It was winter in early 1995, and I was wondering if I still had a business selling Guaranteed Investment Contracts [GICs]. ?Confederation Life had gone insolvent the August prior, and I noticed that fewer and fewer stable value funds wanted to purchase my GICs, because our?firm was small, and as such, did not get a good credit rating, despite excellent credit metrics. ?The lack of a good rating kept buyers away.
Still, I felt I needed to try my best for one more year or so, despite my feelings that the business was?dying soon. ?With that attitude, I headed off in January to sunny Southern California, to attend GICs ’95, something my opposite number at AIG referred to as a Schmoozathon.
Schmoozathon? ?Well, you took your opportunities to ingratiate yourself with current and potential clients, across four days and three nights of meetings, with a variety of parties going on. ?I was not the best salesman, so I just tried to play it as straight as I could.
In the middle of the whole affair was a special lunch where Bill Gross was to be the Keynote Speaker. ?Because I was talking with a client, I got to the lunch a little late, and ended up at a table near the back of the room.
Things were running a little behind, but Bill Gross got up and gave a talk that borrowed heavily from a recent Pimco Investment Outlook that he had written, comparing the current market opportunities to Butler Creek?(see paragraph 6), a creek that he grew up near as a kid, which gently meandered, went kinda straight, kinda not, but didn’t vary all that much when you looked at it as a whole, rather than from a nearby point on the ground.
The point? Sell volatility. ?Buy mortgage bonds. ?Take convexity risk. ?Clip yield. ?Take a few chances, the environment should be gentle, and you can’t go too wrong.
After the horrible investment environment for bonds of 1994, this was a notable shift. ?So he came to the end of his talk, and it was time for Q&A. ?Suddenly, the moderator stormed up to the front of the room and said, “I’m really sorry, but we’re out of time. ?We’ve got a panel waiting in the main meeting?room to talk about the Confederation insolvency. ?Please head over there now.”
Everyone got up, and dutifully headed over to the Confederation panel. ?I was disappointed that I wouldn’t get a chance to ask Bill Gross a question, so as I started to leave, I looked to the front of the room, and I saw Bill Gross standing there alone. ?It struck me. “Wait. ?What don’t I know about Confederation? The best bond manager in the US is standing up front.”
So I walked up to the front, introduced myself, told him that I was an investment actuary, and asked if I could talk with him about mortgage bonds. ?He told me that he could until his driver showed up. ?As?a result, for the next 15 minutes, I had Bill Gross to myself, asking him how they analyzed the risks and returns of complex mortgage securities. ?His driver then showed up; I thanked him, and he left.
Feeling pretty good, I wandered over to the Confederation panel. ?As I listened, I realized that I hadn’t missed anything significant. ?Then I realized that the rest of the audience had missed a significant opportunity. ?Oh, well.
As it turned out, I made many efforts in 1995 to resuscitate my GIC business. ?It survived for one more year, and collapsed in 1996, with little help from senior management. ?It was for the best, anyway. ?It was a low margin, capital intensive business, and closing it enabled me to focus on bigger things that improved corporate profitability. ?I never went to another?Schmoozathon as a result, but the last one had a highlight that I would not forget: meeting Bill Gross.
Photo Credit: Beto Vilaboim || No, you are not crazy — it *is* hopeless
I thought of structuring this post like a fictional story, but I couldn’t figure out how to make it good enough for publication. ?Well, truth is often stranger than fiction, so have a look at this Bloomberg article pointing at a 37% loss in the?ProShares UltraShort 20+ Year Treasury (TBT).
A few points to start with: shorting is hard. ?Leveraged shorting is harder. ?I think I have reasonable expertise in much though not all of investing, and I put most shorts in the “too hard pile.”
That said, I have taken issue with the “interest rates can only go up” trade for 8-9 years now. ?It is not a major theme of mine, but I remember a disagreement that I had with Cramer over it back when I was writing for RealMoney. ?(I would point to it now, but almost all content at RealMoney prior to 2008 is lost.)
Many bright investors (usually not professional bond investors) have taken up the?”interest rates can only go up” view because of the loose monetary policy that we have experienced, and thanks to Milton Friedman, we know that “Inflation is always and everywhere a monetary phenomenon,” or something like that.
Friedman may or may not be right, but when banks do not turn the proceeds of?deposits into loans, inflation doesn’t do much. ?As it is, monetary velocity is low, with no signs of imminent pickup.
At least take time to read the views of those who are long a lot of long Treasuries, and have been that way for a long time — Gary Shilling and Hoisington Management. ?Current economic policies are not encouraging growth, and that is true over most of the world. ?We have too much debt, and the necessary deleveraging inhibits growth.
Think of this a different way: we have a lot of people thinking that they will retire over the next 10-30 years. ?To the extent that you can live with the long-run volatility, I accept the idea that you can earn 6-8%/year in stocks over that period, so long as there isn’t war on your home soil, or a massive increase in socialism.
But what if you are running a defined-benefit plan, investing to back long-dated insurance products, or just saying that you need some degree of nominal certainty for?some of your assets. ?The answer would be debt claims against institutions that you know will be around to pay 10-30 years from now.
In an era of change, how many institutions are you almost certain will be here 10-30 years from now? ?Personally, I would be comfortable with most government, industrial and utility bonds rated single-A or better. ?I would also be comfortable with some municipal and financial company bonds with similar ratings.
If followed, and this has been followed by many institutional bond investors, this would result in falling long-term yields, particularly now when economic growth is weak globally.
Now, rates have fallen a great deal over 2014. ?Can they fall further from here? ?Yes, they can. ?Is it likely? ?I don’t know; they have fallen a lot faster than I would have expected.
I would encourage that you watch bank lending, and to a lesser extent, inflation reports. ?The time will come to end the high quality long bond trade, but at present, who knows? ?Honor the momentum for now.
Full Disclosure: Long TLT for my fixed income clients and me (it’s a moderate?part of a diversified portfolio with a market-like duration)
This is another episode in my continuing saga on dollar-weighted returns. We eat dollar-weighted returns.? Dollar-weighted returns are the returns investors actually receive in a open-end mutual fund or an ETF, which includes their timing decisions, as opposed to the way that performance statistics are ordinarily stated, which assumes that investors buy-and-hold.
In order for active managers to have a reasonable chance of beating the market, they have to have portfolios that are significantly different than the market. ?As a result, their portfolios will not behave like the market, and if they are good stockpickers, they will?beat the market.
Now, many of the active managers that have beaten the market run concentrated portfolios, with relatively few stocks comprising a large proportion of the portfolio. ?Alternatively, they may concentrate their portfolio in relatively few industries at a time, as I do. ?Before I begin my criticism, let me simply say that I believe in concentrated portfolios — I do that myself, but with a greater eye for risk control than some managers do.
Legg Mason Value Trust enthused investors as they racked up significant returns in the late 90s, and the adulation persisted through 2006.? As Legg Mason Value Trust grew larger it concentrated its positions.? It also did not care much about margin of safety in financial companies.? It bought cheap, and suffered as earnings quality proved to be poor.
Eventually, holding a large portfolio of concentrated, lower-quality companies as the crisis hit, the performance fell apart, and many shareholders of the fund liquidated, exacerbating the losses of the fund, and their selling pushed the prices of their stocks down, leading to more shareholder selling.? I?m not sure the situation has stabilized, but it is probably close to doing being there.
Investors in the Legg Mason Value Trust trailed the returns of a buy-and-hold investor by 6%/year over the time my article covered. ?Investors bought late, and sold late. ?They bought after success, and sold after failure. ?That is not a recipe for success.
Tonight’s well-known fund with a great track record is the Fairholme Fund. Now, I am not here to criticize the recent performance of the fund, which due to its largest positions not doing well, has suffered of late. Rather, I want to point out how badly investors have done in their purchases and sales of this fund.
As the fame of Bruce Berkowitz (a genuinely bright guy) and his fund grew, money poured in. ?During?and after relatively poor performance in 2011, people pulled money from the fund. ?Even with relatively good performance in 2012 and 2013, the withdrawals have continued. ?The adding of money late, and the disproportionate selling after the problems of 2011 led the dollar weighted returns, which is what the average investors get, to lag those of the buy-and-hold investors by 5.57%/year over the period that I studied.
(Note: in my graph, the initial value on 11/30/2003 and the final value on 5/31/2014 are the amounts in the fund at those times, as if it had been bought and sold then — that was the time period I studied, and it was all of the data that I had. ?Also, shareholder money flows were assumed to occur mid-period.)
Lessons to Learn
Good managers who have ideas that will work out eventually need to be bought-and-held, if you buy them at all.
Be wary of managers who are so concentrated, that when they receive a lot of new cash after good performance, that the new cash forces the prices of the underlying stocks up. ?Why be wary? ?Doesn’t that sound like a good thing if new money forces up the price of the mutual fund? ?No, because the fund has “become the market” to its stocks. ?When the time comes to sell, it will be ugly. ?If you are in a fund like this, where the fund’s trading has a major effect on all of the stocks that it holds, the time to sell is now.
There is a cost to raw volatility in large concentrated funds. ?The manager may have the guts to see it through, but that doesn’t mean that the fundholders share his courage. ?In general, the more volatile the fund, the less well average investors do in buying and selling the fund. ?(As an aside, this is a reason for those that oversee 401(k) plans to limit the volatility of the choices offered.
Even for the buy-and-hold investor, there is a risk investing alongside those who get greedy and panic, if the cash flow movements are large enough to influence the behavior of the fund manager at the wrong times. ?(I.e., forced buying high, and forced selling low.)
The forced buying high should be avoidable — the manager should come up with new ideas. ?But if he doesn’t, and flows are high relative to the size of the fund, and the market caps of investments held, it is probably time to move on.
When you approach adding a new mutual fund to your portfolio, ask the following questions: Am I late to this party? ?Does the manager have ample room to expand his positions? ?Is this guy so famous now that the underlying investors may affect his performance materially?
Finally, ask yourself if you understand the investment well enough that you will know when to buy and/or sell it, given you investing time horizon. ?This applies to all investments, and if you don’t know that, you probably should steer clear of investing in it, and learn more, until you are comfortable with the investments in question.
One final note: I am *not* a fan of AIG at the current price (I think reserves are understated, among other things), so I am not a fan of the Fairholme Fund here, which has 40%+ of its assets in AIG. ?But that is a different issue than why average investors have underperformed buy-and-hold investors in the Fairholme Fund.
I use factors in my investing. What *are* factors, you ask? ?Factors are quantitative variables that have been?associated with potential outperformance. ?What are some of these factors?
Valuation (including yield)
Price Momentum (and its opposite in some cases)
Insider Trading
Industry factors
Neglect
Low Volatility
Quality (gross margins as a fraction of assets)
Asset shrinkage
Share count shrinkage
Measures of accounting quality
and more…
This is a large portion of what I use for screening in my eighth portfolio rule. ?I’m not throwing this idea out of the window, but I am beginning to call it into question. ?Why?
I feel that the use of the most important factors are getting institutionalized, such that many major investors are giving their portfolios a value tilt, sometimes momentum tilts, and other sorts of tilts. ?I?also see this in ETFs, where many funds embrace value, yield, momentum, accounting, or?other tilts.
Now, we have been through this before. ?In 2007, momentum with value hedge funds became overinvested in the same names, with many of the funds using leverage to goose returns. ?There was quite a washout in August of that year as many investors exited that crowded trade.
I’m not saying we will see something like that immediately, but I am wary to the point that when I do my November reshaping, I’m going to leave out?the valuation, yield and momentum factors, and spend more time analyzing the industry and idiosyncratic company risks. ?If after that, I find cheap stocks, great, but if not, I will own companies that are hopefully not owned by a lot of people just because of a few quantitative statistics.
I may be a mathematician, but I try to think in broader paradigms — when too many people are looking at raw numbers and making decisions off of them solely, it is time to become more qualitative, and focus on strong business concepts at reasonable prices.
Every now and then, a piece of good news gets announced, and then something puzzling happens. ?Example: the GDP report comes out stronger than expected, and the stock market falls. ?People scratch their heads and say, “Huh?”
A friend of mine who I haven’t heard from in a while, Howard Simons, astutely would comment something to the effect of: “The stock market is not a futures contract on GDP.” ?This much is true, but why is it true? ?How can the market go down on good economic news?
Some of us as investors use a concept called a discounted cash flow model. ?The price of a given asset is equal to the expected cash flows it will generate in the future, with each future cash flow?discounted to reflect to reflect the time value of money and the riskiness of that cash flow.
Think of it this way: if the GDP report comes out strong, we can likely expect corporate profits to be better, so the expected cash flows from equities in the future should be better. ?But if the stock market prices fall, it means the discount rates have risen more than the expected cash flows have risen.
Here’s a conceptual problem, then: We have estimates of the expected cash flows, at least going a few years out but no one anywhere publishes the discount rates for the cash flows — how can this be a useful concept?
Refer back to a piece I wrote earlier this week. ?Discount rates reflecting the cost of capital reflect the alternative sources and uses for free cash. ?When the GDP report came out, not only did come get optimistic about corporate profits, but perhaps realized:
More firms are going to want to raise capital to invest for growth, or
The Fed is going to have to tighten policy sooner than we?thought. ?Look at bond prices falling and yields rising.
Even if things are looking better for?profits for existing firms, opportunities away from existing firms may improve even more, and attract capital away from existing firms. ?Remember how stock prices slumped for bricks-and-mortar companies during the tech bubble? ?Don’t worry, most people don’t. ?But as those prices slumped, value was building in those companies. ?No one saw it then, because they were dazzled by the short-term performance of the tech and dot-com stocks.
The cost of capital was exceptionally low for the dot-com stocks 1998-early?2000, and relatively high for the fuddy-duddy companies. ?The economy was doing well. ?Why no lift for all stocks? ?Because incremental dollars available for finance were flowing?to the dot-com companies until?it became obvious that little to no cash would ever flow back from them to investors.
Afterward, even as the market fell hard, many fuddy-duddy stocks didn’t do so badly. ?2000-2002 was a good period for value investing as people recognized how well the companies generated profits and cash flow. ?The cost of capital normalized, and many dot-coms could no longer get financing at any price.
Another Example
Sometimes people get puzzled or annoyed when in the midst of a recession, the stock market rises. ?They might think: “Why should the stock market rise? ?Doesn’t everyone?know that business conditions are lousy?”
Well, yes, conditions may be lousy, but what’s the alternative for investors for stocks? ?Bond yields may be falling, and inflation nonexistent, making money market fund yields microscopic… the relative advantage from a financing standpoint has?swung to stocks, and the prices rise.
I can give more examples, and maybe this should be a series:
The Fed tightens policy and bonds rally. (Rare, but sometimes…)
The Fed loosens policy, and bonds fall. (also…)
The rating agencies downgrade the bonds, and they rally.
The earnings report comes out lower than last year, and the stock rallies.
Etc.
But perhaps the first important practical takeaway is this: there will always be seemingly anomalous behavior in the markets. ?Why? ?Markets are composed of people, that’s why. ?We’re not always predictable, and we don’t predict?better when you examine us as groups.
That doesn’t mean there is no reason for anomalies, but sometimes we have to take a step back and say something as simple as “good economic news means lower stock prices at present.” ?Behind that is the implied increase in the cost of capital, but since there is nothing to signal that, you’re not going to hear it on the news that evening:
“In today’s financial news, stock prices fell when the GDP report came out stronger than expected, leading investors to pursue investments in newly-issued bonds, stocks, and private equity.”
So be aware of the tone of the market. ?Today, bad news still seems to be good, because it means the Fed leaves interest rates low for high-quality short-term debt for a longer period than previously expected. ?Good news may imply that there are other places to attract money away from stocks.
Ideas for this topic are welcome. ?Please leave them in the comments.
Photo Credit: eric731 — People can budget, but can they manage risk?
Investing is difficult. ?That said, we can make it harder still. ?We can encourage people with little to no training to try to do it for themselves. ?Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell. ?We get there late, and then our emotions trick us into action, when the rational investor says, “Okay, I missed that move. ?Where are there opportunities now, if there are any at all?”
But investing can be made even more difficult. ?Investing reaches its most challenging level when you are relying on your investing to meet an anticipated and repeated need for cash outflows.
Institutional investors will tell you, portfolio decisions are almost always easier when there is more cash flowing in than flowing out. ?It means that there is one dominant mode of thought: where to invest?new money? ?Some attention will be given to managing existing assets — pruning away assets with less potential, but the need won’t be as pressing. ?(Note: at really high rates of cash?inflow, investing gets really tough as well, but that’s another story, and one that I successfully lived though 1998-2003…)
1) You don’t know how long you, your spouse, and anyone else relying on you will live. ?Averages can be calculated, but particularly with two people, the odds are that one will outlive an average life expectancy. ?Can you be conservative enough in your withdrawals that you won’t outlive your money?
2) My estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%. ?That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero when you are near the end of a bull market.
Now, most?people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets. ?At present, if interest rates don’t go lower still, that will likely (60-80% likelihood) work. ?But if your income needs are greater than that, your odds of yields over the long haul go down dramatically.
3) Will you be able to maintain an iron discipline, and not overspend your assets? ?It’s tempting to do so, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs. ?It is incredibly difficult to?avoid paying for an immediate pressing need, when the soft cost?is harming your future. ?There is every incentive to say, “We’ll figure it out later.” ?The odds on that being true will be low.
4) How will you deal with bear markets, particularly ones that occur early in retirement? ?Can?you and?will you reduce your expenses to reflect the losses? ?On the other side, during bull markets, will you build up a buffer, and not get incautious during seemingly good times?
This is an easy prediction to make, but after the next bear market, look for a scad of “Our retirement is ruined articles.” ?Look for there to be hearings in Congress that don’t amount to much — and if they do amount to much, watch them make things worse by creating R Bonds, or some garbage like that.
5)?Avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield — it is the oldest scam in the books. ?This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc. ?They have no guaranteed return of principal. ?On the plus side, they may give you capital gains if you use them right, buying them when they are out of favor, and reducing exposure when everyone is buying them.
Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because a decent number of people are buying them as if they are magic. ?The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.
6) Avoid taking too much?or too little risk. It’s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree. ?If you can do that successfully, you are rare. ?What is achievable by many is to maintain a constant risk posture. ?Don’t panic; don’t get greedy — just stick to your investment plan through the cycles of the markets.
7) As assets shrink, what will?you liquidate? ?The best thing would be?being forward-looking, and liquidating what has the lowest risk-adjusted future return. ?What is achievable is selling assets off from everything proportionally, taking account of tax issues where needed.
8 ) Are you ready for Social Security to take a hit out around 2026? ?Once the trust fund gets down to one year’s worth of?payments, future payments get reduced to the level?sustainable by expected future contributions. ?Expect a political firestorm when this becomes a live issue, say for the 2024 Presidential election. ?There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.
9) Be wary of inflation, but don’t overdo it. ?The retirement of so many people may be deflationary — after all, look at Japan and Europe so far. ?Economies also work better when there is net growth in the number of workers. ?It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.
10) You need a defender of two against slick guys who will try to cheat you when you are older. ?If you have assets, you are a prime target for scams. ?Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make your money stretch further. ?But there are other scams as well — run everything significant past a smart younger person who is skeptical, and knows how to say no when needed.
Conclusion
If this all seems unduly dour (and I haven’t even talked about defined benefit plan issues), let me tell you that this?is realistic. ?There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.
Even with skilled advisers helping you, you need to be ready for the hard choices that will come up. ?Better you should think through them earlier rather than later. ?Who knows? ?You might take some actions that will lower your future risks. ?More on that in a future post, as well as the other retirement risk issues.
Photo Credit: Sepehr Ehsani — Which project is better, project A or project B?
I can’t remember where I ran into it, but I found this article on a blog that I had not run into before on Calculating [the] Cost of Equity for Value Investors. ?I think it gets close to the right answer, and I would like to sharpen it here.
My answer to a lot of economic questions is: what’s the alternative? ?Many people look at the shiny formulas in investing but don’t ask what they really mean. ?(More people just don’t look at the formulas… which has its pluses and minuses. ?The math reveals, but it also conceals hidden assumptions.)
After wisely dismissing how to calculate the cost of equity from Modern Portfolio Theory [beta] and the Gordon model, he considers cost of equity based off of return on equity, and begins to get tied up in problems. ?Let me try.
The cost of equity is important for a number?of reasons:
It helps answer the question, “When should a company issue?or buy back?stock?”
It provides a measure for the alternative use of equity capital on competing unlevered projects/investments of equivalent riskiness.
Note the each of the reasons is structured as a series of comparisons. ?I’ll use a discounted cash flow [DCF] analysis as an example. ?Imagine a simple project requiring an investment of equity capital. ?There is a certain cost, and the risk is enough that you can’t borrow money for financing — it must be funded by equity. ?There are expected after-tax cash flows from the project that you think are a best estimate of returns. ?When would you invest in the project?
I would compare investments versus other similar investments, and look at as many similar projects from a riskiness perspective, and see which investment yielded the best return. ?The second place project as returns go is the alternative project for investment by which the winning project is judged, and surprise, the winning project?has a positive net present value evaluated at the rate of the alternative project.
(An aside: it just hit me that I am recreating part of the learning process that I went through back when I was a TA at UC-Davis 31 years ago, helping teach Corporate Financial Management [CFM], while taking quadratic programming [QP] course at the same time — I ended up doing my QP paper on using QP to choose investments to maximize returns without explicitly calculating internal rates of return, thus quietly solving a problem that the undergrad CFM textbook said could not be done. ?FWIW, which isn’t much.)
Now, I’m waving my hands at what I mean by risk, but to me it is the best estimate of the probability distribution of outcomes, thus giving you estimates of what the likelihood and severity of adverse outcomes could be. ?The thing is, in real life we know these figures poorly at best, but the framework is still useful because the investor making the decision needs to choose the project of a class of projects with roughly the same risk profile. ?Though my initial example included only equity-financed projects, this could be expanded to consider all projects, where the amount of debt on projects affects their risk, and the tax-affected?debt cash flows are?a deduction from returns.
The process would remain the same:?look at as many similar projects from a riskiness perspective, and see which investment yielded the best return on the equity. ?The second place project as returns on the equity go is the alternative project for investment by which the winning project is judged.
Back to Stocks
Where does that leave us as stock investors? ?I subscribe to the “pecking order” theory of the cost of capital, which says that firms use the cheapest form(s) of capital to fund their incremental financing needs, which means they should rarely issue equity.?The exception would be if?they are undertaking a project so large that it would make the company significantly more risky if they were to issue only debt for financing.
We do see companies engaging in buyback activity when they can’t find better uses for slack capital. ?In many cases, there are few large projects begging for the attention of management. ?Buying back stock earns the earnings yield for?the firm. ?Managements buying back stock make the statement that there are no more incremental projects of equivalent risk that would have an unlevered return on equity greater than the earnings yield for the firm.
Now maybe shareholders may have a bigger set of investment choices than the firm does, so perhaps dividends could be a better choice for shareholders, but it will have to be a lot better, because?dividends are taxable.
In general, we want to see management teams be careful users of equity capital, taking note of its cost for the benefit of shareholders. ?Every good management team should have their schedule of possible projects for investment, but always recognize there is the alternative of buying back stock as a last resort. ?In that limited sense, the earnings yield is the cost of equity for the firm, unless big profitable projects beckon.
There’s more to say here, but maybe this is a good start. ?Thoughts?
There have been a few parties worrying about crises stemming from ETFs, because they make it too easy for people to sell a lot of assets?in a crisis.
I think that fear is overblown, but I don’t think it is non-existent, and I would like to use a bond ETF as an example of what could be possible.
Most bonds don’t trade every day. ?Only the most liquid bond issues trade every day, and they form the backbone for pricing the bonds that don’t trade.
But how do you price a bond when it doesn’t trade? ?It’s complicated, but let me try to explain…
When a less liquid bond actually has a trade, the bond pricing services take note of it. ?They calculate the yield spread of the less liquid bond versus similar bonds (similar in industry, rating, maturity, currency, domicile, other features) that are liquid, and compare it to:
where that yield spread was in the past
where the yield spread is relative to other similar?less?liquid bonds that have recently traded
where models might imply the yield spread should be, given other securities related to it (stock, preferred stock, junior debt, other bonds in the same securitization, etc.)
where investment banks that make a market in the bonds are indicating they would buy or sell.
Now consider that the bond pricing services are doing this for all the bonds they cover every day, and in real time when?the NAVs are made available for ETFs. ?The bond pricing services attempt to create a set of prices for all securities that they cover that is consistent with the market activity in aggregate, adjusting at a reasonable speed to changing market conditions. ?It’s complex, but it allows investors to have a reasonable estimate of the value of their bonds.
(Note: the same thing is done with illiquid stocks as a result of the late trading scandal in mutual funds back in the early 2000s for setting the NAV of mutual funds — ?less liquid?stocks have the same problem in a lesser way than bonds.)
The technical name for this is matrix pricing, which is a bit of a misnomer — multifactor pricing would have been a better name. ?It works pretty well, but it’s not perfect by any means — as an example, you can’t take the calculated price and trade at that level — it is only indicative of where an uncoerced buyer and seller might trade on a normal day. ?It may be a useful guide, though your broker making a market may disagree, which is part of the art of understanding value in the bond markets.
The Possible Problem
Now imagine an ETF with a relatively large amount of less liquid bonds in it, and a market environment where yield spreads are relatively tight, as it is now. ?In such an environment, even the less liquid bonds may have their yield spreads relatively tight?versus their more liquid cousins. ?Now imagine that a relatively violent selloff starts in the bond market over credit issues.
If you were a bond manager at such a time, surprised at the move, but thought it would go further, and you wanted to lighten up on some of your positions, would you try to sell your liquid or less liquid bonds first? ?Most of the time, you would sell the liquid ones, because it is relatively easy to get the trades done. ?If the selloff is bad enough, it will be impossible to sell the less liquid bonds — practically, that market shuts down for a time.
But if there are very few trades of the less liquid bonds, what does the pricing service do? ?Initially, it might rely on the old spread relationships, leaving the less liquid bonds with higher prices than they should have. ?But with enough time, a few trades will transpire, and then the?multifactor models will catch up “all at once” with where the pricing should have been.
For a time, the NAVs would be high relative to where the bonds actually should trade. ?The unit creation/liquidiation process might not catch up with it, because the less liquid bonds are difficult to source, and there is often a cash payment in lieu of the less liquid bonds. ?That cash payment figure could be too high in my scenario, leading to a rush to liquidate by clever investors sensing an arbitrage opportunity.
Now, would this be a catastrophe for the markets as a whole? ?I don’t think so, but some investors could find the NAVs of their bond ETFs move harder than they would expect in a bear market. ?That might cause some to sell more aggressively, but remember, for every seller, there is a buyer. ?Someone outside the ETF processes with a strong balance sheet will be willing to buy when the price is right, because they typically aren’t forced sellers, even in a crisis.
Practical Advice
If you own bond ETFs, know what you own, and how much of the portfolio is less liquid. ?Have a passing familiarity with how the NAV is calculated, and how units get created and liquidated. ?Try to have a sense as to how “jumpy” investors are in the asset sub-class you are investing in, to know whether your fellow investors are likely to chase market momentum. ?They may cause prices of the ETFs to vary considerably versus NAVs if a large number of them take the same action at the same time.
Know yourself and your limits, and be willing to hold or add when others are panicking, and hold or sell when others are too optimistic. ?If you can’t do that, maybe hand it over to a financial advisor who?stays calm when markets are not calm.
Morningstar estimates that over the past five years, the average investor fell behind Pimco Total Return?s 5.6% annual gain by 1.6 points a year?largely as a result of buying high and selling low. That gap is among the widest of any large bond fund; at the Vanguard Total Bond Market Index Fund, for example, investors have earned returns only 0.4 point lower than those of the portfolio itself.
In the short run, this offers a reason to follow Bill Gross to Janus. ?He is starting with a clean slate, and will be able to implement positions that seem attractive to him that would not have been attractive at Pimco because they would have been too small. ?Managing less money lets Bill Gross be more choosy.
Second, in the short run, growth in bond assets at Janus will temporarily push up the prices of bonds held by Janus. ?Those that get in early would benefit from that if bond assets grow under the management of Bill Gross. ?Just keep your eye on when assets stop growing if you are buying for that speculative reason.
A third potential reason to follow Gross depends on how much Pimco continues to use his quantitative strategies. ?If Pimco abandons them (unlikely, but not impossible), Janus would get the chance to use them on much less money, which would make the excess returns greater. ?If I were considering this as a reason, I would watch the turnover in Pimco’s main funds, and see if certain classes of assets disappear.
My last point here is that the abilities of Bill Gross will do better managing less money, but the effect won’t be so great if he is competing with Pimco to implement the same strategies. ?At minimum, he’s not likely to do worse than at Pimco, and in the short-run, there are some reasons why he will likely do better.
PS — please remember that Bill Gross has two hats: the showman and the quant. ?The quant makes money for clients while the showman entertains them. ?The showman opines about the Fed, politics, etc. ?That can get investors interested because it sounds clever, but that is not how Bill Gross makes money.
This brings up one more point. ?If you do decide to invest with him at Janus, review the prospectus to see what degree of flexibility with derivatives Gross will have. ?If it similar to what he had at Pimco, he is likely following the same strategy.
Recently I was approached by Moneytips to ask my opinions about retirement. They sent me a long survey of which I picked a number of questions to answer. You can get the benefits of the efforts of those writing on this topic today in a free e-book, which is located here: http://www.moneytips.com/retiree-next-door-ebook.??The eBook will be available free of charge?through September 30th. ?I have a few quotes in the eBook.
Before I move onto the answers, I would like to share with you an overview regarding retirement, and why current and future generations are unlikely to enjoy it to the degree that the generations prior to the Baby Boomers did.
The first thing to remember is that retirement is a modern concept. That the world existed without retirement for over 5000 years may mean that it is not a necessary institution. For a detailed comment on this, please consult my article, “The Retirement Tripod: Ancient and Modern.” Here’s a quick summary:
In the old days, when people got old, they worked a reduced pace. They relied on their children to help them. Finally, they relied on savings.
Savings is the difficult concept. How does one save, such that what is set aside retains its value, or even grows in value?
If you go backwards 150 years or further in time, there weren’t that many ways to save. You could set aside precious metals, at the risk of them being stolen. You could also invest in land, farm animals, and tools, each of which would be the degree of maintenance and protection in order to retain their value. To the extent that businesses existed, they were highly personal and difficult to realize value from in a sale. Most businesses and farms were passed on to their children, or dissolved at the death of the proprietor.
In the modern world we have more options for when we get old ? at least, it seems like we have more options. In retirement, we have three ways to support ourselves: we have government security programs, corporate security programs, and personal savings.
Think of this a different way, and ignore markets for a moment.? How do we take care of those that do not work in society?? Resources must be diverted from those that do work, directly or indirectly, or, we don?t take care of some that do not work.
Back to?markets: Social Security derives its ways of supporting those that no longer work from the wages of those that do work.? That?s one reason to watch the ratio of workers to retired.? When that ratio gets too low, the system won?t work, no matter what.? The same applies to Medicare.? With a population where growth is slowing, the ratio will get lower. If the working population is shrinking, there is no way that benefits for those retiring will be maintained.
Pensions tap a different sort of funding.? They tap the profit and debt servicing streams of corporations and other entities.? Indirectly, they sometimes tap the taxpayer, because of the Pension Benefit Guaranty Corporation, which guarantees defined benefit pensions up to a limit.? There is no explicit taxpayer backstop, but in this era of bailouts, who can tell what will be guaranteed by the government in a crisis?
That said, not many people today have access to Defined-Benefit pensions. Those are typically the province of government workers and well-funded corporations. That leaves savings as the major way that most people fund retirement aside from Social Security.
One of the reasons why the present generations are less secure than prior generations with respect retirement is that the forebears who originally set up defined-benefit pensions and Social Security system set up in such a way that they gave benefits that were too generous to early participants, defrauding those who would come later. Though the baby boomers are not blameless here, it is their parents that are the most blameworthy. If I could go back in time and set things right, I would’ve set the defined-benefit pension funding rules to set aside considerably more assets so that funding levels would’ve been adequate, and not subject to termination as the labor force aged.
I also would’ve required the US government to set benefits at a level equal to that contributed by each generation, and given no subsidy to the generations at the beginning of the system. Truth, I would eliminate the Social Security system and Medicare if I could. I think it is a bad idea to have collective support programs. There are many reasons for that, but a leading reason is that it removes the incentive to marry and have children. Another reason is that it politicizes generational affairs, which will become obvious to the average US citizen over the next 10 to 15 years.
Back to Savings
As for personal savings today we have more options than our great-great-great-grandparents did 150 years ago. We can still buy land and we can still store precious metals ? both of those have a great ability to retain value. But, we can buy shares in businesses and we can buy the debt claims of others. We can also build businesses which we can sell to other people in order to fund our retirement.
But investing is tricky. With respect to lending, default is a significant risk. Also, at the end of the term of lending, what will the money be worth? We have to be aware of the risks of inflation and deflation.
In evaluating businesses more generally, it is difficult to determine what is a fair price to pay. In a time of technological change, what businesses will survive? Will the business managers be clever enough to make the right changes such that the business thrives?
You have an advantage that your parents did not have, though. You can invest in the average business and debt of public companies in the US, and around the world through index funds. This is not foolproof; in fact, this is a pretty new idea that has not been tested out. But at least this offers the capability of opening a fraction of the productive assets in our world, diversified in such a way that it would be difficult that you end up with nothing, unless the governments of the world steal from the custodians of the assets.
With that, I leave you to read my answers to some of the questions that were posed to me regarding retirement:
What is a safe withdrawal rate?
A safe withdrawal rate is the lesser of the yield on the 10 year treasury +1%, or 7%. The long-term increase in value of assets is roughly proportional to something a little higher than where the US government can borrow for 10 years. That’s the reason for the formula. Capping it at 7% is there because if rates get really high, people feel uncomfortable taking so much from their assets when their present value is diminished.
How should you handle a significant financial windfall?
If you have debt, and that debt is at interest rates higher than the 10 year treasury yield +2%, you should use the windfall to reduce your debt. If the windfall is still greater than that, treat it as an endowment fund, invest it wisely, and only take money out via the safe withdrawal rate formula.
What are some ways to learn to embrace frugality?
This is a question of the heart. You have to master your desires to have goods and services today that are discretionary in nature. Life is not about happiness in the short term but happiness and long-term. Embrace the concept of deferred gratification that your great-grandparents did and recognize that work and savings provide for a secure and happy future.
How can the average worker start earning passive income?
Passive income is a shibboleth. People look at that as a substitute for investing, because they can’t control investment returns, and they think they can control income.
Income comes from debt or a business. If from debt, it is subject to prepayment or default; it is not certain. Also, income that comes from debt is typically fixed. That income may be sufficient today, but it may not be so if inflation rises. Also your capital is tied up until the debt matures. When the debt matures, reinvestment opportunities may be better or worse than they were when you started.
If income comes from a business, it is subject to all the randomness of that business; it is not certain. It is subject to all of the same problems that an investment in the stock market is subject to, except that you have to oversee the business.
There is no such thing as a truly passive income. Get used to the fact that you will be investing and working to earn an income.
What can those workers who are not employed by a large company or the public sector do to maximize their retirement savings?
You can start an IRA. Until the rules change, you can create healthcare savings account, not use it, and let it accrue tax-free until you’re 59 1/2. Oh, you get an immediate income deduction for that too.
If you are a little more enterprising, you can start your own business. If your business succeeds, there are a lot of ways to put together a pension, deferring more income than an individual can. By the time you get there, the rules will have changed, so I won’t tell you how to do it today; at the time, get a good pension consultant.
Why is calculating how much you’ll need for retirement an important exercise?
You have to understand that retirement is a new concept. In the ancient world, retirement meant continued work at a slower pace on your farm, living off of savings (what little was storable then ? gold, silver, etc.), and help from your children whom you helped previously as you raised them.
Today’s society is far more personal, far less family centered, and far more reliant on corporate and governmental structures. Few of us produce most of the goods and services that we need. We rely on the division of labor to do this.? Older people will still rely on younger people to deliver goods and services, as the older people hand over their accumulated assets in exchange for that.
Practically, modern retirement is an exercise in compromise. You will have to trade off:
How long you will work
At what you will work
What corporate and governmental income plans you participate in
How much income with safety your assets can deliver, with an allowance for inflation
How much you will help your children
How much your children will help you
As such, calculating a simple figure how much your assets should be may be useful, but that one variable is not enough to help you figure out how you should conduct your retirement.
Why don’t more people consult investment professionals? What keeps them from doing so?
There are two reasons: first, most people don’t have enough income or assets for investment professionals to have value to them. Second, people don’t understand what investment professionals can do for them, which is:
They can keep you from panicking or getting greedy
They can find ways to reduce your tax burdens
They can diversify your assets so that you are less subject to large drawdowns in the value of your assets
Other than maximizing your annual contribution, what other things can you do to get the most out of your IRA and 401(k)?
Diversify your investments into safe and risky buckets. The safe bucket should contain high quality bonds. The risky bucket should contain stocks, tilted toward value investing, and smaller stocks. New contributions should mostly feed investments that have been doing less well, because investments tend to mean-revert.
Stocks are clearly risky and investors have emotional reactions to that. How can investors rationally manage their stock investments so that they are less likely to regret their decisions?
When I was a young investor, I had to learn not to panic. I also had to learn not to get greedy. That means tuning out the news, and focusing on the long run. That may mean not looking at your financial statements so frequently.
As for me as a financial professional, I look at the assets that I manage for my clients and me every day, but I have rules that limit trading. I do almost all trading once per quarter, at mid-quarter, when the market tends to be sleepy, and not a lot of news is coming out. When I trade, I am making business decisions that reflect my long-term estimates of business prospects.
Closing
And if that is not enough for you, please consult my piece The Retirement Bubble. ?You can retire if you put enough away for it, but it is an awful lot of money given that present investments yield so little.
