Tag Archives: asset-allocation

Lookin’ For Yield In All The Right Places

In a world of low and in some cases negative interest rates, investors continue to struggle to find yield. As such, they still find themselves in an all too familiar place: Accept less income, or take on more risk in the search for yield. But with global growth still sluggish and bond and stock prices looking expensive, balancing income and risk is more important (and challenging) than ever. The question for investors isn’t “Where can I go for yield?” It is: “In this environment, where can I find meaningful yield without taking on significant or unknown risk? ” There is a bit of a balancing act between yield and risk. Let’s take a look at how it can be done in three areas of opportunities for investors seeking income today. Fixed income Bonds or fixed income essentially play two roles in a portfolio: They offer yield or income, as well as potential diversification benefits as a sort of ballast to counter equity risks. Bonds run the gamut of risk and income. Short-term Treasuries offer the lowest default risk and generally the lowest yield, while high yield bonds typically offer considerably higher yields, but with significantly more risk. These two investments are quite different, but both can play a crucial role in a portfolio. However, the yields of Treasuries are paltry while credit instruments like high yield bonds exhibit equity-like risk, albeit with potentially higher yields. For investors looking to balance yield AND risk, risk-adjusted returns are important. That’s where municipal bonds come in. Municipal bonds aren’t an exciting topic over a cocktail party, however they were one of the best performing bond categories in 2015. According to Bloomberg data on the S&P AMT-Free National Municipal Bond Index, munis returned 3.3 percent in 2015, beating taxable investment grade bonds. This year, munis remain one of the highest sources of yield on a risk-adjusted basis. The sector’s tax-exempt status is another plus, and munis are a portfolio diversifier, with negative correlations to equities and high yield, our analysis shows. Other parts of the fixed income market have experienced volatility recently due to energy exposure or anticipation of Federal Reserve (Fed) moves, but the municipal bond market has been relatively stable. This may surprise some given the recent default announcement of Puerto Rican debt, which is a vivid reminder of why it’s important for investors to be completely aware of what they own and the risk they take in search of yield. (iShares ETFs are not impacted directly by the default, as none hold bonds issued by any U.S. territories, such as Puerto Rico or Guam.) Equity income If you prefer equity-like risk to come from equities in your search for yield, dividend stocks are a logical place to look. But it is important to remember that not all dividend stocks are created equal. As I’ve written before, my preference is for the segment of the market known as “dividend growers,” which as the name implies, are companies with a history of increasing dividends. There are some conditions – and clear distinctions – that may set dividend growers apart from other dividend stocks in today’s market, particularly their attractive valuations, stable earnings and stronger balance sheets. Somewhere in between Finally, there is an often overlooked option for investors looking to balance risk and yield: preferred stocks. Preferreds are income-generating securities that have both stock and bond characteristics. When it comes to risk, they’re somewhere in the middle of the spectrum. Similar to a bond’s coupon payment, preferred stocks pay fixed or floating dividends. They can appreciate in value like a common stock, but they’re not as volatile. Some question if preferred stocks will remain an attractive asset class in a rising rate environment. But since we expect the Fed to continue its dovish stance and rate rises to be gradual, we wouldn’t expect to see big downward spikes in preferred prices. Preferred stocks may also be attractive in this environment due to the fact that they’re issued mainly by financial companies, like banks, where net interest margins generally show improvement. Also, see what my colleague Russ Koesterich has to say on preferreds. Investors looking to balance risk and income while searching for yield may want to consider the iShares National AMT-Free Municipal Bond Fund (NYSEARCA: MUB ), the iShares Core Dividend Growth ETF (NYSEARCA: DGRO ) and the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ). This post originally appeared on the BlackRock Blog.

Outperforming Buy And Hold Does Not Prove Skill

It is common in finance to compare returns of market timing strategies to buy and hold returns. Although this is useful in determining any excess returns achieved by the timing strategy, it is far from a proof of skill. This is because, depending on the path prices follow, random traders may achieve returns much higher than buy and hold. I will approach this problem by providing two examples that are based on simulating random traders who use a fair coin to purchase shares in SPY (NYSEARCA: SPY ) at the close of a trading day and when heads show up. The shares are sold at the close of a day when tails show up and this is repeated for the whole price history under consideration. Then, the simulation is repeated 20,000 times to get a distribution of the net return of all random traders. Starting capital is $100K and commission is $0.01 per share. Equity is fully invested. Results for 2013 Click to enlarge The SPY buy and hold total return for 2013 was about 26.45%. It is shown in the results above that the return for significance at the 5% level is about 22%, which means that this return is better than the return of 95% of random traders. In this case, a return of a market timing strategy below the buy and hold but above 22% can be an indication of skill since it is significant at the 5% level or better. Also note that more than 97% of random long traders made a profit in 2013 due to the strong uptrend. Results for 2015 Click to enlarge Although the SPY buy and hold total return for 2015 was just 1.3%, the minimum significant return for comparison to random traders was about 14%! A market timing strategy would have to generate a return of more than 14% to prove that it was better than 95% of random traders, or significant at the 5% level. About half of the random long traders made a net profit in 2015, still better than casino odds of course. Therefore, even a return of 10% would not be sufficient for proving skill in this case, as it would not be significant at the 5% level. Therefore, comparing to buy and hold for proving skill may not make sense depending on the path prices follow. During strong uptrends, the minimum significant return to support skill may be closer to buy and hold but when markets consolidate it may be much higher because there are always those lucky random traders that skew the distribution of returns. As a corollary, comparing average returns to buy and hold returns may make no sense at all since the difficulty of generating excess alpha varies from year to year. Original article Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Analysis program: Price Action Lab

The Appropriate Portfolio Vs. The Optimal Portfolio

Perfect is the enemy of the good” – Adapted Italian Proverb We all want the perfect portfolio, the portfolio that achieves the highest amount of return for the lowest degree of risk. But one of the inconveniences of a system as dynamic as a financial market is that it’s impossible to consistently maintain the perfect portfolio. This pursuit, unfortunately, causes more damage than good since it leads to increased activity, higher fees, higher taxes and usually lower returns. I have argued in my new paper, Understanding Modern Portfolio Construction , that this pursuit of alpha is misguided and that we should seek the appropriate portfolio as opposed to the optimal portfolio. Here’s my basic thinking: There is an abundance of data supporting the fact that more active investors do not consistently generate alpha or excess return.¹ Alpha is elusive because it doesn’t exist in the aggregate and because we all generate the after tax and fee return of the aggregate financial markets. So, the diversified low fee indexer must ask themselves – if I want to be properly diversified and alpha is impossible to achieve in the aggregate, then is this a pursuit I should bother engaging in? For most people, the answer should be no. For most people, the generation of “alpha” is not a necessary financial goal. Asset allocators should be concerned with generating the appropriate return as opposed to the optimal return. This means building a portfolio that is consistent with your risk profile and managing it across time so that you maintain that profile while maintaining an appropriately low fee, tax efficient and diversified approach. The pursuit of alpha generation not only reduces returns by increasing taxes and fees, but also misaligns the way the portfolio manager perceives risk with the way the client sees risk. Since the portfolio manager is benchmarked to a passive portfolio they likely cannot outperform they will often exacerbate many of the frictions that degrade portfolio returns all the while increasing the risk that the client will not achieve their financial goals. Of course, the “optimal” portfolio might not seem so different from the “appropriate” portfolio, but I would argue that there’s a substantive difference. For instance, let’s look at an example of a 40-year-old man with $500,000 to allocate. Let’s assume he uses the simple “age in bonds” approach and comes to a 60/40 stock/bond portfolio. Every year this asset allocator should rebalance his portfolio so that he owns approximately 1% more in bonds. In all likelihood, the stock piece of the portfolio will outperform the bonds over long periods of time so he will consistently be tilting further away from stocks and into bonds. But why does he rebalance? He rebalances to maintain an appropriate risk profile, not to optimize returns and generate alpha. He is accepting the high probability of a good return and foregoing the risks associated with pursuing the perfect return. This should be the approach taken by most asset allocators seeking to build a proper savings portfolio. Countercyclical Indexing takes this process of risk profile based rebalancing a step further.¹ Since a 60/40 portfolio derives 85%+ of its risk from the equity market piece (and even more late in a market cycle) it is prudent to try to achieve some degree of risk parity across the market cycle. But we should be clear about the process of this rebalancing – we are not rebalancing to achieve alpha. We are rebalancing to better balance our exposure to asset risk across time. Said differently, we don’t implement this rebalancing to capture the best portfolio, but to capture an appropriate portfolio. In doing so, we are accepting that our portfolio might merely be “good,” but by pursuing the appropriate portfolio we are avoiding many of the pitfalls involved in pursuing the perfect portfolio. If more asset allocators abandoned the false pursuit of the optimal portfolio, I suspect they would perform better. Instead, they’ve let perfect become the enemy of the good. ¹ – See the annual SPIVA reports. ² See, What is Countercyclical Indexing ?