Next Asset Class For the "Dumb Money" to Flee: International Bond Funds ?

While some are voicing concerns about retail investors soon fleeing corporate and high yield bonds my view is that the next asset class to see the outflow is foreign bond funds. Investors flocked into this asset class in search of higher yields and I have never liked this asset class. Specidfically I argued that investors were better off in emerging  market bonds and stocks.

The ongoing crisis in Ireland has hit many international bonds hard , The much accepted view of a weakening dollar certainly against the euro seems to have reversed in light of the pressures on the euro block. As a consequence many of the etfs in international bonds have seen drops as of late. For example here are 2 week changes for a few of the etfs. Ytd is in the chart below(pimb and emlc were established this year so the data is for less than ytd)

IGOV intl treasuries  -3.6 (yellow in chat)
WIP int infl protected -3.9(green)
EMLC emerging local currency -4.4 (black)
PICB   intl corp  -5.1 (blue)

Interestingly the MUB muni bond etf was only -.3% for the same period

. A chart below shows performance for mub ns these  international etfs ytd

Intl Bond Etfs (IGOV yellow,WIP green,emlc black, PICB blue,MUB red)

For retail investors who went into this asset class chasing performance these moves will be a rude awakening and whatever yield pickup they were anticipating vs dollar bonds has evaporated in capital losses.

And the situation is likely to get worse. The Ireland bailout will likely be the last time bondholders get away without taking a hit through a restructuring which would mean some kind of reduction in principal similar to the Brady bonds in Latin America in the   1980s  . The prospect of this is already seen in the large spreads of Greek, Spanish and Portugese sovereign bonds. But the implications go further banks across Europe including in economically stable hold large abouts of these bonds....and international bond funds and etfs hold large allocations of the bonds of these banks.  So even a bond fund with few holdings of sovereign bonds or corporate bonds from the weaker countries in Europe could take a hit. This can already be seen in the drop in the international bond corporate.

It gets worse...from the perspective of a US dollar investor european bonds have lost much of their attractiveness as a currency play. The ongoing European crisis should pressue the Euro. A small fall in the currency wipes out all of the yield on etfs like international government (IGOV) which is only 2.44%.

As for emerging market bonds the prospect of higher inflation and an a desire to prevent a weakening of the currency is already leading to higher rates in some of these markets and higher rates mean lower bond prices. Added to that is currency risk and higher rates in the current environment dont necessarily mean stronger currencies. As a wsj article on inflation in the emerging markets notes

One conundrum for investors is how more aggressive tightening would play out in the currency markets. Most investors have been operating on the assumption that with the Fed keeping interest rates at zero for the foreseeable future, any moves by emerging-market countries to raise interest rates would attract even more money from yield-hungry investors.
This is an especially important question for investors who have been piling in to emerging-market bonds priced in local currencies. Many argue it's a no-lose situation, where even if bond prices fall because of inflation pressures, rising emerging-market currencies will still provide them a profit.
But since China tightened in October, the dollar has been on the upswing, albeit with help from concerns about the European debt crisis. In the current market environment, however, higher interest rates in China have been equated with risk aversion, and thus a stronger dollar. The U.S. dollar index is up roughly 4% since mid-October.
Traders say that until expectations for emerging-market rate increases become more widespread, they could continue to prompt safe-haven buying of U.S. dollars.

I wont be surprised to see this "hot" asset class see large outflows and it disappear from the new asset allocation models of many retail investors and advisors. In my view international exposure should be in equities only not fixed income, the currency and sovereign risks outweigh any benefit .

Certainly international bonds are not a replacement for dollar bonds in an asset allocation. The latter should be the stable part of a portfolio and therefore made up of high grade corporates and munis, govt agencies, and treasuries with relatively short duration (5 years at most) to reduce interest rate risk, High yield and convertibles if used should be considered part of the "risk allocation" along with equities and commodities not part of the bond allocation.

Many retail investors including those working with advisors who have used international bonds as part of their bond allocation may be encountering some surprises when looking at losses they though they fled equities to avoid. I wont be surprised to see large outflows in upcoming mutual fund data.

Another ex Wall Streeter Leaves The Dark Side

The NYT reports on Gordon Murray a former high level executive at several major firms who has devoted himself while suffering from a terminal illness to disabusing investors of everything he preached as an institutional bond salesman. He has associated himself with Dimesional Fund Advisors, one of the pioneers of passive (index) investing with a special emphasis on tilting towards small and value.And he has proposed a short and to the point book explaining this approach.

Having made the transition "the dark side" after working in institutional sales from not such a high level of management on Wall Street and at an earlier stage in my career I can certainly identify with this:

Mr. Murray felt compelled to write it is itself a remarkable story of an almost willful ignorance of the futility of active money management — and how he finally stumbled upon a better way of investing. Mr. Murray now stands as one the highest-ranking Wall Street veterans to take back much of what he and his colleagues worked for during their careers.

And needless to say I find only minor quibbles with the following key points from his book

The book asks readers to make just five decisions.

First, will you go it alone? The two authors suggest hiring an adviser who earns fees only from you and not from mutual funds or insurance companies, which is how Mr. Goldie now runs his business.
Second, divide your money among stocks and bonds, big and small, and value and growth. The pair notes that a less volatile portfolio may earn more over time than one with higher volatility and identical average returns. “If you don’t have big drops, the portfolio can compound at a greater rate,” Mr. Goldie said.
Then, further subdivide between foreign and domestic. Keep in mind that putting anything less than about half of your stock money in foreign securities is a bet in and of itself, given that American stocks’ share of the overall global equities market keeps falling.
Fourth, decide whether you will be investing in active or passively managed mutual funds. No one can predict the future with any regularity, the pair note, so why would you think that active managers can beat their respective indexes over time?
Finally, rebalance, by selling your winners and buying more of the losers. Most people can’t bring themselves to do this, even though it improves returns over the long run.
This is not new, nor is it rocket science. But Mr. Murray spent 25 years on Wall Street without having any idea how to invest like a grown-up. So it’s no surprise that most of America still doesn’t either. 

The book (which I quickly downloaded to my kindle) is a good straightforward explanation of the rational for a widely diversified passive portfolio with a tilt towards small and value stocks.And it is a very quick read. For most investors who will ultimately choose to work with advisors it certainly gives enough information to be an informed consumer.

A do it yourselfer would be well advised to add to his knowledge through other material as well.The best place to turn are the works of William Bernstein starting with The Four Pillars of Investing which the author describes as portfolio theory for poets.

Those looking for more information and a more entertaining read might turn to a work by a well known Wall Street refugee who left the Street after being banned from the industry, Henry Blodgett's Wall Street Self Defense Manual

Dunb Money Flows Out of Munis Time to Buy In ?

It is a classic case of retail investors piling into an asset class,many late to the party in chasing performance, and then bailing in a panic on the inevitable selloff . T, his time it was municipal bond funds. The WSJ reports on the latest fund flow data::

Muni Tumult Ends a Fund-Inflow Streak

Run Had Lasted Three Months; Money-Market Funds Grew $11.52 Billion 

By JEANNETTE NEUMANN

Investors pulled an estimated $4.78 billion out of municipal-bond mutual funds last week, according to the Investment Company Institute, as oversupply and other concerns shook the muni market.
That figure represents the the biggest estimated withdrawal since the fund industry trade association began tracking weekly muni-fund outflows in January 2007. The second greatest estimated outflow was $4.2 billion in October 2008 during the heat of the financial crisis.
The outflow for the week ended Nov. 17 ends a roughly three-month run of inflows into long-term U.S. mutual funds and comes amid a weeks-long slump in muni-bond prices, triggered by a surge in issuance ahead of uncertainty about the extension of a popular federal program that provides subsidies for taxable bonds issued by state and local governments. That spike in issuance caused yields, which move inversely to a bond's price, to surge.

"When you see falling bond prices and falling bond-fund returns, it's not unusual to see some outflows from bond funds," says Brian Reid, chief economist of the ICI.
A drop in the prices of the muni bonds held by mutual funds decreases the overall returns the funds pay their investors, causing some investors to cash out.
The estimated $4.78 billion withdrawn represents 1% of total muni-bond fund assets, Mr. Reid says. Retail, or individual, investors hold an estimated two-thirds of outstanding bonds in the $2.8 trillion muni market, through individual accounts and mutual funds. The rest is held by large institutional investors.
The price volatility in the muni market was compounded by the effects of the Federal Reserve's bond-buying efforts, which have driven the yields on 30-year Treasurys higher. Rates on long-term municipal debt generally move in sync with long-term U.S. Treasurys.
Also, some individual investors have been spooked by news of the fiscal strain facing states and cities that issue the bonds, says Guy Davidson, who oversees about $30 billion in muni bonds at AllianceBernstein. The magnitude of the outflows "just speaks to how nervous people are," he says. 
Retail is doing what retail always does," says Hugh McGuirk, head of T. Rowe Price's muni-bond team. "Once you get a little price movement in one direction, retail [investors] tend to chase performance or move out of the funds that are going down."...Muni-bond prices began to recover slightly late last week.
Lipper FMI, a unit of Thomson Reuters that also tracks muni-bond mutual funds, on Wednesday reported that the funds lost an estimated $2.3 billion for the week ended Nov. 24. That comes on the heels of last week's record amount of money withdrawn—$3.1 billion, the largest weekly outflow since the firm began tracking the data in 1992. It followed 19 consecutive weeks of inflows averaging $535 million. Muni-bond prices began to recover slightly late last week, stanching the outflows slightly, says Tom Roseen, a senior analyst at Lipper. "It might have lessened, but it's still huge," he says.

 and from the ft the report is here

 noting how much retail flows impact the muni market,

Muni woes could sour appetite for bonds

By Aline van Duyn and Nicole Bullock

Published: November 23 2010 19:11 | Last updated: November 23 2010 19:11

A sudden change in the behaviour of investors in a corner of the US bond markets could have far wider repercussions – for everything from junk-rated debt to blue-chip corporate borrowers.

For the first time in nearly two years, investors have pulled substantial sums of money out of US municipal bonds, a move that has already led to cash-strapped states, cities and other public bodies paying higher interest rates.

As the main buyers of municipal debt, the move by individual investors to withdraw $3.1bn from mutual and exchange-traded funds specialising in the debt sold by local governments and municipalities around the US had an immediate impact. Yields on municipal bonds, which move inversely to prices and represent the borrowing cost for issuers, shot up.

Behind the change in investor behaviour are concerns about the Federal Reserve’s huge asset-buying programme.

Yet even if the outflows stop – Lipper, the fund tracker, will release new data late on Wednesday – the fact that so many investors have pulled out of the market at the first sign of losses has potential ramifications for all debt markets.

The behaviour of individual investors, in particular, matters. The amount of money they have poured into bonds – from top-rated blue-chip corporate debt to riskier junk bonds – has been at all-time highs.

Any herd behaviour by those investors could therefore determine how quickly markets sell off when prices start to fall.

“The recent moves in municipal yields could be a potential harbinger of things to come in other bond markets,” says Greg Peters, global head of fixed income and economic research at Morgan Stanley.

“Retail got out very quickly, and because retail investors have put so much money in all types of bonds in the past 18 months, these markets are more sensitive to retail behaviour than ever before.

Retail investors, wealthy savers who put money in mutual funds, have invested nearly $670bn in bond funds since the start of 2008, Morgan Stanley says. At the same time, just over $290bn has been taken out of equity funds as investors have lost their appetite for the volatility of equity investments and, in some cases, lost faith in the earning power of stocks after a decade of losses.

The fact that most of the bonds are held via mutual funds makes them more sensitive to price moves, even though part of their appeal to investors is the relative “safety” of bonds. If investors own bonds directly, then they are paid interest and only lose money if the issuer defaults. But the value of shares in a mutual fund depends on the prices of bonds. If prices of the bonds owned by the fund fall – or bond yields rise – then the value of the fund falls too.

“It [municipal outflows] was like any negative feedback loop: the selling causes a negative trail where mutual funds have to sell bonds, which causes loss, which causes more selling,” says Tom Metzold, a portfolio manager at Eaton Vance, which has about 16 per cent of its assets in municipal bonds.

Marilyn Cohen, the founder of Envision Capital Management, which manages fixed income portfolios for individuals, says many investors had made gains on municipal bonds and were not used to seeing their online accounts down.

“A lot of these are first-time investors who capitulated in the stock market. At the first sign of bad news, many said they were getting out,” she says.

 As the money flows out some savvy investors may already be sniffing aroiund for values. Certainly in the short end of the yield curve things may already be somewhat attractive. Looking at the short term muni etf MUB in comparison to the equivalent treasury bonds, one finds that the yield on the muni 3.70%has crept over that of the equivalent treasury bond etf (IEF) at 3.62% for the firstt time since the muni etf started trading. For an investor in the top tax bracket that would be a taxable equivalent yield of 5.72% quite a nice cushion against possible movements in interest rates in this duration. For a buy and hold investor this could be an attractive level to buy in. Even if rates go higher and there are some declines in price the total return would still likely look quite attractive relative to treasuries. In fact an article in barrons recommended buying MUB, some bond funds and certain individual bonds.

The FT warns of a spillover into US corporate and junk bonds, I think (as described in another of today's post) the risk is more likely in interenational bonds.

On the other hand the Economist report on bonds cites Richard Bookstaber an analyst I respect greatly who has another view

Bears are rubbing their paws. Mr Fabian has seen an uptick in inquiries from hedge funds looking to profit from a muni crash. They hope the widely held view that muni defaults are unlikely will be proved as big a misconception as the notion that house prices never fall. Rick Bookstaber, an adviser to the Securities and Exchange Commission on risk, sees uncomfortable parallels between munis and mortgage-backed markets, including opacity, over-reliance on ratings and leverage (since amassing future obligations to public employees to pay them less today is a form of borrowing). Thousands of state and local entities should pray the comparison ends there.

Vanguard Chief warns of A Bond Bubble in Long Term Bonds

Vanguards website shows something  I have never seen on the front page: a link labelled "danger risk ahead" with a link to an article by chief investment officer Gus Sauter warning investors(dumb money?) who have been plowing into long term bonds: I certainly concur.

Vanguard's investment chief cautions bond investors

November 22, 2010

Top of Form

Bottom of Form

Bonds have been on a roll, with double-digit returns posted by several fixed income categories this year. Such a winning streak may tempt you to think you've got a free lunch: return with no risk.

That's hardly the case.

Vanguard believes bonds and bond funds can play a valuable role in nearly any investor's portfolio. At the same time, we also believe it's important to have a balanced perspective and keep your eyes open to risks.

Chief Investment Officer Gus Sauter spoke with Vanguard.com about his outlook for the bond market and why you should have tempered expectations.

What's your main concern right now?

I'm increasingly worried that people aren't aware of the risks in the bond market. We have very low interest rate levels. But at some point, the economy will strengthen and those interest rates will rebound. Investors who have pushed out further on the yield curve by investing in longer-term bonds will then see a greater decline in the principal value of their investments.

When you're seeking yield by moving into longer-term bonds, you're exposing yourself to greater fluctuations in principal. Those fluctuations are likely to be negative at some point in the future, and they'll be negative by a greater magnitude for longer-term bonds than for shorter-term bonds.

 Many, if not the majority of investors are not aware of the concept of bond  duration which is used by professionals instead of maturity as a measure of risk of a bond or bond fund/etf. Simply stated duration measures the change in price for a 1% change in interest rates: a one year bond will decline 1% for a 1% decline in interest rates for a 10 year duration the change in price would be 10%. Morningstar or the fund/etf provider will have the duration on their websitte for a fund/etf.  So looking at this chart it is pretty clear that further appreciation of long term bonds(falls in yields) is unlikely.

The yield for the 30-year U.S. Treasury bond generally has declined since the early 1980s. Note that there is no data for yield for 2003, 2004, and 2005 because the U.S. Treasury had suspended issuing 30-year bonds during those years. Source: Federal Reserve Board.

There is a straightforward way to reduce the risk of a bond portfolio: shorten the duration. To give the most extreme example moving from TLT the 20+ year etf to the shy short term treasury etf reduces the duration from 15.16 to 1.82. Of course the yield falls massively as well from 4.06% to .27% . Investors may want to look for a mix of short and intermediate bonds, corporates treasuries and agencies to boost the yield of their bond holdings while reducing the duration of their holdings. Sauter doesn't give specific advice but he does write the following:

That certainly doesn't mean you should avoid a sensible allocation to bonds; it just means you need to be aware of the risks,,,.

….The problem is that when you're at historically low rates, as we are now, you're not likely to get much more principal appreciation. In other words, yields aren't likely to go significantly lower, and at some point when the economy does strengthen, they're likely to push higher. When that happens, you'll actually have principal depreciation that will at least partially, and perhaps entirely, offset some of your yield. And we know that the yield component itself is less than it has been over the last 30 years….

When interest rates do start to push higher, the big question is how fast they'll move up. If rates move sharply, we could experience a year or more where investors receive a meaningfully negative total return from bonds. That's certainly happened in the past. And it's very possible, if not probable, at some point in the future.

More Signs of Dumb Money This Time in Muni Bonds ?

Sure looks like retail muni bond investors have gotten whipsawed big time in their muni bond investments. This is particularly costly in the volatile and illiquid muni bond market where selling into a panic is particularly costly. In fact if investors were selling out individual bonds or positions in open end mutual funds they might not have seen the full cost of their panicked selling as they didn't see the spreads they faced for their individual bonds or the pices used to calculate the net asset value at which their mutual fund sale was executed.


it. WSJ reports

Muni Tumult Ends Fund-Inflow Streak

By JOHN KELL And MATT JARZEMSKY

The muni-market tumult upended a roughly three-month run of buying in long-term U.S. mutual funds.

Investors pulled an estimated $5 billion from long-term funds, the first week of net outflows, or selling, since late August, according to the Investment Company Institute.

The race for the exits was seen particularly in municipal-bond funds. Muni-bond values have slumped this month on a confluence of events, from surging Treasury yields to large new supply to the midterm election.....

A net $4.33 billion flowed out of bond funds in the week ended Nov. 17 after $3.96 billion was added the previous week, ICI said. Taxable funds had inflows of $457 million while municipal ones saw $4.78 billion in withdrawals.

Not mentioned in the article is probably the main cause for the muni bond selloff fears of a large supply coming into the bond market because of the end of the Build America bond program. The large increase in supply of conventional munis was expected to depress prices.

The fears appear to be unfounded as the wsj reports today

BAB Program Likely to Get Another Year

The Build American Bonds program, which provides federal subsidies for taxable bonds issued by state and local governments, is likely to survive another year, top Senate Republicans indicated.
The program is set to end on Dec. 31, and its possible expiration was one reason cited for the recent selloff in the municipal-bond market.

......Uncertainty about the program's fate helped lead to a glut in issuance that played a large part in roiling the muni-bond market over the past two weeks. A sharp selloff stabilized late last week, and muni-bond prices in the past few days have climbed slightly as issuance slowed ahead of the Thanksgiving holiday.

Those that sold off in the panic doubtless got burned particularly badly whether they held conventional muni bond funds, individual bonds, or muni bond etfs. The muni bond market is nortoriously illiquid has poor transparency. Retail investors attempting to liquidate small "odd lot" holdings in the panicky markets likely sold at very disadvantageous prices.

In the etf world much was made of the muni bond etf (MUB and others) trading at a "deep discount" to intrinsic value. While the low prices at which the MUB traded is not debatable I am a little skeptical that the "deep discount" to intrinsic value really existed. There are no real time prices for all of the bonds that make up the index so the etf price actually probably presented a better reflection of where munis were trading that the "intrinsic value' listed on data systems. After all if the intrinsic value represented a real world price the gap between the etf and the MUB would have narrowed massively through arbitrage. Here's a chart of the most widely traded muni bond etf (MUB) . Note the spike in volume at the time of the massive selloff...dumb money  panicking out ?

Those using alternative investment vehicles instead of the etf were unlikely to have made out better. Investors in closed end funds likely did worse as many of those funds traded at a discount to net asset value.

And the mere fact that there isn't intraday pricing for open end bond mutual funds and for "intrinsic value" doesnt mean that investors in those funds weren't burnt if they liquidated their fund in the panic.The investor in the open end mutual fund is really buying or selling a blind item. He never really knows how the bond prices are chosen that are used to calculate the net asset value fund . There is no single price source for the bonds and to the best of my knowledge there is no regulatory aurthoriity or other body that  requires a uniform methodology for this.

Here is the price chart of  the vanguard intermediate term tax exempt fund.(VWITX) Doesn't look much different than the MUB etf. So it doesnt strike me that the muni bond investor who chose an open end mutual fund vs and etf avoided the impact to he bond selling frenzy.

Looking at the sharp price selloff (and subsequent recovery) along with the fund flows it seems apparent to me that the latest example of retail investors late to the party buying high and selling low can be seen in the muni bond market.

Commodities: High Volatility, Dumb Money....and A Rebalancing Bonus

I noted last week the large daily moves in commodities as an example of "irrational markets:. The WSJ reports on that volatility

Prices of everything from gold to copper and cotton leapt to new highs, only to be slapped down just as quickly. Trading volume in many commodities roared to records, including for silver, cotton and corn. Since the beginning of October, the Dow Jones-UBS Commodity Index's 30-day realized volatility has doubled to 25%, the highest since September 2009.

For commodities, the overarching reason for the volatility is the outsize reaction to new signs that China has stepped up its moves to tighten credit and contain inflation. But the huge amount of money flooding into commodities markets appears to be helping exaggerate those moves.

The reason for those movies "hot money" no doubt some of it "dumb money" that bought in late in the rally and liquidating at a loss on the selloff, while others get whipsawed buying high selling low in the volatile markets. Even if the actual buying comes from money managers it can reflect retail flows into commodity funds.

With that money has come a new breed of investors more focused on trading in and out of commodities to profit from price moves rather than the standard producers and consumers relying on the market to manage their risks.

Since August, money managers, such as hedge funds, have raised their bullish bets on oil, copper, soybeans and many other markets. These funds' total net-long positions all peaked in the week ended Nov. 9, before being cut in the past week, according to the Commodity Futures Trading Commission.

All this suggests volatility will at least be around, if not increase, in the short term, even if many people believe commodities overall have a lot further to rally.

"When you have this large [speculative] exposure built up, you do run a risk," said Tim Evans, a commodity analyst at Citi Futures Perspective, a commodity-research arm of Citigroup. Because "you've used up your potential to draw in more new money—that's the time when you are vulnerable to a reversal."

in other words "dumb money" coming in late and getting burned on the short term market reversal.

Investors "are getting more and more nervous as we get close to year end," said Andy Smith, senior commodity strategist at Bache Commodities. They are "not sure whether they should take the money off the table and run for the year or stay in the game."

 In contrast to the the nervous short term investor in commodities trying to market time, ook at the above from the perspective of the long term investor. That long term investor  has an allocation to commodities and a policy of rebalancing to target, The volatility of a  sharp rally followed by a reversal in the midst of a long term uptrend is just what he wants. He can sell off part of his position at a product to get back to his target allocation and buy more on the dips when he becomes underweighted. If the long term trend is positive he adds a "rebalancing premium" to his gains on the commodity position,

Burton Malkiel Speaks And His View is Updated A Bit

Burton Malkiel is doing the rounds to propmote the 10th edition of the classic Random Walk Down Wall Street. His core view that investors should index and not time still holds, not surprisingly. Here are his current thoughts. I couldn't agree more:

Here he gives some advice in of all places the motley fool and urges its followers to limit their individual stock picking, if they feel they must do it at all:(my Bolds). I think he is being polite to his hosts in  his opinions of the kind of approach advocated at stock picking sites like motley fool.

Hill: How has your investment philosophy changed since you first wrote the book in 1973?

Malkiel: I'd say the one change; it is not really a change, but the one thing I emphasize far more than I did before is international diversification. In the '70s, the U.S. was really the sort of main stock market of the world. Today, the United States is only about 42% of the world economy. The rest of the world is growing more rapidly. By "the rest of the world," I don't mean Europe. What I mean is the emerging markets -- particularly economies like China, India, Brazil -- are growing much more rapidly than the United States.

So I think one of the things that I have emphasized more, particularly in the latest edition, is a tendency for investors to have a home country bias. That is to say, to simply invest in stocks in their own home country. I think that is a mistake. I think people are generally not sufficiently diversified internationally, and in particular, I don't think that they have the kinds of positions that they should have in the most rapidly growing emerging markets.

I'd say the other thing that probably has changed, and this is sort of one of the reasons why there are sort of new editions coming out all the time, the instruments available for investors are vastly different from what they were when I first wrote Random Walk. For example, I had mentioned earlier, index funds didn't exist when the first edition came out. Now there are lots and lots of index funds; there's a lot of competition and expense ratios have gone down.

But the other thing that you find now is you have exchange-traded funds. I am a great believer in exchange-traded funds for the long-term investor. I don't think that you ought to trade these things. I am not sure that I would use them for speculation, but expense ratios are rock bottom on the exchange-traded funds and so these kinds of new instruments are very important for people in putting their portfolios together and I don't think it is a change in philosophy, but it is a change in the kinds of instruments you can use to follow the philosophy.

Market Myths

Hill: What do you think is the biggest myth about the stock market?

Malkiel: I think the biggest myth about the stock market is that there are expert investors who can consistently beat the market. It just isn't true.

Now my view would be, because that isn't true, at least the core of every portfolio ought to be indexed. Now fully understand that telling an investor that you can't beat the market is like telling a 6-year-old that Santa Claus doesn't exist. And anyone with a speculative temperament is going to say, "Look, I want to go and pick some of my own stocks." And I think that is fine, and you can do it with much less risk if the core of your portfolio is indexed.

So I think things like the stuff that comes over the transom from The Motley Fool, with suggestions about individual stocks, I think this is fine for people, but I think what they ought to do is have the core of their portfolio, however, indexed. Then you can go and speculate on individual stocks with very much less risk than if it was your entire portfolio.

In a Forbes interview he is even more specific about his views on international allocation, and by international allocation he is referring to emerging markets. I'm with him

When you were talking before about putting a significant part of your portfolio into emerging markets, how do you define significant? That seems to be a number that varies widely across the Street.
Here's a guide: The U.S. is only a little over 40% of the world economy. So I would first of all say that at least half of your money ought to be overseas. Secondly, with respect to being overseas, the emerging markets are at least half just in terms of their GDP, their economic importance is at least half of non-U.S. markets. So just as a rough rule of thumb with ones equities, because this will give you the percentage that I'm in and that I've recommended, suppose you put 50% in the U.S., and I'm a little over in the U.S. because when you buy a stock like General Electric ( GE - news - people ) or Coca-Cola ( KO - news - people ), they have a lot of international exposure because they do a lot of business over there. So the allocations I've used would be, this is a rough rule of thumb, 50% U.S., 25% foreign developed and 25% emerging markets, including making sure that the growing ones like China, India and Brazil are in there.

Bernanke's Speech Today Attention Should Be Paid

Much attention is correctly being paid to Ben Bernanke's speech in Germany this morning. It's worth reading the full text on the fed's website which includes the graphs.  No Greenspan type doublespeak here. He pulled no punches in calling for surplus countries to allow their currencies to appreciate to reflect their massive trade surpluses (with china at the head of the pack). Most of the analysis is being devoted to the currency issues. But I found this comment, which seems to have received less attention, even more interesting

In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable. Monetary policy is working in support of both economic recovery and price stability, but there are limits to what can be achieved by the central bank alone. The Federal Reserve is nonpartisan and does not make recommendations regarding specific tax and spending programs. However, in general terms, a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.

Buy and Hold : Don't Bury It Yet

I truly had planned to write an article on this subject inspired (sic) by articles like this one in the weekend WSJ that proclaimed       and by the profusion of new mutual funds designed to "make money in up or down markets'. But the esteemed Prof Burton Malkiel beat me to the bunch in a great article in the WSJ today. If you read one article about personal investing this year this is the one to read. I may have some quibbles and implement slightly differently but no one could go wrong following the advice.

from the article:

Many obituaries have been written for the investment strategy of buy and hold. Of course, investors would be better off if they could avoid being in the stock market during periods when it declines. But no one—either professional or amateur—has ever been able to time the market consistently. And when they try, the evidence shows that both individual and institutional investors buy at market tops and sell at market bottoms.
Money poured into the stock market at the peak of the Internet bubble during the first quarter of 2000. Stocks and mutual funds were liquidated in unprecedented amounts at market bottoms in 2002 and 2008. Professional investors had large cash holdings at market bottoms but tended to be fully invested during market tops. Buy and hold investors in the U.S. stock market made an average annual return of 8% during the 15 years from 1995 through 2009. But if they had missed the 30 best days in the market over that period, their return would have been negative. Market strategists called for a sharp market decline in late August 2010 as technical indicators were uniformly bearish. The market responded with its best September in decades

A few key points Malkiel makes, several of which I have made in the past in making the case for a diversified portfolio of low cost index funds or etfs.

• Diversification does work no investor should be 100% US stocks
• Investors should have  a good sized allocation to emerging markets
• There is a rebalancing premium over a period of 1996 - 1999 was between 1 and .33% a year
• Even in the "lost decade" of the 2000s a well diversified portfolio rebalanced would have generated posiitve returns. His sample portfolio is graphed below vs 100% stocks.
• Timing can be devastatingly costly. Missing only a few trading days can cut massively into long term returns.

He concludes:

The chart nearby illustrates how someone who invested $100,000 at the start of 2000 and, following my advice, used index funds, stayed the course and rebalanced once a year, would have seen that investment grow to $191,859 by the end of 2009. At the same time, someone buying only U.S. stocks would have seen that same investment decline to $93,717.

The recommended index-fund portfolios contain bonds, U.S. stocks, foreign stocks (including those from emerging markets) and real-estate securities. The diversified portfolio, annually rebalanced, produced a satisfactory return even during one of the worst decades investors have ever experienced. And if the investor also used dollar-cost averaging to add small amounts to the portfolio consistently over time, the results would have been even better.

If you ignore the pundits who say that old maxims don't work and you follow the time-tested techniques espoused here, you are likely to do just fine, even during the toughest of times.

Malkiel's Graph

I ran some numbers on a portfolio of indices with a 65/35 stock bond mix and a globally diversified stock portfolio with a tilt toards value stocks small and large. Not surprisingly my results also did not spell the end of buy and hold.

Ten Year return rebalanced annually 5.8% annualized return $100,000 would have grown to $181,000

without the rebalancing the return was cut to 5.13% with a final value $169,000

As for the recent "disaster years" for buy and hold an investor with an etf portfolio that rode the roller coaster since Jan 0f 2007 would be positive for his portfolio with $100,000 intiial investment worth $106,900 The chart compares the portfolio (green) with the 100% sp 500

The investor who had "given up" and gone 100% tbills would see an account balance of $102,100

Perhaps not a big difference but remember this was a "black swan" three years and the buy and hold investor did better.

• 
  

The Convoluted Logic Of The Mutual Fund Industry

The WSJ/Marketwatch report on the efforts by regulators to put limits on 12b-1 fees which are fees ostensibly used for marketing expenses and add to the costs of mutual fund investors who pay management fees as well. Most of thos 12 b-1 fees are used to pay brokers to incentivize them to market these funds over those with no such fees. The net result is higher cost to invesors.

The article reports

There’s an economic equilibrium that’s been in the marketplace, and government isn’t going to be able to change that by fiat,” said Paul Stevens, chief executive of fund industry trade group the Investment Company Institute, in an interview. “Is government supposed to put price controls on mutual funds?,” asked Barbara Novick, vice chairman of BlackRock Inc. (NYSE:BLK) , the world’s largest asset manager by assets. “I don’t think so; we see a fair number of investors who vote with their feet.”

Stevens also took issue with the timing of the proposals, arguing that the regulatory changes due to new financial legislation, not least the question of whether brokers should be held to a fiduciary standard, should be first addressed.....

Ah yes the industry still has a problem with the fiduciary standard which requires that brokers put the clients interests firtst.

The criticisms were focused in particular on the proposed limits to sales charges and plans to let brokers set their own up-front charges. The SEC plan suggests that rather than have funds set sales charges, brokerage firms could compete on price.
BlackRock was one of many industry players to argue that letting brokerages set prices may lead to less competition.

Sorry if I don't follow the logic that letting brokerage firms compete on price  is the same as price controls. But then again I often don't understand the arguments presented by the mutual fund industry either on their strategies for new products or their arguments against regulatory reform.

Novick said larger firms would be able to undercut smaller rivals because they can better absorb the administrative costs that come with each account. This, she said, would lead to less choice for investors as the larger firms would dominate the market.

Question for Those Advocates of A Gold Standard

Like Seth Lipsky of the wsj. I guess he's not aware of the inforrmation in this article (below)

Funny, I thought a key goal of american economic policy was to reduce dependence on the Chinese. This data means that the money supply in the United States would be determined by the gold mining and sales policy of the Chinese government. So if they wanted a "strong dollar" against their currency they could just pull back on  the amount of gold they put on the market. But US policymakers are trying to get the chinese to weaken their currency against the US dollar.

So unhappy with the Fed and want to replace it with the gold standard meet your new main central banker.

from the English version of the official People's Daily

China's gold production to exceed 320 tons this year

With imbalance between supply and demand in the global gold market, the world's gold production leader China is expected to continue to increase production. Deputy General Manager of China National Gold Group Corporation Du Haiqing predicted in Tianjin on Nov. 17 that China's gold output this year will be greater than 320 tons.

China's gold production surpassed South Africa in 2007 and now ranks first in the world. China's gold output has been increasing for three consecutive years along with the rising prices, and China has remained the world's largest gold-producing country.

According to the China Gold Association statistics, China's output of gold in 2009 totaled 314 tons, an increase of 11.34 percent.

China imports about 100 tons of gold each year. Adding 100 tons of imports to China's output of roughly 314 tons last year would yield a total supply of about 414 tons.

This year, gold output has consistently exceeded figures for 2009, at least until August, the latest month for which figures are available. In the first eight months of 2010, gold production was up 8.85 percent from the same period of 2009, at nearly 218 tons.

China is finding new gold reserves faster than it is producing the precious metal, so there is no danger of the country exhausting supplies.

China electrified the gold market last year when the State Administration of Foreign Exchange, part of the People's Bank of China, revealed that state reserves had jumped to 1,054 tons since the last such announcement in 2003, when it had 600 tons.

Joining those determining US monetary policy would be the rest of the world's top gold producersListed in order they are:: Australia, South Africa,Russia,Peru,Canada, Australia. Don't like the Fed:  ? meet your new central bankers under a gold standard.

Of course you wouldnt have to be a gold producer to control the supply of gold and the US money supply by manipulating the amount of gold in circulation and the price. A wealthy country like Saudi Arabia could simply buy up much of gold (or simply flood the futures or etf market) creating that massive inflation in the US everyone thinks a gold standard would prevent. The price of gold would pull up the prices of all the worlds commodities. If they wanted to create  massive deflation  they could simply drive down the price of gold effectively wiping out the savings of all americans as they found their savings accounts buy nothing.

Funny I thought a major goal of the US to reduce dependency on wealth potentially unstable states in the Middle East. Under a gold standard not only would our economy be dependent on their oil production it would be dependent on  whether they chose to use their healthy reserves to manipulate the gold market.

Still think the gold standard is a good idea ?

Rational Markets Constantly Evaluating All Information and Pricing Accordingly ?

You be the judge of what news created these moves as commodity and emerging markets etfs  today (nov 18)recovered from yesterday's selloff. Daily price changes for nov 18 (all +)


EEM emerging  2.38%

DBA agricultural 3.65% (pictured in one month graph)
DBB base metals 3.52%
DBC general commodities  2.75%

More On Employment (and commodities and household debt) and Inflation

 my comments in blue my bolds

A touch of reality in the actual inflation data released today:(wsj)

Inflation Remains Muted

U.S. consumer prices continued to rise modestly in October on the back of higher gasoline prices, but underlying inflation was flat for the third month in a row.
Separately, home construction in the U.S. plunged to the lowest in 18 months during October, an indication that the moribund industry's recovery is sluggish.
The seasonally-adjusted consumer price index last month rose by 0.2% from September, the Labor Department said in a report Wednesday. It was the third consecutive month that higher energy costs helped to push prices up.
However, the so-called core inflation rate that's more closely watched by the Federal Reserve was unchanged as the price of new and used cars fell. Taking out energy and food prices that can be volatile from month to month, underlying consumer prices have not moved since July.
The annual underlying inflation rate hit 0.6%, the lowest level since records began in 1957. That's well below the Fed's informal inflation target of between 1.5% and 2.0%.

Today's WSJ has an excellent article on how employment and inflation are linked at the hip

...U.S. consumers, in other words, are hardly better-equipped today to handle higher prices. That is no small matter. It limits the risk of an inflationary outbreak. If consumers don't have rising incomes or savings to pay for higher food and energy costs, for example, they will have to adjust by pulling back on spending elsewhere. That is a deflationary, not an inflationary, outcome. In previous inflationary periods, such as the mid-1970s, employment income posted annual growth as high as 10.2% in mid-1974, notes Moody's Capital Markets. Through September, it was up just 2.5% from the previous year. And "we're still potentially looking at a further deceleration of wages," says the group's chief economist, John Lonski, as part of the "market-clearing process" of putting the unemployed back to work.
This helps explain why companies from Cisco Systems Inc. to Wendy's/Arby's Group Inc. are reluctant to raise prices, even if their own costs are often climbing. Wal-Mart Stores Inc., for example, is offering $9 Wrangler jeans, $59 digital cameras and free online shipping this year in an effort to lure holiday shoppers.

If inflation is too much money chasing too few goods the money has to be earned in wages and spent. The fed actions may not get the economy going but that will only be if corporations and banks continue to sit on their cash . As for consumers looking at this chart it seems household debt may be a big restraint on future spending (although never rule out the american consumers propensity to use their credit cards)

But what about commodity prices and future inflation. ?As anyone that is following the commodity markets at all knows, commodities are extremely volatile subject to speculative excesses and short term factors like weather or political risk. There is no doubt that these factors add to the short term voaltility of commodity prices, their impact on longer term prices (and long term prices) is more questionable. As the economist writes:

Fund managers, who allocated a pittance to commodities a few years ago, now put up to 5% of their cash into them. Commodities diversify portfolios: in theory, at least, price moves are uncorrelated to shares and bonds. They act as a hedge against a depreciating greenback. And since 2005, when China began importing huge volumes of raw materials, commodities have also offered exposure to its rise.

As the sums devoted to commodities have grown, so have complaints about the damage that speculative cash causes. Investors came under heavy fire in 2008 as the price of oil and food raced upward. More recently they have been knocked for rises in wheat and corn prices. Yet the benefits that investors bring—the liquidity and price information that make for efficient markets—barely get a hearing.

In fact there is little empirical evidence that investors cause more than fleeting distortions to commodity prices. The most persuasive explanation for the rises and falls of commodities is demand and supply. In 2008 a still-growing rich world and a boom in developing countries pushed demand for oil and food up against the limits of supply. Wheat prices spiked this August after a drought and fires in Russia, an important supplier, prompted an export ban. The recent surge in sugar prices comes after a bad harvest, that of corn after official warnings of a lower-than-expected crop.

Here's a chart form Paul Krugman's blog (whatever you think about hsi politics he brings great graphs on his blog)

 The graph illustrated the economist's assertion there is a large short term variation around the long term trend in commodities. The long term trend is up due to the emerging markets growth story, but commodity markets even more than capital markets overshoot. What that means for investors is that a long term allocation to commodities makes sense and those large fluctuations create great opportunities for that long term investor to take advantage of those large fluctuations to sell high and buy low to reap the "rebalancing premium".

And what about those grocery prices and the claim that the cpi which is ex food and energy is disconnected from the grocery prices consumers see every time they shop. Here's another graph from Krugman

This shows inflation over 10, 9, 8 ....1 year periods. Blue is groceries red is cpi . Krugman writes

What we see is that grocery prices have tended to rise faster than inflation as measured by the core CPI, but not by all that much: over the past 10 years the grocery inflation rate has been about half a point faster than the core inflation rate. If you look at more recent data, what you see is that grocery prices have bounced around; if you’re asking about the one-year inflation rate, grocery prices have risen somewhat faster than the core rate, but over the past two years grocery prices are actually down.
Does this look to you like a situation in which real people experience soaring inflation,

The fed may be" pushing on a string" and QE2 may quite possibly (for the reasons cited above among others) not turn the economy around. But inflation should be well down on the list of investors worry list.

"Dumb Money" late to the Market ?

bubble bubble ?

 The large selloff in commodities today gives back the gains since around September. In my view much of this reflects those way late to the party who bought in amid the front page articles of late (see my blog of Nov 11). Technical analysis as I look at it expresses the behavioral economics observations about investors in real time and these charts reflect much of those recent flows into commodities taking losses or getting out at break even. Technical analysis would see the next wave of recent buyers selling off at their entry point of buyers around september (hence support in technical analysis jargon) or for those holding on they would be sellers at the recent highs (resistance)

agricultural etf

Agriculture Etf (DBA)

copper

silver etf (SLV)

Interestingly and not totally surprising given the behavior on the upside and the retail flows into this area, the emerging market etf  chart looks quite similar

Emerging Market Etf (WWO)

The FT today had an excellent piece on the commodity selloff. .My bolds:

A steep slide in commodity prices that sent sugar tumbling 23 per cent in just two days has brought an abrupt halt to the apparently unstoppable bull run that has brought many markets to multi-year highs. Is this the start of a “great correction” or just a blip? …..

The scale of the sell-off in sugar has been impressive. Prices suffered their biggest one-day decline in 30 years on Friday. The benchmark Reuters-Jefferies CRB index, a basket of raw materials, dropped more than 3.5 per cent on the same day, the biggest fall since April 2009. Commodity prices continued to fall on Tuesday.

Analysts, though caught out by the suddenness of the slide, were not wholly surprised that it happened. Before the sell-off, they say, prices had looked stretched following a powerful rally. A correction was on the cards. As Jonathan Kingsman, a Swiss-based soft commodities consultant, says: “The higher they climb, the harder they fall.”...

As prices started to drop, some hedge funds and other big investors moved aggressively into profit-taking mood, accelerating the sell-off as they tried to lock in their strong annual gains to protect their performance and bonuses. In some cases, that selling pressure quickly turned into a rout as falling prices triggered a string of automatic sell orders on the way down.

But a closer look reveals that many commodities prices are well anchored and still trading near multi-year highs. Analysts and traders say markets are well supported by robust supply and demand fundamentals.

“The fundamentals have not changed overnight,” says Michael Lewis, head of commodities research at Deutsche Bank in London, referring to strong demand from China, the world’s biggest importer of raw materials from copper to soyabeans, and other emerging countries, and weak supply growth.

Instead, brokers and traders say the sell-off has simply removed much of the speculative froth from the market. Richard Feltes, vice-president at futures brokerage RJ O’Brien in Chicago, says that “overloaded commodity longs” have retreated to the sidelines. Away from the volatility of futures trading, many physical commodities markets remain tight.

High volatility markets are the best candidates for benefitting from the rebalancing premium.