Sensible Investments

Asset Managers Have Turned Against Emerging Markets; Should You?

2011-03-01T16:03:00.000-08:00

One would expect that the “hot money” of retail investors, which tends to buy high and sell low, would be quick to pull the trigger and chase higher performer assets. And they did. Emerging markets stock mutual funds shed 0.4% of assets in the week-ended Tuesday Feb 15., emerging markets stock ETFs redeemed 2.1% of assets, or $3.1 billion
But according to what the mutual fund companies tell us, their professional and experienced managers on the other hand would have the discipline to examine whether or not 8 weeks of data justify a major change in their investment strategy. They might be expected to take a closer look at whether the political instability of the headlines or the signs of inflation really warrant the wide divergence in performance of the last 8 weeks. Perhaps it might represent a chance to rebalance at attractive prices.
According to a New York Times article it seems that those investment “professionals” are as fickle as the most trigger happy individual investor.....

read the rest here

Wednesday Notes

2011-02-23T14:11:00.001-08:00

The VXX and VXZ keep moving

the volatility of volatility is increasing. Right now the SPY is only .7% but VXX is up 5.8% and VXZ is up 2%. This means the delta (hedge ratio) or the movement in the ETNs relative to the move in the underlying is increasing as well. Of course this parallels the moves in the VIX
VIX Posts Biggest Two-Day Increase Since May as S&P 500 Tumbles
Illinois Non Taxable Munis

Is the state of Illinois close to junky ? The Wsj reports the taxable bond issue to go to market today will yiled around 2.4% above treasuries for the 2019 maturity , Based on etfs (hyg,ief,lqd) inv grade corps are +1.16% junk + 3.20%. Investor demand seems strong particularly from abroad...maybe they know something. And as I have noted it is possible to lock in the spread without locking in to current long term rtes. Purchasing a bear etn for the appropriate maturity/duration hedges out the interest rate risk and locks in the spreads.

Dumb Money chasing Performance ?

Recent data on mutual fund flows for the beginning of the year has shown (surprise) money flowing from bonds into stocks chasing past performance. And in the bond areas the money has flowed into higher risk areas of the credit market including emerging market bonds and high yield bonds. So much for the argument from some observers than investors in 2010 went from stocks to bonds in order to reduce their risk, It seems more likely they were simply chasing performance.

And as for recent flows retail money has clearly been flowing most out of emerging markets. Barron's noted on feb 17:

I'm Quoted in the WSJ Commenting on Bond Funds

2011-02-22T22:02:00.000-08:00

I'm quotes in a Feb 8 article in the WSj on "go anywhere" bond funds

Lawrence Weinman, a fee-only financial adviser in Los Angeles, says go-anywhere bond funds may wring out a bit more return, but may be taking more risk in the process. "The problem with go-anywhere bond funds is they can do anything; they can add on all the risks that I try to control—credit risk, duration maturity risk, currency risk," he says. Some can take on equity exposure with convertible bonds or invest overseas without hedging, he says.
"You're betting on the management being able to do that. I'm pretty skeptical in terms of persistent manager skill," he says.

How to Play the Yiekd Curve With ETNs

2011-02-20T18:02:00.000-08:00

In addition to the ETNs that focus on particular parts of the yield curve which I reviewed in my previous article, iPath has introduced instruments that allow investors to take positions on the shape of the yield curve. Specifically, these instruments allow one to take a view on the spread between 2 year and 10 year Treasuries. Institutional investors and traders have long taken positions on this relationship through futures and swaps but these instruments offer the simplest and most direct means for smaller investors to do so. The two iPath ETNs are ticker symbol STPP which increases value when the yield curve steepens (the differential between 10yr and 2 year rates increases) while the ETN with the ticker FLAT increases in value when the curve flattens

read the rest here

Interesting ETNs for Fixed Income Management

2011-02-17T18:03:00.000-08:00

Since August, Barclays iPath has introduced two sets of ETNs that make available to smaller investors bond portfolio management tools which were previously only available through the use of futures or swaps markets. They allow investors to take positions on the particular parts of the yield curve or on the shape of the yield curve.

read the rest on seekingalpha

as expected

2011-01-27T23:01:00.000-08:00

see previous (jan 13 post)

wsj Jan 27'

Gold Slumps to Four Month Low

wsj jan 25

ETF Investors Slowed Gold Investments in 2010

and first of many stories of this type large medium and small:

wsj jan 26

Small Gold Trader Makes Big Splash

Daniel Shak's Aggressive Bet Grabbed Sizable Chunk of Contracts, But Prices Fell and Wager Went Bad

Food Riots, Increased Fear of Inflation , Sovereign Debt Crisis and Continued Currency Crisis...But Why Isn't Gold Going Up ?

2011-01-13T07:52:00.000-08:00

Looking on a global basis it would seem that the world is far closer to the gloom and doom scenario of the gold bugs that at any time in the last 2 years (or more)

Surging prices in the commodities that fuel actual inflation: oil, food, and base metals.
As a consequence food related riots and demonstrations in the thrid world: so far India, Bangladesh,Algeria and Tunisia(top photo)
High inflation in Brazil (8%) and elsewhere in Latin America due to strong currency and high commodity prices.go
Sovereign debt crisis in Europe currently focused on Portugal .
As a consequence of that debt crisis a weakening trend for the Euro.

Yet just as these crises are identifying gold has barely budged while other commodities have surged. Below th is a chart for the last three months (click to enlarge for gld (gold in green) +1%, FXE (euro etf red)-5.9%,USO (oil etf black) +7.8%,DBA(agriculture blue)+11%.,DBB(base metals yellow)

Why is this happening ?

The Gold rally hasn't really been based on economic analysis. Those with an economics bent can't see a rationale for owning gold: it neither has any actual use (other than jewelry) and doesnt pay interest. The only rationale for holding it is the prospect of being able to sell it to someone else at a higher price.

On the other hand the commodites that actually have something to do with real economic activity (food, base metals and energy) are responding to real economic forces be they growth in the developing world or short term events that cause shortages such as weather. Doubtless once these get moving based on fundamentals a momentum factor kicks in here as well, But unlike gold there is an economic rationale.

The "analysis" that spurred the price rise were more a mantra than an analysis. Gold has historically been a poor inflation hedge. The rest of the rationale for gold rested on a provincial analysis of the conditions only in the United States but looked at globally they seem pretty thin. A readoned analysis would show they argue far more for holding other commodities as well as that paper money hated by gold bugs...the US dollar than for holding gold.

Basic commodities are a far small part of US consumers outlays and thus inflation than in the rest of the world, labor costand housing s are a far bigger components of inflation and they are not going up any time soon.
If one is looking for apocalyptic political instability with riors in the streets it is already happening in Europe and the third world if such instability leads to a flight to gold why wouldnt riots in Greece, France and Britain cause that to happen.
The US certainly faces a long term crisis because of tis debt but that criisis is at a far more advanced stage in Europe. Shouldn't such a debt crisis lead to european purchases of gold ?
Because of the European debt crisis the Euro is undergoing weakness. If the rationale response to a crisis with a major currency is to sell the paper currency and buy gold why is the money flowing from the dollar and other paper currencies instead.
With the prospect of the US economy strengthening US interest rates have moved up a bit making the marginal cost of holding gold a bit higher. Looking around the world that cost is even higher. Money has been flowing into Brazil where 7% interest rates and an appreciating currency make holding gold not such an attractive proposition. In a global economy all of these are alternatives.

Looking at the above developments and the lack of movement in gold it's hard not to conclude that in the final analysis the gold rally has been a pure momentum play. In other words once things got going Gold kept going up because it was going up and more and more people bought for that reason far more than any "analysis" of gold's fundamentals.

There definitely is a momentum factor in markets particularly commodity markets (there certainly is some of that, along with fundamentals driving the other commodities) we also know that such momentum plays are pretty ugly especially for those not nimble enough to get in and out early. One would expect that will be the case for retail investors.

Once the momentum slows even without sharp declines the "fast money" of professional commodity players will move out and into the commodities that seem to have momemntum. After all why hold gold if sugar,copper,oil and even stocks have upward momentum all of these are traded in the futures markets by professional commodities traders. The retail investor looking at gold as a binary buy/sell decision will likely hang on longer suffering more pain on the way down.

The FT reports

But investors are stoking the commodities bull run with some big bets. Money flows into commodities have been huge. Barclays Capital estimates $60bn was injected into commodities in 2010. Some observers believe speculative trading has sent prices to excessively high levels, making a sharp recoil likely should the fragile economic optimism fade.
Figures from the Commodity Futures Trading Commission, the US regulator, reveal very bullish bets among money managers such as hedge funds.
In late December they owned a record net “long”, or buying, position in crude oil futures and options on the New York Mercantile Exchange. In September the same types of traders held record net longs in corn.
As well as hedge funds analysing global economic trends, money managers include trend followers who use computer programs to ride market momentum and “high-frequency” traders who move in and out of positions in microseconds. Electronic traders helped send volumes last year in energy, metals and agricultural commodities at the CME, the largest US futures exchange, to a record.

Could we be on the verge of that dreaded point in the gold market when the music stops and everyone runs for the door at the same time ? It could well be.

(I can't wait to see the comments on this one)

Spending Time Readin Those Beginning of The Year Market Forecasts ? Even the Forecasters Tell You Not to Bother

2011-01-10T07:23:00.000-08:00

A great article on market forecasts in the NYT reviewing their terrible track record, and the many reasons why it's near impossible to forecast the market. The article notes that the forecast consensus for 2008 was for a strong market. Most entertaining to me is that some of the best known names in market forecasting say that their forecasts are basically useless:

But how much credence should we place in forecasts like these?
Byron R. Wien, the veteran strategist who has been issuing market forecasts for decades and is now vice chairman at Blackstone Advisory Services, says the quick answer is this: Don’t take these forecasts too seriously, and don’t view them as the literal truth.

but my favorite quote from the article is the following:

Aaron Gurwitz, the chief investment officer at Barclays Wealth. “I don’t think market forecasts provide very useful information,” he says.
Instead, he focuses on asset allocation and on expected returns, volatility and correlations of specific asset classes over long periods. “I would really like my friends and neighbors to stop asking me whether I think the market is going up or down,” he says. “Investment strategy is the practice of decision-making under uncertainty,” he says, and it’s not wise to act as though the future is anything but uncertain.

Good advice, but even the above is difficult to do. Historic correlations are proving less and less to be useful as a guide to the future as the cross correlation of asset classes --a fancy way of saying the extent to which all classes of equities move together--- has increased over time. The past may not give much of a guide not only to forecasting market direction but also to correlations, Just another reason why investing strategy is decision making under uncertainty. Also another reason not to market time and stock pick and instead to have a globally diversified portfolio including stocks, bonds and commodities composed of low cos index instruments.

A Better Market for Active Fund Managers in 2011...or an Even Worse One

2011-01-05T08:30:00.000-08:00

A WSJ blog reports on research from (surprise) Merrill Lynch that the future will be better for active managers than it was last year:

Active Managers in 2011: A Wheat/Chaff Moment?

December’s 6.5% melt-up on the S&P 500 caught a lot of investors by surprise, not least of which were active managers. According to numbers put out by Bank of America-Merrill Lynch yesterday, 39% of actively-managed funds beat the market in December — not bad, but lower than the 44% that beat in November.

A fortune report on the merrill reseach notes it was one of the worst year's ever for active managers

Entering December, a quarter of funds were running ahead of their benchmark indexes, Subramanian writes Tuesday in a note to clients. But another dismal month, with fewer than half of managers beating their bogies, took that number down to a dismal 20% by year-end.

yet amazingly the merrill research report argues:

With a new year upon us, and the economic recovery back on track (fingers crossed), this may be the moment to separate the wheat from the chaff, as far as active stock pickers go. With stock clustering starting to wane, good companies will likely be freer to rise on their own fundamental strengths — and weak companies more likely to fall on their inherent weaknesses. In BAML’s parlance, then, this is the year stock pickers “make a comeback,”

indeed hope springs eternal

The evidence for the above is pretty slim as it is based on a small decrease in correlation between stocks of late (and the active managers didn't have much better success during that period). In fact, the longer trend: the growth of high speed intra day trading and the growth of etfs which means at a minimum a high correlation of stocks within industries if not the overall market, argues the cross correlation of stocks will continue.And this can only mean a more difficult market for active managers going forward rather than a better one.

Seems whatever the short term decline in correlation the long term trend is clear. From cnbc website

Investing Dying as Computer Trading, ETFs & Dark Pools Proliferate
There's an old Wall Street adage meant to inspire investors that goes "it's not a stock market, but a market of stocks." Consider that dead.
Computer trading, dark pools and exchange-traded funds are dominating market action on a daily basis, statistics show, killing the buy and hold philosophy still attempted by many professional and retail investors alike. Everything moves up or down together at a speed faster than which a normal person can react, traders said.
High frequency trading accounts for 70 percent of market volume on a daily basis, according to several traders' estimates.

The theory that buy-and-hold was the superior way to ensure gains over the long term, has been ditched completely in favor of technology," said Alan Newman, author of the monthly newsletter. "HFT promises gains are best provided by holding periods measuring as few as microseconds, possibly a few minutes, or at worst, a few hours."

While individual investors must cede the intraday profits to the high speed traders, in my view it doesn't necessarily mean that a long term well diversified global portfolio suffers from these trends, After all if stocks are more correlated holding a broad basket for the long term should still be a viable strategy with lower fees and lower taxing helong the results.

.After all during an earlier period specialists, floor traders and institutional trading desks in a slower trade environment profited from the daily trading flow (otherwise a seat on an exchange wouldn't have been a valuable asset) Indivdual investors didnt get a piece of those profits either. So the more things change the more they stay the same: market makers extract a profit from providing liquidity.

In fact the argument below argues for etf portfolios rather than stock picking:

The problem is only made worst by the proliferation of exchange-traded funds, traders said. The vehicles, which make trading a group of stocks as easy as buying and selling an individual security, passed the $1 trillion in assets mark at the end of last year, according to BlackRock. This is probably why all ten sectors of the S&;P 500 finished in the black for two consecutive years, something that's only happened one other time since 1960, according to Bespoke Investment Group.

If the above has occurred for 2 consecutive years, why would there be any evidence to expect a "stock pickers" maket going forward. After all the growth of high speed trading and etfs in accelerating, not slowing.

This frustrating trend for stock pickers is doubtless behind the latest "product" from the mutual fund industry: "alternative strategy, go anywhere funds."From the WSJ

In 2010, a growing number of companies offering actively managed mutual funds finally began to get creative in their efforts to halt the erosion of their business caused by low-cost, index-tracking exchange-traded funds....

The alternative funds are actively managed, too, but they aim to invest and perform differently from funds that hold standard investments like stocks or bonds or cash. Alternative funds may hold uncommon assets or use particular strategies that historically haven't moved in lock step with plain-vanilla investments. For instance, many of the alternative stock funds buy some shares in hopes they will rise, while also placing bets that other shares will fall in price.....

The fund companies have had success in marketing:

Investors seem to like the idea. The funds have taken in more than $22 billion in the past year, Morningstar says....

and they have been marketing them for good reason (for them):

One big reason the fund companies like alternative funds: They can charge much higher fees than they do for traditional funds because of the more complicated strategies, which can include sophisticated derivatives. The average management fee on alternative stock funds is 1.04%, compared with 0.62% on actively managed funds holding big-company U.S. stocks, according to Morningstar.

Of course etfs on broad market categories can be purchased with even lower fees...as low as .10%

The likelihood these funds will be better will perform better for investors than they do for the fund companies seems slim. If it is difficult to beat the market picking individual stocks I'm not sure it would be more difficult "going anywhere". Furthermore if the long term trend is for higher correlation across stocks in particular industries it would seem a particularly environment for the strategy of " "paired stocks" matching longs and shorts. Add in the higher fees and the hurdles to beat the indexed portfolio seems even higher.

And even the recent divergence among US stocks hardly argues for stock picking. Small stocks have diverged from large stocks recently, but a well diversified etf portfolio would have benedfited from this, without being dependent on individual stock selection

At the end of last year, something strange happened. After tracking the S&P 500 for most of 2010, the Russell 2000 Index, made up of many small companies with very different characteristics and merits, broke away in the final three months to double the gains of large cap benchmark for the year.
"Small cap outperformance in the last quarter is a very good sign this trend is ending," said Joshua Brown, money manager and author of The Reformed Broker blog. "Winners and losers are starting to separate themselves after a year of the whole risk-on (buy anything), risk off (sell everything) of the last year."
Of course, you could have just bought the iShares Russell 200 Index ETF (NYSEArca:IWM - News) in September.(or simply held them as part of a diversified portfolio all year benefiting when large and small stocks moved together and capturing the small stock outperformance.)

Report Card on The Black Swan Hedge

2011-01-03T11:56:00.000-08:00

Even with the strong stock market this year, the rise of optimism and consequent sharp decline in the VIX, a hedged portfolio composed of vxx and vxz dragged down only moderately even this year.performance this year. The vxx was particularly hard hit as the contango really generated a big hit. My rough calculation is that a mix of vxx and vxz equal took down a diversified portfolio of "risk assets" (global stocks and some commodities) by around 2%.

For a portfolio composed of 95% sp 500 2.5% vxx and vxz the portfolio total return was 12.1% vs 15.1% for 100% sp 500. And the portfolio volatility was reduced from sp 500's 18% to 15.1% for the hedged portfolio. In other words in a bad year for the hedge (strong underlying market, decline in implied volatility=vix) the hedged portfolio performed exactly as one would expect: lower return and lower volatility vs 100% stocks unhedged, (chart below)

I would venture to guess that many people that tried to time the market, particularly those that moved to medium or longer term bonds suffered a bigger drag on performance. A 20% AGG aggregate bond index /85% sp 500 portfolio would have returned 13.3% with 14% volatility. Not a big improvement considering the volatility hedged portfolio has better risk/reward characteristics should bonds continue to reverse or if stocks sold off sharply.

Looking at an alternative "black swan " edge in the options I still would go for the vxx/vxz. A 10% out of the money (110 strike with the sp 500 at 1257.64 closed the year at 25.20 which would be 2% for six months and remember unlike the volatility etns this has a high probability of expiring at zero in fact according to option pricing theory a 50% chance of expiring worthless.

So I would say the report card for the vxx/vxz hedge in a particularly bad year was a low B. A higher proportion of vxz to vxx rather than equal weight going forward And of course those that initiate the hedge now are buying into very low vix levels, not to say they cant go lower.

Some of the new volatility related products which have various mechanisms that could moderate the impact of the contango in the futures are intriguing and worth examining later.

Stock Pickers Market ? According to the WSJ The Answer is Yes...or No

2010-12-22T13:25:00.000-08:00

wsj sept 24, 2010

'Macro' Forces in Market Confound Stock Pickers

wsj Dec 18, 2010:

The Return of The Market-Beating Fund Manager
The Stage Is Set for Stock Pickers to Shine. Here's What You Need to Know to Find the Best

an analysis of the December 18 article is forthcoming

A Peek At the Future For the US ?

2010-12-22T07:24:00.000-08:00

No movement on the budget deficit and I certainly wouldn't rule it out. This is the scenario smart people have been warning of for years. Of course in more subtle ways than this (below) it may already be happening.

from the FT:

China extends help to tackle euro crisis

By Jamil Anderlini in Beijing and Peter Spiegel in Brussels
Published: December 21 2010 13:00 | Last updated: December 21 2010 18:44

China has promised to take further “concerted action” to support European financial stabilisation, including continuing to buy the bonds of countries at the centre of the sovereign debt crisis, according to senior European officials....

Beijing has emerged as one of the more enthusiastic backers of distressed European sovereign debt in recent months.....

Mr Wang’s comments boosted the euro’s value against the US dollar, but China’s public support for Greece and Portugal over recent months has not prevented their bond yields remaining near record highs.
European officials said that although China had not explicitly linked its bond purchases to any specific issues, Beijing asked in the talks for the EU to grant it “market economy” status and lift a long-standing arms embargo.

Bond Funds: Exactly As I Expected

2010-12-20T14:27:00.000-08:00

In my view this (below)was totally predictable: investors piled into bonds with the rationale that they were seeking a "safe investment" while in fact they were simply chasing the outperforming asset class. And with low yields at the short end of the yield curve they piled into longer term bonds...which are the riskiest once rates start to rise. Meanwhile corporations rebuilt their balance sheet by selling billions of $ in low interest rate long term debt.

WSJ reports:

Bond Funds Take It on the Chin
By JANE J. KIM
Bonds are supposed to be safe,(in my view anyone that understands bonds knows that long duration bonds are in fact quite risky remember a 20 year duration bond falls 20% in value with a 1% increase in rates)

but the world's five largest bond mutual funds have all posted losses in the past two months—with three of them losing more in December than in November.

And now surprise here the retail investors are bailing from the bond funds.

As the losses mount, investors are pulling back. They yanked $5 billion out of bond funds during the week ended Dec. 15, pushing the five-week total outflow to a record $7.6 billion, according to EPFR Global, a Boston fund-flow tracker.
A selloff in U.S. Treasurys is spreading to most bond sectors, including corporate and municipal bonds. The yield on the benchmark 10-year Treasury, which moves in the opposite direction of price, has jumped about a full percentage point in the past month on fears that aggressive monetary and fiscal stimuli could trigger inflation and higher interest rates down the road.
"This is the first time you've seen a broad selloff across bond sectors since October 2008," says Miriam Sjoblom, an analyst at investment-research firm Morningstar Inc. Back then, at the worst of the financial crisis, the Barclays U.S. Treasury Index lost a fraction of a percent, while other credit sectors got slammed.

While the five biggest bond funds are still up for the year, they have performed poorly of late. The $250 billion Pimco Total Return Fund, the world's largest bond fund, lost 3.42% from Nov. 4 through Dec. 17, compared with a 2.51% loss in the BarCap U.S. Aggregate Bond Index over the same period, according to Morningstar. The second- and fourth-largest bond funds, the $89 billion Vanguard Total Bond Market Index Fund and the $38.4 billion American Funds Bond Fund of America Fund, respectively, have lost 2.64% and 2.79%.

and investors learned the meaning of duration and the relative risk of short vs long term bonds:
The losses were smaller in the $38.3 billion Vanguard Short-Term Investment Grade Fund, which lost 0.91% over the period in part because of the fund's shorter-duration securities, ...
Three of the five largest funds have lost more so far in December than they did in November. Through Dec. 17, Pimco Total Return, Vanguard Total Market Bond Index and American Funds Bond Fund of America were down 1.31%, 1.60% and 1.34%, respectively, while the Vanguard Short-Term Investment Grade Fund was down 0.40%, according to Morningstar.

The interesting question is how the flood of retail performance chasing investors has changed the behavior of a market usually dominated by insurance companies, pensions and endowments. It is quite possible that much like the commodity markets which have more retail investors due to the growth of etfs, we will see a more extreme move in bonds caused by the retail outflow. At some point this will provide an opportunity for savvy buyers of bonds just as the low rates caused by the retail buyers created an opportunity for corporations to float cheap debt..

Steepening Yield Curve Economic Optimism....Or Something Else

2010-12-20T14:26:00.000-08:00

WSJ reports on the steepening yield curve,

Economic Optimism in Treasury Yield Curve

By MIN ZENG

NEW YORK—A closely watched gauge in the Treasury-bond market is signaling the U.S. economy may gain more traction.
The spread between shorter- and longer-maturity U.S. government-bond yields has widened to near a record high as longer-dated yields rise on expectations that inflation pressures will revive....

The common theory is that when yield spreads widen, which is when the so-called yield curve steepens, it suggests investors are optimistic about the strength of the economy. They are demanding higher yields in longer-dated Treasurys than in shorter-dated ones in order to compensate for the risk of inflation, which is a main threat to bonds' fixed returns over time.

When yield spreads widen, banks are the big winners because the lower short-dated yields mean they can borrow cheaply to fund short-term obligations while lending out to businesses and consumers at higher rates.
Higher long-dated Treasury yields also help pension funds and insurance companies cover their long-term obligations. The flip side is that higher yields push up mortgage rates. Homeowners' mortgage rates tend to track the 10-year Treasury yield, and higher rates hurt the already-struggling housing market. It also gets more expensive for companies to borrow in capital markets.

A couple alternative or additional explanations:

The selloff in long bonds corresponded with the passage of the tax cut extension. While it may spur growth the tax cuts will almost certainly increase the deficit (sorry Mr. Laffer I'm not a believer in your curve. After all the tax cut is really keynesian it is deficit spending or has the same effect, perhaps more efficiently than a stimulus plan... perhaps not.

So perhaps the bond vigilantes of the Clinton era are back fearing more supply coming on the market pushing down prices and raising yields. This is probably a mixed blessing remember that the bond vigilantes pushed the administration to close the budget deficit. The treasury stopped issuing long term bonds during that period (no need to fund a large deficit) and rates fell.

The large retail flows into bonds came from investors who were ignorant that it is quite easy to lose money in bonds particularly in the longer maturities I wouldn"t rule out large outflows from the funds pushing bond prices down.

\By contrast the natural buyers of bonds pensions, endowments and insurance companies who constantly have new inflows look at higher rates as a welcome respite since the higher rates make it easier to meet their futuere obligations,

The otrher group to have a natural benefit from a steep yield cuve as they borrow short (deposits and cds) and lend long with mortgages. Of course the higher mortgage rates are likely to slow down whatever recovery exists in the real estate market/

While retail investors likely got burnd with rising long term rates, corporations, as I noted were playing the low long term rates correctly. Those that issued long term bonds throughout the year benefited from record low rates. Unfortunately for the economy they have been using the cash for stock buybacks and dividends not job creating investments.

Of all the arguments for the yield steepening I find the inflation argument the weakest. First off I have faith that signs of economic growth will be swiftly met with contractionry monetary policy.

Mr. Market has expressed an increase in inflation expectations . This cambe seen in terms of the TIPS/Conventional Treasuries doens't indicate a particularly strong forecast of inflation The real yiield on the 10 yr tip moved up this month from .83 to 1.05% that puts the implied inflation forecast for the next 10 years of 2.83% within the Fed's target inflation rate but quite a good sized move from 2.12% at the beginning of the month.

When Is A Bond Fund Not Exactly A Bond Fund ?

2010-12-18T09:14:00.000-08:00

Seems like the answer is most of the time when it comes to actively managed bond funds. I have long been a critic of the Pimco Total Return Fund. I pointed out that due its lack of transparency and mandate to go anywhere in the fixed income arena, one never really knows how one's bond allocation is invested,

Bloomberg reports that the "go anywhere " fund can know venture into securities directly linked to the equity market:

Bill Gross’s Pimco Total Return Fund, the world’s largest mutual fund, is expanding its policy to allow investments in equity-linked securities for the first time since 2003.
Pimco Total Return may put as much as 10 percent of assets in securities including preferred stock and convertible bonds as early as the second quarter of next year, according to a filing today with the U.S. Securities and Exchange Commission. The fund won’t invest in common stock, the Newport Beach, California- based firm said.

The article mentions a point I have been making for quite a long time. Holding this fund is more of a act of faith in Bill Gross's asset management skill than a choice of bond allocation. Gross can pretty much invest in any type of bond he wants dollar or non dollar denominated:

Gross, who said in October that asset purchases by the Fed will probably signify the end of the 30-year rally in bonds, has invested the Total Return fund in a mix of government-related debt, mortgage securities and emerging market bonds. A top performer over the past five years, the fund trailed most of its large rivals during a debt selloff in the past month.

What was particularly strking to me was that according to Morningstar venturing into convertible bonds and preferred stock is commonplace among actively managed fund. And the Morningstar analyst whose role is supposedly to look out for the interests of the retail investor sees nothing wrong with this:

“This brings Pimco in line with other bond funds in the same category and gives them more flexibility,” Miriam Sjoblom, an analyst with Morningstar Inc. in Chicago, said in an interview. “In moderation, this could increase returns without adding considerable risk to the portfolio,” she said.

Despite all the evidence that Morningstar research produces on the advantages of indexing somehow their analysts always seem to repeat the party line of the active managers : in this case the assertion that it is possible to increase returns without adding risk.. I would look at this fact as more evidence that a proper allocation should include the exact opposite of these "go anywhere " bond funds, The use of index instruments with clear limitations on what they hold is the better path to transparency and managing risk.

I Agree With Him....But At Least So Far We Have Both Been Wrong

2010-12-15T08:02:00.000-08:00

I wrote on Nov. 29 that the selloff in muni bonds may represent a longer term buying opportunity. Apparently "bond guru" Bill Gross, the world's largest bond manager agrees with me (or should I say I agree with him) Investment News reports

Bill Gross bets big on muni bonds
Plows $4.4M of his own money into tax-exempt funds; 'optimism about a recovery'

December 14, 2010Bill Gross, the co-chief investment officer of Pacific Investment Management Co., spent $4.4 million of his own money this month to purchase shares of five municipal-bond funds run by his firm after tax-exempt debt tumbled.
Gross, 66, who manages the world's biggest bond fund at Pimco, has more than doubled his holdings of the firm's closed-end municipal bond funds, according to Securities and Exchange Commission data. He bought about 451,000 shares of Pimco municipal bond funds in December, bringing his total holdings to about 878,000 shares.
The municipal bond market has dropped in the past two months due to a jump in new bond issuance and rising Treasury rates. Tax-free holdings lost 2.29 percent in November, the third consecutive monthly slide and the longest since 2004, according to the Bank of America Merrill Lynch Municipal Master Index, which accounts for price changes and interest income.
“Bill Gross's leadership in being a buyer is notable as it reflects his optimism about a recovery in the underlying fundamentals of municipal bonds,”....

He bought 50,000 shares of the Pimco Municipal Income Fund III on Dec. 10 at an average price of $9.75, according to public records. That fund hit a 52-week high of $12 on Sept. 8

At least for now it looks as if we bothwere a bit premature. 3 month chart of MUB municipal bond etf is below

Chasing Returns as Asset Allovcation....Late to the Party ?

2010-12-14T09:27:00.000-08:00

As is almost always the tendency of retail investors their footprint is seen in chasing top performing assets. This was clearly the case in November. Index Universe reviews the flows in November. Money flowed to (surprise !) emerging markets and small cap stocks in November quite late to the party after these asset classes are closing out a year strongly outperforming the broad based stock and bond indices.

As I have mentioned there is a strong tendency for such flows to continue at year end and the beginning of the new year. After that it is anyone's guess but the large flows of funds into the market that is late to the party leaves the market vulnerable to a sharp selloff should these asset classes start to fall.

Looking at the ytd relative performance of the funds with the major inflows vs the sp 500, total us stock market (vti) and aggregate bond index (AGG) it's pretty clear the flows chased performance

Here is the table with dollar inflows in millions.:

VWO

Vanguard Emerging Markets

Vanguard

1,734.80

Vanguard Mid-Cap

Vanguard

1,322.14

IWM

iShares Russell 2000

BlackRock

1,201.37

Vanguard Small-Cap

Vanguard

833.40

IWD

iShares Russell 1000 Value

BlackRock

669.54

SLV

iShares Silver

BlackRock

567.84

VBR

Vanguard Small-Cap Value

Vanguard

494.27

VBK

Vanguard Small-Cap Growth

Vanguard

484.19

FAS

Direxion Daily Financial Bull 3x

Direxion

404.85

MINT

PIMCO Enhanced Short Maturity Strategy

PIMCO

403.29

Performance Chasing Bond Fund Money Is Starting to Flee

2010-12-13T07:27:00.000-08:00

As I have pointed out much of the massive retail flows into bond funds likely doesn't reflect as much of a search for "safety" vs stocks as simply chasing the asset class with the most recent outperformance. Therefore as the bond market has reversed it didnt surprise me to see the following in Barron's

Since the Pimco Total Return is by far the largest bond mutual fund (and often shockingly the only bond fund choice in some 401k plans I have seen). The outflow from the fund is likely indicative of a larger trend among bond funds.

from the Barron's article

Pimco Total Return Fund Slips In Past Month; Investors Pull Money

Posted by Murray ColemanThe Bill Gross-led Pimco Total Return Fund (PTTRX) faced $1.9 billion in redemptions during November — its first month of net outflows in two years, according to Morningstar.

Another aspect of the large exodus from this fund is another issue I have raised before. As a "go anywhere fund" investors have no idea how the portfolio is allocated as to credit quality, bond category, duration and even nationality of the bond's held in the portfolio, The investment in this fund is less an investment in an asset class and more a bet that manager Bill Gross would continue his market beating record. It was inevitable that the fund would stumble and inevitable that hot money would flee the fund once that happened, The fund is down around 6% mtd, underperforming the index (see 3 month chart vs the the total bond market etf AGG)

Of late it is underperforming the other large active funds as wel more from Barron'sl:

A separate report by Bloomberg comparing return data over the past 30 days, through Dec. 8, found that PTTRX lost more than all but one of the 10 largest bond mutual funds.
The only top 10 bond fund that did worse was the Vanguard Inflation-Protected Securities Fund (VIPSX).

The reason behind the decline may be because Pimco has revised it's much publicized forecast of the "new normal with lower returns and slow growth. It seems plausible based on this view they would hav been positioned on the long end of the yield curve. The fact that their performance underperformed the indices in a month when the long bond sold off sharply is additional evidence leading to that conclusion,

As for the forecast the never shy Mohammed el Erian of Pimco is back in the media with what I guess is his "new,new normal:

Equities climbed on Dec. 9 when Mohamed El-Erian, the chief executive officer and co-chief investment officer of Pimco, raised his forecast for next year’s U.S. growth as policy makers spend up to $600 billion to buy Treasuries through so-called quantitative easing. Pimco said the economy may grow 3.5 percent in the fourth quarter of 2011 from the year-earlier period, up from 2.5 percent.
Pimco, manager of the world’s biggest bond fund, said since May 2009 that gains in financial assets would be below historical averages for years to come. Bill Gross, the other co- chief investment officer, said on Dec. 3 that a Labor Department report showing hiring trailed forecasts in November shows gross domestic product isn’t expanding fast enough to sustain market rallies.
‘Stable Wings’
“The old normal was 6 to 7 percent,” Gross said in a Dec. 3 radio interview on “Bloomberg Surveillance” with Tom Keene. “The new normal is a 3 percent plus or minus nominal GDP. It speaks to 2 percent growth and 1 percent inflation. We are running at a half-size-paper-airplane type of economy as opposed to one with stable wings and full thrusting jet engines.”

That bond funds in general and PTTRX specifically should see such large outfolows after one bad month indicates that further declines in bonds will lead to more outflows which could lead to further bond declines which in turn could cause more outfolows triggering a negative circle.

The question is where the money will go. My feeling is that historical patterns will continue and the money will flow into stocks with investors particularly chasing the outperforming categories: emerging markets, small caps and commodity related companies as well as commodities themselves.

Two tendencies that tend tto occur and at year end and the beginning of the new year are likely to push these classes higher,

1.The practice of window dresssing by money managers who want to show they hold little cash and own the top performers

2. The retail readjustments that often occur at the beginning of the year when investors put new IRA contributions to work and readjust their allocations.

This should lead to some momentum through the beginning of the year...after that who knows. My inclination would not to be to add to these asset classes to ride the momentum but rather to rebalance holdings of these asset classes sometime early in the year to capture that rebalancing premium. Year end is probably not the best time to do the rebalancing. As this article points out the argument for tax harvesting before year end my in some cases not be as persuasive as generally thought.

Long Term Bond Bubble Bursting ? What Will Retail Investors Do ?

2010-12-09T16:29:00.000-08:00

I have written for quite awhile that in the bond market it has been the dumb money buying long term treasury and corporate bonds and "smart money" corporations grabbing the cheap money by issuing record amounts of corporate bonds. The low long term rates were unsustainable. Yesterday's bond sellofff attributed by some to the higher growth and larger deficits that may come out of the tax proposals show how violent the moves can be in long term bonds.

Retail investors have been flocking into bond funds for the last year or more. Supposedly this was in search of "safe investments" compared to the volatile stock market where they had suffered losses. In fact I would argue they weren't looking for safety but rather chasing returns of the most recently outperforming asset class.

These investors were simply riding the last wave of a massive decline in interest rates/rally in bonds. The positions were hardly "safe investments" particularly if they extended maturities in their bonds to avoid the paltry yields in the short maturities., As rates went down the longer duration bonds gained disproportionately compared to other bonds, I assume for some investors this was evidence their bond investments were ""safer" than stocks.

But as these investors are probably just starting realize, what goes up the most can go down the most, Those long duration bond holdings will suffer greatly should rate rise. Just the relatively modest increase in long term rates of late has been quite damaging to holders of long term bonds. Over the last 3 months TLT the 20 year+ treasury bond etf has declined 8.3% while the short term treasury bond etf SHY is unchanged. Surely all bonds are not equally "safe" investments

One very interesting question is how the "new" bond market filled with many,many more returns chasing retail investors (as opposed to a market in the past dominated by institutional investors) will react when rates bottom and they start to seee losses in their bond funds. If many of them run for the exits at the same time it could get ugly, More on that in the future.

How Dumb Money Could Get Smarter

2010-12-06T23:21:00.000-08:00

I have noted many times how retail investors chase hot asset classes and wind up buying high and selling low. WSJ reports on some research that supports that observation and recommends a remedy:

Over the years, the funds research company Morningstar Inc. has found that investors can profit if they invest in the most-unloved stock-fund categories and hold on for the next three to five years. Sometimes, the least-popular categories can be narrow ones on which you might not want to place a big bet.
But this year, through October, the biggest redemptions by investors have been in three bread-and-butter categories focused on large stocks in the U.S. and abroad: Morningstar's large-growth, large-value and world-stock groupings.
If your gut reaction is, "Thanks, but I don't do charity cases," think again. It's an old story: Ugly-duckling mutual fund transforms into profitable swan.
Chicago-based Morningstar found that buying what other investors sell generated a 3.7% annualized gain over the decade through July, while the most-loved fund categories lost an average 1.2% a year and the Standard & Poor's 500-stock index shed 0.8%. (The most-loved categories this year through October: diversified emerging markets, commodities and foreign large blend.)

More Evidence That Past Performance of Actively Traded Mutual Funds is a Poor Predictor of the Future

2010-12-06T23:14:00.000-08:00

from the wsj

We looked for diversified U.S.-stock funds in the top 20% of their Morningstar Inc. category for the past five or 10 years but now in the bottom 10% of their peer group so far in 2010. There are more than a dozen such funds that recently had at least $500 million in assets.

No Surprise For Me in this Report

2010-12-06T13:23:00.000-08:00

my post of Nov 29

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

Money left bond mutual funds in the two weeks through Nov. 23, according to the Investment Company Institute, the first outflows since December 2008, roughly when the bond bull market began.
Even seemingly bulletproof emerging markets have suffered bond-fund outflows for two straight weeks, according to data tracker EPFR Global.

The Pain of Contango in the VXX But Not Time to Throw In the Towel

2010-12-06T07:27:00.000-08:00

The VXX short term volatility etn rolls over contracts on an ongoing basis selling the near term futures as it nears expiration and buying the near one. As a consequence, when the volatility curve is steep indicating investors are nervous about long term volatility in the form of a sharp selloff even if the near term market is stable and moving upwards.

This has been the case with the VXX which has the strange characteristic of sharply increasing volume despite sharply declining price. This to me is a sign longer term professional investors are making use of the instruments since retail investors would have long ago sold out of an instrument with such large declines.

Barrons reports

These risk-avoiding hiding places include the obvious— high-grade bonds and gold—but also stretch to tactical asset allocation strategies and owning "volatility" as an asset class, through such things as futures on the CBOE Market Volatility Index, or VIX.
Zlotnikov pointed out a few months ago that investors "will go to great pains to avoid repeating the most recently made mistakes, but have few qualms about repeating mistakes from long ago. Today, this shows up as investors' extrapolating of the historically highest volatility" of 2008 into 2009.
Gordon Fowler Jr., CEO and chief investment officer at wealth manager Glenmede, made a similar point, suggesting last month that "protection against extreme outcomes…has become unprecedentedly expensive."
This is the muscle memory of the crisis still animating investor behavior. The iPath S&P 500 VIX Short-Term Futures exchange-traded note (ticker: VXX), which profits from rising volatility, has more than $1.4 billion in assets, despite having launched in January 2009 and the fund having lost almost 90% since inception. For more than a year, prices on the relatively newly tradable futures on the VIX—which measures the options market's implied forecast of stock index jumpiness—have shown a steep premium in more distant contracts. This means traders have consistently bet on a surge in market turmoil a month or three or six hence.

This market activity has made the medium term volatility etn far less painful in price declines, ytd the vxz is -10.7% and the vxx -69.7% (chart below) Athough should volatility in the markets heat up on a large stock decline the vxx will offer more leverage than the vxz in a positive direction as the hedge makes its impact/

Even at these numbers a small position in VXX would have not been devastating a position equal to 3% of a portfolio would have shaved 2.1% off overall portfolio performance. A 5% position which I would deem the upper limit in a portfolio would have knocked 3% off portfolio return. And a mix of 3% vxx and 2% vxz would drag down portfolio performance by a bit under 2.5%.

One analyst from Sanford Bernstein wonders whether the investors in the volatility etns are fighting the battles of past markets that may not be appropriate now.

Zlotnikov pointed out a few months ago that investors "will go to great pains to avoid repeating the most recently made mistakes, but have few qualms about repeating mistakes from long ago. Today, this shows up as investors' extrapolating of the historically highest volatility" of 2008 into 2009.

As one whose clients hold these instruments I would argue that the threat of a black swan is a constant in the market and a small position in these as part of a portfolio makes sense. I certainly have company a large number of volatility related etfs have come to market, a number of fund companies and hedge funds have established "black swan funds". And there is an effort which I applaud to construct a broader volatility/fear index than the VIX which is linked only to the S+P 500. The Barrons article notes:

Just last week, BofA Merrill Lynch introduced a Global Financial Stress Index, "a comprehensive, cross-market gauge of risk, hedging demand and investment flows. The index is designed to help investors identify market risks earlier and more accurately than commonly used risk indicators, such as the VIX index," according to its news release.

The index might well do just that, perhaps even better than well-established indicators such as the Bloomberg Financial Conditions Index. (It certainly does the job in back tests, of course.) Yet the fact that, to the research folks at the No. 2 U.S. brokerage house, this seemed a propitious time to initiate an early-warning system for financial upheaval says plenty about the mindset of investors.

With the uncertainties in Europe and potentially elsewhere a period of market turmoil certainly one as severe as this summer's Greek related decline is certainly a strong possibility , During that period the VXX increased over 90% and the vxz increased in value over 30%.Perhaps it is not the best time to give up on black swan hedging and maybe even a time to look like initiating such a position,

An interesting new ETN from UBS has a strategy for reducing the impact of contango by shorting 50% of the notional amoount in short term volatility futures and going long the medium term. Based on historical data (but not real world trading yet) shows the strategy merits investigation.

Disclosure
Advisor's clients hold positions in botb VXX and VXZ,

What Would Milton Friedman Say ?

2010-12-02T10:15:00.000-08:00

As I have noted before, those that invoke Milton Friedman in warning of inflation as a consequence of Fed policy have a limited knowledge of Friedman's monetary theory. They are looking at only one measure of money M1 rather than the broader measures of money.. It also doesnt reflect the velocity money.

This is explained well in the FT's alphaville

Effective money, our favored broad money aggregate for the US, is the sum of plain old bank money – M2 or savings and checking deposits – and shadow money, which is based on the outstanding value of liquid debt securities which can be repo’d quickly for cash. (The thought is if a $100 security is so liquid that you can borrow, say, $95 in cash by posting the security as collateral, then owning the security will affect your behavior just like owning $95 in cash.)
Because effective money is influenced by monetary policy, fiscal policy, bank balance sheet expansion, and shadow bank credit expansions (e.g. ABS funding of auto loans), our aggregate is broad enough to tell us something useful about the economy and the possible direction of inflation.
Effective money was $27.7 trillion in February 2007 and collapsed to $25.7 trillion by late 2008. Much of the fall was in private shadow money, which suffered from a collapse of funding liquidity (rising haircuts), a sharp fall in bond prices, and very weak net issuance. However, this deflationary shock was offset by a public balance sheet expansion. Later in the recovery private shadow money rebounded, and our latest estimate of effective money is now $33.8 trillion

, parts of the expansion – especially on the monetary side – are easily reversible with central bank balance sheet and interest operations including the payment of interest on reserves, which could cull any sharp increase in bank credit expansion.
Fourth, although credit expansion has begun to revive in certain places, there really is no sign yet of runaway demand growth in the US. And unemployment and the output gap remain very high.
But of all these reasons, the one we would urge monetarists and inflation worriers to ponder most is the first....

So far at least, we suspect that there has been nowhere near enough money printing to raise the risk, let alone guarantee, runaway inflation.

As for Friedman himself, hats off to the blogger who dug up this (below) from a Q+A after a speech by Friedman:

As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”

Of course in the case of the US the Fed didnt raise rates (gradually one would have hoped ) to burst the buuble, the US bubble was burst by the collapse in the financial and housing markets, but the subsequent dilemma was similar.

It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.(why? because velocity did not increase)

In other words if interest raes at zsero as a consequence of the first tool of central bank monetary policy, the appropriate action is to use "quantitative easing" not to sit still.

Well, at least about this issue

If Muni Bonds Had a Terrible Month in November...How Would One Describe the Month for International Bonds

2010-12-02T09:24:00.000-08:00

The Financial Times reports on November in municipal bonds.:

Munis see worst falls since Lehman collapse

By Nicole Bullock and Michael Mackenzie in New York

Published: November 30 2010 18:34 | Last updated: November 30 2010 18:34

US municipal bond markets have suffered their worst month since the collapse of Lehman Brothers, amid rising interest rates, a flood of new issuance and fears over possible defaults by cash-strapped states and cities.

The Barclays Capital municipal bond index was on track on Tuesday for a fall of 2.2 per cent in November, the biggest monthly loss since September of 2008, when Lehman Brothers went bankrupt and the index dropped 4.7 per cent.

The poor performance was driven, in part, by higher Treasury yields as US government debt prices fell for the second month in a row during November. The total return for US Treasuries was -0.87 per cent for the month according to Barclays Capital and the yield on 10-year notes was set to close out the month at 2.77 per cent, up from 2.60 per cent at the end of October.

Other asset classes also dipped last month, with US corporate and mortgage bonds lower.

But as I have mentioned in an earlier post the losses investors are facing in another "hot" asset class: international bonds particularly those of developed countries. Here are returns for the month of november for bond etfs:
MUB muni bonds, IGOV developed market intl, WIP developed markets inflation protected, EMLC emerging markets, and PICB international corporate bonds. The losses in all of the developed market categories are far in excess of those losses in munis.

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

2010-11-29T12:18:00.000-08:00

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

2010-11-29T12:16:00.000-08:00

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 ?

2010-11-29T08:25:00.000-08:00

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

2010-11-26T09:13:00.000-08:00

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 ?

2010-11-24T12:03:00.000-08:00

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

2010-11-22T13:20:00.000-08:00

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

2010-11-22T08:16:00.000-08:00

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.

2010-11-19T17:23:00.001-08:00

Bernanke's Speech Today Attention Should Be Paid

2010-11-19T08:38:00.000-08:00

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

2010-11-19T08:33:00.000-08:00

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

2010-11-19T06:54:00.000-08:00

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

2010-11-18T18:47:00.000-08:00

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 ?

2010-11-18T14:19:00.000-08:00

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

2010-11-17T09:40:00.000-08:00

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 ?

2010-11-16T15:54:00.000-08:00

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.

An " Investing Strategy "For Those That Think Inflation Is Going Sky High

2010-11-16T09:30:00.000-08:00

I noticed some commentators outside the economic/financial world recommending that folk pay down their own debt to prepare for the coming high inflation.

In fact the correct strategy would be to borrow as much at a fixed rate as possible and invest the proceeds even if it goes for now into a 6 month or one year cd at around 1%. or invest it in inflation protected bonds with a druation that matches the maturity of the loan.

In an inflation scenario the borrower would be paying pack the loan with dollars that are worth less against a principal that does dont increase with inflation. Additionally the interest rate would be fixed at its nominal interest rate, as rates rise with inflation and with high inflation the nominal interest rate will become a negative real (nominal -inflation rate).

On the investment side as inflation rises so would nominal interest rates. As the CDs roll over the new investment rate would be higher compensating for the increase in inflation.

With the inflation protected bonds the bonds inflation adjusted component would of course increase with inflation, Even with the fixed interest rate on some maturities of TIPs negative the strategy still holds as the inflation adjustment would still be worthwhile.

Think this strategy doesn't make sense ? It's exactly what major corporations are doing in the bond market. The onlly different is that they are either sitting on the cash they raise, paying dividends, buying back stocks or are looking around for acquisitions like the large Caterpillar deal announced yesterday.

The Mutual Fund Industry's New investment strategy ....or just a new product to sell ?

2010-11-16T09:26:00.000-08:00

As the use of exchange traded funds explodes as noted in Barrons this weekend and as seen in this graph

The mutual fund industry sems to scrambling to find a new way to entice individual investors. With fewer and fewer investors buying into the active managers claim of stock picking skill, we are now faced with a variety of "absolute return", "long short" or go anywhere funds sold as a way to get access to active managers able to spin gold out of yarn : positive returns whatever the market conditions with less volatility to boot.

The WSJ reports today on another wrinkle to this group of
products the hedge fund like mutual fund which the article notes perform this ambitious feat:(my bolds and comments in blue)

Hedged mutual funds provide stock-like returns with less volatility. Moreover, they provide more transparency and regulation than hedge funds. "We think there'll be a huge move to these types of funds," Mr. Krusen said.

Hedge funds take short positions, bets on falling prices, as well as long positions that benefit from rising valuations. They also can use borrowed money, or leverage, to magnify returns. They usually lock investor money up for a quarter or more, and some are free to trade any securities or derivatives anywhere in the world.
The goal is to generate positive returns, irrespective of the direction of the overall market. This is usually all wrapped up in a limited-partnership structure in which the manager charges an annual fee of 2% or so and takes about 20% of profits each year.
Traditional mutual funds typically take long-only positions and try to beat benchmarks, such as the S&P 500-stock index. The average net expense ratio of mutual funds is about 1.3%, according to Morningstar. Mutual funds don't take any cuts of profits. In contrast, the Flexible Fund's net expense ratio is 3%, according to Morningstar.

It's not hard to understand why this structure might appeal to managers like AQR management that previously only managed hedge funds. Hedge funds typically charge "2 managementand 20% of profits " But if the fund suffers large losses the 20% can only be charged once the fund recovers to the "high water " mark. So with a 30% loss a hedge fund manager would have to recover 42% before beginning to collect the performance fee. This structure led many hedge fund managers to simply close their funds return the money to investors....and start fresh with a new fund. It doesnt take a quant PhD to do the math that 3% annual fee from retail investors would likely be a better trade than "2 and 20" in a hedge fund, particularly when institutional investors have been pushing back for lower fees.

As for whether the strategy makes sense at all, I see no logical reason to assume active managers would be more successful using more complex strategies in the toolbox of these funds than other types of active managers.

Furthermore the structure presents some additional risks. Hedge funds often have "lockup" periods which have the disadvantage of not allowing easy liquidity for investors who also must give several weeks prior notice even before liquidating at the end of the lockup period. There is some merit to the claim by hedge fund managers that such a structure protects them from having to liquidate positions in difficult markets when "hot money" runs to the exits. Even with the structure as it exists such flows can occur leading to liquidations that can cascade into further losses in a panicked market, leading to large losses for those that are invested with a long term horizon. For that very reason sophisticated hedge fund managers such as Yale Endowment insist that their investments with a hedge fund manager be held separately. That way if positions in the fund need to be liquidated to meet redemptions, Yale's positions need not be sold off.

But consider the mutual fund structure for these high risk leveraged strategiies. While the transparency and daily liquidity have benefits the likelihood of hot money flows is extremely high. We know retail investors chase the market. One can only imagine what would happen if a hedge fund type mutual fund reported a one month loss of 20% money would flow out of the fund and positions would be liquidated most likely at extremely distressed values punishing the long term investors. And the reverse would pose a danger as well: money would flow into hot funds, and the managers would be encouraged to put more money into existing positions at less attractive prices or to scramble to invest the money in ways to keep up the returns (and the inflows) taking more and more risk. If there was a virtue to hedge funds in being able to take longer term positions because investors would be committed for extended periods it would all be gone with the mutual fund structure the pressure for short term performance would be intense and the positions and trades wouldbe highly influenced by flows in and out of the funds.

Of course none of this keeps Wall Street from pushing these new untested products playing on investors fears and the well known behvioral finance behavior of "recency" drawing long term conclusions with a disproportionate weight on recent events" From the article:

Investment bank Goldman Sachs Group Inc., one of the largest hedge-fund managers in the world, advised investors to add this new breed of mutual fund to their portfolios in a September report. The 2008 financial crisis left many uncertain about whether a traditional mix of stocks and bonds can generate enough return, the bank said.

Ironically of course a simple portfolio invested 65% in the US total bond market and 35% in the US stock market would have grown 28.9% since the beginning of 2009. Maybe the new new thing will become a simple globally diversified low cost portfolio of index instruments despite the lack of wall street advocating this approach. Particularly when this performance is viewed as a major achievement:

Barrons website

Report: Hedge Funds Running Neck-To-Neck With S&P 500

Posted by Murray Coleman

As noted earlier by a previous study, hedge fund assets keep rising and investors keep putting more new money into managers’ hands.
As long as returns are relatively positive, that’s likely to be the case for awhile longer.
In October, the trend we’ve been seeing of improving hedge fund performance continued. As a whole, hedge funds gained 2% in the month, according to the Barclay Hedge Fund Index compiled by BarclayHedge.
After back-to-back gains in the past two months, the index this year was up 7.24% — nearly matching the 7.84% return of the S&P 500 benchmark.

Maybe the smart money is not in the flows described above but among the bifg flows into etfs.shown in the graph at the top of the page.

A related barrons blog post touts a 3 of these :"funds that hedge " noting some with more reasonable fees and strong performance although all are significantly below a globally diversified portfolio for the last 2 years and 2 of the 3 suffered hefty losses of over 25.8%(ivaex) and -20.8% (mdlox)in 2008 compared to a -21.3% for a simple 65/35 us stock/bond mix. Even the outstanding performer of the group in 2008(paudx) lost 7.8% so much for the ability to make money in up and down markets

Some Terrible Investing Advice from the WSJ

2010-11-15T07:12:00.000-08:00

I dont't think I have seen so much bad advice for individual investors in a single article since the WSJ began its personal investing column entitled my comments in blue

How to Play a Market Rally

Stocks Have Surged—but Investors Who Want to Lock In Some Profits Now Need to Do It Carefully

By BEN LEVISOHN and JANE J. KIM

The article starts off with this beaut:

Forget "buy and hold." It is time to time the stock market.
For 10 long years, market rallies have ended badly for investors. Now, with stocks up 15.6% in four months, strategists are beginning to suggest that ordinary investors start dialing back on risk.

first of invvestors with a globally diversified portfolio + an allocation to bonds haven't had such a bad ten years certainly compared to someone who invested 100% in the s+p 500 the "benchmark" for the "lost decade" No informed investor would hold that 100% sp 500 portfolio.

The first step is to disabuse yourself of the notion that it's impossible to time the market. It turns out that sometimes you can. When markets are stuck in a trading range for an extended period, selling into strength and buying into weakness can outperform buy-and-hold investing.
If that sounds like sacrilege, it may be because mutual-fund firms have spent decades persuading you to keep your money in their stock funds through thick and thin so they could collect bigger profits.

The article goes on to give 2 simplistic market beating formulas

Consider an investor with a $1 million portfolio on Dec. 24, 1998, the first time the Standard & Poor's 500-stock index was at its current level. But if the investor had merely held on, he would have seen essentially zero appreciation through Nov. 11 of this year. If that same investor instead had sold one-tenth of his portfolio every time the stock market gained 20% and allocated one-fifth of his cash to the market when stocks fell more than 10%, he would have gained about $140,000, according to a Wall Street Journal analysis

and here's market beating strategy #2

An approach using broad valuation measures performed even better. One metric, the ratio of stock-market capitalization to gross domestic product, tracks the market's value versus that of the underlying economy. An investor with $1 million on Dec. 24, 1998, who sold 10% at the end of each month when the ratio was above 115% and bought stocks with 20% of his cash when the ratio was below 75%, produced a gain of around $365,000. (The average has been about 91% over the period

but they themselves admit their "market beating formula " would have failed to outperform the market since 2002. They give no data for any other periods including any prior to 2000-2009. I wouldnt suggest the authors quit journalism to start a hedge fund based on their market beating formula.

They then go on to recommend 4 investment moves 2 of which are absolutely disml:

The first:

Go Anywhere Funds

Investors who wish to take some profits on stocks and redeploy it elsewhere should consider "tactical allocation" mutual funds that allow managers to jump into and out of asset classes at will.

When the stock market trades in a band, as it has for the past decade, these sorts of funds can perform well. According to data from investment-research firm Morningstar Inc. through October, "world allocation" funds have returned 5.08% annually over the past five years and 5.78% annually over 10 years, compared with the S&P 500's 1.73% annualized gain over five years and an annualized loss of 0.02% over 10 years.

Was it the brilliance of the manager or the simple fact that these funds held non US stocks and bonds that produced that performance ? How much better did they do than a well allocated global stock and bond index portfolio. And what good is a performance number from a category when strategies can "go anywhere" and there is no persistence of performace among active fund mangers

Some tactical funds handily beat traditional equity funds during the financial panic.

and of course many didn"t:

"There were many investors in 2008 and 2009 who were disappointed by how little their fund managers could do to react to or react ahead of what was developing," says Loren Fox, senior analyst at research firm Strategic Insight.

And of course the mutual fund industry is never slow to jump on a fad so that investors cant put money into a strategy based on past performance of a few standouts and put money in funds that have zero perfomrnace data. :

So far this year, financial-services firms have launched 28 world allocation funds, according to Morningstar.

This Advice May be Even Worse:

A typical move after a powerful stock rally is to sell shares and buy bonds. But with the Treasury markets surging to record highs recently, putting more money there could be even riskier than leaving it in stocks.

true for investors in long duration bonds where a 20 year duration bond would cause a loss of 20% on a 1% move up on interest rates. But move the duration down to 3 years and that number is 3%.

Their suggestion "rising rate funds" which are really floating rate funds...: with plenty of credit risk.

Instead of Treasurys, investors should consider "floating rate" funds, which buy variable-rate corporate loans—and therefore collect more money when rates rise. In 2003, for example, when the Fed started raising rates, floating-rate funds gained 10.4% while short-term bond funds gained 2.5%, according to Morningstar.
There are at least 31 open-end funds and 10 closed-end funds to choose from. Morningstar's picks in this category include the Eaton Vance Floating-Rate Fund (evblx)and the Fidelity Floating Rate High Income Fund,(fahyx) which boast experienced management teams and solid track records.
Warren Ward, a financial adviser in Columbus, Ind., says he is considering the Fidelity Advisor Floating Rate High Income Fund for his clients because of manager Christine McConnell's experience through up and down markets.

These funds hold bank loans which carry high credit risk and are illiquid. As a consequence they are disastrous during periods of panic when liquidity dries up and the default risk of these loans rises. In 2008 the fund dropped 30.41% even with a 46% recovery in 2009 an investor in this fund who put money into the fund in 2007 and had the stomach to hold on has underperformed someone who simply invested in the aggregate bond index by 3.85% in annualized return. The Fidelity fund which of course gets its "high income" really high yield from higher credit risk, plugned 38.9% in 2008.

High risk bond funds are not a good place to diversify away from stock market risk. The risk in these funds is more akin to the highest credit risk bonds = high yield as the two charts below show comparing the funds to the low cost vanguard high yield bond fund (vwehx)

Investors willing to take some credit risk and not interested in signigicant exposure to credit risk should consider something like the vanguard short term investment grade corporate bond fund (graphed here vs the eaton vance fund.) a far less risky choice. Graph below compares it to the" less" risky of the two funds recommended in the article.

More on Gold: Bad Choice for A Currency and At Some Point A Bubble That Will Burst

2010-11-15T06:35:00.001-08:00

my comments below in blue

James Grant has the gold standard "argument" in the NYT

A far more comprehensive article on gold appeared in the FT over the weekend. It had many great points but here is one to ponder for those advocating a move to a gold standard particularly in the midst of the deepest economic decline since the great depression. A gold standard policy is a sure path to continued economic contracion.

To casual observers, central bank policy looks like printing money; the beauty of gold has always been that no one can make any more of it than what is already under lock and key or remains in the ground. The very extent of the rise in its price, however, shows the difficulty of using gold as money. Since the turn of the millennium, the Fed’s favourite price index has risen by 22 per cent, while over the same period the price of gold in dollars has risen by 498 per cent. Put another way: if there were no dollar, and US shoppers paid for their groceries with gold coins, since 2000 the amount of gold needed to buy a loaf of bread or rent an apartment would have fallen by three-quarters.
Deflation of 75 per cent in a decade is not an ideal characteristic for money. From a central banker’s point of view, the problem is that the rise in the gold price has not done a good job at predicting rises in the price of everything else. “Gold is a very poor reference point because it fluctuates so widely,” says Fred Bergsten of Washington’s Peterson Institute for International Economics....

the long term factors controlling gold's price, supply and ultimately money supply and economic growth in a gold standard system:

Among fundamental factors, traders highlight stagnant mine output in spite of record high prices. Global gold production hit a peak of about 2,645 tonnes in 2001 and stayed below that level until this year, according to estimates from GFMS, a consultancy. Worse, mining output is shifting to riskier producers in Africa and central Asia and away from the four traditional – and now mature – producing regions: South Africa, the US, Canada and Australia. Their combined output fell to 756 tonnes last year from 1,260 tonnes in 2000.
Only a surge in gold scrap, as owners of old jewellery cashed in on high prices, has cushioned the drop in mine output. Demand has also been robust as the growing middle class in countries such as India turns some of its new wealth into golden baubles.
Such factors are specific to gold and say nothing about wider inflationary pressure

The current factors pulling up gold's price:

But there have also been dramatic changes to financial buying of gold. New investors – such as pension funds and insurance companies – have piled into gold through novel instruments known as exchange traded funds, which make it easier to buy and sell bullion

The pension funds, insurance companies and some other longer term investors may be holding gold as part of a long term allocation to commodities. But the marginal buyer pushing the price at this point are speculators and uninformed individuals who know can easily buy gold through low cost instruments such as etfs or expensive illiquid ones touted on cable tv and talk radio. Their main rationale for buying gold is either doomsday scenarios peddled by the personalities on those programs with gold ads or for others they're buying it because it keeps going up. At some point, I have no idea when, this will end and it won't be pretty.

As for a gold standard... it;s the ultimate conrtractionary monetary policy: Here's what a scholar at a conservative think tank has to say:

While it may be useful to know that investors would prefer to own renminbi rather than dollars or euros, it is difficult to do anything about it. “Fed critics who cite the rise in the price of gold as a signal of incipient higher inflation have to acknowledge that they are in effect calling for the Fed to tighten policy,” warns John Makin, resident scholar at the American Enterprise Institute in Washington. “They need to consider the profoundly negative impact on asset prices and economic growth that would follow.”

wsj nov 15

Precious-Metals ETFs Explode; Are Investors Late?

By JOHN SPENCE

Exchange-traded funds are making it easier for individuals to place sophisticated bets on precious metals, but there are concerns these buyers are hopping on the bandwagon late.

As I was Saying...

2010-11-15T06:35:00.000-08:00

On October 14 I wrote about how individual investors should stay away from sttuctured products

November 11 I was quoted by Bloomberg News expressing skepticism about the products

WSJ Nov 13:

Structured Notes: Not as Safe as They Seem

By JANE J. KIM and BEN LEVISOHN
Brokerages are rushing out more instruments that promise some equity returns with less risk. In theory, the products work well. But investors should ask some questions before diving in.

Arthur Laffer Has A Growth Agenda for The US While Another Supply Sider Joins Those Ganging Up on Ben B

2010-11-12T06:45:00.000-08:00

my comments here are in blue

Arthut Laffer has some advice on how to get growth in the US going in today's WSJ

Before running to take his advice readers might want to take a look at pg 191 of his 2009 book :

"The greatest supply side success of recent times (other than the Reagan Revolution) is the Irish Economic Miracle. "(pg 191)

from page 1 What's News section of the WSJ with Laffer's op ed piece is promoted on the same page 1

The European Union said it stands ready to step in and help Ireland with its financial situation as investors grew increasingly worried about the challenges facing the region's weaker countries and drove the euro to a one-month low.

btw Here's fellow supply sider Alan Reynolds of the Cato Institute who had strong words of critique against current fed polcy in the WSJ earlier this week. giving his views on proper policy in the US while opining on Ireland on June 10 of this year:

Though Greek deficits and debts have dominated the news lately, Ireland's fiscal crisis was widely considered at least as dangerous to the euro late last year. Ireland is in the worst trouble of all the eurozone countries, the International Monetary Fund then reported. Ireland's budget deficit was as large as that of Greece in 2008, and the Irish economy had shrunk 9 percent in 2009.
But we don't hear much about Ireland today. Why not? Because that country successfully repeated what it had done so boldly in the late 1980s — slash spending on payrolls and benefits, subsidies and transfer payments.....

Unlike Greece, the Irish economy is showing encouraging signs of recovery. Manufacturing increased strongly in March and April, and consumer confidence and retail sales are also up.
"The Irish approach to tackling the recent recession," investment adviser Michael Johnston said, "was vastly different than the strategies implemented by the U.S. and much of the rest of the developed world. Most governments cranked the printing presses into high gear and began injecting round after round of capital into the global economy. Ireland went the opposite direction, imposing draconian budget cuts and reeling in government spending."
The Irish approach worked in 1987-89 — and it's working now.
This is a lesson that Washington should learn sooner rather than later.

FT today from the always insightful Gillian Tett

More remarkable still, it has also imposed a painful austerity plan, in a bid to reduce debt. This has hitherto been largely accepted by long-suffering voters; social cohesion still appears surprisingly high.
Yet, instead of being rewarded by the markets, Ireland is now in the crosshairs. Ten-year government bond yields have just surged above 8 per cent. Hedge funds in places such as New York are forecasting a default. And, on a visit to Dublin this week, I bumped into several distressed debt experts, some of whom joked that “Ireland is now even worse than Greece”. And not just because of the weather.

btw another darling of these guys was Latvia whose economy is recovering a bit now after the longest economic decline in the EU with a quarterly GDP contration of 18% in 2008, unemployment that hit 19.4% and a $10 billion bailout from the IMF World Bank and EU

I don't envy Bernanke. But I certainly think this piece by Floyd Norris gives a more balanced view of his situation and the contast of the "can't get no respect" attitude of critics so many of whom were eerily absent from criticizing "the wizard" Greenspan over his 20 year reign. With fscal policy changes off the table (just as advocated by Alan Reynolds above) the only levers left to get the economy moving again are monetary. Good luck Prof Bernanke we need it.

Fed Efforts to Revive Economy Find Critics
By FLOYD NORRIS
Can you remember when the Federal Reserve was above criticism? When politicians vied for Alan Greenspan’s favor and fell all over themselves praising his wisdom?
Now poor Ben S. Bernanke, who succeeded Mr. Greenspan as Fed chairman, is being blasted from all sides. It is bad enough that his latest effort to revive the American economy has taken on a name previously used for a 40-year-old cruise ship that no longer sails — QE2.

He is attacked by Americans for printing money and by overseas officials for trying to help American trade by undermining the dollar. Some Republicans claim to believe the country would be better off without a central bank at all.
If the stock market were falling, you can be sure the Fed would get the blame. But it has been rising of late, and in some critiques that is proof of the Fed’s perfidy. The Fed is creating inflation, its critics say.
Overseas, there is a widespread belief that the purpose of QE2, for the second round of quantitative easing, must be to depress the dollar and thus give the United States an unfair trade advantage. “It’s inconsistent,” thundered the German finance minister, Wolfgang Schäuble, in an interview with Der Spiegel, “for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money.”

I am Quoted By Bloomberg News

2010-11-11T11:19:00.000-08:00

Wealthiest People Buy Least Structured Products, Study Shows

By Zeke Faux - Nov 11, 2010

The wealthiest investors in the U.S. put less of their holdings into structured products than the less affluent, according to a study commissioned by the Securities Industry and Financial Markets Association.
Individuals with more than $5 million in assets allocated 0.41 percent of their investments to structured products last year, data from the study show. For those with less than $250,000, that proportion was 1.33 percent. Investors with $250,000 to $1 million put 1.53 percent of their holdings in the products, the most of any group.
Structured products, which are debt bundled with derivatives, are marketed as an alternative way to bet on stocks and interest rates and manage risk. Wealthy investors prefer to “cut out the middleman” by trading the components separately, said Lawrence Weinman, an investment adviser in Los Angeles.
“The smaller the asset base, the more likely the investor works with people who are just trying to sell them certain products,” said Weinman, a former institutional derivatives salesman at Paris-based bank Societe Generale SA. Brokers often earn higher fees on structured products than stocks or mutual funds, he said.
The study, released Nov. 1 by the New York-based trade group, included data submitted by 17 brokerages on 38.2 million investors, about a third of U.S. households. Andrew DeSouza, a Sifma spokesman, provided additional data in an e-mail. Sifma commissioned Oliver Wyman, a New York-based consulting company, to evaluate the impact of applying a fiduciary duty to brokers.
Clients’ Interests
Brokers are now required to offer clients “suitable” investments, while investment advisers have a fiduciary duty to put clients’ financial interests first. In January, the U.S. Securities and Exchange Commission will finish its study of a uniform standard for brokers and advisers. The agency was required to consider the rule change by the Dodd-Frank financial regulation law.
People with $1 million to $5 million in assets had 0.73 percent of their investments in the securities, the study showed. Individuals in the study held $70.4 billion of structured products overall, or about $1,800 each.
U.S. investors bought a record $42.4 billion of structured notes this year, according to data compiled by Bloomberg. Morgan Stanley issued $10.1 billion, the most of any bank. Bank of America Corp. issued $7.9 billion, the second-most.

Another Reason Why Inflation Isn't Coming Courtesy of Milton Friedman

2010-11-11T08:57:00.000-08:00

MIilton Friendman is best known (among economists not political pundits) for his quantity theory of money i,e, monetarism:

from Wikipedia
he equation of exchange can be used to form a rudimentary version of the quantity theory of the effect of monetary growth on inflation.

V

and

Q

were constant, then:

and thus

where

t

is time.

which says that the inflation rate equals the monetary growth rate plus the growth rate of the velocity of money minus the growth rate of real expenditure. If one makes the quantity theory assumptions that, at least in the long run, (i) the monetary growth rate is controlled by the central bank, (ii) the growth rate of velocity is purely determined by the evolution of payments mechanisms, and (iii) the growth rate of real expenditure is determined by the rate of technological progress plus the rate of labor force growth, then while the inflation rate need not equal the monetary growth rate, an x percentage point rise in the monetary growth rate will result in an x percentage point rise in the inflation rate.

Looking at thiese charts(from the great website it seems clear to me Friedman would not be looking at the prospect of future inflation. There is no velocity to money. Unfortunately it also may mean that the economiy is in a " liquidity trap" and the fed's easing will do little to help the economy (which doesnt mean it's not worth a try)

Here(immediately below) is the "V" from the equation

and here (immediately above) is the "M"

here is money supply and inflation expectations via the tips/conventional bond spread (excuse the scan from the FT). . Note that M2 (money in circulation) hasn't changed even as the monetary base M1 increased. The Fed can only move M1 M2 reflects whether or not the banks sit on the money or lend it out creating a multiplier of wages and consumer spending. M2 creates spending an potentially inflation. Money sitting in the vault and not circulating can't create inflation (or jobs).

a nice article on the deflation vs inflation argument is here

Bubble Bubble....?

2010-11-11T08:52:00.000-08:00

LA Times page 1 Nov 9

Rumblings of inflation grow louder

Commodity prices are rising — driven by higher consumption, bad weather and investor demand — and Americans are starting to feel it in their pocketbooks.

WALL STREET JOURNAL PG 1 November 9

Commodity Prices Surge

Gold, Cotton Touch New Highs as Fed Stimulus, Chinese Growth Drive Demand

BoA Merrill Lynch launches UCITS-qualifying commodities funds

4 Nov 2010

Bank of America Merrill Lynch is launching it Commodity Alpha & Beta family of UCITS III funds, namely the MLCX Commodity Enhanced Beta Fund; the MLCX Agriculture Optimal Crop Fund; and the MLCX Commodity Alpha Fund.

DFA Plans to Roll Out a Commodity Fund

Investor demand trumps DFA's skepticism about commodities as diversifier and inflation hedge

Article | August 23, 2010 | By Michael S. Fischer

Dimensional Fund Advisors (DFA) is expected to roll out the DFA Commodity Strategy by year-end, according to a report by Morningstar Advisor on Monday, August 23. Morningstar noted that DFA had registered with the Securities and Exchange to launch the new product on August 16....
Morningstar suggested that in offering the new fund, DFA acceded to the wishes of its large clients. But it had to put aside its skepticism about the long-term usefulness of commodities as a portfolio diversifier and inflation hedge. DFA, Morningstar said, bases most of its fund offerings on academic research demonstrating that small-cap value stocks tend to outperform over the long term.

Kenneth French on the DFA website:

KRF: No, my views have not changed—at least on this topic. Here's the thrust of my 2004 presentation....As a result, investors who use commodity funds to hedge inflation almost certainly increase the risk of their portfolios. Six years after my presentation, I still think these points are correct. Commodity funds are probably a good investment for some investors, but not for the reasons many of their advocates suggest.

glenn beck,com: (transcript form november 9: radio program 10 million listerners

GLENN: No, no. I will tell you this. We have had our financial advisors, the guys who are stat-related guys, they are not politicians. They are more like the David Walkers of the world, you know, that they're just, all they do is look at stats. All they do is look at stats. And all of them are saying around the corner. All of them are saying starting in January you're going to see real price inflation. One of our experts, and I don't name them because they advise us off the air. They're not, they're just -- you know, quite honestly I think many of them don't want to be associated with me because they don't want all the trouble associated..., an This is what they do for a living. And one of them said by next year a quarter of this nation will not be able to afford food. A quarter of the nation will not be able to afford food. I have to tell you, I'm never, ever right on timing. I have -- I'm not giving you my projection of timing. I'm telling you that there are these experts that say this. Is this true? I have no idea. I will tell you that historically speaking printing money leads to unbelievable inflation and gigantic interest rates. That's what happens. Period. So is it going to happen? At some point, yes. When? I don't know. I just ask you to please prepare.

Now, people have been writing me and saying, Glenn, what do we do? How do we prepare? ... And if you can save money and buy extra food and put it on the shelf, do so. If you can spend the extra money on having some food storage, if you are somebody who, you know, you've got grandkids now and you can't get the kids to listen to you and you have some extra money, buy it and put it on the shelf for them. ...

Experts are now telling me that it's happening next year. I don't know. I just know that prices of commodities have gone through the roof. I know that when I started telling you about gold, it was $700. When they were making fun of me and telling me that I was going to destroy people's lives because they were all going to go broke and you were just a hapless dupe when you were buying it at $1100 an ounce, today it is over $1400 an ounce. Could be worth $300 tomorrow. I don't know. But please look at the direction of --

PAT: I like how you say that, though, for the reverse psychology element. You tell them that so they will go ahead and buy it...

GLENN: Shhh.

PAT: And then when it does drop --

GLENN: Shhh.

the following appears at the top of the site:

Re: my post on inflation and unemployment

2010-11-11T08:23:00.000-08:00

David Leonhardt in the NYT

Yet Another Reason Not To Own Actively Managed Funds : Bonds or Stocks

2010-11-09T17:23:00.000-08:00

so much for knowing much about a fund from its label,,,and so much for "style purity"

Wsj reports:

....Even managers of some high-yield mutual funds are reducing their exposure. The John Hancock High Yield Fund has increased the stock allocation of its $1.1 billion portfolio to its legal maximum of 20%, up from 13% a year ago

This "Top Guru" Admits His Forecasts Are Only a Bit Better Than A Coin Flip

2010-11-09T17:16:00.000-08:00

Mohammed el Erian of Pimco is never shy about speaking publicly with his market forecasts. Yet Investment News reports:

...(there has been a ) 16% advance in the S&P 500 since July 2, according to data compiled by Bloomberg. The index surged 12% in September and October, the biggest rally for those months since 1998.

Pacific Investment Management Co. LLC, which oversees the world's biggest bond mutual fund, said in May 2009 that rising government deficits and regulation would hold gains in equities and bonds below historical averages. Mohamed El-Erian, Pimco's co-chief investment officer, said recently that his projection has a 55% chance of coming true.

don't like that forecast ? here's another from the same article:

“Of the leading economic indicators, one of the most important is the stock market,” said Mr. Birinyi, whose Birinyi Associates Inc. advised clients to buy stocks in March 2009 when the S&P 500 began rising from a 12-year low. “The market's saying something, and it's saying the economy is going to be surprising on the upside

Inflation on The Way ? Not Till Unemployment Falls by 50% ....anId unfortunately that is not in the cards for the forseeable future

2010-11-08T10:02:00.000-08:00

see above (I got this from Krugman's blog... you can argue policy but numbers dont lie)

You dont get inflation with no increase in wages(and note the average hourly earnings number here is not inflation adjusted) as you can see in the attached chart....and with 10%+ undemployment (more like 16% + if you add in discouraged and underemployed) we are far from a situtation where employers have to raise wages to attract/retain workers. That and the extremely low velocity of money makes high levels of inflation an unlikely consequence of QE 2. Unemployment would have to drop by at least half before one could anticipate any significant wage pressure and absent the increases in labor costs the inflation risks are low as the chart shows.

More later on fed policy but for now let's observe that this prescription from Fed Governor Warsh in today's WSJ for policies to get the economy out of the doldrums:

Pro-growth policies include reform of the tax code to make it simpler, more transparent and more conducive to long-term investment. These policies also include real regulatory reform so that firms—financial and otherwise—know the rules, and then succeed or fail. Regulators should be hostile to rent-seeking by the established, and hospitable to the companies whose names we do not know. Finally, the creep of trade protectionism is anathema to pro-growth policies. The U.S. should signal to the world that it is ready to resume leadership on trade.

is like prescribing a garden hose to put out a forest fire.

Despite all the talking heads screaming hyperinflation ( I have one in my ear right now on CNBC) and buying gold I dont think my view is actually in the minority. In fact a forecast of moderate inflation is exactly what is being shown in the treasury bond market:

Here are the market yields in the treasury market where one can take a position directly on future inflation :

                                               5 year             10 year       20 year

conventional treasuries             1.17               2.66              3.66
tips(infl protected bond)          -.34                 .49                1.18

implied inflation forecast           .83    2.17    2.48

as the economist writes in the buttonwood column this week:(the graph appears there as well) You might also find it interesting to compare the grey line in this chart which shows market inflation expectation with the chart at the top of the page that shows actual inflation.

If you compare the yield on conventional bonds with the yield on the index-linked Treasury bond that matures in 2028, the result is an implied inflation rate of 2.4%. That hardly sounds like the Weimar Republic.

Despite all the talking heads screaming hyperinflation ( I have one in my ear right now on CNBC) and buying gold I dont think my view is actually in the minority. In fact a forecast of moderate inflation is exactly what is being shown in the treasury bond market:

Here are the market yields in the treasury market where one can take a position directly on future inflation :

                                               5 year             10 year       20 year

conventional treasuries             1.17               2.66              3.66
tips(infl protected bond)          -.34                 .49                1.18

implied inflation forecast           .83    2.17    2.48

If you compare the yield on conventional bonds with the yield on the index-linked Treasury bond that matures in 2028, the result is an implied inflation rate of 2.4%. That hardly sounds like the Weimar Republic.

as for all those folk running into gold including $ billions from retail investors many taking their advice form screamers on tv and radio ? The economist column observes:

So why is gold, a classic anti-inflation hedge, still doing so well? The answer to this enduring puzzle may lie in the level of real interest rates. As Chris Watling of Longview Economics points out, gold’s last great bull run was in the 1970s, when real yields were negative. Positive real rates in the 1980s and 1990s had bullion trading sideways for 20 years. In a world of negative yields, owning gold has no opportunity cost.

To follow the logic through: if/when inflation goes up investors will demand higher real yields in the bond market to compensate themselves for the nascent inflation. As real interest rates adjust to take account of this the opportunity cost of owning gold will go up and gold will at a minimum cease to go up. Given the massive flows into gold including leveraged plays I would say "cease to go up" would be a massive understatement. In other words should inflation actually emerge gold would be exactly the wrong position. Even worse would be a position in long term nominatl bonds established at current levels. Higher actual inflation could likely be bad for both bonds and for gold.

The massive flows into bonds and gold strike me as classic cases of retail "dumb money" with retail investors invariably buying high and selling low. An excellent academic paper on the evidence of the "dumb money" phenomenon among investors in US stock mutual funds can be found here

I put that into the category of "dumb money" (check this great academic article on the phenomenon of retail investors as "dumb money")

one last observation...as anyone who questions gold knows one prediction always comes true....the gold bugs will soon inhabit the comments section here.

FT Business Book of The Year....An Excellent Choice

2010-11-08T08:07:00.000-08:00

The Financial Times recently awarded it's business book of the year and made this excellent choice; Fault Lines Raghuram Rajan, The book is not a comprehensive view of where we are at in the world economy, how we got here and some ideas on how to deal with the crisis. Rajan has the distinction of having addressed the Federal Reserve's 2005 Jackson Hole conference and, with Fed Chairman Greenspan in the audience, warned of the impending financial crisis.

Rajan's book has a perspective that might be particularly surprising given that he is on the faculty of the University of Chicago Business School. A primary part of his thesis is that politicians and central bankers unwilling to deal with the root causes of greater income inequality used the short cut of cheap money and access to credit so that individiuals and the nation of the whole could borrow in order to create an (illusory) standard of living. With all the incentives in place to borrow, inadequate regulation and controls on leverage the stage was set for the crisis. He finds plenty of blame to spread around and spares no group in his criticism. And here is a free market economist that argues that the road back to a stable economic system must include both stronger and better regulated free capital markets, increased means to narrow income gaps through better educational opportunities, universal access to healthcare, and an improved social safety net (and yes even progress on global warming).

On the international realm he probably too optimistically puts faith in a greater role for international economic institutions reflecting some frustration with his experience as chief economist of the IMF. He presents a nice overview of China's role in the international economy and the necessity for it to move past its policy of an articficially low currency value and export oriented growth into a more balanced policy with more emphasis on domestic economic growth.

As for where Rajan thinks we are at right now in the US economy, I doubt much has changed in his views from these he expressed in an interview with the New Yorker's John Cassidy:

Where do we go from here?
The real problem is that the United States has, in many ways, been encouraging too much consumption as a palliative for other things that haven’t been solved. So we muddle along because the crisis wasn’t deep enough [to force big changes]. We used all our bullets. We don’t have any bullets left, and we are in the process of encouraging risk-taking all over again. I’m not saying we are necessarily going to have another crisis soon. But what do we have in reserve if we haven’t dealt with the fundamental problems? That’s my worry—that we will emerge without a serious sense that there are problems we need to fix. We will have identified bonuses as an issue, or something like that, and imposed some constraints. But we won’t have dealt with the underlying deep problems.

And clearly on the international side of things we are further not closer from any kind of international agreements on trade or exchange rates.

another example of the perils of actively managed funds

2010-11-02T12:48:00.000-07:00

The WSJ has a good article on using etfs for tax swaps, something I have been doing since I began my practice. But in the midst of the article it presents a pretty strong example for not using actively managed mutual funds:

.....Getting rid of a subpar mutual fund? The same harvesting methods apply. Look for an ETF whose contents resemble those of the fund as closely as possible. Dodge and Cox Stock has been popular with investors, but this large-cap-value offering has lost about 40% of its value over the past three years. Part of its misfortune is due to Hewlett-Packard Co., which is down more than 18% so far this year and recently was about 4.6% of the Dodge & Cox fund's portfolio.
Over the past three years, Dodge & Cox Stock has moved similarly to the Russell 1000 index, according to an investor tool called the Best Fit Index on Morningstar.com. Best Fit suggests how closely a fund mirrors a benchmark index. By this measure, 97% of Dodge & Cox Stock's movements copied the index. (To find a fund's Best Fit Index, enter its ticker in the quote search window, click on Ratings & Risk and scroll down.) It would be simple to swap this fund for a Russell 1000 ETF such as iShares Russell 1000 Index, in which H-P is under 1% of assets.

10 year chart of dodge and cox dodgx

Two things stand out in this description:

1. Choosing a mutual fund based on past performance can turn out to be a pretty mad strategy.Not surprsiingly the money flowed into this fund chasing performance and has fled massively ($8.7 billion between 2007 and august 2010) in response to subpar performance.
2.This actively managed fund tracked 97% of the index yet massvely underperformed. In other words its "alpha" or manager contribution to return independent of the index was extremely negative. And why is that because the manager was confident enough to overweight HP close to 5x more than the index.
3. Further complicating things for an investor: even though folk like Morningstar categorize it as a US large cap value fund 17% of its holdings are in foreign stocks. So much for "style purity".

So an investor favorite produced more risk, less return than the relevant index and at higher cost. Even though this fund should be praised for its very low .5% annual management fee it can't match the Vanguard Russell 1000 value etf with a fee of .15%

In other words why bother ?

The Amazing Rebalancing Premium

2010-11-02T08:21:00.000-07:00

Jason Zweig has an excellent article in the WSJ about advisors who go along with clients's desires to increase allocations to the most recently outperforming asset classes.

He writes:

Investment professionals are supposed to exercise independent judgment; in Warren Buffett's words, they should be fearful when others are greedy and be greedy only when others are fearful.

Financial advisers contend that one of their most important functions is encouraging clients to "rebalance," or sell whatever has gone up and buy whatever has gone down.
The TD Ameritrade and Schwab numbers suggest, however, that financial advisers have been unbalancing instead of rebalancing their clients' accounts. By selling stocks as they fell and buying bonds as they rose, advisers may have ended up exposing clients to more risk, rather than less

That's a shame of course because imo one of the key reasons to use an advisor is to prevent the tendency of investors to fall into all the investing pitfalls well documented in the behavioral finance literature. My rule of thumb in my practice is to tell the client falling into one of these pitfalls "you're paying me to talk you out of doing this". I do this on the first 2 calls on the third call I tell the client "it's your money and I'll follow your instructions even though I think you are making a mistake". After that I try, not always successfully, to avoid any "I told you so " discussions. In my view the only reason to make a major change in allocation is a change in the clients personal circumstances although I might include the client's recognition that his risk tolerance (which really means his tolerance for loss) is not really what he thought it was.

Rebalancing make intuitive sense after all one is selling high priced asset classes and selling low priced ones. Contrary to how it may feel asset classes that have appreciated greatly are actually more risky than those that have suffered sharp declines. But the most interesting thing about rebalancing is that it is a "free lunch" it increases returns while reducing risk .Of course classic finance tells us that this is impossible but the numbers don't lie ?

Consider this portfolio from Sept 2000 to Sept. 2010 (the" lost decade" for stock investors US stocks returned nothing over the period):

35% total bond index
40% US total stock market
12.5% Developed International
12.5% Emerging International

Investor A rebalances each year selling out performers and buying underperformers to get back to his target allocation, His initial $100,000 invesmtent would have grown to $166,000

Investor B did not touch his portfolio letting his holdings in the outperformers grow. His portfolio grew to $150,000

But that is only part of the argument for the rebalancing. The annual standard deviation for investor A was 11.37 vs 14.1 for the non rebalancer rebalancing reduced risk. Here's another way of looking at risk that may actually be more striking for the non finance geek.

for the non rebalancer the worst 12 month period was a loss of 38.8% for the rebalancer : -30.3.

So if you are investing on your own work you hardest to fight the trend and rebalance. And if your advisor is as Zweig puts it:..

instead of holding your hand, some advisers might prefer to pull you by the hand in the direction you are already headed.

You and your advisor may be in a dysfunctional relationship .

a good article on rebalancing from Financial Advisor Magazine it includes this chart on the rebalancing premium for a simple 60/40 stock bond mix

I am Quoted in the Current Issue of Business Week

2010-10-28T23:11:00.000-07:00

In an article on emerging markets investing

Believers in a new era are more sanguine. "Emerging markets get a lot of performance-chasing," concedes Lawrence Weinman, a Los Angeles investment adviser. "But I do think that beneath the hot money flows there is a growing realization that the relative economic growth in the world just won't be in the States." Weinman says the investors he works with are changing their allocation models to commit more to China, Brazil, India, and other fast-growing markets.

More Wisdom on How to Beat the Market from CNBC gurus

2010-10-28T16:47:00.000-07:00

The CNBC hype machine is helping push their analyst's Gary Kaminsky's book on tv and by publishing an excerpt on their website. Problem is nobody checked what section they excerpted even though the website automatically updates with current quotes for any stock that is mentioned, Hence we get this whopper (my highlights):

One stock that I have followed closely is a company called Lululemon [LULU 44.13 -0.53 (-1.19%) ], a company that makes athletic apparel for yoga, dance, running, and other activities for men and women. I am shorting the stock, and as I write this chapter, Lululemon is selling for about $26 per share. The stock is down a little more than $1, or 4 percent, in a 24-hour period.

In the introductory part of his book he explains that he will be showing a long term investing, not a trading strategy so I doubt the illustration is presented as an example of how to make "fast money" shorting a stock and buying it back within 24 hours. And of course the beauty of a book like this is that there is no way to track particular recommendations. I also have no opinion of LULU stock ,

But here is a chart for LULU which is currently 69% above the level where he sold it short

and if you prefer another talking head from CNBC the one that operates at a higher decibel level here's Cramer

September 28, 2010 2:51 PM EDT

Shares of lululemon athletica (Nasdaq: LULU) have surged more than 6% today following a tout and recommendation from Jim Cramer on CNBC's Mad Money last night.

The pundit admitted that he may have gotten this one wrong before, pointing out that since reporting what Cramer called a "fabulous, knock-out, thing-of-beauty quarter" on September 10, shares have been on fire (up 28%).

But before you switch gurus hold on...the stock has done nothing since Cramer's opinion of september 28 . The big runup came before then ...+36% from the beginning of sep till that date.

I think a good rule of thumb would be....if the advice is so good why are they giving it away ?

Milton Friedman and Today's Monetary Policy

2010-10-28T08:06:00.000-07:00

I wrote on March 3

It seems inconsistent to me that the same people that argue the most that the US economy is headed the way of Europe seem to think inflation is coming soon. I think they forget the quantity theory of money equation from the monetary from their macoeconomics 101 class (or never took it) This is despite the fact that many who think inflation is coming around the corner are arch conservatives and the major advocate of this view in recent history was Milton Friedman. The basic equaltion is this:
MV= PT (the Fisher Equation)

Each variable denotes the following:
M = Money Supply
V = Velocity of Circulation (the number of times money changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services
.... merely raising the money supply by taking interest rates low is not sufficient to cause inflation.

David Wessel in the wsj has a great piece which finds that Friedman, on balance would likely be a supporter of quantititative easing by the Fed. Wessel reviews several parts of the Freidman "dashboard" (see graphic) and concludes on balance Prof Friedman would have been comfortable with QE2.

On velocity Wessel notes:

He would look at velocity, the number of times a dollar turns over in a given year, to gauge demand for money. "To keep prices stable, the Fed must see to it that the quantity of money changes in such a way to offset movements in velocity and output," he wrote in this newspaper in 2003.
When velocity is stable, the Fed should keep money growth steady. When velocity swings widely, the Fed shouldn't be passive. Velocity rose sharply from 1990 to 1997 and then plummeted; the Fed offset that and kept inflation stable, he said with praise. Velocity has been falling—which means each dollar the Fed prints has less oomph. POINT: For QE.

A recent op ed in Investors Business Daily makes similar points about Friedman and current monetary policy and is even less ambiguous in its conclusions

...were Friedman alive today, he would balk at the notion that the Fed is out of ammunition. He would remind us that in the early-to-mid-1930s, when the economic environment was far worse and short-term interest rates were near the zero bound, monetary policy easily generated a recovery. Therefore, the Fed could do likewise today.Friedman would likely make the case today for more aggressive monetary action. It is time for "Helicopter Ben" to earn his nickname.

TIPs: As I Was Saying...

2010-10-28T07:26:00.000-07:00

on august 17 I wrote on this blog and on seeking alpha

If TIPS Are So Bad, Why Do They Keep Going Up?

With 10 year tips at a real yield of around 1.1% and then year treasury bonds at around 2.95%, replacing tips with conventional treasuries means that inflation will have to remain below 1.85% over the life of the bond for the position to prove attractive. This is the implied inflation forecast in the treasury/tips yield curve. Historically an implied inflation forecast like this embedded in the treasury/tips differential has been considered a buy rather than a sell signal.for tips.

here's a 3 month chart of tip the TIPS etf

This week the following happened in the tips market (wsj)

A combination of low interest rates and growing fears of rising prices enabled the U.S. government to sell inflation-protected Treasury bonds with a negative yield for the first time ever on Monday.
That means if inflation doesn't appear as investors expect, they could end up paying to lend money to the government.

The Treasury sold $10 billion of five-year Treasury inflation protected securities, or TIPS, at an auction on Monday with a yield of negative 0.55%.

The negative yield on five-year TIPS owes partly to the fact that nominal five-year Treasurys yield just 1.18%, which is barely higher than consumer price inflation for the past year.
The difference between regular Treasury yields and TIPS yields, often called the "breakeven inflation rate," is a rough measure of the market's inflation expectations for the future. That breakeven inflation rate has grown since the Fed made it clear it was going to restart its bond buying, an effort known as quantitative easing.

Paul Vigna discusses Monday's markets and why the yield for TIPS went negative for the first time ever.
In the case of five-year TIPS, the negative yield suggests inflation expectations of about

1.70%—hardly runaway inflation, but better than deflation.

and the wsj writes today of the future prospects:

TIPS to Top $100 Billion in 2011

The Treasury Department has ramped up TIPS supply since the start of this year, aiming to improve the market's size while getting a better handle on its large debt-sale program. TIPS account for around 7% of the overall Treasury market at $8.48 trillion.
Demand for TIPS has surged in recent weeks as many investors sought to hedge risks related to the Federal Reserve's expected plan to buy bonds, known as quantitative easing. Some fear the plan will stimulate longer-term inflation as it tries to bolster the struggling U.S. economy. The value of TIPS rises along with increases in consumer prices, while inflation erodes the return on conventional bonds.
Top fund managers at Vanguard Group Inc. and Pacific Investment Management Co., two of the world's top five investors of TIPS, expect TIPS sales next year to hit $120 billion. That thought is echoed by Michael Pond, co-head of U.S. rates strategy at Barclays Capital Inc., the world's largest dealer of TIPS.
Sales have already jumped to $76 billion so far this year, up from $58 billion for all of 2009.
"The Treasury would like a viable and liquid TIPS program because having a reasonable sized TIPS issuance program gives the government inflation-fighting credibility, plus a liquid real time measure of inflation expectations," said Mihir Worah, who manages the $18.7 billion Real Return Fund at Newport Beach, Calif.-based Pimco, a unit of Allianz SE.
Kenneth Volpert, who co-manages $32.4 billion in Vanguard Inflation-Protected Securities Fund, the world's largest TIPS fund, said that the more auctions, the more trading and liquidity will be in the market, which will help increase TIPS's allure with a wider audience.
Individual investors are still the main TIPS players. But this year, institutional investors—including foreign central banks, mutual funds and hedge funds—have become more actively involved. The growing market offers both fresh trading opportunities and diversification for portfolios dominated by conventional fixed-income securities.

Still Think Your "Full Service" Broker is Objective When He Recommends Muttual Funds ?

2010-10-26T15:07:00.001-07:00

from Financial Advisor Magazine my bolds* and comment in blue*
Brokers Flee Brokerages As Declining Assets Show Broken Model

...More than 7,300 brokers have left the four biggest full-service brokerages -- Morgan Stanley Smith Barney, Merrill Lynch, Wells Fargo Advisors and UBS Wealth Management Americas -- from the beginning of 2009 through June, according to financial services research firm Aite Group LLC in Boston and company filings.

Losing Assets

Some brokers have fled internal clashes from mergers during the financial crisis: Bank of America Corp. rescued Merrill Lynch four months before the Smith Barney deal. Others have been recruited by discounters such as Charles Schwab Corp. to join their networks of independent firms.....

While lacking the clout of big brokerages, independent firms boast of one advantage with clients: no conflicts of interest. Brokers at Merrill Lynch, for instance, are pressured to sell funds managed or approved by the firm because they pay a higher commission than those run by other companies, says Paul De Rosa, who worked at the brokerage for 26 years before co-founding his own firm, Gateway Advisory LLC, in Westfield, N.J., in January.

De Rosa set up Gateway Advisory as a registered investment advisor, which has a fiduciary duty to put its clients’ financial interest first when giving advice, according to U.S. Securities and Exchange Commission rules. RIA firms must also disclose conflicts. To avoid them, RIAs like Gateway typically shun commissions and charge a flat fee of less than 1% of assets under management regardless of the funds they recommend.

I do have one question however, why did it take this gentleman 26 years to figure out that there was a conflict of interest in the way his previous employer dealt with clients ?

“

About GDP Weighting and Emerging Market Allocations in Portfolios

2010-10-26T15:07:00.000-07:00

from today's FT

my bolds and comment in blue

Emerging nations: a beacon of opportunity
By Jerome Booth
Published: October 25 2010 19:19 | Last updated: October 25 2010 19:19

If you are looking for a market bubble do not look to emerging markets. The US and Europe remain a huge super-bubble. Emerging markets, by contrast, are safe. Putting one’s head in the sand and denying this reality has the attraction of plentiful company, but constitutes the opposite of prudence. Remember, lemmings also like to crowd together and the collective name for them is a “suicide”.
Unlike Europe and the US, emerging markets do not have a credit crunch, in essence a multi-year, very painful, deleveraging – that is, wealth destruction. But if you have not experienced 30 years of rising financial leverage, the past 10 to excess, you cannot get a credit crunch. Emerging markets are in a very different cycle to the developed world now, with inflationary not deflationary pressures....

although I have a preference for emerging markets equities over debt I share some of the reasoning here:

The size of the emerging debt market is thus driven by demand, which is growing in an iterative way because of behavioural constraints. I am a big believer in GDP weighting – cap-weighted indices of publicly listed securities (typically misnamed “investible”) are a very poor representation of global investment opportunities. A better measure of global economic activity – and hence the full universe of investment opportunities – is past income – GDP, and that implies 50 per cent allocations to emerging markets.
Also the largest problem in the institutional investment industry arguably is misaligned incentives, which causes massive herding. It is the combination of these two deficiencies, combined with prejudice about emerging markets and inexcusably deficient concepts of risk and uncertainty that lead to gradual allocation.
A pension fund manager told me recently: yes, he agreed that GDP weighting was sensible and he was massively underweight, and yes, the industry suffered from herding where everyone was watching their peers, but he still had to be in the herd, though he could be at the edge of the herd. The result is that institutional investors invest a fraction of what they think is appropriate in emerging debt until their peers catch up and the result is gradual allocation over a period of many years. This is currently happening with many different types of investor peer groups all over the globe. Hence we have a gradual structural shift, not a temporary reversible move.

If He Knows The Secrets Then Why Is He Writing Books and Talking on TV....

2010-10-26T12:58:00.000-07:00

instead of managing money and collecting hefty fees for his money management ?

The folks at Dimensional Fund advisors long ago coined the word "financial pornography" for this sort of stuff. CNBC "fast money" guru and apparently ex money manager touting his new book and surefire strategy to beat the market and telling us why index funds are a fool's investment
you can catch it here.
Among his criticisms of index funds: "if you invest in an index fund you just get the return of the index"...brilliant.

from the blurb for the book

Kaminsky brings more than two decades of experience to his low-risk, high-return system, demystifying Wall Street for novice and seasoned investors alike. Between 1999 and 2008, Kaminsky’s team at Neuberger Berman grew record-breaking returns far above the S&P benchmark. And they didn’t do it by magic. They did it by constructing a specificstrategy and sticking to it, regardless of the investing climate. It is a strategy that anyone can learn and apply, step-by-step, in any market.
With Kaminsky’s expert guidance, you’ll learn how to be more disciplined and vigilant with your investments, maximizing your returns in a minimum amount of time. You’ll not only make money in most markets, but you’ll lose much less money when those around you are losing their shirts. And you’ll be able to strengthen and protect your assets—particularly in the slow-growth decade ahead—with the confidence and know-how that drives Wall Street’s smartest investors to the top of their game.
Yes, you can beat the market—when you’re Smarter Than the Street.
Biographical note
Gary Kaminsky is the cohost of CNBC’s "The
Strategy Session" and has been one of Wall Street’s
savviest money managers for the last two decades.
He worked at Neuberger Berman, LLC, where Team
Kaminsky’s assets grew from $2 billion to $13
billion during Wall Street’s lost decade.

my ? why is this wasting his time guy wrtiting books and gabbing on tv everyday ?
And why is he willing to give away the secrets to make money in any market for only $26 ($17.16 at amazon, even less on your kindle). Seems to me that would be the mother of all bad trades.

Seems to me he should be either:

1. managing one of the worlds largest hedge funds collecting massive fees
2. sitting on a yacht in the south of france living the good life
and/or
3. competing with the Gates foundation to give away as much money as possible to worthy causes

something's wrong with this picture

Performance Chasing...Probably But If Not Investors May Be Making a Good Reallocation in their Portfolios

2010-10-24T13:27:00.000-07:00

The latest mutual fund data on cash flows has been released and (surprise) they show investors, both individual and institutional, are performance chasing pouring money into the highest performing sector emerging market stocks

from the wsj

Fund managers have regained risk appetite, but still lack conviction about positive momentum in U.S. stocks, according to survey results released Tuesday by Bank of America Merrill Lynch.
The survey found that asset manager risk tolerance jumped this month by the biggest margin since April 2009, with the proportion of fund managers "overweight" on stocks tripling to 27%, from just 10% in September. However, the drive for stocks is being driven by global emerging markets. Nearly half of asset managers are sitting heavy in emerging-market equities, according to the survey.
Among diversified global equity ETFs, which primarily invest worldwide equity securities but can include shares of U.S. companies, the Vanguard Emerging Markets Stock ETF has expanded the most. Inflows into the ETF have raised total assets by $15.7 billion, or 39%, this year. The iShares MSCI Emerging Markets Index Fund has taken in close to $4 billion, or 8.2%, in assets. Meanwhile, the SPDR S&P 500 ETF, a fund that mirrors the U.S. benchmark index, has shed $5.6 billion in funds, or 6.7% in assets.
The trend has to do with outperformance of non-U.S. stocks, but also is "a recognition of what came to light during the 2008 financial crisis, that the financial system in developed countries is not necessarily any better or less risky than in emerging markets," said Gregg Wolper, senior analyst at Morningstar. "Add in concerns with dollar weakness and it's reason to look elsewhere."

While investors may be engaging in a great deal of performance chasing here there may be some good rationales for these flows, provided they represent a long term change in asset allocation rather than simply a short term portfolio shift. US investors both institutional and individual have long showed a "home bias" keeping too much of their investments in US stocks. US stocks make up around 44% of world market capitalization so those investing in only US stocks are missing a measure of diversification. This is the case even taking into account that many of the largest US corporations generate much of their income from abroad.

But even making use of the standard indices for allocating assets outside of the US is likely not the best strategy. Those indices (and the etfs that track them) reflect the capitalization of world stock markets and thus are tilted sharply towards the developed market economies which have a high proportion of their firms listed on public equity markets. Those countries with the highest market capitalization get the highest weightings, while emerging markets whose equity capitalization is relatively smaller have low weightings. As world economic growth has shifted the world equity market capitalization less and less represents a measure of the world economy, a trend that is likely to continue.

An alternative approach to international allocation would be a GDP weighted index which sets the country allocation based on relative weight in the world economy. Such an index exists the MSCI GDP Weighted Index, although as of yet there is no etf or mutual fund based on it. This is in a way analogous to the various times of "fundamental indexing" strategies that use methodologies based on critieria other than market capitalization in weighting their holdings

As MSCI writes

An Alternative to Market Capitalization Weighted Indices for Global Markets
The MSCI GDP Weighted Indices are designed to reflect the size of a country’s economy rather than the size of its equity market by using country weights based on a country’s gross domestic product (GDP). Some investment professionals prefer to weight countries in a regional index by GDP rather than by market capitalization because:
GDP figures tend to be more stable over time compared to equity markets’ performance-related peaks and troughs
GDP weighted asset allocation tends to have higher exposure to countries with above average economic growth, such as emerging markets
GDP weighted indices may underweight countries with relatively high valuation, compared to market-cap weight indices.
Largest Absolute Weight Difference Between the Standard Market Capitalization Weighted MSCI ACWI and its GDP-Weighted Equivalent
Country Market-cap Weighted GDP Weighted Weight Difference(GDP-Market Cap)
China 2.39% 9.26% 6.87%
Germany 2.95% 6.31% 3.36%
Italy 1.08% 3.99% 2.91%
Russia 0.83% 2.32% 1.49%
Spain 1.31% 2.75% 1.44%
India 1.00% 2.42% 1.42%
Switzerland 2.93% 0.93% -2.01%
Canada 4.57% 2.52% -2.05%
United Kingdom 8.11% 4.10% -4.01%
United States 44.39% 26.76% -17.63%
Data as of June 1, 2009
The largest overweight countries in the MSCI ACWI GDP Weighted Index are classified as emerging markets, such as China, Brazil, India, Russia and Mexico, which are some of the fastest growing economies but have market capitalization weights that are smaller than their economic weights.
However, the list of over weighted countries also includes some developed markets, such as Germany and Italy.
The US and the UK have the largest disparity in size between their substantial market cap weights and their smaller economic weights.

Country	Market-cap Weighted	GDP Weighted	Weight Difference(GDP-Market Cap)
China	2.39%	9.26%	6.87%
Germany	2.95%	6.31%	3.36%
Italy	1.08%	3.99%	2.91%
Russia	0.83%	2.32%	1.49%
Spain	1.31%	2.75%	1.44%
India	1.00%	2.42%	1.42%
Switzerland	2.93%	0.93%	-2.01%
Canada	4.57%	2.52%	-2.05%
United Kingdom	8.11%	4.10%	-4.01%
United States	44.39%	26.76%	-17.63%

Key Benefits
Alternative Approach to Capturing the Country Factor
Relevant Benchmark for GDP Weighted Asset Allocation
Broad Country Coverage

a research report from MSCI is here:

GDP Weighting in Asset Allocation

Thus there is in my view a strong argument for investors to increase their holdings in emerging markets based on the current composition of the world economy. In addition the following factors argue for such an increased relative weighting :

Unlike during earlier boom periods for emerging markets, the growth in these countries is not funded primarrily with foreign borrowing.
The growth of the middle class in these countries should fuel domestic demand and make these countries less dependent on exports to the developed world a trend likely to accelerate
The demographic "bubble " in these countries is younger thus skewed to populations likely to increase spending and savings in the future. At the same time the demographic "bubble" in the developed world will be increasingly those withdrawing savings from public and private pension and retirement savings.
The growth of the middle class will mean more savings and thus more funds to be allocated to local equity investments. Retail investing is at its infancy in much of the emerging markets.
As these economies become more sophisticated more corporations will go public and the relative market capitalization of these countries will increase in world indices. Thus those that invest based on gdp weighting will be "ahead of the curve" relative to cap weighted international investors.

All of these trends mean that the future weighting of emerging markets on both a relative gdp and relative cap weighted basis will increase in the future. And all of this argues for a greater weighting in emerging markets than that dictated in a cap weighted index, greater than that in most US portfolios. There is certainly a strategic move being made by institutional investors worldwide into emerging markets which will help these markets. No doubt there is still the risk of hot money flowing in and out and there is not much to the argument of "decoupling" of the emerging market stock markets to the rest of the world, correlations are likely to remain high. But correlation does not mean there will be no outperformance, it simply means that both markets will move in the same direction at the same time.

Here is a chart of the correlation between the US total stock market (VTI) and emerging markets (EEM), over the past two years the correlation is very high.

And here is a chart of the returns over the same period (emerging in blue). The two move in the same direction, but the difference in performance is enormous.

In both my client and personal portfolios my weighting for emerging markets in the international portion of their equity holdings is significantly larger than the 26.6% that is the weighting for emerging markets in the cap weighted world ex US etf (VEU). Making use of both the emerging markets index VWO and the emerging asia etf (GMF) the international allocation is tilted more towards emerging and more towards emerging asia than the VEU and for that matter more towards asia than the cap weighted VWO. I have kept to the allocation except to rebalance to the target allocation.

If the investor flows into emerging markets represents a strategic reallocation of equity portfolios so that the portfolios have more international holdings and less of a home bias reflecting world market capitalization, world gdp weightings and/or trends for long term economic growth I would view it positively.

Unfortunately, based on our knowledge of investor behavior and of past flows in and out of emerging markets ,this data probably represents a large amount of hot money chasing performance. As is usually the case it will likely run the minute there is a selloff invariably buying high and selling low .

If there is good news in this it is that these flows can work to the advantage of the long term investor who rebalances to keep to his asset allocation. That investor can gain from the "rebalancing premium" when he sells a bit of his holdings to get back to the target allocation and buys back to get to the target allocation when the inevitable short term sellof pushes his holdings below the target allocation. Unlike the market chaser, the rebalancer is selling high and buying low. In fact the rebalancer actually picks up a bit in portfolio performance due to the volatility caused by the hot money (the rebalancing premium). It's not hard to envision that this has occurred numerous times in the volatile emerging markets where short term moves of 20% are not infrequent:

This Makes Sense to Me

2010-10-22T08:09:00.000-07:00

from the NYT

A Basket of Assets in One Investment

By JOHN F. WASIK

AS investment vehicles, exchange-traded funds seem like a perfect fit for retirement portfolios.

The funds, known as E.T.F.’s, are generally relatively low cost and easy to understand. Listed and traded openly on exchanges, E.T.F.’s are baskets that invest in assets as various as global stocks and gold.

Yet picking the right E.T.F. is crucial. Far too many E.T.F.’s are overmarketed and some of the complex funds are loaded with nuances that most investors do not understand. E.T.F.’s can pose an almost irresistible, but risky, temptation to limit your bets to a single industry sector, country or commodity.

This is a particularly good time to invest in E.T.F.’s because major fund managers and vendors are battling one another to win customers by lowering costs. Brokerage commissions and internal fund management “expense ratios” are the major costs of owning E.T.F.’s. By taking advantage of this commission war, investors can increase the net returns on retirement funds....

With more than 1,000 funds to choose from in a $1 trillion industry, which E.T.F.’s do you add to your portfolio? You can start with the simple principle of diversification. Do you have funds that cover the entire United States stock and bond markets? How about international stocks and bonds?

It is also prudent to consider which risks you want to insulate your retirement portfolio from: market downturns, inflation, currency fluctuation and losing out on opportunities abroad, for example.....

Beware, too, of advisers who say they can beat the market with portfolios of E.T.F.’s.

Here I think the writer is oversimplifying a bit or is at least unclear . No adviser should say he can beat the indices that are tied to the underlying etfs. Of course it is possible that a diversified portfolio composed of etfs tied to indices other than the s+p 500 such as the one recommended in the article (see above in bold ). Could outperform (or underperform) the s=p 500 . And such a portfolio certainly offers more diversification and could have a different risk/return profile. The the s+p 500 which is a large cap US stock index in fact it doesnt represent 'the market" in fact it is not a very good proxy for the entire US stock market (unlike a total stock market index represented by an etf such as vanguard's VTI)

While you can always construct a portfolio on your own, it makes sense to consult a certified financial planner or registered investment adviser to see what your portfolio needs — and does not need — before you buy these vehicles. An investment policy statement outlining your objectives is essential. Duplicating what you already have makes no sense. (of course i agree with that one)

Structured Products for Individual Investors :Stay Away

2010-10-22T08:08:00.000-07:00

In my earlier life on the institutional side of the financial world I specialized in marketing "structured products' to corporations and institutional investors. I can tell you that our department was extremely profitable. Why ? because the complex structure of these instruments made it difficult for most of the buyers to figure out what the underlying components of the product were hence the spread (markup) of the product were far larger than those of plain vanilla products. In structured products unlike those traded on exchanges there is no transparency of pricing. Furthermore it is near impossible to know the value of the structured product over the life of the instrument. There is also no liquidity in most cases as the investor cannot sell the option prior to expiration.

To give one example a "structured product" which combined a floor on the loss on an investment but limited the upside potential was relatively easily constructed combining a put purchase and a sold call option. In fact the worst thing that could happen for our structured product group was when some of the structured products began to be traded on exchanges with transparency and liquidity for trading...why ? that meant the end of the massive profit opportunities. Of course most of these new markets were accesible only to large institutional investors.

With many of the profit opportunities no longer available in the relatively simple structured products, financial institutions moved on to market them to individual investors who do not have access to these institutional markets. Furthermore these structured products, unlike products traded on an exchange carry the credit risk of the issuer.

The NYT had an article on such structured products today my bolds and comments in blue

October 20, 2010

An Investment for the Experienced

By JOHN F. WASIK

DEPENDING on whom you talk to, structured products are either clever ways of hedging specific portfolio risks or another demon from Wall Street.

As vehicles that use derivatives to protect or enhance an underlying stock, bond or index, structured products are sold by nearly every major bank and brokerage house — and more than $34 billion of them were sold in the United States in 2009.

Yet they are not for investors who don’t fully understand them, because they are riddled with complexity, are mostly opaque and have lost money for investors in the past.

“These are complicated investments, and people should know what they’re buying,” said Tom Balcom, a fee-only adviser with Ibis Wealth Management in Boca Raton, Fla. He said he had “yet to put more than 35 percent of a client’s portfolio in structured products,” adding, “If you don’t understand what these products are, stay away from them.”

Sean O’Toole, 43, who owns and operates an event-marketing agency in Fort Lauderdale, Fla., worked with Mr. Balcom to add structured products to his portfolio.

seems Mr. Balcom is ok with his clients buying structured products for less than 35% of their portfolios

“I’m not betting the farm,” Mr. O’Toole said. “I like diversification. I’d rather be over-conservative if we see another double dip.”

An ultracautious investor concerned about the prospect of another huge stock market decline, Mr. O’Toole has two-thirds of his portfolio in cash and one-third managed by Ibis in structured products like buffered return enhanced notes, which put a cap on the potential gain in return for protection against a market decline. He pays no commission for the vehicles and a 1 percent annual asset management fee to Mr. Balcom.(of course the large markups on these products is not visible to the investor)

Before Mr. O’Toole bought structured products, he had experience with options strategies, an essential prerequisite for anyone interested in structured products.

He should have kept to those liquid transparent options imo.

While structured products are not household names, they are hot sellers, and sales growth is estimated to be about 24 percent this year, according to structuredretailproducts.com, a service that monitors the industry.

Banks continue to market them aggressively as well. Structured note offerings are up 58 percent this year (through August), according to Bloomberg. The global market for these vehicles exceeds $1.6 trillion.

could that be because institutional investors burned in the past by these investments have been shying away ?After all it is much easier to sell a big structure note to an institutional investor (as in the good old days) then to sell large numbers of small ones to individuals.

But the numerous disadvantages of structured products make them ill-suited for investors who want low-cost, government-guaranteed or liquid investments.

Once you invest your money, you are essentially locked in for the duration of the contract. Brokers may say they can buy them back, but often little or no secondary market exists for many of them. They may charge you another commission to do so and not guarantee the price you initially paid. Despite their many promises of principal or downside protection, investors can still lose money. Investors in principal-protected notes issued by Lehman Brothers, which filed for the largest bankruptcy in history on September 2008, found out the hard way that they held unsecured Lehman debt. Their principal was not protected, and most lost all of their investment.

Structured products have been linked to an estimated $1 billion in investor losses in the Lehman notes alone. UBS, the Swiss bank and brokerage firm, was one of the largest sellers of the notes and is being sued by investors and regulators in the United States and Britain...

Other structured investment vehicles like reverse convertibles and equity-linked notes are also the subjects of state investigations and investor lawsuits.

Don’t be cowed by the daunting calculus employed to hedge risk and produce returns. A competent adviser should be able to explain — and clearly illustrate — all risks (credit, market and liquidity), conflicts and expenses like commissions, underwriting fees, bid/ask spreads and embedded derivatives costs.....

If you don’t get a clear explanation or are uncomfortable tying up your assets in a virtually illiquid product, move on. These products don’t lend themselves to comparison and you can’t monitor them like you would a stock or mutual fund.

Most structured notes are “a hot mess,” said Janet Tavakoli, president of Tavakoli Structured Finance in Chicago and author of several books about them. “Most professionals can’t analyze them. When I have done it, I find these notes are loaded with hidden fees and hidden risks.”

What Will Be the Bond Markets Reaction to Quantitative Easing ? Read the Message of the Market

2010-10-14T10:11:00.000-07:00

It seems pretty clear that with both the fiscal and monetary stimulus have not put a dent in the unemployment rate While the public political debate has been filled with disappointment that the fiscal stimulus has not provided a cure to the high employment rate the Fed's actions haven't accomplished much towards that goal either. With more fiscal stimulus off the table it is clear the fed is searching around for what remains in its toolbox. Short term rates are essentially at zero, so it seems a near certainty the fed will move to quantitative easing = purchasing bonds to take intermediare rates lower. At the same time there seems to be the beginning of a campaign to indicate that a bit of inflation will be tolerated in an environment where the greatest risk is contnued high employment.

A careful look at the bond market's recent movements give a clear indication of the consensus forecast:

fed intervention in the intermediate term of the yield curve will pull those rates lower (price higher)
long term inflation makes long term rates unattractive

hence the 30 year treasury spread over the 10 year treasury has moved to a record level of 1.4% , it was around 2.2 % a year ago ( a graph of the treasury yield curve is attached)

continued rally in TIPS (inflation protected bonds) in anticipation of higher inflation in the longer term

other charts below: TIP (tips etf), FIVZ (intermediate term treasury etf),edv 25+ yr treasury etf

EDV 25+ Yr Tresury etf

FIVZ 5-7 Year Treasury ETF

TIP Inflation Protected Bond ETF

Active Bond Fund Investors Beware :Your Fund May Be More Risky Than You Think

2010-09-30T07:14:00.000-07:00

That actively managed bond fund you own may be more risky than you think The wsj reports

my bolds my comments in blue

How Safe Is Your Bond Fund?
A Change in How Portfolios Are Rated Gives More Weight to Risky Holdings

By JANE J. KIM

Your bond fund may be riskier than you think.
For years, the fund industry and research firms such as Morningstar Inc. have assessed the safety of bond funds by analyzing their holdings' underlying credit quality. Now, amid concerns that the measurement could understate the risk that the bonds will blow up, Morningstar has changed its methodology to count lower-rated bonds more heavily.
The move—which took effect Sept. 1—means that more than half of the domestic taxable bond funds tracked by Morningstar saw their so-called average credit-quality ratings fall under the new methodology.
In some cases, people who thought they were investing in an investment-grade bond fund may find themselves in a portfolio whose credit risk is more like a junk-bond fund, says John Rekenthaler, Morningstar's vice president of research.
About 43% of bond funds fell by one credit grade and about 13% dropped by two credit grades, according to Morningstar. A few funds—including Federated Real Return Bond Fund, Cavanal Hill Intermediate Bond Fund, Neuberger Berman Short Duration Bond Fund and TCW Short Term Bond Fund—dropped by more, in some cases to non-investment-grade ratings, such as BB, from investment-grade ratings, such as AA. (See table.)

Of course it's the lower credit quality of the assets not the manager's skill that likely accounted for the higher returns of thse funds compared to those short term bond funds that held higher qusality assets such as a short term treasury fund.. That has worked well recently as credit spreads ahve narrowed. But of course when a crisis hits the lower credit quality bonds will suffer. And given that many investors view short duration bond funds as the stable core of their portfolio...that could lead to some unpleasant surprises.

....the percentage of domestic taxable bond funds that had average credit ratings of "AA"—or investment-grade status—fell to 13.85% under the new methodology from 36.38%. Funds with average credit ratings of "BB"—or junk-bond status—more than doubled to 13.36% under the new system from 5.49%. "If the credit rating moved down more than one notch, I'd look closely in making sure you understand the strategy of the fund," says Morningstar's Mr. Rekenthaler. "If it only moved down a notch, I wouldn't worry about it at all."
Bond funds that invest mainly in corporate bonds and private mortgages were generally the most affected, he says. Funds that employ a "barbell" investing strategy—investing in extremely safe investments at one end and higher-risk investments at the other—also tended to see big drops in their average credit-quality ratings.

I doubt many individuals investors have the time or the skill to drill down on the strategy of their active bond fund manager and even if they did the data they would be using would be quarterly in arrears so it would not give a real time view of the fund holdings and strategy.

My solution: invest in a bond index fund or etf you will have total transparency and know exactly the characteristics of your portfolio in terms of duration, maturity, and credit quality.

Active Equity Fund Investors Beware The End of Quarter Window Dressing !

2010-09-29T09:29:00.000-07:00

Just caught an analyst explaining how the end of the quarter always features active mutual fund managers engaging in "window dressing". What does that mean ? These managers increase their holdings in stocks that have best performed during the quarter. "Even though they haven't owned the stocks during the period when they went up" the CNBC reporter noted "correct" responded the money manager being interviewed.

In other, words that quarterly report from the active fund manager listing his holdings tells you nothing about what he held over the course of the quarter. And you really never know what the fund owns,

Of course non of the above holds for index funds and etfs Although the index fund investors will doubtless benefit from the window dressing particularly a shift from cash to equities. That only holds forever for investors that are not engaging to activity simiilar to the window dressing by purchasing what has gone up in the previous quarter.

About Those Performance Chasing Individul Investors Moving from Stocks to Bonds...

2010-09-22T12:35:00.000-07:00

Here are total returns for three months through yesterday:

3 Months

Total Bond Index etf (AGG) 2.7%
Total Stock Index (VTI) 4.6%
Emerging Mkts (EEM) 10.1%
Small Cap Value (VBR) 3.2%
SP 500 (SPY) 9.2%

12 Months (chart below)

Total Bond Index etf (AGG) 7.9%
Total Stock Index (VTI) 9.7%
Emerging Mkts (EEM) 14.3%

Small Cap Value (VBR) 10.4%
SP 500 (SPY) 9.2%