Another Look at the Total Bond Market Index Fund/ETF... It May Be Riskier Than You Think

I wrote last week that investors have know made the Vanguard Total Bond Index the worlds largest bond fund replacing the actively managed Pimco Total Return Fund.

But an excellent article in the WSJ explains the relationship between duration/maturity and price risk on bonds.

Although duration is not exactly the same as maturity the relationship is the same the longer the maturity of the bond the greater its price sensitivity to changes in interest rates. So nor surprising that in the era of declining...and record low...interest rates long term bonds have had eye popping returns.

As the article notes:
Look at last year’s returns for U.S. Treasurys. Securities maturing in five to 10 years returned 6.4%. Those maturing in 20 years or more returned 27.5%, Barclays index data show. That gap is due to the power of “duration.”

But the power of duration works in both ways at some point (yes the date seems to always get pushed back) the Federal Reserve will start raising rates and the move in bond  prices will be negative

For that reason the Vanguard Total Bond Market Index (ETF BND) may not be the best choice.

 The fund has a current yield of 1.92% and a duration of 5.6 years. That means a 1% increase in interest rates will cause of 5.6% decline in price.

As a point of comparison BSV the Vanguard Short Term Bond ETF has a yield of .97% and at 2.7 years a bit less than half the duration, A 1% increase in interest rates would yield a 2.7% decline in price.

Many people have a short memory but in 2013 the bond markets had a "taper tantrum" a sharp bond market selloff in response to market concerns the Fed was about to raise rates. Not surprisingly longer duration bonds saw the largest losses. In 2013 BSV eeked out a small gain or .17% (total return) while BDN dropped 2.12%.

The NY Times and the 4% Rule

The NYT has a very interesting article on the debate over the "4% rule" and the issue of what is the "correct" amount that can be withdrawn from a retirement nest egg without running out of money.

The "correct" response is "it depends". Once again proving that finance is not physics. There are so many variables and imponderables that not only is there not "one answer" there must be adjustments made along the way..as is the case in some of the approaches discussed. Just like the expert in the article it makes sense to work with a professional on an ongoing basis.

I would say two things. One will never go wrong spending less and saving more.  And "stuff happens' both pre and post retirement making precise plans based on one "answer: basically useless.

Nevertheless a good read here

Indexing vs. Hedge Funds Buffett's Bet on Indexing Looks Good

It never ceases to amaze me how hope spings eternal about hedge fund success despite the evidence to the contrary.

Warren Buffet seems to know which side to be on in the debate from the FT

Warren Buffett versus the hedge funds

With three years to go, Warren Buffett is comfortably winning his charity bet that a low-cost index tracker would trounce a portfolio of hedge funds over ten years.

Returns from the S&P 500 index fund is beating a portfolio of funds assembled by hedge fund manager Protégé Partners by 63.5 per cent to 19.6 per cent, according to a slide Mr Buffett presented at Berkshire Hathaway’s annual meeting this past weekend.

Buffet observed

The hedge fund managers have done very well over that period,” Mr Buffett said, noting that, on a notional $1bn portfolio, they would have made $20m in management fees “just for coming to the office. The investors in the hedge funds have paid a very big price.”

Apparently the hedge fund industry has a new marketing approach:


So why is money still pouring into the hedge fund industry? The answer is that investors do not think of hedge funds as an alternative to stocks, but more often now as an alternative to bonds. Mr Buffett’s comparison is no longer a fair one — and the consequence is that the industry’s meagre returns will not improve any time soon.

It seems most investors should be happy they dont make the cut as "accredited investors" eligible to invest in hedge funds. But they should be wary of "hedge fund like" investments they can have access to.

Interesting btw that Buffet chose to make the wager an index fund and not Berkshire Hathaway performance vs the hedge funds.

And from the NYT

For investors in hedge funds, like big pension funds, 2014 was not a lucrative year. But for those who managed their money, the pay was spectacular.

The top 25 hedge fund managers reaped $11.62 billion in compensation in 2014, according to an annual ranking to be published on Tuesday by Institutional Investor’s Alpha magazine.

That collective payday came even as hedge funds, once high-octane money makers, returned on average low-single digits. In comparison, the benchmark Standard & Poor’s 500-stock index posted a gain of 13.68 percent last year when reinvested dividends were included.....

Still, what makes such nine- and 10-figure paychecks remarkable for 2014 is that many of the top earners had mediocre performances at best. Only half of the top 10 earners recorded returns that exceeded that of the S.&.P 500.

For investors, 2014 was the sixth consecutive year that hedge funds have fallen short of stock market performance, returning only 3 percent on average, according to a composite index of 2,200 portfolios collected by HFR, a firm that tracks the industry. Hedge funds are lightly regulated private pools of capital open to institutional investors like pension funds, university endowments and wealthy investors.

Such large investors continue to shovel money into the $2.9 trillion hedge fund industry, desperate to make returns in an environment of near-zero interest rates. So far this year, $95 billion of new capital has flowed in.

It Seems Bond Investors Are Getting Smarter

WSJ journal reports that the Vanguard Total Bond Market Index fund has replaced Pimco Total Return (under new management replacing "Bond King"Bill Gross)

Seems many investors have not followed  Bill Gross to Janus Funds. Nor have they flocked to Doubline manager Jeffrey Gundlach's proclaimed by many to be the new "Bond King  as in a Bloomber artic. \They  moved to the Vanguard's index fund. This despite the creation of an ETF.under Gunlanch's management.

It seems investors realize that a core bond  holding should be more than a big bet on a star managers future successes. Items like these below no doubt contributed to their thinking.

Learning that their fund manager might hold big short positions on German Bunds like Bill Gross(and find out via a tweet)

Bill Gross says German bund is ‘short of a lifetime’

In fact, Gross went as far as to call the 10-year benchmark German Bund “the short of a lifetime” in a Tweet Tuesday.

or  Puerto Rican mutual bonds like Jeff Gundlach J

DoubleLine's Gundlach recommends buying Puerto Rico munis

from a CNBC article about his ETF
This is an active managed bond ETF, with bonds picked by Gundlach's team. It will consist mostly of investment grade debt like U.S Treasurys and various flavors of mortgage-backed securities, but it could also include corporate high yield debt, and even some emerging market debt. This is active management...so Gundlach and his team can change the investment mix.

“

What Goes Around Comes Around...and the Patient Long Term Investor Gets Rewarded

Seems in the fickle world of active managers performance chasing is alive and well. Long term asset allocating investors will get a lift as their allocation to Europe performs well and will be trimming their positions rebalancing  as the performance chasers pile in. Via Bloomberg

Europe gets the nod as the best place to invest for the first time since at least 2009 in a Bloomberg survey of financial professionals, unseating the U.S.

Thirty-five percent of those surveyed in the Bloomberg Markets Global Poll said the euro zone would be among the one or two markets offering investors the best opportunities over the next 12 months.

It was the first time that Europe came out on top since the survey of traders, analysts, money managers and executives who are Bloomberg customers began asking that question in October 2009. The U.S., with a 33 percent share, fell to second, the first time it’s not been No. 1 since November 2010. 

Here is a one year chart of VGK, the Europe ETF vs SPY the S+P 500..think there is some performance chasing going on by those surveyed above ?

Total return year to date: Europe 9.9% (VGK) S+P 500 3.3%

The article notes the following:

Russia, Brazil and China were seen as markets to avoid over the next 12 months, with investors saying the Chinese economy is in the worst shape in two and a half years.

Looking at the chart below of FXI the China ETF vs the S+P 500 I am not so sure the next survey will have the same results. FXI is up 26.6% year to date.

Should Dual US/Israeli/Citizens move their investment accounts to Israel ?

There are 2 fundamental principles to investments which are essential to successful long term success: controlling taxes and expenses. Based on those 2 criteria alone the case for US/Israel dual citizens maintaining their investment accounts with US brokerage firms is a very strong one.

Beware the dreaded PFIC

PFIC Passive Foreign Investment Company is the biggest potential pitfall for US Citizens investing in non US mutual funds. A summary of the PFIC rules is here more information is available on the IRS website.

The bottom line for investors is that foreign mutual funds including Israeli funds and  ETNS (teudat sal) fall in the category of PFICs. As a consequence investors face far higher taxes and more complicated reporting requirements when investing in Israeli mutual funds. This is the case even if the Israeli fund invests in the same strategy as the alternative US fund.

The tax paid on the Israeli mutual fund that is a PFIC can be more than twice the tax compared to US  funds which are not PFICs. Also investments in PFICs require additional reporting to the IRS which may create additional expenses.

The lowest cost investment alternative to create a diversified portfolio is through US based exchange traded funds (ETFs). These can be purchased in a self directed account at minimal cost at a discount brokerage firm or through a managed account of ETFs offered through investment advisors/asset managers.

Can I purchase US exchange traded funds in an Israeli account ?  Yes, one can purchase US ETFs in Israeli brokerage accounts or find an asset manager that manages a portfolio of US exchange traded funds. However, not all Israeli brokerage firms will open accounts for dual US/Israeli citizens because of the paperwork/reporting requirements.

Generally speaking the expenses associated with investment accounts and asset management are significantly higher in Israel than the United States. There ae a few discount brokers in Israel that do have fees and commissions lower than those charged by the major banks’ investment departments asset management services are generally higher in Israel than can be found in the United Staes..

Individual stocks and bonds purchased outside of the US do not create PFIC issues.

As a dual US/Israeli citizen can I open a US brokerage account ? Yes, although there are many US brokerage accounts that are no longer interested in opening accounts for US citizens residing abroad there are others that will. However, many US mutual funds will not accept investments from non US residents…that is not the case for exchange traded funds.

Special Tax Status for New Immigrants to Israel (Olim Chadashim)

New immigrants are exempt for ten years from Israeli taxes on foreign passive (investment) income and capital gains including those on assets acquired after the date of immigration. Such income of course is subject to US taxes. Returning Israelis that fall into the category of “toshav chozair” receive such beneftits for ten years.

Additionally proper tax sensitive management of the account can reduce potential Israeli tax liabilities at the end of that ten year period.  This exemption gives a significant tax advantage Israeli tax liabilities at the end of the exemption period.

(None of this is to be considered authoritative tax advice or recommendation of specific securities or investment strategies you should consult the appropriate professional(s) for advice taking into consideration your specific circumstances)

Mr. Weinman offers a full range of services related to investments for dual US/Israeli citizens and can be reached at lweinman@lweinmanadvisor.com

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S+P 500 5 Day Chart