Friday, March 27, 2015

Your Bond Allocation Doesn't Matter as Much as You Think

Quick... which of the three allocations A, B, or C is 60% S&P 500 Index / 40% Barclays U.S. Aggregate Bond Index,  55% S&P 500 Index / 45% Barclays U.S. Corporate Bond Index, or 62% S&P 500 Index / 38% Barclays Treasury Bond Index going back all the way to the inception of the Barclays U.S. Aggregate Bond Index in 1976?

Tough right? How about a chart of a growth in $1 invested in each of the allocations

Still nothing? That's because you can access credit risk two main ways... through stocks or through spread, while rate exposure at the end of the day all comes back to rates on Treasury bonds. An allocation with a higher equity tilt, balanced with bonds with no credit risk (i.e. a pure Treasury allocation) provides the same exposure (and returns) over time as one with a lower tilt towards stocks with additional credit coming from spread.

So what?

While I do think there are times when there are more attractive means of gaining credit exposure through stocks, investment grade bonds, high yield bonds (a simple model I presented back in 2010 highlights how this might add value), you need to make a material reallocation to move the needle. On the other hand, a buy and hold investor can and should allocate to credit and rates in what is the most: (1) structurally efficient (i.e. minimal transaction costs), (2) cost effective (i.e. cheapest), (3) tax-efficient. 
  1. Structurally efficient: stocks and treasury bonds both trade at much tighter bid/ask spreads than corporate bonds. More important, during periods of stress, treasuries are MUCH more liquid - winner: stocks and treasuries
  2. Cost effective: interestingly enough, the cheapest treasury bonds ETFs are slightly higher in cost than the cheapest Aggregate Bond ETFs, but both are slightly higher than ETFs for the S&P 500; either way, we're talking bps here - a wash
  3. Tax-Efficient: the more you are allocated to stocks, the more tax efficient you become as capital gains are taxed at a much lower rate than bond coupons - winner: stocks and treasuries
Takeaway... while stocks balanced with treasuries may have a slight edge in terms of implementation, at the end of the day, it really doesn't matter. If you are spending too much of your investment time trying to decide whether to slightly change your bond allocation away from treasuries to another duration sensitive area of the bond market given fears of a rate hike, please spend your time elsewhere.

Footnote: I initially listed what allocations A, B, and C were... then I remembered it doesn't matter.

Wednesday, March 25, 2015

Fearful of Rising Rates? Stocks Have You Covered

Josh Brown (i.e. The Reformed Broker) has a nice piece questioning the merit of unconstrained bond funds. Embedded within that article was this gem:

In fact, since 1976, U.S. stocks and bonds have not declined at the same time for more than two consecutive months. Over the last 60 years, there’s only been one year in which both stocks and bonds posted an annual decline (1969).
You can actually make a bolder statement than that given that the Barclays US Aggregate Index' inception wasn't until 1976. The S&P 500 and "Agg" have never declined at the same time for more than two consecutive months. As surprising to me was that stocks and bonds on a stand-alone basis have only declined more than two straights months about 5% of the time (i.e. once every year and eights months).

So if rates rise from here (negatively impacting bonds), how will stocks perform? I'm glad you asked.

Jeremy Schwartz (@JeremyDSchwartz) outlined a few months back during a back and forth that stocks (especially small cap stocks) have historically performed very well during periods of rising rates... going back all the way to the 1950's.

Taking that one step further, the below breaks out performance by small, mid, large across value and growth during periods of rising rates since 1994 (I can only get daily Russell data going back 20 years). In this case, rising rates is defined as periods where the 10 year Treasury rose more than 100 bps without a 50 bp decline (there have been 9 such periods since 1994). Not only have stocks broadly performed exceptionally well in these periods (with small caps outperforming), growth stocks have performed even better (the less "bond-like" the stocks, the better the performance in rising rate environments).

For those fearful of a sell-off in rates... what to do? Well, if history holds, simply hold a balanced portfolio consisting of stocks and bonds. Want to be bolder? Tilt slightly towards small and/or growth. As for unconstrained bonds... let investment managers fleece you somewhere else.

Source: Russell, S&P, Barclays

Monday, March 23, 2015

The Benefit of Slowing Down the Rebalancing Process

One of the top Google “rebalance free lunch” results is an article quoting one of the brightest minds in finance, Clifford Asness, that I think most investors would agree with:

"Rebalancing is one of the few free lunches out there," said Clifford Asness, managing principal of New York hedge fund AQR Capital, in a recent interview with the Online Journal. "You're generally selling things that have gone up the most and buying things that have gone down the most."

While the article is from 2004 (and he may have changed his tune), I like that he felt rebalancing was a free lunch despite the strong research he has done over the years specific to momentum, something he acknowledges the rebalancing process eliminates in the same article:
 "Someone who doesn't rebalance is a tacit momentum investor." 

The key points in my mind as to why rebalancing may not be a free lunch:
  1. Momentum works: much research exists outlining that momentum can improve risk-adjusted performance (here is a great white paper by Cliff Asness himself)
  2. Relative outperformance doesn’t equal a relatively more expensive asset: quite simply, stocks SHOULD outperform over time as they can grow their earnings, while bonds pay a static coupon. So rebalancing doesn't always mean selling high and buying low.

It would be good enough if slowing down the rebalancing process did not materially hurt performance, as there are significant benefits associated with slowing down (lower transaction costs, tax benefits through delayed capital gains, and any behavioral benefit of looking at your account less often), but rebalancing less has actually improved average results specific to a 60% S&P 500 / 40% Barclays Aggregate Bond index since the latter’s 1976 inception with seemingly more potential outperformance than underperformance over any 36-month iteration.

Source: S&P, Barclays

Friday, August 3, 2012

Employment Survey's Diverge

The Washington Post details:

One is called the payroll survey. It asks mostly large companies and government agencies how many people they employed during the month. This survey produces the number of jobs gained or lost. In July, the payroll survey showed that companies added 172,000 jobs, and federal, state and local governments cut 9,000.
The other is the household survey. Government workers ask whether the adults in a household have a job. Those who don’t are asked whether they’re looking for one. If they are, they’re considered unemployed. If they aren’t, they’re not considered part of the work force and aren’t counted as unemployed. The household survey produces each month’s unemployment rate.

In July, the household survey showed that the number of people who said they are unemployed rose by 45,000. In a work force of155 million, that doesn’t make a big statistical difference. But it was enough to raise the unemployment rate to 8.3 percent from 8.2 percent in June.

Unlike the payroll survey, the household survey captures farm workers, the self-employed and people who work for new companies. It also does a better job of capturing hiring by small businesses.
But the household survey is more volatile from month to month. The Labor Department surveys just 60,000 households, a small fraction of the more than 100 million U.S. households.
Looking at the data, the household survey was even worse than that. Not only did the number of unemployed rise by 45,000, the number leaving the workforce spiked (resulting in the number employed dropping significantly), resulting in the unemployment rate rising despite the better headline number.

Source: BLS

Friday, July 27, 2012

GDP Expands 1.5% in Q2

Bloomberg details:

The U.S. economy expanded at a slower pace in the second quarter as a softening job market prompted Americans to curb spending.

Gross domestic product, the value of all goods and services produced, rose at a 1.5 percent annual rate after a revised 2 percent gain in the prior quarter, Commerce Department figures showed today in Washington. The median forecast of economists surveyed by Bloomberg News called for a 1.4 percent increase. Household purchases, which account for about 70 percent of the world’s largest economy, grew at the slowest pace in a year.

Consumers are cutting back just as Europe’s debt crisis and looming U.S. tax-policy changes dent confidence, hurting sales at companies from United Parcel Service Inc. (UPS) to Procter & Gamble Co. (PG) Cooling growth makes it harder to reduce unemployment, helping explain why Federal Reserve Chairman Ben S. Bernanke has said policy makers stand ready with more stimulus if needed.
Looking at the data, we see the declining contribution by consumption, offset in part by a quarter over quarter (small) rise in investment and a less negative impact from government cuts (i.e. addition by the elimination of subtraction). Overall, considering what was going on during Q2 this report isn't awful, but certainly isn't encouraging considering we are now three years out of the recession.

Source: BEA

Thursday, July 19, 2012

Leading Economic Indicators Decline by Most Since Last September

Bloomberg details:

The index of U.S. leading economic indicators fell more than forecast in June, a sign the U.S. economic expansion is slowing.
The Conferences Board’s gauge of the outlook for the next three to six months decreased 0.3 percent after a revised 0.4 percent increase in May, the New York-based group said today. Economists projected the gauge would drop by 0.1 percent, according to the median estimate in a Bloomberg News survey.

Source: Conference Board

Monday, July 9, 2012

Consumer Credit Jumps... a Good Thing?

Bloomberg details:

Consumer credit climbed more than forecast in May, led by the biggest jump in credit-card debt in almost five years that may signal Americans are struggling to make ends meet.

The $17.1 billion increase, exceeding the highest estimate of economists surveyed by Bloomberg News and the largest this year, followed a $9.95 billion gain the previous month that was more than previously estimated, the Federal Reserve said today in Washington. Revolving credit, which includes credit card spending, rose by $8 billion, the most since November 2007.
In a "normal" mean-reverting downturn, an increase in consumer borrowing is a good sign as it allows a consumer to maintain their purchase level (even without the current income to pay for it), with the expectation that they can cover their borrowing when their wages "revert" higher in the future.

A quote from someone who believes we are still living in the old world (we may be, I'm just not so certain):
“When the economy’s not doing well, that’s when you want the consumer to spend, and if it means borrowing to do that, then that certainly would be encouraged,” said Millan Mulraine, a senior U.S. strategist at TD Securities in New York, who projected credit would rise by $15 billion.
The concern is that we are now in year 4 year of the muddle through recovery, thus some concern that people are spending money on goods via debt that they may have trouble repaying. Back to Bloomberg:
A pickup in borrowing coincides with a slowdown in hiring and declines in consumer confidence that indicate the job market is failing to spur enough gains in wages to cover expenses. Employers added fewer workers to payrolls than forecast in June while the jobless rate stayed at 8.2 percent.
Regardless, overall nominal debt (even excluding student loans) is once again rising. A bullish sign for the short run. Mixed (in my opinion) for the longer run.

Friday, July 6, 2012

Gaming the System... Disability Edition

In my post outlining the decline in employment (excluding teens), reader Mike pointed out another interesting phenomenon:
One of the stories I read about this month's BLS report dealt with the rise in people on disability. I thought charting this over a few dozen years and several recessions might tell an interesting story.
Unfortunately, the BLS only reports this data going back to 2008, but the most recent data shows an interesting trend. From the looks of it, we have what appears to be a not-so-coincidental mirror image between the decline in those unemployed with the rise in the number of people not working via claims of disability. I know next to nothing about disability, but my guess is individuals whose employment benefits have run out, have been increasingly taken advantage of disability (or tried to) as a replacement.

Source: BLS

Employment (Excluding Teen Hires) Turns Negative

Peter Boockvar provides details of the ugly job report:

June Payrolls totaled 80,000, 20,000 less than expected and well below the ADP whisper. The two prior months were revised down by a net 1000. The private sector added 84,000 jobs (13,000 from goods producing, 71,000 from services) vs expectations of a gain of 106,000. The unemployment rate held steady at 8.2% as the 128,000 increase in the household survey was basically offset by the 156,000 increase in the size of the labor force.
Below is an updated chart of the stagnant unemployment rate and slightly up ticking broader unemployment measure.

Unfortunately, things were even worse than that. When looking at the household survey, we see that the headline measure of unemployment doesn't account for the fact that teen employment (likely low pay part-time workers on summer break) accounted for more than 100% of all new jobs. Excluding teens (the second bracket from the left in the chart below), we can see that negative employment number. In addition, individuals over 20 continue to flee the workforce (more than 150,000 more 20+ year olds were classified as "not in the labor force").

A truly ugly report on first glance.

Source: BLS

Wednesday, July 4, 2012

Breaking Down Volatility of the VIX

I had never heard of the VVIX index (the volatility of the stock market's volatility "volatility of VIX") until a week back when Bill Luby from the always insightful 'VIX and More Blog' posted about the recent gap seen between the historical volatility "HV" of the VIX (i.e. the trailing volatility of the VIX index) and the implied volatility "IV" (i.e. what was currently priced in as the forward expected volatility of the VIX index).

To Bill:
Much to my surprise the current 20-day HV is 144, while the current IV is only 98. In other words, the markets expect the VIX to be considerably less volatile in the month ahead than it has been over the course of the last month.
But as we'll see, based on the historical relationship between the VIX and VVIX, the pricing wasn't all that unexpected. Over the previous month, the VIX index had fluctuated between roughly 17 and 26, so (ignoring any opinion of the market for a moment) the reading of 98 was actually right in the heart of where one would expect it based on historical data since the VVIX index 2007 inception.

And this is where things get interesting.

The historical chart shown above makes the assumption that the volatility of the VIX index is lower when the VIX index is lower, which would have been my first guess had I not really thought about it. When I did think about it, that actually makes no sense whatsoever.

  • Volatility is a measure of change in percent terms
  • A change from a low starting value is a much higher percentage change than an equivalent unit change from a high starting value (i.e. a 2 point change from 10 is a 20% move... a 2 point change from 80 is a 2.5% move)
With that understanding, the chart below showing the realized one month change from various VIX starting points shouldn't be too surprising because a 15 point move higher in the VIX from a starting value of 15 is much more likely than a 40 point move higher in the VIX from a starting point of 40.

The interesting thing is that this conflicts with how the VVIX (vol of VIX) has been priced. At low levels of VIX, the VIX is MORE likely to have wide outcomes (in percentage movement) while at high levels the mean reverting characteristic of the VIX has made a move down from high levels much more likely.

A chart attempting to summarize the first two charts is shown below. It shows the realized one-month forward volatility of VIX resulting from various starting VIX and VVIX index values. Interestingly enough, it shows that realized volatility of VIX spikes when the VIX index is low, but only when the market isn't pricing it in.

Potential thoughts from the above to consider further...
  • When the VIX and the implied volatility of the VIX are low, buy options on the VIX (i.e. calls / puts)
  • When the VIX is high and implied vol on the VIX is high, sell calls on the VIX
Source: CBOE

Monday, July 2, 2012

Common Investor Errors...

Early last week, Barry Ritholtz outlined what he believed were the top ten most common investor errors:

Here is my short list:

1. High Fees Are A Drag on Returns
2. Mutual Fund Are Inferior to ETFs
3. Reaching for Yield is Extremely Dangerous
4. Asset Allocation Decisions matter more than stock selection
5. Passive is usually better than Active Management
6. You must understand “The Long Cycle”
7. Behavioral Issues Are Costly
8. Cognitive Errors as well
9. Understand your own risk tolerance
10. Pay Guys Like Me For the Right Reason

While I think this is an interesting / solid list, I don't necessarily agree with a number of them. In his post I responded with the following:
Can we disagree on some of these?

2. Mutual Fund Are Inferior to ETFs: Too broad a statement. Some mutual funds are great (inexpensive, track indices almost exactly, prevent owners from day trading [see your #7] behavorial issues being costly), while many ETFs are very poor (broad tracking error, expensive, leveraged inverse ETFs)

3. Reaching for Yield is Extremely Dangerous: Everything is based on appropriate compensation for the risk an investor takes… 5 years ago an investor sitting in cash received [a 4-5%] risk-free return. 0% [yielding] cash is now return-free risk. An investor “reaching for yield” now may actually now be a risk reduction exercise.

4. Asset Allocation Decisions matter more than stock selection: agree, but by definition asset allocation decisions are “active” decisions, hence….

5. Passive is usually better than Active Management: seems in conflict with #4
Diving right into my point #2 (because ETFs seem to be uniformly praised these days) is that mutual funds are not all inferior to ETFs (stating ETFs are superior is too broad of a statement). This is especially true for sectors / asset classes where the underlying securities are less liquid and the ETF itself trades with minimal volume (volume isn't nearly as important if the underlying securities are liquid... a point for another day). In these instances, it is more likely that the price of the ETF can move significantly from the ETF's net asset value "NAV" (the actual value of its holdings) and the bid/ask spreads widen, both of which can be negative to an investor.

One example can be seen year-to-date with Muni ETF MUB performance relative to that of a muni mutual fund. I am not vouching for the Fidelity fund below (it was the first to come up when I looked for a national muni fund with roughly 7 years of duration).

In addition to the underperformance of MUB, the volatility is 3x higher at 6.8% vs 2.2% due to the widely fluctuating ETF price vs the underlying NAV which hit a 4% premium in February (i.e. someone buying that day paid 4% more than the securities were worth).

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