit market gains. Continued interest rate cuts by the Fed are likely, but as was the case in 2007 will have little stimulative impact.
We would view the most likely scenario for US market returns in 2008 as below, or at best equal to the lower end of US long term stock returns ( 8%- 11). Developed markets, also experiencing similar conditions in the financial sector will likely produce similar returns, with US investors gaining a bit from a lower dollar.
We view last year’s performance in emerging markets as highly unlikely to repeat. The same could be said for energy and commodities. The key question is whether these markets will experience a sharp correction or just a much lower positive return.

It is not uncommon for falls of 20% within a quarter for emerging markets and significant short term falls in commodity prices. We would not be surprised by continued volatility but think resilient investors will be rewarded by an outperformance of emerging markets relative to developed markets here and abroad and thus should maintain a long term allocation to these markets .For similar reasons, a relatively small portion of portfolios should be in stocks tied to energy and other commodities.

In the credit markets, continued Fed easing will take short term interest rates lower. However, long term rates are unlikely to decline. The most important question is how long current anomalies in credit markets continue .Corporate bonds and cds are trading at historically high spreads relative to treasury bonds. Municipal bonds currently have yields at virtually the same rates as treasury bonds of the same maturity. Neither of these relationships is likely to continue for long and investors would be well rewarded to taking advantage of them.

About Those Alternative Asset Classes...

Various experts (almost invariably connected to firms that market or manage these investments) tout the importance of having exposure to hedge funds and private equity in one’s portfolio in order to create returns in excess of the overall stock market.
Being the skeptic I am about such matters I was hardly surprised to find this article in the Financial Times

Private equity underperforms market

By Martin Arnold, Private Equity Correspondent
Published: November 22 2007 16:48 | Last updated: November 22 2007 16:48

Private equity has on average underperformed the stock market in the last decade, according to a detailed survey of the buy-out industry submitted to the European Parliament on Thursday…..The research – based on data from 6,000 private equity deals and about 1,000 buy-out funds – shows that average private equity returns have underperformed the benchmark S&P 500 share index by 3 per cent, after fees charged to investors.“This does not correspond with the stereotype of the industry making its investors extremely rich,” Mr. Gottschlag told the Financial Times. “Investors have not had much fun in this asset class, even though they have all been obsessed with gaining access to the best-performing funds.”
And talk about crude math, how about this:
Excluding fees and carried interest (a widely used profit sharing scheme), returns from private equity outperformed the S&P 500 by 3 per cent.
“So private equity is generating value somewhere, but its fee structure means the general partners capture double the out-performance they generate,” said Mr Gottschlag, who is also head of research at Peracs, an advisor to buy-out investors.

So yes, private equity is a profitable asset class…..for those that manage the private equity funds

Mr Gottschlag admitted that some private equity firms were consistently outperforming the stock market. But he was sceptical about the number of buy-out funds that say they are “top-quartile” in performance rankings.

And private equity seems like Lake Wobegeon where everyone is above average the Professor states:
“I have never met a general partner who was not top-quartile. So I wonder where three-quarters of the industry is hiding,” he said.And remember the data used came before the current period of tight credit where private equity firms have had to walk away from deals due to limited or expensive financing.

More Strange Advice on Investing

An article on safer alternatives to stock market investing in the Oct 28 NYT entitled:

Shedding Stock-Market Vertigo (but Still Making Some Money)

starts out logically enough ,mentioning some sensible alternatives including CDs and Treasury Inflation Protected Bonds.

Then the article veers off into the strange recommendation of actively managed bond funds. As we have noted before there is nothing particularly safe about these funds. The investor is simply giving his money to a bond “guru” who takes bets across the entire spectrum of fixed income investments. Much as with an actively managed stock fund, you never now what you own and what risks are lurking in the portfolio, particularly in the currently unstable bond market.
The article cites the recommendations of a Morningstar analyst (my bolds):

he has identified two — Metropolitan West Total Return and Pimco Total Return — as likely to benefit from credit market fears.
“They both have a history of opportunistic buying,” he explained. “Great managers love volatility.”

They may love volatility but is that what an investor really wants when he flees from “stock market vertigo”?

Mr. Peterson of Schwab likes Pimco Total Return and the Loomis Sayles Bond fund, which has international exposure, along with high-yield holdings intended to enhance performance.

Translation: they load up on credit, currency and sovereign risk to squeeze out higher returns .

Daniel J. Fuss, the Loomis fund manager, has excelled at finding the optimal mix of investment-grade and junk bond holdings, Mr. Peterson said. “Loomis is more of a credit analysis play,” he said. “They shift between investment grade and high-yield.”

This manager puts the conservative part of your portfolio in the riskiest types of bonds “high yield (junk) bonds. And with many forecasting a recession this is precisely what you do not want to own.

In all, his fund holds 22 percent in below-investment-grade holdings, along with roughly 17 percent in nondollar credits, chiefly in the Brazil real, the New Zealand dollar and the Mexican peso. These issues provide higher yield than dollar-denominated debt and would benefit from a continued decline in the dollar. This year through Thursday, the fund has produced a total return of 9.2 percent and has outperformed its multisector bond category average in each of the last five years.

Junk Bonds, Brazilian Real Bonds and Mexican Peso Bonds....Does that look like a portfolio designed to prevent market vertigo ? It looks to me like an accident ready to happen.

Once again it bears repeating. The only reliable way to reduce the risk of a portfolio is to increase the holdings of short term treasury bonds, treasury inflation protected bonds or investment grade bonds. Anything else is some kind of a bet on the direction of interest rates, credit spreads, currency risk, or sovereign risk. In fact a strong case could be made that even the investment grade bonds should be excluded from the list. Certainly a terrible choice would be an actively managed bond fund where you have no idea what risks the manager is taking.