Some securities I own are illiquid. A few are very illiquid. When I wrote for theStreet.com, we had a warning that we posted for every security mentioned where the market cap was less than half a billion dollars, because what we wrote could budge the market, and sometimes it did. I remember when I wrote a post about personal lines P&C insurers, and I mentioned Safety Insurance [SAFT], which was definitely small, as one of the companies that I thought was worth owning, and we did own it at the firm that I worked for. The stock popped about 5% before settling down.
But frenzies to buy are usually tame compared with frenzies to sell. There is an urgency to preserving value that makes the seller particularly zealous in getting out rapidly.
In the last three weeks, I’ve experienced this twice with two securities that I own. In both cases I bought moreas the seller got aggressive. Let me show you what happened.
Image Credit: Aleph Blog
This is a graph of National Western Life Insurance over the last three weeks. It’s my largest holding in one of my strategies. On September 23rd, near the close, an aggressive seller, on no news, sold a large block of stock, driving down the price temporarily. I was one of those buying from him, but by no means the biggest buyer.
Image Credit: Aleph Blog
Then there is TCW Strategic Income Fund [TSI], which is the second-largest holding as bond funds go for my clients, behind PIMCO Enhanced Short Maturity Active ETF [MINT] which I use for liquidity. Yesterday, someone was aggressively selling until 2PM or so, and then they seemed to be done. They may have been selling for three days prior to that. In this case also, I was buying as they were selling, and in this case I caught the bottom tick. Again, there was no news, but when is there ever news for a bond fund?
My main point is this: be willing to be a buyer on days when there is no news, an it is not a sector effect, when a security that you know well is getting thrown out the window for no good reason. Occasionally mad bombers show up and they have to sell down to the last share. Having known some institutional traders, that last sale can be quite aggressive because they want to be DONE!
THere was a guy at theStreet.com, I think his name was Ken Wolff who often talked about “dumpers.” Stocks where a bad event happens, and everyone runs to sell, and there is a climax of volatility where the aggressive sellers have sold their last shares. You see the spike up in volume, and the spike down in the price. His idea was that it was simple to buy then, and close out the trade at the end of the day. On that front, I thought he was pretty clever.
Panic never leads to good results. Understand what you own very well, and be willing to buy when other market participants are irrational.
Photo Credit: Jason Woodhead || Forget the United States Oil Fund — if you want to own oil, buy a tank and store the oil on your own property. 😉
This should be a short post. Buffett likes to own T-bills when he doesn’t have anything that he wants to buy. Why? He is storing value until the time comes when he can buy something that he thinks offers a superb return over the long haul.
And now for something that seems completely different: commodity investing, when it was introduced in the nineties, offered “yield” from rolling the futures contracts from month-to-month. That ended when the trade got too crowded, and the “yield” went negative. The ETFs that pursued these strategies were inventory financing charities in disguise. They still are, even though their strategies are more complex than they were.
Think for a moment. Why should you earn a yield-type return off of owning a commodity? Really, that should not exist unless there is a scarcity of speculators willing to let producers hedge their risk with them. There is a speculative return, positive or negative, from holding a commodity, but in the present environment, where there is no lack of people willing to hold commodities, there is no yield-like return, unless it is negative.
As a result, commodities should be viewed as storage, not an investment. Do you think in the long run that gold will be more valuable than it is today? It might be wise to store some away. That said, you have to be careful here. In inflation-adjusted terms, most commodities have gotten cheaper over time, with occasional violent rallies that convince people to speculate (all too late).
Storage is not investing. Storage tucks something away, and it will not change, even if its price changes because of changes in the economy.
Investing is far less certain — you can lend to or buy equity in a venture which could produce astounding returns, or you could lose it all, or something in-between. With investing, it is rare that you will end up with what you started with.
This is not to say that storage is a bad thing — we exchange our savings in bank balances to store value in a different form. A bank could go bust. If enough go bust at the same time, value could be lost if the government does not back up the FDIC. Holding T-bills preserves value to the degree that the government is willing to pay on its own debts in fiat currency, which is pretty likely.
Holding a commodity with a price you think will correlate strongly with the prices you will experience in retirement is not a bad idea. That said, it is storage. It will not grow your purchasing power the way that investment will.
As such, I encourage you to mostly invest, and store a little. Storage is more certain, but has no return. Investing has returns, both positive and negative, but generally over time provides more value than storage.
PS — owning a home, except in a crowded area that is growing, is not an investment but is storage. You should not expect capital gains in real terms from owning a house. That said, it will provide you with rent-free living for a long time once the mortgage is paid off. (Please ignore the property taxes, insurance and maintenance costs.)
1) I still can’t post images at my blog. If you can believe it, WordPress is trying to fix it. The one cost involved is that the last three posts will be wiped out, and all comments since 4/8.
2) I’ve spent the time since my last post improving my models. I played around with a seven-parameter model, but found that it took ~10,000x as much time to converge to a solution, and there were multiple solutions with very different results that fit close to equally well. My conclusion was that they were different ways to amplify noise.
Instead, I created a second model based on the idea that the rate of growth of total cases was exponentially decaying at a rate slower than that of the first model. The new case figures have been coming at rates far closer to the second model.
I’m sensitive to when models keep having errors in the same direction… 2-3 weeks ago, errors were close to even — as many up as down. But since then more new cases have persistently come in than the first model would have predicted.
Austria, Switzerland and Germany are fine, but most of nations I have modeled have a long way to go, if model 2 is closer to the truth. Add five weeks onto getting to the 99% point.
As such, don’t put me in the camp of optimists any more. I recognize my initial predictions were wrong. Some of it stems from increasing testing as time has gone on. Indeed, what will happen if that study in New York is correct (seems to be too small of a sample, and perhaps biased), and maybe 10-15% of the NY population caught COVID-19 with almost no symptoms? That is mostly a good thing, and might even be a testimony to how little reported cases moved up in the face of that — social distancing restrains the spread of COVID-19, particularly with those who would be most harmed distancing via self-quarantine.
3) I think the history books will end up calling this the voluntary recession, where governments chose ham-fisted solutions out of fear, and did not consider the long-run implications of draconian solutions like general quarantine. What are the effects on:
Unemployment
Division of labor
Pensions, both public and private
health care for those that don’t have COVID-19
Small businesses that run out of resources
Death rates rise from sudden recessions. Might it be more than the lives saved via general quarantine. What Sweden is doing makes more sense. Yes, their death rates are a little higher, but they didn’t close many things at all — their populace has covered up, and kept working. They integrated social distancing into their total lives, including work.
4) But, after the crisis is over, there will be some things that we realize we did not need. Will a video teleconference do as well as a trip to a remote office? How much additional productivity do we get or lose from having staff in a single location? Hay, I can cook for myself! I don’t have to go to restaurants! We don’t need low-end malls! And more… we just don’t know what all will change. That said, never underestimate the ability of Americans to forget.
5) There are charities that help some businesses finance their inventories. They are called commodity ETFs. Long ago, I wrote about the folly of buying ETFs that follow complex strategies. USO always underperformed. This past week was the worst of it.
Negative prices for oil futures are like negative interest rates. If you can safely store paper currency, you will never have a negative interest rate. If you can safely store oil, then a day will come when you can use or sell it.
6) One of my clients asked me what I thought about what the Fed is doing now. My answer is this: they aren’t doing much. The market took their bluff and ran with it. How is this?
All of the risk flows back to the US Treasury explicitly or implicitly, via loss of seigniorage.
They are mostly financing assets, not buying them.
When they are buying assets, they aren’t taking much risk, either in duration or credit.
The QE that they are doing is just a closed loop with the banks — it doesn’t get into the general economy.
The Fed makes me think of a nerdy kid who thinks he is being cool, but all the cool kids know he is a nerd. That said, in this case a good bluff can be quite effective if the cash keeps flowing.
Personally, I like the fact that the Fed is taking little risk. That’s the way a central bank should be. But that’s not the way the markets are interpreting the matter — they think the Fed will always rescue them.
7) But at least at present, I don’t think we are using MMT yet, unless you mean that the Fed buys government debt.
To me, the big question is when do foreign entities get sick of owning US Dollar claims? When do foreign governments finally say that they won’t subsidize exporters anymore, and will stop investing in US Dollar claims?
Of the major governments, the US is the “cleanest dirty shirt,” but when will the free ride of cheap capital end? Nature abhors free lunches, and this one has gone on for a long time… pity that the competition is so poor.
8 ) When will we learn that savings doesn’t inhibit growth? Stable households and businesses survive better, and ultimately spend more.
9) 60/40 stocks/bonds as an asset allocation has been maligned, but not for any good reason. Yes, high-quality interest rates are low. The real value of bonds is that they don’t fall as much as stocks. In a stock market where valuations are still high, though not relative to bond yields, stocks should play a larger role, but not so much as to eliminate the value of having assets that protect the portfolio against hard falls.
Photo Credit: Steve Rotman || As Simon and Garfunkel sang, “The words of the prophets are written on the subway walls…”
Debt-based economies are unstable. Economies with a lot of short-term debt are more unstable. The Fed is like Johnny One-Note, or Fat Freddie with a hammer. They only know one tool, and it will solve all problems.
Are there problems from too much debt? More debt will solve the problem. Shift debts from the private to the public sector. Don’t let the private market solve this on its own.
Though the bed debt is not in the same place as the last crisis, we are once again trying to play favorites through the Federal Reserve and rescue entities that took too much risk.
My view is let them fail. The whole system is not at risk, and the COVID-19 crisis will pass in two weeks. The great risk is not from the disease, but from the ham-handed response from policymakers who are short-sighted, and highly risk averse to the point of not wanting to cross the street for fear of dying.
Have we become like the Chinese, who bail out their banks and non-banks regularly? Who can’t bear to see any significant institution fail?
(Yes, I know they are getting more willing to see entities fail in China, but why are we getting less that way in the US? Let market discipline teach companies to not have so much debt.)
Here are three things to consider:
Bond ETFs Flash Warning Signs of Growing Mismatch — The Fed now think its purview extends to managing the discounts of bond ETFs? Let the system work, and let profit seeking institutions and individuals benefit from artificially high yields. Let insurance companies do what I did: purchase a cheap package of bonds in an ETF, and convert it into the constituent bonds, and sell those that you don’t want for a profit. (Losses from ETFs premiums and discounts are normal, and it is why the dollar weighted returns are lower than the time-weighted returns.)
The same applies to repo markets. As I have said before, the accounting rules need to be changed. Repo transactions should not be treated as a short-term asset, but as a long asset with a short-term liability, because that is what it is. With Residential Mortgage-Backed SecurIties in trouble, the market should be allowed to fail, to teach those who take too much risk to not do that. This failure will not cascade.
The same applies to the crony of Donald Trump — Tom Barrack. He pleads his own interest, seeking for the Fed or the Treasury to bail him out, and those who are like him. Let him fail, and those who are like him.
Market participants need to know that they are responsible for their own actions, particularly in a small and short-lived crisis as this one. COVID-19 as a systemic crisis will be gone within weeks.
My statement to all of those listening is “When will we set up a more rational system that discourages debt?” We could made dividends tax-exempt, and deny interest deductions for non-financial corporations, including financial subsidiaries of non-financial corporations. Of course we would grandfather prior obligations.
Are we going to wait for the grand crisis, where the Fed will continue to extend credit amid roaring inflation, or where extend no credit amid a tanking economy? This is what eventually faces us — there is no free lunch. The Fed can’t create prosperity via loose monetary policy, and Congress cannot create prosperity via loose fiscal policy.
The bills eventually come due. The USA might get the bill last after the failure of China, Japan, and the EU, but it will eventually get the bill.
As such, consider what you will do as governments can’t deal with the economic and political costs of financing the losses of the financial system.
Photo Credit: David Lofink || Most things in life have limits, the challenge is knowing where they are
I was at a conference a month ago, and I found myself disagreeing with a presenter who worked for a second tier ETF provider. The topic was something like “Ten trends in asset management for the next ten years.” The thought that ran through my mind was “Every existing trendy idea will continue. These ideas never run into resistance or capacity limits. If some is good, more is better. Typical linear thinking.”
Most permanent trends follow a logistic curve. Some people call it an S-curve. As a trend progresses, there are more people who see the trend, but fewer new people to hop onto the trend. It looks like exponential growth initially, but stops because as Alexander the Great said, “There are no more worlds left to conquer.”
Even then, not every trend goes as far as promoters would think, and sometimes trends reverse. Not everyone cares for a given investment idea, product or service. Some give it up after they have tried it.
These are reasons why I wrote the Problems with Constant Compound Interest series. No tree grows to the sky. Time and chance happen to all men. Thousand year floods happen every 50 years or so, and in clumps. We know a lot less than we think we do when it comes to quantitative finance. Without a doubt, the math is correct — trouble is, it applies to a world a lot more boring than this one.
I have said that the ES portion of ESG is a fad. Yet, it has seemingly been well-accepted, and has supposedly provided excess returns. Some of the historical returns may just be backtest bias. But the realized returns could stem from the voting machine aspect of the market. Those getting there first following ESG analyses pushed up prices. The weighing machine comes later, and if the cash flow yields are insufficient, the excess returns will vaporize.
In this environment, I see three very potent limits that affect the markets. The first one is negative interest rates. There is no good evidence that negative interest rates stimulate economic growth. Ask those in nations with negative interest rates how much it has helped their stock markets. Negative interest rates help the most creditworthy (who don’t borrow much), and governments (which are known for reducing the marginal productivity of capital).
It is more likely that negative rates lead people to save more because they won’t earn anything on their money — ergo, saving acts in an ancient mold — it’s just storage, as I said on my piece On Negative Interest Rates.
Negative interest rates are a good example of what happens you ignore limits — it doesn’t lead to prosperity. It inhibits capital formation.
Another limit is that stock prices have a harder time climbing as they draw closer to the boundary where they discount zero returns for the next ten years. That level for the S&P 500 is around 3840 at present. To match the all time low for future returns, that level would be 4250 at present.
Here’s another few limits to consider. We have a record amount of debt rated BBB. We also have a record amount of debt rated below BBB. Nonfinancial corporations have been the biggest borrowers as far as private entities go since the financial crisis. In 2008, nonfinancial corporations were one of the few areas of strength that the bond markets had.
One rule of thumb that bond managers use if they are unconstrained is that the area of the bond market that will have the worst returns is the one that has grown the most during the most recent bull part of the cycle. To the extent that it is possible, I think it is wise to upgrade corporate creditworthiness now… and that applies to bonds AND stocks.
Of course, the other place where the debt has grown is governments. The financial crisis led them to substitute public for private debt in an effort to stimulate their economies. The question that I wonder about, and still do not have a good answer for is what will happen in a fiat money world to overleveraged governments.
Everything depends on the policies that they pursue. Will the deflate — favoring the rich, or inflate, favoring the poor? No one knows for sure, though the odds should favor the rich over the poor. There is the unfounded bias that the Fed botched it in the Great Depression, but that is the bias of the poor versus the rich. The rich want to see the debt claims honored, and don’t care what happens to anyone else. The Fed did what the rich wanted in the Great Depression. Should you expect anything different now? I don’t.
As such, the limits of government stimulus are becoming evident. The economic recovery since the financial crisis is long and shallow. The rich benefit a lot, and wages hardly rise. Additional debt does not benefit the economy much at all. We should be skeptical of politicians who want to borrow more, which means all of them.
One of the greatest limits that exists is that of defined benefit pension plans vainly trying to outperform the rate that their risky assets are expected to earn. They are way above the level expected for the next ten years, which is less than 3%. Watch the crisis unfold over the next 15 years.
Finally, consider the continued speculation that shorts equity volatility. You would think that after the disaster that happened in 2018 that shorting volatility would have been abandoned, but no. The short volatility trade is back, bigger and badder than ever. Watch out for when it blows up.
Summary
Be ready for the market decline when it comes. It may begin with a blowout with equity volatility, but continue with a retreat from risky stocks that offer low prospective returns.
Picture Credit: David Merkel || E & S are hollow, G is solid
There are fads in investing. They eventually go away. Remember ARM funds? The Americus Trusts? (Neat idea, killed by a legal change). The nifty fifty? Hot industries that produce a lot of IPOs?
I also think cryptocurrencies are a fad, and also factor and volatility investing, at least in terms of the ETFs that are offered to retail investors.
And, I think ESG is a fad, at least in terms of the way it is being deployed today. My main point is that E (environmental) & S (social) are mostly subjective, and not related to investment returns or risk control. G (governance) is mostly objective and related to investment returns and risk control.
Now some will say “But wait, there are all these journal articles showing that ESG produces better volatility-adjusted returns.” Quantitative finance has a laundry list of problems:
We have only one world, one history, one data set. We’ve gone over the data set numerous times, knowing its proclivities. It’s not hard to tease “alpha” out in a study, but it is difficult to realize alpha in real life.
Researchers often take multiple passes over the data set as they do their analyses. Only the ones with results supporting the expected conclusions get a paper published.
Neutral observers don’t exist — their pay and social standing get determined by producing a series of statistically significant results, regardless of whether they tortured the data to get there or not. (Aside: when I read some of the macroeconomic crud out of the Federal Reserve, and I see the abstruse technique employed to get a result, I know the data has been tortured, and of course the model does not predict well.)
As such, I don’t trust the research on ESG. The limited history that we have for general inquiries is even shorter for ESG analyses. The likelihood of picking up spurious correlation is high. As such, unless I have a good mental model for how environmental or social issues affect long-term growth in value, I can’t use them as a fiduciary. I have those mental models for governance, so I use them — just not the same way as some of the quantitative governance models do.
Governance issues are perennial; they are not a fad. The agency problem, where corporate managements pursue goals that are in their interests, but not in the interests of shareholders never goes away. It can be reduced by a variety of measures, like splitting the CEO and Chairman positions. removing management influence over the audit and compensation committees, end things like that.
That said, there are exceptions to the rules, and certain strong managers running companies with highly focused and ethical cultures might be allowed more running room. Berkshire Hathaway doesn’t fit most of the rules, and in general it has done well. One size fits most, but not all.
It’s similar to the way I view management use of free cash flow. With a talented and honest management team, I want the management to have the freedom to retain all of the cash flow for growth if they see the opportunities. But most managements aren’t that good, and they should pay a dividend. Buybacks should only be done when the stock is notably cheap compared to the private market value of the firm, and the balance sheet remains solid.
That’s why I think many simple governance scores are mistaken. You have to take a look at the management team and culture in order to do a broader evaluation of the governance. I for one a comfortable buying stakes in a company where there is a control investor if the control investor is known for treating the outside passive minority investors fairly, and does not scrape too much off the top.
I expect companies that I own to follow the laws of the countries that they work in, and engage in ethical behavior. My rule is simple: if a company tries to cheat one set of stakeholders, the odds are higher that they will cheat shareholders at some point. Most of my significant losses have stemmed from some sort of fraud issue… this is etched in my mind.
But many of the details of environmental and social factors seem utterly tangential to me — I don’t see how they drive value. Let the government press its claims on corporations to avoid discrimination and limit pollution. That is the proper locus for these issues, particularly if you are a fiduciary. What is in the best financial interests of your clients should be your guiding principle.
Note as well that the implementation of E, S, and G are nowhere near standardized. G is probably the closest. (This also applies to factor investing as well, which is constantly engaging in new specification searches sharpening their statistical analyses.) Even if I wanted to do E & S, how would I know that I have the right figures? How would I know that they weren’t a product of backtest biases?
Also, as Matt Levine points out, many applications of ESG don’t make a lot of sense, even if these were desirable goals. As such, I look at many of the ESG products being put out there are marketing fads to take the attention of retail away from earning returns… after all, it is tough to beat the market, and ESG will give you many ways to have have a built-in excuse.
Do I know that I am in a minority for my views here? Yes. But I am often in a minority, and I would argue that the degree of agreement with ESG is paper-thin. It’s good while it brings in assets to manage, but the moment it doesn’t bring home the bacon, it will be jettisoned.
I’m in the minority for now. I expect the majority to come my way, not vice-versa. No illusions — it will take time for that to happen.
Photo Credit: Sitoo || No, you can’t eat money. But without money farmers would have a hard time buying what they need to grow crops, and we would have a hard time bartering to buy the crops
Data obtained from filings at SEC EDGAR
Tonight I am going to talk about one of the most underrated concepts in finance — the difference between dollar-weighted and time-weighted returns, and why it matters.
So far on this topic, I have done at least seven articles in this series, and you can find them here. The particular article that I am updating is number 3, which deals with the granddaddy of all ETFs, the SPDR S&P 500 ETF (SPY), which has been around now for almost 27 years. It is the largest ETF in the world, as far as I know.
From the end of January 1993 to the end of March 2019, SPY returned 9.42%/year on a time-weighted or total return basis. What that means is that if you had bought at the beginning and held until the end, you would have received an annualized return of 9.42%. Pretty good I say, and that is an advertisement for buy and hold investing. It is usually one of the top investing strategies, and anyone can do it if they can control their emotions.
Over the same period, SPY returned 7.29%/year on a dollar-weighted basis. What this means is if you took every dollar invested in the fund and calculated what it earned over the timespan being analyzed, they would have received an annualized return of 7.29%.
That’s an annualized difference of 2.13%/year over a 26+ year period. That is a serious difference. Why? Where does the difference come from? It comes partially from greed, but mostly from panic. More shares of SPY get created near market peaks when everyone is bullish, and fewer get created, or more get liquidated near market bottoms. Many investors buy high and sell low — that is where the difference comes from. This also is an advertisement for buy and hold investing, albeit a negative one — “Don’t Let This Happen To You.”
Comparison with the 2012 Article
Now, I know few people actually look at the old articles when I link to them. But for the sharp readers who do, they might ask, “Hey, wait a minute. In the old article, the difference was much larger. Time-weighted was 7.09%/year and dollar-weighted was 0.01%/year. Why did the difference shrink?” Good question.
The differences between time- and dollar-weighted returns stems mostly from behavior at turning points. As I have pointed out in prior articles, typically the size of the difference varies with the overall volatility of the fund. People get greedy and panic more with high-volatility investments, and not with low-volatility investments.
That said, most of the effects of the difference are created at the turning points. During the midst of a big move up or down, the amount of difference between dollar- and time-weight returns is relatively small. The big differences get created near the top (buying) and the bottom (selling).
So, since the article in 2012, the fund has grown from $80 billion to over $260 billion at the end of March 2019. There have been no major pullbacks in that time — it has been a continuous bull market. We will get to see greater divergence after the next bear market starts.
Be Careful what you Read about Dollar-Weighted Returns
I’m not naming names, but there are many out there, even among academics that are doing dollar-weighted returns wrong. They think that differences as cited in my articles are too large and wrong.
The idea behind dollar-weighted return is to run an Internal Rate of Return calculation. To do that you have to have a list of the inflows and outflows by date, together with the market value of the fund at the end as an outflow, and calculate the single rate that discounts the net present value of all the flows to zero. That rate is the dollar-weighted return, and you can use the XIRR function is Excel to help you calculate it. (Note that my calculations use a mid-period assumption for when the cash flows.)
The error I have seen is that they try to make the dollar-weighted calculation like that of the time-weighted, creating period by period values. Now, there is a way to do that, and you can see that in the appendix below. As far as I can tell, they are not doing what I will write in the Appendix. Instead, they treat each year like its own separate investing period and calculate the IRR of that year only, and then daisy-chain them like annual returns for a time-weighted calculation.
Now, the time-weighted calculation does not care at all about investor-driven cash flows, like purchases and sales of fund shares, aside from dividend payments and things like that. It does not care about the size of the fund. It just wants to calculate what return a buy and hold investor gets. [Just remember the rule that an NAV must be calculated any time there is a cash flow of any sort, otherwise some inequity takes place.]
The dollar-weighted calculation cares about all investor cash flows, and ultimately about the size of the fund at the end of the calculation. It doesn’t care about when the returns are earned, but only when the cash flows in and out of the investment.
The odd hybrid method is neither fish nor fowl. Time-weighted corresponds to buy and hold, and dollar-weighted to the returns generated by each dollar in the fund. The hybrid says something like this: “We will calculate the IRR each year, but then normalize the fund size each year to the same starting level so that the fund flows at tops and bottoms do not compound. Then we show them year-by-year so that the returns are comparable to the total returns for each year.
As H. L. Mencken said:
Explanations exist; they have existed for all time;?there is always a well-known solution to every human problem?neat, plausible, and wrong.
Source: Quote Investigator citing Mencken’s book “Prejudices: Second Series”
In an effort to make a simple annual comparison between the two, they eradicate most of the effects of selling low and buying high. More in the Appendix.
Summary
Be aware of the difference between dollar-weighted and time-weighted returns. If you have a strong control on your emotions, this is not as important. If you tend to panic, this is very important. It is more important if you buy highly volatile investments, and less so if you size your volatility to your ability to bear it.
To fund managers I would say this: if you are tired of all of the inflows and outflows, and are tired of getting whipsawed by your clients, maybe you should take a step back and lower the overall risks you are taking. This will benefit both you and your clients.
Appendix
Here’s how to run an annual calculation of dollar weighted returns that be correct. For purposes of simplicity, I will assume a simple annual calculation that has multiple cash flows inside it. (If we are working with a US-based mutual fund, there would be reporting of change in net assets every six months.)
Calculate the first year (dw1) the way the hybrid method does. No difference yet. Then for the second year, run the IRR calculation for the full two-year period (IRR2). Then the second year only dollar-weighted return (dw2) would be:
((1+ IRR2) ^2) / (1+dw1) -1 = dw2
and for each successive period it would be:
(1+IRR[n])^n(1+IRR[n-1])^(n-1) – 1 = dw[n]
That is more complex than what they do, but it would preserve the truths that each entail. It would make the values for the yearly dollar-weighted returns look odd, but hey, you can’t have everything, and the truth sometimes hurts.
Full disclosure: a few of my clients are short SPY as part of a hedged strategy.
Picture Credit: Olivier ROUX || Simplicity almost always beats complexity.
I’m not a fan of EIAs. I’m not a fan of variable annuities, unless they’re really simple with rock-bottom expenses and no surrender charges. I’m not a fan of ETNs. I hate structured notes. I’m also not a fan of ETFs that are filled with derivatives.
* Small compared to the pool that they fish in * Follow broad themes * Do not rely on irreplicable assets * Storable, they do not require a ?roll? or some replication strategy. * not affected by unexpected credit events. * Liquid in terms of what they represent, and liquid it what they hold.
The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.
But tonight I have another complex investment to avoid, and a simple one to embrace. First the avoid…
There was a piece at Bloomberg Businessweek called ETFs With Downside Protection? It?s Complicated. These are called defined outcome ETFs. Basically they are a bundle of equity options that cut your losses, while limiting your gains on a given equity index. (Also, you don’t get dividend income, and have to pay manager fees.) In-between the cap on gains, and where losses kick in, your returns should move 1:1 with the index. The same will be true with losses after the first N% get eaten — below N% losses, you begin taking losses.
Illustration of Defined Outcome ETF returns as compared to an index fund using the same index as the Defined Outcome ETF
I wanted to keep the illustration simple. This hypothetical defined outcome ETF caps gains at 10%, and absorbs the first 15% of losses. This example assumes no fees, which would likely be lower on the index fund. This example assumes no dividends, which would get paid to you in the index fund, but not on the defined outcome ETF.
Defined outcome ETFs purchase and sell tailored options that are backed by the central counterparty the Options Clearing Corporation — a very strong, stable institution. Credit risk still exists, but if the OCC goes down, many things will be in trouble. The options exist for one year, after which gains are paid to and losses absorbed by ETF shareholders. The ETF then resets to start another year following the same strategy with slightly different levels because the relative amounts of the cap and the loss buffering rely on where equity volatility is for a given index at the start of the year.
Unlike an index fund, your gains cannot grow tax-deferred, though if you have gains, you can roll them over into the next year.
I’ve read the offering documents, including the sections on risk. My main argument with the product is that you give up too much upside for the downside protection. The really big up years are the places where you make your money. There aren’t so many “average” years. The protection on the downside is something, but in big down years it could be cold comfort.
The second part is the loss of dividends and paying higher fees. Using the S&P 500 as a proxy, a 2% dividend lost and a 0.5% added fee adds up to quite a cost.
There are implementation risks and credit risks but these risks are small. I ran a medium-sized EIA options book for a little more than a year. This is not rocket science. The investor who is comfortable with options could create this on his own. They list more risks in the offering documents, but they are small as well. What gets me are the costs, and the upside/downside tradeoff.
Yes, interest rates are low. Yields on some stocks are higher than the yields on the Barclays’ Aggregate [bond] Index. But if you only bought those bonds, you would have a rather unbalanced portfolio from a sector standpoint — heavy on utilities and financials. The Barclays’ Aggregate still outyields the S&P 500, if not by much, like 0.8%/yr.
The real reason that you hold bonds and cash equivalents is not the income; it is risk reduction. I’m assuming no one is thinking of buying the TLT ( 20+ Year Treas Bond Ishares ETF), which is more of a speculator’s vehicle, but something more like AGG ( US Aggregate Bond Ishares Core ETF), which yields 0.3% more, but the overall volatility is a lot less.
With AGG, fixed income claims of high investment grade entities will make it through a deflationary crisis. In an inflationary situation like the 70s, the bonds are short enough that over a five year period, you should make money, just not in real terms.
It’s good to think long term, and have a mix of fixed and variable claims. The bonds (fixed claims) lower your volatility so that you don’t get scared out of your stocks (variable claims) in a serious downdraft.
The models I have run have returns max out in an 80/20 balanced fund, and the trade-off of risk for return is pretty good down to a 60/40 balanced fund. In my personal investing, I have always been between 80/20 and 60/40.
Thus the need for bonds. In a bad scenario, stocks will fall more than bonds, and the balanced fund will buy stocks using proceeds of the bonds that have fallen less to buy stocks more cheaply. And if the stock market rises further, the balanced fund will sell stocks and use the proceeds to bank the gains by buying bonds that will offer future risk reduction, and some income.
As such, consider the humble balanced fund as a long-term investment vehicle that is simple and enduring, even when rates are low. And avoid complexity in your investment dealings. It is almost never rewarded.
It is very difficult to get a high real rate of return over a long time.? This article peels apart the math, and brings out the quantitative factors that play a role in the analysis.
Clarifying the return series that I use for my forecasts of future stock market returns, and is it likely for an investor to earn a 3% real return over a long horizon?
Because of underfunding, there will be more cuts. ?Depend on that happening for the worst funds, and at least run through the risk analysis of what you would do if your pension benefit were cut by 20% for a municipal plan, or to the PBGC limit for a corporate plan. ?Why? ?Because it could happen.
This is an underrated report from the US Government, but even it is forced to downplay how the situation is for Social Security and Medicare.? Things aren’t getting better, and time is running short.? The next time I write about this is when the 2018 report comes out.? Until then remember my more recent piece?Notes from an Unwelcome Future, Part 1.
It is possible to over-save, and underspend.? You should leave some inheritance for your heirs, but don’t deprive yourself of the benefits that having some assets provides.
In general it is better to take payments over time than to receive it as a lump sum.? If you do have a lump sum that comes to you, take care not to spend it too rapidly.
How would you live if you were trapped in Venezuela, Turkey, Zimbabwe, or some other badly run country with high inflation.? Here are a few bits of advice.
Truly gruesome.? What’s the difference between what a buy-and-hold investor earned on Ken Heebner’s main fund versus what the average investor earned on the fund?? Really, it’s astounding.
Over time, all classes of risky assets tend to become correlated with each other.? This is because investors naively diversify their risky assets across these classes, and then engage in panic selling behavior with all of these classes as a group.
As the yield curve steepens, more investment opportunities become uneconomic.? Don’t say that monetary policy is accommodative when you are tightening.
At Christmas, the Wall Street Journal republishes a vacuous opinion piece by Vermont Royster that is little better than liberation theology for conservatives.? He twists Scripture out its contexts to make it mean what is never meant.? Bogus beyond measure.
