ETF Prime Archive

Beyond Steak and Potatoes (Stocks & Bonds)

Some things really do “never” change.  Take, for example, the drumbeat we hear, every time there’s a meaningful downturn in equity markets, of those good ol’, familiar, “tried and true”, “Stocks & Bonds Allocation ABCs” vibes from a seemingly endless parade of would-be allocation medics.

But what have we learned over the last forty years about asset allocation and how have conditions and secular trends of the past 20 years impacted and shaped the asset allocation mind sets and perceptions of risk which investors have carried into the most recent downturn? 

Harry Markowitz’ work on Modern Portfolio Theory (MPT) long ago got nearly everyone in the investment room to at least acknowledge the importance of diversification across and within asset classes.  But, in practice, certain lessons remain to be learned.  1) While diversification is achieved by combining uncorrelated assets into a portfolio, nowhere did Markowitz’ work suggest an investment universe limited to stocks and bonds alone or to the exclusion of any particular asset class (e.g. commodities, currencies, REITs).  2) Correlations are dynamic … witness the capital flight from nearly all non-treasury assets to the safety of treasuries during the most recent downturn. 3) Discipline – dare I say it?  It’s one thing to have a strategy that, by virtue of its design, warrants sticking to through thick and thin (and many are not so-designed).  It’s quite another to have the conviction to actually stick to it.

My hunch is that in 2015 or 2020, historical economic chart visuals and timeline displays will likely block off nearly two-decades stretching from the late 1980s through the late 2000s as a period during which a fairly stable mix of equities and bond-friendly conditions and trends predominated.  Highlighted will be secular declines in interest and inflation rates, punctuated by brief “corrections” where diversification across equity and bond assets alone got the job done reasonably well.  These are what we’ll regard as the key tectonic features and shapers of both investment thinking and investment activity. The relatively narrow equities / bonds view of what constitutes the relevant and necessary asset universe, of course, “works” reasonably well in that sort of environment.  

Equities and bonds are, of course, primary, critical and core allocation components.  But if we are, in fact, wading into an extended period of weak growth that may, ultimately, be combined with the bite of inflationary pressures, the two asset allocation wheels (stocks and bonds) alone may make for a very, very long and far less than pleasant ride.

Strategic thinking, consistently reinforced over the last twenty years, I’m afraid, has got us into a sort of Pavlovian allocation funk – Ring the volatility bell, move once again (in crisis mode) to review, evaluate and beat to death the equities / bonds allocation strategic mix.  And, when it gets difficult to breathe and it “feels” refreshingly right, let’s resort to crowning “cash” (a.k.a. very short-term fixed income) as “king” and an asset class in its own right, serving as the life-saving third wheel.

I believe that by 2015 or 2020, the investing world might rather fully regard what we currently loosely term “alternative” investments as a full-fledged, well-defined asset class encompassing commodities, real estate, currencies and a relatively narrow, related subset of “demographically-advantaged” equities.

Few of today’s investment managers have professional experience stretching deeply into the 70s — a time when all but the largest of institutional investors lacked access and/or expertise to manage exposure in “alternative” asset areas.  It is interesting, and timely, that during the last two or three years we’ve managed to arrive at a far better-stocked tool box.  And, yet, most investors and advisors still see the investment space only in terms of the hammer (equities) and screwdriver (bonds).  Oh, what many a 70s/80s manager would have given to have the breadth and purity of access to assets on a par with today’s retail investor (at least in hindsight, right?)!  But, of course, visual acuity and skill beyond these two dimensions haven’t really “mattered” so significantly since those difficult times that ultimately drove many to don leisure suits and resort to listening to the Bee Gees et al.

But that’s not to suggest that the world is all that complicated either.  The name of the game, quite simply, is quality return potentials combined with true diversification into less than perfectly correlated assets – always has been, always will be.  And I think that this might be close as we’ll ever get to a universal truth in the investment management business.

Unfortunately, most investors and advisors are entirely in left field – or, rather, miles beyond the left field fence – when it comes to recognizing sources of concentration risk which they hold while, concurrently, carrying pockets of severe under-exposure.  Take a look under the hood, for Pete’s sake!  What is the composition of your aggregate equity portfolio holdings in terms of market capitalization and growth/value and sector composition and dispersion?  Over time, how variable are these concentration characteristics?  What are the quality-composition and distribution and issuer concentration profiles within the body of fixed income holdings?  What about duration and currency distributions of those fixed income holdings?  What is the nature and size of exposures to commodities, currencies (through equities, fixed income and currency instruments), real estate, emerging industries in the US and globally?  If “diversification” is part of your risk management m.o., which attributes do you set out to monitor, manage and contain, which do you allow to float and how do you track the package? 

The real starting point for all of us is to know what you currently hold – areas of concentration risk and pockets of under-exposure and, then, systematically moving to contain and allocate according to what actually limits concentration and under-exposure – beyond what any stocks/bonds “only and forever” allocator “purist” would have you do.  And beware of “… it’s worked for the last 20 years …” feel-good validation techniques.  True containment of concentration risk and true diversification into meaningful areas of under-exposure are what was needed in the 70s and 80s – but such capabilities weren’t accessible to the masses.  Generically speaking – investors of the 70s and 80s, whether so inclined or not, couldn’t invest in “alternative” assets and, consequently, were stuck with choices that were doomed to messy and highly correlated fates in the stagflationary environment of the time.

While we’ve got a far from perfect menu, we have the basic tools to get the job done better, perhaps, than even the best-equipped institutional players of the 70s – without aiming to “time” the vagaries of the business cycle.  And that means more than just dining on steak and potatoes.

Spiders and Diamonds and Qubes, Oh My…

Come on, admit it. We’ve all opened a quarterly financial report sometime in our investment lives, winced at the numbers, and asked one simple, elegant question -why can’t I just put my money into something that will match the market?

Exchange traded funds, or ETFs in market shorthand, are a relatively new group of financial instruments created to answer that question. 

The concept is simple. Buy a bunch of stocks that match the ones in the Dow Jones 30 Industrials, Standard & Poor’s 500 or whichever market index you want to match, then let the money ride until you want to cash out. The same idea works for bonds, commodities and presumably just about anything else bought and sold in a formally organized public marketplace.

Many ETFS have colorful names, often based on pun on the fund’s name or trading symbol. SPDRS, the Standard & Poor’s Depository Receipts fund tracking the S&P 500 and the first ETF traded in the U.S., are known as Spiders. The Diamond, listed on the ticker as DIA track the Dow Jones Industrial Averages. Qubes, named for its symbol QQQQ tracks the Nasdaq 100 index. And the list goes on.

Industry watchers at the Investment Company Institute  and Morningstar Research count more than 840 different funds traded on U.S. securities and commodities exchanges, with combined assets of more than $608 billion. Trading volume climbed from a dead start zero before U.S. trading began in 1993 to more than 1 billion shares a day in 2006, according to market mavens at Northern Trust.

So, how do they work?

As with mutual funds, ETFs are built around diversified baskets of securities, which for most funds are chosen to duplicate a market index you want to track. But where mutual fund builders ask for cash when they begin building those baskets, ETF sponsors ask their institutional investors to deposit the actual securities in the fund. In return, the sponsor refashions this megamillion collection of securities into so-called creation units that securities firms can divide into more manageable chunks for retail investors to buy.

What the retail investors get is an ETF that looks like a mutual fund but acts very differently. To over simplify, mutual funds buy and sell securities to hit their chosen performance targets while ETFs stick with the securities they start with and see where the targets take them.

This creates many practical differences for retail investors too. Investors can trade ETFs throughout the day like stocks and, if they choose, buy on margin or sell short. Mutual funds trade once a day, based on closing market prices.

Smart Money?

SmartMoney magazine recently released its list of the 100 “best time-tested” mutual funds.  But as an article from the Motley Fool illustrates, this list looks anything but smart and could cost you money.  43% of the mutual funds recommended on this list have front-end sales loads averaging a lofty 5.4% of assets.  In other words, for nearly 1 out of every 2 mutual funds you might select off this list, you would need the fund to increase in value by 5.7% just to get to breakeven. 

This doesn’t sound like a smart investment strategy in any environment and seems particularly shaky in light of the average domestic equity fund losing 37.6% in 2008. 

But wait, there’s more.  Although, mutual funds love to boast about their past performance records and SmartMoney’s list claims to represent the funds with the highest total returns since 1987, the Motley Fool points out that the average management tenure for this list of funds is only 12.5 years and thus, “this means that the vast majority (85%) of the uber-impressive track records the funds on the list boast are in no way attributable to the current manager”.  Put another way, assuming you actually think a fund manager can outperform the market (which is a topic for another day considering that ishares found 75% of active fund managers underperform on an annual basis), 85% of the current managers of the funds on this list didn’t have anything to do with the returns provided on the list. 

Smart money to me is an investment vehicle that doesn’t have front-end loads and where returns aren’t tied to transient fund managers trying to outperform the market.  ETFs anyone?

Wall Street Journal: Use of Bond ETFs Growing

Most people who are familiar with ETFs see them as a better way to create well diversified equity portfolios and give them access to alternative assets like commodities or real estate.  They typically don’t consider fixed income ETFs as essential building blocks of a portfolio.  That perception is changing, though.  As the Wall Street Journal reports, investors are increasingly using ETFs to replace existing holdings in their bond portfolios.

Fixed income ETFs have all the same benefits as equity ETFs – transparency to exactly what you hold, low costs, and tax efficiency.  Being able to know what types of bonds you hold each day is especially important right now due to the volatile environment we’re in, and the unusual spreads and pricing relationships we have in some sectors of the fixed income world(municipals yielding more than government bonds!).

The number of fixed income ETFs right now can’t match the sheet number (and redundancies) of bond mutual funds.  That’s actually a good thing – – it’s easy to find the ETF that can target the section of the bond market you or your financial advisor are interested in.

Why Mutual Fund Companies are Stuck

The whole of the mutual fund distribution space is “stuck,”  if for no other reason than none of its primary practitioners can bring themselves to categorically call a spade a spade.

What and where’s the spade?

Actively managed mutual funds are the spade.

The mutual fund food chain- from fund sponsors to wire house brokerages to discount brokerages and to insurance and annuity companies – has far too many current and historical earnings and cash flows tied to actively managed mutual funds to be out on the streets hammering away with some plain and simple truths on matters that divide the exchange-traded fund (ETF) and actively managed mutual funds –  transparency of holdings, breadth of coverage, consistency of coverage, cost, tax advantages, trading flexibility for managing risk,  and the persistent failure of active managers to beat generic passive index benchmarks.

For those businesses with a significant portion of their earnings and cash flow streams tied to actively managed mutual funds, the truth hurts. Facing, acknowledging and communicating the truth comes with risk of alienating clients and advisors who have been trained or conditioned over the past twenty years to believe the hollow, active mutual fund manager storyline of  chest-beating and hard-selling, of  managers who’ve realized a two or three year streak against their peers or an index, and their misplaced confidence and hints that more of the same certainly must follow despite requisite disclaimers and the sheer weight of historical evidence to the contrary.

Given the above realities, ETFs represent superior alternatives in nearly every corner of the investment universe.  Conflicted, inconsistent and flawed advice has come to typify active mutual fund manager-based so-called solutions and emerged against both a backdrop of reinforcing secular trends (interest rates, inflation, dollar softening) and a series of benign and thus  psychologically reinforcing,  economic shocks over the past twenty years.  Both the mutual fund message and its messengers now clearly represent second class solutions for managing risk and returns.  And that’s why mutual fund companies are stuck.