Category: Asset Allocation

In Defense of Home Bias

In Defense of Home Bias

Posted on by David Merkel

I ordinarily like the writings of Jason Zweig, so this post is not meant as a criticism of him.? He wrote an interesting article suggesting that US investors may suffer reduced performance because they invest too much in US stocks.? Ideally, shouldn’t investors seek out the stocks that are likely to perform the best, regardless of where they are located in our world?

Ideally, yes.? Practically, there are difficulties.? I write this as one who has always allocated more than the average to international stocks.? Investing internationally assumes several significant things:

  • There will be no war that changes the amount or terms of commerce.
  • There will be no legal changes that affect property rights abroad.? This includes exchange controls.
  • I will get the same flow of news that an investor in the target country will get.
  • I understand the differences in the accounting rules, and will not get tripped up if they are more liberal than in the US.
  • I understand that regulations are different in foreign countries as well.
  • Transacting in non-ADR foreign stocks from the US can be expensive for retail accounts.? Buying mutual funds that invest in foreign stocks carries expensive management fees.
  • Economic policy will remain rational in the target country, or at least, better than that of the US.
  • I understand the trading nuances of the target country.

Home bias is normal, around the globe.? We understand the business dynamics of our own countries far better than foreign countries, together with our understandings of accounting, regulation, exchange controls, information disclosure, legal systems, economic policy, etc.

Even within the US, there is home bias among investors to the extent that we tend to invest more in companies that are near to us — perhaps it is a greater flow of informal information.

I would encourage all of my readers to invest abroad but to do it selectively.? Does the country allow for relatively free capital flows?? Do they honor the rule of law?? Is their accounting as good as that in the US?? Are there war risks?

There are risks in investing abroad that do not exist locally.? Make sure you minimize those risks if you invest abroad.

Book Review: The Only Three Questions That Count

Book Review: The Only Three Questions That Count

Posted on by David Merkel

I resisted getting this book when it first came out.? Much as I enjoy Ken Fisher as a writer, and appreciate the interaction that I have had with him over the years, the title turned me away.? “Three questions? Only three?? Investing is far more complex than that.”? I would say that to myself.

After reviewing his most recent book, I said to myself, “Well, you’ve reviewed all of his books but one; you may as well do it.”? So, I borrowed the book from a friend.

I wish I had read it sooner.? The three questions are simple ones, and they have been mentioned elsewhere on the internet, so here they are:

  • What do you believe that is actually false?
  • What can you fathom that others find unfathomable?
  • What the heck is my brain doing to blindside me now?

The idea is to get us to think more deeply.? Test the received wisdom to see if it is really true.? Look for unusual areas of competitive advantage that you have that are possessed by few.? Your emotions will often lead you astray: look for opportunity amid fear; look for shelter amid wild abandon.

Competitive advantage in investing is an elusive thing.? The clever idea that you might discover is just one journal article away from an academic toiling in obscurity, but will go to a? hedge fund two years from now.

Patterns that work in one market should work in most markets.? If your discovery seems to work in most places, it might work well, until it is discovered and used heavily.

I found a number of insights useful.? Like me, he uses E/P relative to bond yields to try to estimate whether markets are rich or cheap.? I also found his insights about how the yield curve affects style investing to be useful.? I do something like that through my industry rotation.

Now, in the intermediate-run, most things that people are scared about don’t affect the market much.? Government deficits seem to be a positive for stocks in the short run.? Trade deficit?? Little effect on stocks.? Weak dollar?? Little effect.? This book debunks a number of common worries, though I would say that if the problem got significantly bigger, perhaps the result would be different.

Ken Fisher offers what I would deem to be good advice on Asset Allocation, and how to make sell decisions, amid many other issues.? I enjoyed the book a lot, and would recommend it to my readers.

Quibbles

Occasionally, the book seems disjointed.? Ken Fisher is covering a lot of ground, and he takes a decent number of “side trips” to explain concepts.? The flip side of that is that the book covers many areas of the equity markets, and helps to explain what drives them.

Now, sometimes I wonder if multivariate approaches might reveal different conclusions than what Ken Fisher comes to.

Who would benefit from the book: Investors with moderate experience in investing who are finding the going harder than they expected.? This book will help them take a step back, and think twice about investment decisions.

If you want to buy the book, you can buy it here: The Only Three Questions That Count: Investing by Knowing What Others Don’t (Fisher Investments Press)

Full Disclosure: Book reviews are my main profit center at my blog.? They allow me? to create a win-win situation for me and my readers.? I don’t want my readers to waste their money to reward me.? I would rather they buy things that they want to buy at competitive prices through Amazon.? If they enter Amazon through my site, I get a small commission, and their price does not change at all.? Such a deal.

R Bonds R Bad 4 U

R Bonds R Bad 4 U

Posted on by David Merkel

I have long been a fan of immediate annuities, particularly those that are inflation indexed, as retirement products for seniors.? Yet, they do not get bought by retirees.? Why?? Well, insurance products are sold, not bought, typically, and when the agent sells an immediate annuity, that is his last sale on that money.? They would rather sell a less suitable product that offers them another sale down the road.? And, people like having flexibility with and control over their investments, even if that leads to less money for them in the long run.? Annuitizing a portion of one’s lump sum lowers risk, and takes the place of investing in bonds in the asset allocation.

Most people like the reliability of their pensions, and Social Security, should it be paid, but do not seek the same thing when investing their private money.? One would think they would invest that money for growth if they had a strong stream of income elsewhere, but often that money is conservatively invested as well.

People get fooled by yield, and in an environment like this, more so.? People try to make their investments do more through targeting higher yields, while ignoring the possibility of capital losses.

Most people can budget, if pressed to do so.? Few can manage a lump sum of capital, and know what to invest it in, and how much to take from it per year.? Few have the discipline to buy an immediate annuity or limit their withdrawals to 4% of assets per year.

But where there is chaos and confusion, some in our government will seek to create a “solution.”? The ill-defined solution that sounds a bit like a Stable Value Fund is what is getting called “R Bonds.”? Here’s the idea: for those with 401(k)? or IRA balances, if they should retire, and not decide what to do with the money, the assets would get automatically get placed into a Retirement Bond, and for two years, the retiree would receive income.? They can opt out before that happens.? If after two years they still don’t decide, the income continues.? There is nothing mandatory about this program, should it come into existence; people who are asleep about their finances may find themselves trapped in it, at least for a time. [Note: there are scandalmongers alleging out-and-out theft being planned by the US Government.? From what I can see that is not true for anyone that keeps his wits about him.? All the proposals allow people to “opt out.”]

But let me go further.? Scrap the idea of “R bonds.”? Issue a limited number of Trills for retirees to use, or create a special variant of TIPS that pays until someone dies.? These are easy solutions that do not require a lot of changes to the legal codes, or changes in investment behavior.

Now, there is not just one proposal out there.? Let me give the two most comprehensive:

With interest rates so low on the short end, I don’t see how the returns could be that great from “R Bonds.”?? I would play for higher returns given the risk of inflation.? Today that would mean safe stuff that yields little, while waiting for a correction in the fixed income markets, and high quality common stocks with some yield.? And, annuitization at present?? I would wait for higher rates.

Other posts on the topic worthy of your consideration:

Now, all that said, there is a reason to be politically aware here.? Governments have in the past forced people to convert assets that were more valuable for those that were less valuable.? And, we have the example of Argentina doing it in the present with pension assets, and also when their currency blew up — most debtors faced a forced conversion to less valuable bonds.? With the pension nationalization, it was done in the name of protecting people’s pensions, but ended up benefiting the finances of the Argentine Government.

So, be aware.? R Bonds, as currently proposed, are a bad idea.? But there are worse ideas not yet proposed that might be proposed in the guise of protecting your future.? Let us work to make sure they never get implemented.

Yield = Poison (2)

Yield = Poison (2)

Posted on by David Merkel

My first real post at the blog was Yield = Poison.? In late February 2007, prior to the blowup in the Shanghai market, I felt frustrated and wanted to simply say that every fixed income class seemed overvalued.? Short and safe seemed best.

It reminded me of a discussion that I had with a colleague two jobs ago, where in mid-2002, the theme was “yield is poison.”? I did the largest credit upgrade trade that I could in the second quarter of 2002, prior to the blowup of Worldcom.? Moved the whole portfolio up three notches in four months.? Give away yield; preserve capital for another day.

I feel much the same, but not as intensely in the present environment.? Spreads could come in further if the government keeps providing low cost liquidity to those who make money on the spread they earn on financial assets.? But most fixed income assets do not reflect likely default costs.? Perhaps the long end of the Treasury curve is worth a little allocation of assets here, if only as a deflation hedge, but if the Fed is going to start lightening up on their QE, and the Treasury will be having high issuance, I might want to stand back for a while? while supply will be high, and try to buy near the end of the quarterly refunding.

There is another sense in which I say “yield = poison,” though.? When rates for safe assets are low, retail and professional investors are both tempted to stretch for yield.?? Wall Street is more than happy to deliver on your desire for yield.? It is their top illusion, in my opinion.

Two examples from my bond trading days: the first was some local brokers asking to buy a small amount relatively highly-rated junk bonds from us.? They were offering a full dollar over the usual market price.? They called me, since I ran the office, but I handed them over to the high yield manager, who said, “Jamming retail, are we?”? [DM: placing overpriced bonds in customer accounts.]? After a lame reply which amounted to,”Look, don’t ask us about what we are doing, we’re offering you a good deal, do you want to sell your bonds or not?”? the high yield manager sold them a small amount of the bonds, and we didn’t hear from them again.

The second example was when a bulge bracket firm called me and asked me if I owned a certain very long duration bond.? I said yes, and he made me an offer several dollars above what I thought they were worth.? With a bid that desperate, I said I could offer a few there, and more a little back, but for the block he would have to pay more still.? He offered something close to the “more still” price, and I sold the block to him there.

As we were settling the trade, I asked him, “Why the great bid?”? He said, “We need the bonds for retail trusts.? They get an above average yield, but if rates fall, after five years, we buy them out at par, and keep the bonds.? If rates rise, they take the loss.”

Even on Wall Street, if you have a good relationship, you get an honest answer.? That said, it made me sorry that I sold the bonds, even though it was the best thing for my client.

There are many ways to frame the yield question at present, here are two:

  • You are on a fixed income, and you are having a hard time making ends meet.? Should you lend longer to earn more, go for lower rated credits, or do nothing?
  • You are earning almost nothing on your money market fund.? You need liquidity, but where else could you invest it?

I would be inclined to buy a mix of foreign-denominated bonds, but most people can’t deal with that.? So, I would advise them to build a “bond ladder” where they have high quality issues maturing every year for the next 10 years.? As each bond matures, I would use the proceeds to buy bonds ten years out, re-establishing the 10-year ladder.

But don’t reach for yield.? Odds are, you will get capital losses great than the excess yield you hoped to receive.? And remember this, don’t buy products someone else wants to sell you.? Specifically, don’t buy high yielding investment products that Wall Street sells to enhance your income.? They prey upon those who want more money, and are weak in their knowledge of how the markets work.

To professionals: don’t reach for yield now; long-run, you are not getting paid for the risks.? You have seen how illiquid structured products can be in the face of credit uncertainty, and impaired balance sheets of holders and likely purchasers.? You have seen how spreads can blow out (bond prices fall), and roar back in (prices rise again) in the absence of safe places to invest money.

I’ll give the Treasury and the Fed this: they have created an environment where savers are punished, and have to take significant risks to get yield.? They have created a situation where the markets are dependent on subsidized credit, and speculation dominates over lending to the real economy.? They are pushing us deeper into a liquidity trap, as low-to-negative return investments in autos, homes, and banks get supported by cheap public credit, rather than getting reconciled in bankruptcy, so that capital can be redeployed to higher returning projects.

Anyway, enough for now — more later.

Book Review: Dynamic Asset Allocation

Book Review: Dynamic Asset Allocation

Posted on by David Merkel

James Picerno writes the popular blog? The Capital Spectator. One of his main topics is asset allocation.? He has a book coming out in February called Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.

Asset allocation is important.? It determines much of the returns investors will receive.

This book goes into a long discussion of modern portfolio theory, and the author finds MPT to be valuable, but needs to be supplemented by other factors other than the market portfolio.? Market capitalization, individual stock valuation, and overall market cheapness/dearness plays a role in asset allocation.? This rectifies the main complaint of value investors regarding asset allocation, in that relatively lower prices should lead investors to allocate more to an asset class.

There are elements of my own view here, which says that asset allocation should look at sustainable yield levels adjusted for the likelihood of those yields occurring, and the potential for downside risk.

Also, the author spends time on the special situations of asset allocation for the individual or institution — how old you are, or, what industry you are in.? I experienced that at one firm I was at where I managed the profit sharing assets.? We underweighted financials because our firm did well when financials did well.? We did not want employees worrying about their assets if the firm was having a bad year.

I recommend the book, but it is not a popular book.? Average people will not get a lot out of it.? The book requires a moderate knowledge of finance to make it valuable to the reader.

Who would benefit from this book: those who have a strong interest in asset allocation, and like or are willing to tolerate a decent amount of academic discussion of modern portfolio theory.? As academic views go, this is a better one.? That said, many people will find this book a tough slog because they don’t want to deal with the academic arguments.

If you want to buy it, you can get it here: Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.

Full disclosure: I earn a small commission from Amazon for anyone entering Amazon through my site, and buying anything there.? Your price does not rise from my commission.? Don?t buy anything you don?t want to buy if you want to reward me for my writing.? Only buy what you need if Amazon offers you the best deal.

<a href=”http://www.amazon.com/gp/product/1576603598?ie=UTF8&tag=thalbl-20&linkCode=as2&camp=1789&creative=9325&creativeASIN=1576603598″>Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor</a><img src=”http://www.assoc-amazon.com/e/ir?t=thalbl-20&l=as2&o=1&a=1576603598″ width=”1″ height=”1″ border=”0″ alt=”” style=”border:none !important; margin:0px !important;” />
The Return of My Money, Not the Return on My Money

The Return of My Money, Not the Return on My Money

Posted on by David Merkel

Before I begin, I want to thank longtime readers, and ask them to give me some feedback.? I have a category entitled Best Articles; what would you nominate to be in there.? Also, what would you take out?? I’ve tagged a few articles from the early days, but since then, have not done much with it.? If you have ideas, please let me know.? Thanks again.

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As bond investors go, I tend to focus on what can go wrong more than most, so when I looked at the cover of Barron’s today, I said, “Oh, no.? Pushing yield now?”

It’s no secret that most safe investment grade debt does not yield much now.? Many investors, hungry for yield, must look for other ways to earn income, even if it means greater hazard of capital loss.? That is another impact of the federal reserve flooding the debt markets with liquidity — the safe investments yield little, forcing those that want yield to take significant risks, whether those risks are lending long, high credit risk, operational risk (common stock and MLP dividends), or subordinated credit risk (preferred stocks).

The history of chasing yield is not promising.? In general, average retail investors reach for yield at the wrong time, and Wall Street is more than happy to facilitate that through structured notes and other high yielding investments where the risk is greater than the excess yield.

But wait — I can endorse some of the article.? I like utilities here.? I don’t own Verizon or AT&T, but I could imagine owning them.? MLPs in energy distribution?? Probably safe; consider their competitive positions and consider where things might go wrong.? I’m not jumping to buy them, though.

Where I can’t sign on is with preferred stocks and convertibles.? All of the preferred stocks that the article cites are financials with marginal investment grade ratings.? The convertibles are from a grab bag of low junk-rated securities.

How quickly we forget the ugliness of 2008.? If we have a second dip in the financial economy for whatever reason, the preferred and convertible securities will do the worst.? In order to get significant yields one must take credit risks in excess of average loss costs — it is safe to say at times like this, the purchase of risky securities is not rewarded.? Be wary with all purchases of risky debt at present.

On Sovereign and Quasi-Sovereign Risks

On Sovereign and Quasi-Sovereign Risks

Posted on by David Merkel

I like investing internationally, because of the diversification it offers, both in stocks and bonds.? Or, think of it as a hedge.? Will the American Experiment continue to prosper?? We have come a long way from the Founding Fathers, and more than half of it is not good.

But there are some place in our world that I will not invest in.? I have two requirements.

  • Contract law must be close to that in the US, or better.
  • Accounting practices must be close to the quality of the US, or better.

Sounds simple, but foreign tales are beguiling.? There is an exclusiveness about them, and a sense of greater knowledge for the one who has bothered to learn a trifle.? My acid test is watching over a long period and seeing how they treat foreign shareholders.? That is a good measure of the morality of management.? If they cheat foreign shareholders, they will eventually cheat domestic shareholders as well.

So, what don’t I invest in?

  • Russia
  • China
  • Most of the Middle East.
  • Venezuela
  • And other places that do not protect foreign shareholders on a level that is at least close to that of citizens.

The idea is to avoid situations where your rights as a shareholder might be ignored.? It does not matter how cheap an asset is; if the ability of the asset to be liquidated is low, so should the valuation of the asset be low.? Don’t buy pigs in pokes.

This has application today with Dubai.? The Dubai government is telling creditors that it will not stand behind Dubai World, and nor will the UAE, but Abu Dhabi will stand behind UAE banks.? This is tough on foreign creditors because foreign creditor rights in Dubai have not been tested until now.? Even domestic rights are unclear.

A Note on Debt Risks

Much Islamic debt, because of the prohibition on interest, acts like an extremely volatile hybrid bond during times of stress.? This incident will prove instructive on how these bonds keep or lose value in a reorganization.? What happens here will probably have an impact on how much money will be willing to flow into these vehicles in the future.? Personally, I never found them compelling, and probably won’t in the future.? There is something compelling about straight senior unsecured debt that pays interest.? I think the guarantees involved, together with straightforward reorganization processes, create a fair game where it is easier to decide whether lending or borrowing makes sense.

Complexity in bonds is usually a loser for the lender — whether complexity of the borrower’s finances, complexity of holding company structures, complexity of the governing laws, or even enforcing a complex contract where the lender duped the less-knowledgeable borrower.

What applies to corporate debt — long term buy and hold investors do okay with investment grade debt, but less well with junk debt, and worse the junkier it gets.? Layer on top of that the difficulty of being able to psychologically buy and hold during a crisis.? Even if you personally have the fortitude to do so, there may be others that influence you that don’t.? (E.g., the rating agencies come along near the trough of the crisis, and tell the CEO that they will downgrade you if you don’t sell bonds with the risk du jour.? Or, your clients look at their statements, and see the unrealized losses and beg you to sell — it doesn’t matter, the screaming is always the loudest at the bottom (in hindsight).

A Final Note on Sovereign Risks

Sovereign and quasi-sovereign risks like Dubai World may play a larger role in overall credit risk as the broader crisis plays out.? When I was younger, I thought the great risk of the Euro was that it would be too weak.? Bite my tongue.? The risk is that it could be too strong, and marginal European countries (Greece, Iceland, Ireland, Spain, Portugal, and many Eastern European countries) that have too much Euro-denominated debt relative to their ability to tax and pay will find themselves pinched — and they can’t inflate their way out.

When I first came to bond investing (early 90s), sovereign risks were viewed? skeptically, excluding the large Western nations — bond managers had been taught by the greyheads who had seen sovereign defaults, and the difficult of recovering money in default, still had a bias against sovereign and quasi-sovereign risks.? That bias is largely gone today, after a period of few sovereign losses.? Yes, Mexico, Russia and Argentina have given their share of heartburn, but the significant growth in the emerging markets has made bondholders forgiving.? Add in the long term structural deficits of the US and Japan, and it makes for a really interesting investment picture.

Be aware.? If you hold sovereign debts, look at the ability of the government to tax and pay over the long haul.? On quasi-sovereigns, analyze the explicit guarantees, if any, and the governing law — as you can see with Dubai World, in a crisis, only the guarantees matter, and only to the degree that they are enforceable under law.? With Dubai World, it will be judged in Dubai courts by a judge appointed by the ruling family of the emirate, which owns the equity of Dubai World.? Not a strong bargaining position in my opinion.? The only thing worse than relying on the kindness of strangers, is relying on the kindness of adversaries.

A Final Aside

I knew about how dodgy the investments were that Dubai and its corporations were undertaking, so I was always a skeptic, though I never wrote about Dubai, because it is so far afield for me.? What I did not know was the near slavery of foreign workers tricked to go to Dubai, and then forced to work with little to no rights.? Read the story, it is not pretty, but reinforces a belief of mine that governments and corporations willing to cheat one group of people, will cheat other groups of people as well.? Character is important in any credit decision, and the government of Dubai does not have good character in my book.

Pension Apprehension

Pension Apprehension

Posted on by David Merkel

I have a bunch of pieces “ganged up” to go on real estate, international economics, government policies, market risks, and a book review on “Think Twice,” but tonight the topic is pensions, with a side order of Bill Miller.? Hopefully I will get to the other topics next week.

Defined benefit [DB] pension plans have run into the perfect storm: lousy equity returns and low high-grade bond yields.? It makes the last great pension crisis in the late ’70s look good — at least they had higher yields back then.? Thus this article from the Washington Post.? Many pension plans face almost impossible odds of catching up, raising the odds significantly of more plan terminations, where the two main losers are healthy defined benefit plans, who will have to pay higher amounts for PBGC coverage, and pensioners with high benefits, because those benefits will be cut.

That places pension plan sponsors in a bind.? What to do?? Take more risk, contribute more assets to bridge the funding gap, terminate the plan, or declare bankruptcy?? It is worse for US states, who can’t declare bankruptcy.? And municipalities don’t have the PBGC behind them; the pension liabilities are difficult to shake.

Why are there these problems?? Three reasons:

  • Actuarial funding methods were too optimistic for sponsors, and led them to underfund.
  • Investment assumptions were too generous, which also led to underfunding.
  • We have a cultural problem where we hide deficits/profit shortfalls through adjusting pension assumptions, or trading lower salary increases for pension benefit increases, which don’t hit the bottom line immediately, but increase funding needs for years to come.

With life insurance reserving, we use assumptions that are conservative for reserves and capital.? Pension reserving is best estimate.? If a life insurance reserve is inadequate, it must be raised to adequacy.? Pensions have a lot more flexibility, even with the recent legal changes.? It should not have been that way — pension reserving should have required pre-funding and conservative reserving.

We had boom years in the ’90s, and most DB pension plans were overfunded for a while, but the boom gave the illusion that returns would be stupendous for a long time, and companies stopped contributing as much or at all to their DB plans.? Some of that was IRS policy; the IRS did not want companies hiding income by contributing to the employees’ DB plans.? Thus the IRS capped the degree of overfunding at the time when overfunding was needed.

The states have their own issues in that it was always easier to defer making payments to the DB plans, because no one wanted to raise taxes, or defer spending plans.? Now the true costs have come home to roost because of the financial crisis.? Not only are interest rates and asset values lower, but tax revenues are down significantly, and unlike the US government, the states can’t print their way out of it; there are no foreign buyers that think they have to buy the states’ debts.

I have said before that it is foolish to take more risk in order to try to get ahead of the pension promises.? Periods of debt deflation are not kind to those taking risks.

That applies to defined contribution [DC] plans as well.? This article in Time suggests that 401(k) plans be scrapped, which are a type of DC plan.? A few notes:

  • 401(k) plans were an accident that got shoved into a piece of legislation for providing supplemental savings benefits.? It was probably design for a special interest, but was discovered by an then-obscure Ted Benna, who started a practice around it.
  • Whoulda thunk that it would get bigger than DB plans?? Few thought it possible until the early ’90s.
  • During the boom years, few questioned the abilities of plan participants to direct their own investing.? The bust years have made that inadequacy plain.? Average people don’t know how to allocate assets.? They are either too conservative or aggressive.? Few choose the middle ground of a Ben Graham 50/50, or a DB plan 60/40 (stocks/bonds).
  • Participants are also not well equipped for receiving and managing a lump sum of assets at retirement.? Few will buy an immediate annuity for part of their funding needs, smart as that is.? They also will not limit themselves to withdrawing only 4% of assets per year at most.

As for the Time article, I take issue with this phrase: “This isn’t how retirement was supposed to be.”

Oh please, retirement is a modern innovation that only the developed world achieved, and only because they had more than enough children (with technological development) to fund the economic growth of the entire system.? Now that developed countries are down to replacement rate or less, the only way these systems hold together is through tax subsidies or optimistic assumptions.

The world is not so bountiful that everyone can have an easy time after age 62, without taxing others to make it happen.

Now, the 401(k) was not a bad idea, but there were limitations:

  • People did not contribute enough.? They should have contributed to the max, but many only did it to the degree of the match, and and some did little to nothing.
  • They were too aggressive or too conservative, which led to greed, panic, and underperformance.? A middling allocation would have served most well, and could have been maintained through good times and bad.
  • Perhaps it would have been better to have had trustee-directed plans, where participants could have chosen the amount to save, but trustees would have invested for them.? One can’t easily tell when bad markets will come, thus it pays to have dispassionate advisors do he investoing for those that will give in to fear and panic.
  • People were poor at choosing how to distribute their 401(k) assets — few chose immediate annuities, for two reasons: it means the forfeiture of assets for a stream of cash for life, and insurance agents don’t want the money locked up; they want to earn multiple commissions.

Some of the large insurance companies are offering deferred income benefits, i.e., pay so much today, and we will give you an income of such and so at age 65, if you are still alive then.? They are not yet common, and will say that it is a tough benefit for insurers to fund.? Not many fixed income assets are not long enough to fund such a risk.

Regarding the termination of DB plans, and their replacement with DC plans, I predicted that 15+ years ago.? Why?? As the Baby Boomers got older, there would be no way that a corporation could afford the huge benefits, because the pension funding methods were back-end loaded, as I said before.? Corporations had to pony up a lot more to fund the retirement of a 60-year old than a 25-year old.? Corporations that did not terminate their DB plans would lose investors to those that did terminate, becausetheir profits would be a lot lower.

And, If the IRS had not made it tough to overfund DB plans, perhaps we would have more of them today.? Alas, it is not so.

So, what can I say?? Don’t blame 401(k) plans for broader societal trends.? Corporations would have had to terminate their DB plans simply due to demographics.? Also, understand that the economy is limited, and stocks are not magic.? Stock don’t guarantee a good return or even a positive return.? Also, don’t blame 401(k)s and other DC plans for people not investing enough.

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Okay, time for the side dish.? So Bill Miller has had a comeback over the year to date.? Big whoop.? He is still behind the S&P 500 over the last 10 years, though over the last 19 years, he is still ahead by 1-2%/year.? This is not as impressive as John Neff, by any means.

What has fueled the returns of Mr. Miller?? Low quality companies bouncing back from a crisis that the Government/Fed bailed them out of.? What Bill Miller does not do is value investing.? Value investing is not “buying them cheap,” but buying with a margin of safety.? Financials have not had a margin of safety for a long while.

Given that I think that companies with a lot of debt will underperform in the future, so do I think the Bill Miller will underperform as well.? That is an area where he he been sloppy in the past; given the weakness in the current economy, it will bite him again.

Risks, Not Risk

Risks, Not Risk

Posted on by David Merkel

While at our last denominational meeting, I made the offer to the pastors of my denomination that if they needed investment advice, they could contact me for advice.? Out of eighty or so pastors that that could have asked for advice, one e-mailed me.? (The pastors and elders did elect me to the pension board, to help manage the relationships with the defined contribution fund managers.? I’ll do my best for them.) The pastor is young-ish, with a wife and six kids.? He had 60% invested in a broad bond fund which had a high exposure to investment grade corporates and high yield (and AAA CMBS), and 40% in a stable value fund. This is a redacted version of what I wrote to him:

You’ve been playing it conservatively.? At this point conservative is good.? If I were not tardy in responding to you (my apologies), I might have suggested taking a little more risk at the time when you wrote.

This is the way that I view asset allocation:? look at the risk factors in the investment markets, and look at the funding needs of the person or institution that owns the assets.? (I.e., so what are we saving for?)

Most people don’t save enough.? The $4000 per year is good, but most people need to put more of a buffer aside than that, whether in IRAs (for retirement) or in a taxable account (for emergencies, future coollege aid to children, etc.)? You have six little liabilities that may need some help starting out as they reach adulthood.? Consider saving more.

Now for the risk factors:

  • Equities — somewhat overvalued at present.? (US and foreign)
  • Credit — Investment grade credit is slightly overvalued, and high yield is overvalued.
  • Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.? There will be more defaults, both in commercial and residential.
  • Yield Curve — Steep.? It is reasonable to lend long, so long as inflation does not take off.
  • Inflation — Low, but future inflation is probably underestimated.
  • Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
  • Commodities — the global economy is not running that hot now.? There will be pressures on resources in the future, but that seems to be a way off.
  • Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.
What this leads me to is this: I don’t know all of the bond and stock funds you can use at present, though I will after the next pension board meeting.? The bond fund you are using was a great play over the last 9 months, but is probably overvalued now.? If there is a more conservative bond fund, you might want to shift some funds there.? If not, use the fixed fund.? I don’t think we have an international bond fund, or an inflation protected fund?available, but if we do I would add some there.

On a pullback in the stock markets, I would look to add some stock into the mix.? I would add some with the market 10% lower, and would add considerably with the market 30% lower.? If there are international stock funds, I would use them 30/70 with US funds.

Consider this a start of a discussion.? I’m not bullish on much right now.? This is a time to preserve capital, not make returns.? Let me know what you think, and sorry for being so slow to get back to you.

If I were talking to an institutional investor, I would have added illiquidity as a risk factor, which I think is fairly priced right now. I might have also added that I would be bullish on GSE-sponsored mortgage bonds and carefully selected CMBS.

Aside from that, I was pleasantly surprised in Barron’s to see Mark Taborsky of Pimco thinking about asset allocation the way I do.? There is no generic risk.? There are many risks.? Are you getting fair compensation for the risks that you are taking?? If not, invest in other risks, or if there are few risks worth taking, invest in cash, TIPS, or foreign fixed income.

Modern Portfolio Theory has done everyone a gross disservice.? It is not as if we can predict the future, but the use of historical values for average returns, standard deviations, and correlations lead us astray.? These figures are not stable in the intermediate term.? The past is not prologue, and unlike what Sallie Krawcheck said in Barron’s, asset allocation is not a free lunch.? With so many people following strategic asset allocation, assets have separated into two groups, safe and risky.

To this end, it is better to think in terms of risk factors rather than some generic formulation of risk.? Ask yourself, am I getting paid to bear this risk?? Look to the risks that offer the best compensation, and avoid those that offer little or negative compensation.
Plan for Failure

Plan for Failure

Posted on by David Merkel

Imagine for a moment that you are managing a large corporate bond portfolio for a major institution.? One of the first things you should internalize is that you will be wrong.? You will buy bonds of companies that will get into unexpected trouble, and their prices will decline.? Or, you play it safe as a panic deepens, and then as the fog lifts, you underperform because you did not hold onto risky bonds that would recover.

Face it: in volatile times we get it wrong.? We panic at troughs, and chase the rabbit when the market runs contrary to our bearish expectations.? But what do you do when you are on the wrong side of a trade?

The first thing to do is sit down with all concerned parties and ask their opinions.? (If you are working on your own, this point is moot.)? If everyone who has an opinion agrees, and the position still worsens, the final step must be taken.? Look at all external analytical opinion, and find someone that disagrees.? Circulate the disagreeing opinions out, and ask all concerned parties what they think.? Or, simply ask, what arguments have they made that we haven’t heard?? Do those arguments make any sense?? If they make sense, close out the position.? If not, it may be time to add more amid the pessimism.

But it is better to prepare in advance for bad times than to react on the fly.? Good investment processes plan for failure.? They realize that not every investment will win, and so they limit the downside of possible bad investments through:

  • Diversification
  • Hostile review when the investment falls by a given amount.
  • Limitations on size of positions.
  • Holding safe assets

Good investment management considers where asset values could go in the short run, and the possibility that money could be pulled if performance is bad enough.? But it also looks to the long run value of the assets, and is willing to sell when values are too high, and buy when values are too low.

As a corporate bond manager, when I got on the wrong side of a trade, I would call my analyst to me and ask her for her unbiased opinion.? If she was certain that things were good, and gave good answers to my questions, I would add to my positions.? But if she gave me the sense that things were falling apart, I would take my losses.

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When I went to work for a hedge fund in 2003, one of the first questions I was asked was? how I would position the portfolio.? I found myself to be the lone bull.? When asked why, I said that we were in the midst of a liquidity rally, and that short positions were poison when liquidity was adequate to finance marginal companies.? My argument was not bought, but I focused my part of the portfolio on marginal insurance companies that would benefit most from the liquidity wave.

Today, there are many bearish hedge funds that are licking their wounds.? What to do?

1) First, assess your funding base.? Estimate how much assets will leave if the underperformance persists.

2) Look at your positions relative to your expectation of prices two years out.? Eliminate the positions with the lowest risk-adjusted expected returns, whether short or long.? Keep the positions on (or add to them) that offer the most promise.

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Bad times offer an opportunity to concentrate on best ideas.? Good times offer opportunities to avoid risk.? In this time of liquidity prompted by the Fed, take the opportunity to lessen risk, because eventually the Fed will have to shift its position, and suck liquidity out of the economy.

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