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Noisy Market Hypothesis: Tilt Your Portfolio To Achieve Superior Returns (Part 1)

Summary In previous articles, we’ve shown how maintaining a diversified portfolio “beats the average retail investor”. In this articles, we will raise the bar and review the ways of “beating the market”. Initial building blocks (i.e. list of ETFs) for Satellite Portfolio are presented. This is the third article in the series that aims to develop portfolio investment approach that “beats the market”. The goal is to equip readers both with “knowledge about the path” and “confidence to stay on the path”. In the previous two articles, we’ve reviewed the ways of “beating the average retail investor”: These two articles serve as a practical guide to structuring core portfolio. We now move to the next step – satellite portfolio. We are raising the bar We saw what it takes to “beat average investor” and that doing so is pretty easy. All you need to do is maintain a diversified allocation to various asset classes. The key word is “maintain”; in other words, an investor should choose consistency over chasing the next “hot” stock or industry. As a reminder, please see the graph below; I hope that it will serve as a motivation: (click to enlarge) Source: J.P. Morgan and Dalbar Inc. Of course, managing emotions and staying the course is easier said than done. Especially, if your approach performed poorly for few years while your friend keeps on bragging about “that great stock” which made him a small fortune. How astonishing it is to see that few years of performance guide our long-term decisions. Just take a look at reactions that the second article in this series stirred up. It is true that commodities had very poor performance during last 4-5 years (and so did emerging market stocks). However, I wonder if half a decade performance warrants calling the commodities inappropriate for the portfolio [1]. History of the stock market is full with examples when the stock market pundits would conclude that some asset classes are no longer appropriate for portfolio, e.g. “stocks are dead” (typically, at the bottom of the market), just to observe market come back with a vengeance and prove all naysayers wrong. Putting short-termism aside, let’s go back to our long-term perspective. Commodity futures deliver equity-like returns (and risks as well) and have less than perfect correlation with stocks (i.e. provides diversification benefit). However, the focus of this article is not commodity futures, not even “Core Portfolio”. Our focus is “Satellite Portfolio” and how we can achieve even better returns through employing proven strategies. Our focus is on raising the bar. Noisy Market Hypothesis (NHM) and how to “beat the market” NHM provides a more realistic depiction of stock market dynamics when compared to Efficient Market Hypothesis (EMH). EMH claims that stock prices at every point in time represent the unbiased estimate of the true value of the firm. Such claims would have been true in ideal worlds where investors and speculators would not face liquidity constraints, tax considerations, institutional limitations, and many other externalities. Add to this list “popular delusions and madness of crowds” and you start questioning whether the even weak form of EMH is possible. I’m not suggesting to discard EMH. In the long term, information gets embedded in stock prices, but it may take a while. Quoting the “father of value investing” (Benjamin Graham): “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” In other words, in the short term, market “noise” might drive prices of particular stocks or even group of stocks significantly away from its intrinsic value and keep it there for a while. Just think of any stock market bubble. Unfortunately, taking advantage of such cases of mispricing is not easy. John Maynard Keynes reminds us that “the market can stay irrational longer than you can stay solvent.” As such one should expect that no trading strategy will consistently produce superior returns. This is one of the main implications of NMH. However, no need to despair. Based on academic research, Jeremy Siegel (father of NMH) concludes that over the long term it is possible to achieve better risk-adjusted return than holding very broadly diversified a portfolio. Jeremy Siegel mentions that taking advantage of “noise” might be achieved through “fundamental indexation” (i.e. weighting your holdings based on “fundamental factors”) instead of capitalization-weighted indexation. In other words, if the investor is able to stomach underperformance of his/her portfolio in short- and medium-term (which would be years), they might be well compensated in the long term for taking advantage of “fundamental factors”. We will discuss two of such fundamental factors – size (small caps) and style (value stocks) – in this article. Why value stocks and small capitalization stocks “beat the market”? Efficient Market Hypothesis (EMH) implies that strategy achieving higher absolute return is likely to be higher risk strategy. In other words, investors are compensated for taking the risk (only systematic risk, according to MPT) and, therefore, high risk equals potentially high return. As such, EMH advocates would claim that long-term outperformance of small caps and value stocks is due to higher risk. One can see why small caps would be a riskier proposition, however, value stocks are already selling at discount – how can they represent increased risk? One would expect that high-flying “hot” stocks with high multiples would expose investors to larger potential crash in price, compared to already “cheap” value stocks. However, EMH advocates would remind us about “value” trap. It’s when value stock continues to remain cheap for years and potentially keeps on getting worse. Instead of presenting you with arguments and counterarguments of various schools of thought, let me present you my version of why value and small-caps outperform. Small caps: Are riskier: typically higher volatility, higher chance to experience financial troubles (i.e. small to secure stable funding sources or access markets during rough patches). Are less liquid: low float, low trading volume, and higher bid-ask spreads. Are “under the radar”: not enough analyst coverage and institutional limitations (big asset managers or speculators might find it hard to establish meaningful exposure to single small-cap stock due to the limited amount of available issuance; at the end of the day, we are talking about small-cap stock). Value stocks: Might experience “value trap” (we will discuss how to address this concern in our next article). Are not “hot” names: typically boring names with seemingly mediocre stories. In “Stocks For the Long Run”, Jeremy Siegel presents information regarding the historical performance of small caps and value stocks from 1926-2012. For more details, please refer to his book; here, I’ve provided relevant excerpts: (click to enlarge) Source: Jeremy Siegel (click to enlarge) Source: Jeremy Siegel How do I know that small caps and value stocks will continue outperforming? Past performance is not a guarantee of future performance, isn’t it? “History does not repeat itself, but it often rhymes”. And, I think that’s the blessing for those who will follow the recommendations in these articles consistently and disregard short-term market gyrations. Just because history does not exactly repeat itself, investors tend to lose confidence in proven strategy after few years of underperformance. Some of the main reasons are thought to be human nature and memory. It is only human to throw away proven strategies and jump on the bandwagon as they face “this time it’s different” environment. This was the case during tulip mania of early 1600s and in recent history (just recall peak of the dot-com bubble in 2000). How many of such cases of mass disillusionment were experienced during these 400 years? And what lessons we learned? It either we believe that ” this time it’s different” or memories faded away since the last roller-coaster. Or, perhaps, we remember that experience vividly and will try to outsmart the market this time, by jumping off the train just before it falls into the abyss. There is, of course, an argument that market participants realized the existence of small cap and value phenomenon and traded up these stocks. Supporters of such arguments claim that due to “arbitraging away” these opportunities – small caps do not offer any alpha, it’s purely higher beta play and value stocks correctly reflect the valuation of less than stellar companies (again, no alpha here). We will review if such arguments are warranted in the future articles when we finalize our proposed allocations for a satellite portfolio. Before we discuss execution, let us draw a preliminary conclusion. As a group of investors continue jumping from one bandwagon to another in search of alpha, another more passive investors might benefit from staying put. Unless, you have a crystal ball, it’s advisable to identify portfolio allocation and don’t deviate materially from these target allocations. In the long term, tilting your portfolio in the direction of small caps and value stocks is expected to lead to superior returns. However, it might take years before you achieve superior return; markets might favor large caps and/or growth stocks for long stretches of time. List of ETFs For core portfolio, recommended allocations are presented in previous two articles. For satellite portfolio, I suggest tilting portfolio to small-cap stocks and value stocks. Following are ETFs that I recommend to achieve this goal: (click to enlarge) Source: Vanguard, and my own recommendations As you can notice, all four are Vanguard ETFs. I recommend Vanguard ETFs mainly because of their low fees (I am not affiliated with Vanguard and do not receive any compensation for recommending its products). There are other low-cost ETFs as well; typically, I use other ETFs for very specific tax reason. I will plan to cover this topic in my book (expected to publish in Amazon in December 2015 or January 2016) or potentially in the future Seeking Alpha articles. Following table provides a brief summary about the recommended ETFs: (click to enlarge) Source: Vanguard Size (i.e. small cap) and style (i.e. value) are not the only factors that historically proved to generate superior returns. We will discuss “other” factors in the next articles and determine sensible allocation to various factors. At that point, I will present detailed execution plan (i.e. the list of all ETFs and allocations to each). To conclude, the superior performance of small cap and value stocks (and some other factors that we will discuss in the next article) has been identified decades ago. However, the opportunity is still there. Maybe sometime in the future large portions of stock investors develop longer-term approach, bid up the prices, and bring systematic alpha of small cap and value stocks to zero. That “sometime in the future” could be a so distant phenomenon that might not even happen during my lifetime. To quote from John Maynard Keynes: “In the long run we are all dead.” In a meantime, I don’t mind additional 2-4% return compounding for decades. References/Bibliography Jeremy Siegel, The Noisy Market Hypothesis , Wall Street Journal, June 14, 2006 Jeremy Siegel, The Future for Investors: Why the Tried and the True Triumph Over the Bold , 2005 Jeremy Siegel, Stocks for the Long Run 5/E: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies , 2014 Next article: Noisy Market Hypothesis: Tilt Your Portfolio to Achieve Superior Returns (Part 2) Disclaimer: I’m not a tax advisor, please consult your tax advisor for any tax related matters. ETFs covered: The Vanguard Mega Cap Value ETF (NYSEARCA: MGV ), the Vanguard Value ETF (NYSEARCA: VTV ), the Vanguard Mid-Cap Value ETF (NYSEARCA: VOE ), the Vanguard Small Cap Value ETF (NYSEARCA: VBR ), the Vanguard Small Cap ETF (NYSEARCA: VB ) and the Vanguard Small Cap Growth ETF (NYSEARCA: VBK ) [1] Once again, I would like to highlight that I’m not supporter of buying spot commodities (e.g. gold bars, silver coins) – I suggest using commodity futures. I will plan to write an article on this topic in the future.

A Rate Hike Will Threaten This Bond Fund’s Reach For Yield

Summary HYT has moved towards higher duration issues to maintain distributions, making it more heavily exposed to a rate hike than other high yield funds. HYT’s dividend history and its current failure to earn income to cover distributions indicate a rate cut in 2016. Nonetheless, there is an opportunity to purchase HYT when the market discounts its underperformance too heavily — although that time has not come quite yet. BlackRock Corporate High Yield Fund (NYSE: HYT ) is a thinly traded and often overlooked closed-end fund that seeks consistent high income to shareholders through active capital allocation in the high yield taxable bond and debt derivative universe, with a smattering of equity on the side. To its credit, the fund has a solid track record of paying special dividends that have driven its total yield above 8% for most of its history since inception. This must be counterbalanced by a consistent decline in dividends and a fall in NAV that make it suspect for the income-seeking investor. Currently, the fund deserves attention because a recent dividend cut for HYT and turmoil in the high-yield market as a whole have generated interest in just about any high-yielding CEF. But there is cause for caution. The Dividend History Unfortunately, regular dividends have been consistently falling for this fund for a long time: (click to enlarge) In 2015, shareholders faced a 7.3% dividend cut after similar cuts came to the fund in 2012, 2013, and 2014. Dividends have fallen 41% since the fund’s inception, and the fund’s market price has fallen by a third. The Capital Losses Some CEF investors like to catch funds that trade at a discount to NAV using the logic of value investors: get dollars when they’re on sale for 80 cents. In addition to the falling dividends HYT pays out, there is another reason why this strategy will not work with HYT. The fund’s overall capital losses are not abating. According to the fund’s most recent annual and semi-annual reports , the fund has lost 7.4% of its value from June to September. Over a one-year period to September, the fund lost 3.14% of its NAV. Since then, the fund has lost another 0.6% of its NAV. Greater Exposure to Rising Rates We can largely attribute these losses to a cratering in the high yield market, which has also caused a distressing decline in the NAV of high yield funds such as Pimco High Yield Fund (NYSE: PHK ) and caused me to sell my holdings in that fund (I discuss this decision here ). In the case of PHK, management seems to be preparing for this fall in junk debt values by shifting the portfolio towards shorter duration holdings at higher yields. In theory, this will free up capital for new issues at higher rates if the Federal Reserve raises rates in December or early next year. In the case of HYT, this is not management’s strategy. In September, HYT had 75% of its holdings with maturities ranging between 3-10 years, with over half having maturities between 5 and 10 years. In June, 68% of its holdings were in the 3-10-year maturity window, with 44% in the 5-10-year maturing range. This means there is now a higher risk of HYT losing more of its NAV if the Federal Reserve raises interest rates and rates for high yield debt goes up as well. Even if the Fed doesn’t raise rates, if the market worries about higher default rates due to declining profitability on the stronger dollar, or because of cheap oil, or any other of the myriad reasons that have driven a fall in the high yield market in 2015, HYT is more exposed than PHK and other actively managed high yield funds. The CLO Bet HYT is also making another small bet by moving into CLO investments. In its last annual report, HYT disclosed approximately $24.5 million in CLO investments, which is over half of its $49.5 million invested in asset-backed securities. On the plus side, CLOs remain only 2% of HYT’s total portfolio. There is potential for credit spreads to narrow if the Federal Reserve does raise interest rates and causes other interest rates, such as LIBOR, to follow suit, but this will have significantly less impact on HYT than on other high yield funds, both in the CEF and BDC universe, which have invested more aggressively in CLOs to boost returns. A good example of a much higher risk high yield fund that has seen weak NAV growth and high market value declines based on CLO exposure is Prospect Capital (NASDAQ: PSEC ). Their high CLO holdings are discussed in this prescient article by BDC Buzz. PSEC has fallen 12.7%, excluding dividends, since BDC Buzz’s article (although it was by no means his first warning on the dangers in that company). For HYT, this means its CLO holdings are relatively conservative. On the surface, this sounds good; but they are in fact so conservative that it is difficult to determine the purpose of holding such a small portion of the portfolio in these volatile assets. Additionally, many of those CLOs are in small and middle-market companies or BDCs that service the small and middle-market companies, again compounding HYT’s exposure to companies that are more likely to suffer higher default rates. For example, as of its September report, HYT held $2.1 million in asset-backed securities whose counterparty is Ares CLO Ltd. and another $877,000 to WhiteHorse subsidiaries of H.I.G. Capital, a diversified private equity investment firm. Matching Income to Distributions Since CLOs pay a higher yield than market-issued bonds, these are part of the fund’s overall strategy to make income match distributions. Unfortunately, the fund is still falling slightly short of its payout. Since March, the fund has paid $1.21 million of its distributions as a return of capital and its dividend coverage has remained below 85% for five months. Its current ROC is a small fraction of the overall value of the fund and is by no means a cause for alarm at the present time. However, it does indicate the strong likelihood of another dividend cut in 2016 as we have seen over the past few years, meaning investors should calculate their expected income from this fund not based on its current yield but on its likely future yield. Also, because of the long duration of the fund’s holdings, its ability to churn into higher yielding new issues will be limited, making it even less likely to enjoy a higher rate of income on its holdings if yields on corporate debt rise next year. Discount to NAV When deciding whether to purchase HYT or not, investors should also consider the fund’s discount or premium to NAV and how this is likely to trend in the future. Except for a brief spell in 2012, the fund has always traded at a discount, and its current discount is the steepest it has been since 2008. (click to enlarge) The fund’s current 13.47% discount is slightly above the 52-week average of 12.37%, although the last year’s tumultuous and volatile high yield bond market may make the last year’s average a less reliable indicator of timing a purchase in this fund than in the past. While investors looking for mean reversion may be tempted to buy as its discount seems curiously low, the above considerations about portfolio duration, ROC, and poor positioning for rising rates should make investors pause before jumping in. Conclusion HYT is not positioning itself for a rising interest rate environment and has seen a steep discount to NAV priced in as a result. Additionally, the fund’s consistent dividend cuts mean that it cannot be purchased as a source of reliable income. However, it can be purchased when the market undervalues its income potential. A careful analysis of the fund’s shift of its bond holdings by duration and a closer understanding of its allocations to CLOs and its exposure to smaller companies is necessary before making a purchase on this name.