Tag Archives: management

4 Simple Actions To Consider After Fed Liftoff

We finally have liftoff. This week, after months of anticipation, the Federal Reserve (Fed) initiated its first rate hike in nearly a decade , raising the Fed Funds Rate by 25 basis points (bps). Why not a bigger blast off? The Fed has made it clear that rate “normalization” will happen gradually, meaning rates will likely remain below historical averages for the foreseeable future. But while it may take years to get back to a 4 to 5 percent Fed Funds rate, higher rates are on their way. The good news for investors is that just a few simple actions can help you prepare your bond and equity portfolios for this new rising rate environment . In the wake of the Fed’s decision, here are four such moves you may want to consider. 1. Consider Your Duration While longer-duration bonds can provide portfolio diversification benefits, shortening the duration of your bond portfolio can potentially help manage losses due to rising interest rates. Remember, duration is a measure of a bond’s sensitivity to interest rate changes. The longer the duration, the more a bond’s price is impacted. When interest rates change, a bond’s price will change in the opposite direction by a corresponding amount. For example, if a bond’s duration is 5 years and interest rates rise 1 percent, you can expect the bond’s price to fall by approximately 5 percent. Therefore, bonds with higher duration generally have greater price volatility and the potential for losses when rates rise . 2. Focus on Credit Instead of owning only Treasuries, you may want to focus on adding credit exposure. Credit exposure adds credit risk (the risk that the issuer won’t pay you back) to a portfolio, but it mitigates some interest rate risk. In addition, investors are compensated for taking more credit risk with higher yields, so increasing exposure to higher quality credit risk may enhance income and offset potential price declines due to rising rates. 3. Shift to Cyclical Sectors It’s important to remember that when rates rise, it’s not just bonds that are affected. Equities are affected too. Higher rates mean that borrowing money becomes more expensive, so it’s harder for businesses and consumers to finance everyday needs. As such, traditionally defensive sectors, like utilities and telecommunications, typically become increasingly vulnerable in a rising rate environment due to their existing large debt positions. At the same time, higher rates generally are a sign of an improving economy, boosting the case for adding exposure to cyclical sectors, which have tended to outperform when the economy is strong. I prefer to get cyclical exposure through two sectors: U.S. technology and U.S. financials (excluding rate-sensitive REITs). With their large cash reserves, U.S. mature tech companies are much less vulnerable to rising rates than companies in more debt-laden sectors mentioned above. In addition, tech sector revenues may increase if economic growth continues to expand and consumers and businesses spend more. Meanwhile, for some financial institutions, like banks, rising rates could mean higher profits, as net interest margins may increase. 4. Seek New Sources of Income You may also want to take a look at your dividend strategies when interest rates rise. Although traditional high dividend payers (think the utilities and telecom sectors) have performed strongly in recent years, they’ve become quite expensive by most valuation metrics. And the previously low interest rate environment paved the way for many of these defensive businesses to load up on debt to expand their operations, while continuing to pay high dividends to investors. As such, many of these companies will likely come under pressure when rates rise. In contrast, dividend growth stocks have historically demonstrated less interest rate sensitivity and may be an attractive way to maintain yield in a rising rate environment. In contrast to high dividend payers, they tend to be more reasonably valued and have more potential to sustainably grow dividends over time. So, although rates are expected to moderately increase, you can prepare your portfolio now for a rising rate environment by considering simple actions such as these. These simple steps may help to insulate your investments while also capturing new opportunities. Funds, such as the iShares Floating Rate Bond ETF (NYSEARCA: FLOT ), the iShares Short Maturity Bond ETF (BATS: NEAR ) and the iShares 1-3 Year Credit Bond ETF (NYSEARCA: CSJ ), can provide credit exposure with short duration. Meanwhile, the iShares U.S. Technology ETF (NYSEARCA: IYW ), the iShares U.S. Financial Services ETF (NYSEARCA: IYG ) and the iShares Core Dividend Growth ETF (NYSEARCA: DGRO ), can provide exposure to the U.S. technology sector, the U.S. financials ex-REITs sector and dividend growers, respectively. This post originally appeared on the BlackRock Blog.

Picking Stocks For The Long Term Is Harder Than You Think – So Don’t

Summary It is important to distinguish between stock picking and index investing, because they require different approaches. A common assumption with index investing is that, over the long term, indexes will rise. Often, investors make the same assumption when picking individual stocks, but they shouldn’t. It is extraordinarily difficult to find individual stocks that offer value, long-term predictability, and index out-performance. That doesn’t mean that we should abandon stock-picking. It just means that it is very important to take into account the medium-term prospects of a stock. Alpha is more likely to be achieved if one develops a medium-term investment thesis and then sticks to it. I generally try to avoid referencing super-investors for a variety of reasons, but this article will be an exception. There have been many, many articles and comments on Seeking Alpha that reference Warren Buffett’s investing advice. What is often not taken into account, however, is that Buffett’s advice is directed at two distinct categories of investors: active, knowledgeable investors; and passive, less knowledgeable investors. For passive investors, Buffett’s basic advice is to invest the majority of one’s capital into a low-cost S&P 500 index fund, and perhaps hold some capital in cash in case there is a downturn in which one needs money and does not wish to sell their stocks while the stocks are undervalued. The reasoning behind this is that over the long-term, a large basket of US stocks are likely to outperform other asset classes, and you can purchase a large basket of US stocks rather cheaply. As for investors who are active, intelligent, and knowledgeable, they should look for some combination of value and long-term predictability, and also have a high portfolio concentration, low turn-over, and if possible, aim to seek out companies with small capitalization. (This is summarizing a lot of what Buffett has said, done, and written over the years into one sentence. I would be happy discuss any reasonable objections of the summary in the comments section.) It is important to note that these two investing approaches are often mutually exclusive. You cannot have a high concentration and index at the same time. You also cannot assume that an individual stock that has a low correlation with its respective index will rise over long periods of time like you can with an index. In fact, I think that the relationships may be opposite one another. (Meaning the longer you commit to holding an individual stock, the more likely it is the stock will decline in value, while the longer you commit to holding a US focused index fund, the more likely it is that it will rise in value.) Not everything is mutually exclusive between the two approaches. You can buy a small-cap value fund that charges only small fees (but you can also expect more volatility if you do so). You can limit turnover when purchasing individual stocks, just as many indexes do. You can also try to find long-term individual stocks to purchase, but consider this: If Warren Buffett and Charlie Munger–two of the best investors in the world–can only find one or two worthy long-term picks in any given year, what makes you think that you can find more than that? So, while there is some potential overlap between the approaches, the areas that are mutually exclusive are often forgotten by investors, and the ones that aren’t mutually exclusive either have high volatility or are difficult to find. The mistake I see is that often times investors want to combine an indexing approach–and the assumptions that come with it–with a stock picking approach. Specifically, investors want to (1) be diversified beyond 3-10 holdings even though long-term value stocks are hard to find, (2) assume the historical bias toward long-term index gains applies to individual stocks, (3) assume that picking individual blue-chip stocks that have a high correlation with indexes will outperform indexes, and (4) assume that their goals are unrelated to the performance a benchmark. I will set assumptions 1, 3, and 4 to the side for this article, #1 would make this article too long, #3 is obviously a poor assumption, and #4 is simply a different topic altogether. So this article will focus on why investors have to be careful not to assume that the long-term historical upward bias of index funds also applies to individual stocks that are weakly correlated with the index. The Problem with Visibility: Visibility of the long-term future of individual stocks is more cloudy than people think. Quite often investors will assume that a company will perform well twenty years from now because it has performed well in the decades leading up to that point in time. If the investor purchases the stock and the stock price drops, quite often the investor will insist that the drop in price is okay because they are “holding for the long term”, and long term the company will be fine. It is absolutely critical the investors realize just how difficult it is to forecast out ten or twenty years on an individual stock. That is a key difference between an index and an individual stock. It might be okay to assume the S&P 500 index will be higher in twenty years than it is now. But if one were to pick an individual stock at random from the S&P 500, there is a greater than 50% chance that in twenty years the company will not even qualify as part of index. Half of the components of the S&P 500 in 1999 are not in the index today , only 16 years later. But, Cory, you say, I am not picking my stocks at random, I am picking only blue-chip stocks like Johnson & Johnson (NYSE: JNJ ), Coca-Cola (NYSE: KO ), Exxon Mobil (NYSE: XOM ), Procter & Gamble (NYSE: PG ), and Kinder Morgan (NYSE: KMI ) –I’m only partially kidding about Kinder Morgan. Your picks are probably not going to be perfect, right? My response is that if you only purchase huge, blue-chip, depression resistant companies, and you are going to diversify beyond ten of them just in case a couple of them turn out to be duds, then your performance will probably be similar to an S&P 500 index. You cannot assume that big, widely followed blue-chip companies will be available for purchase at value investor prices very often. And you cannot assume that value opportunities with small-cap companies will possess the same long-term visibility as big, blue-chips. It seems clear that those who purchase only the biggest and safest stocks are few and far between. Many stock-pickers might have a core portfolio of these companies, but they also branch out to other areas in search of alpha with regard to either yield or total return. In many cases what we have are stock-pickers who are moving beyond the confines of blue-chips in search of alpha who are carrying with them the assumptions that rightly apply only to indexes or the blue-chip stocks that are highly correlated with the indexes. Specifically, the assumption that if they just hold on to something long enough, it will rise or pay out steady dividends for the next ten or twenty years while also out-performing the market. This assumption can lead to under-performance or disaster. It is not an assumption that should be made. So, if one wants to seek alpha by picking individual stocks, what is it one could do to deal with the emotions and short term volatility in the stock market that compel investors to sell at the wrong time, without resorting to the fallback of aiming to hold for the long-term? I think the solution is to develop both a short and medium-term thesis while picking stocks, and only when a thesis comes to fruition should one consider holding a stock for the long-term. In my next article, I will explain the method I have been using recently with some success. Note: Please consider “following” me for real-time notification of my latest articles. My views are a constant work in progress and I am always interested in hearing other points of view, so if you have any thoughts, please feel free to share them in the comments section.

Introducing The ETF Monkey 2016 Model Portfolio

Summary For the past couple of weeks, I have been reading extensively through the 2016 investment outlooks of top-quality research firms. In this article, I will present six themes that I gleaned from my research. Ultimately, I will assign weightings and present The ETF Monkey 2016 Model Portfolio. In future articles, I will develop ETF-based portfolios based on this model, from three major providers. First of all, I would like to begin with a word of thanks to my 366 followers, and 88 real-time followers. When I started my work here on Seeking Alpha using the pseudonym ETF Monkey, I had a total of 59 followers from my previous work and, I believe, only five or six real-time followers. I am deeply grateful to each and every one of you! This past July 1, I presented The ETF Monkey Vanguard Core Portfolio . The portfolio features what I call “beautiful simplicity,” demonstrating that one can build a low-cost, greatly diversified portfolio with as few as three ETFs. Like many other authors here on Seeking Alpha, I would now like to offer my thoughts on a model portfolio for 2016. I have spent a fair amount of time over the past couple of weeks reviewing various 2016 outlooks from a variety of quality sources; including PIMCO , BlackRock (NYSE: BLK ), Wells Fargo (NYSE: WFC ), Vanguard , Bank of America Merrill Lynch (NYSE: BAC ), Goldman Sachs (NYSE: GS ), Deloitte , and AAII . Needless to say, there is a great deal of divergent thought represented in these outlooks. And, certainly, I was not able to carefully read every last word of every outlook. What I focused on, though, was looking for common themes ; ideas that ran through more than one outlook. From that research, I have developed The ETF Monkey Model 2016 Portfolio . In this article, I will feature the main themes that struck me, as well as outline what I believe to be a model asset allocation for the year ahead. But I am also going to go a step further. I will follow up this “theoretical” work in future articles by selecting what I believe to be the best ETFs to use to actually construct this portfolio. I will do so for three different major providers: Vanguard, Fidelity (featuring iShares funds), and Charles Schwab (NYSE: SCHW ). The idea will be that investors who use these three providers can select commission-free ETFs both to build and subsequently rebalance their portfolios, all without incurring excess trading costs. Finally, using closing prices on December 31, 2015, I will both build and track each version moving forward to get some idea of comparative performance. I will also track all of them against the performance of The ETF Monkey Vanguard Core Portfolio. As readers may surmise, I have a two-fold goal from this exercise: To attempt to determine how much of a difference selecting ETFs from different providers makes if one starts from the same basic place. For example, in some cases, one provider may offer a better expense ratio for a certain component or asset class. How much difference does this make over time? To attempt to determine if this “ideal” 2016 portfolio is able to outperform the rather basic ETF Monkey Vanguard Core Portfolio, built very simply using three core Vanguard ETFs and using the weighting derived from the Vanguard Target Retirement 2035 Fund ; designed for an investor approximately 20 years from retirement. Let’s begin by taking an overall look at the big picture. The Big Picture As they say, “a picture is worth a thousand words.” With that in mind, I am going to open this section, called “The Big Picture,” by very literally presenting three big pictures. Here’s the first one, from PIMCO’s 2016 outlook, featuring 10-Year return estimates across several asset classes: (click to enlarge) Take a quick look across those projections, particularly the asset classes highlighted in red. You will see each of those show up in some fashion in the themes I will develop as the article progresses. Here is our second big picture. This one is from BlackRock’s 2016 Outlook. (click to enlarge) Similar to the first picture, look at the boxes and arrows, and what they indicate. You may already be able to discern some common themes simply by comparing these two graphics. Finally, using the S&P 500 index to represent the U.S. stocks and various Vanguard ETFs as proxies for other averages, have a look at how various markets have performed over the most recent two-year period. In the graph below, the Vanguard FTSE Developed Markets ETF ( VEA) represents developed markets as an overall group, the Vanguard FTSE Emerging Markets ETF ( VWO) represents emerging markets, and the Vanguard FTSE Europe ETF ( VGK) represents Europe specifically. ^GSPC data by YCharts With that overview, we now come to six investment themes gleaned from my research, which I believe will benefit investors in 2016. Theme #1: The “New Neutral” Some investors may recognize the phrase “new neutral” as being from PIMCO, and you would be correct. Here is a brief quote concerning its overall expectations: At the center of our New Neutral thesis is the belief that even as central banks raise rates, they will do so slowly and prudently… We don’t foresee an inflation problem… Low interest rates and moderate inflation together support a muted but prolonged business cycle, and we believe this combination helps to sustain current asset valuations. We would argue that the tailwind from ever-lower policy rates… is largely past us. Moreover, current valuations… are likely to constrain potential returns going forward. Therefore investors must adjust to a world where returns on asset classes and the paradigm for constructing optimal portfolios over the next five years are unlikely to resemble those of the last five or even 30 years. Echoing similar sentiments, BlackRock’s 2016 Outlook offers the following: The wave of central bank liquidity looks to have crested. Monetary policy may take a back seat to other cycles for the first time since the financial crisis. Finally, this from Vanguard’s 2016 Investment Outlook: The U.S. Federal Reserve is likely to pursue a “dovish tightening” cycle that removes some of the unprecedented accommodation exercised due to the “exigent circumstances” of the global financial crisis. In our view, there is a high likelihood of an extended pause in interest rates at, say, 1%, that opens the door for balance-sheet normalization and leaves the inflation-adjusted federal funds rate negative through 2017. Essentially, this theme posits a period of muted results as we move forward. At the same time, while the tailwind provided by the current interest rate environment is almost surely behind us, the Fed is expected to move slowly with respect to raising interest rates, allowing some maintenance of current asset valuations. Theme #2: Better Opportunities May Exist Outside the U.S. Our second theme takes note of the historically high valuations currently reflected in the U.S. market, and the fact that one may find better returns in 2016 by being willing to look beyond the shores of the United States. For this section, we will think very broadly in terms of the entire international segment, both with respect to developed and emerging markets. I will feature two specific targets in later sections. The BlackRock 2016 Outlook features this theme extremely succinctly: Valuations appear to have leapt ahead of the business cycle in many markets, especially in the U.S. We have essentially been borrowing returns from the future. PIMCO’s outlook appears to agree with this thesis, as explained here: In developed markets, to name a few examples, we believe global equities outside of the U.S. offer better forward return potential than those within. Across credit sectors we see superior opportunities in European financial and U.S. housing sectors. With respect to government debt, we generally find inflation-linked securities more attractive than their nominal counterparts. Finally, from Vanguard: The growth outlook for developed markets, on the other hand, remains modest, but steady. As a result, the developed economies of the United States and Europe should contribute their highest relative percentage to global growth in nearly two decades. Based on this theme, I will include a relatively modest allocation for domestic (U.S.) equities and what may be considered to be a somewhat aggressive allocation in developed international markets in my model portfolio for 2016. Theme #3: Consider Europe The BlackRock 2016 Outlook specifically features Europe as a candidate for consideration. It writes: For example, we suggest building exposure to cheaper developed markets where monetary policy is unambiguously expansionary and valuations are more forgiving, such as in Europe and Japan. This is backed up by a helpful table comparing the valuation levels of U.S. securities against their European counterparts, both in various sectors as well as overall. (click to enlarge) PIMCO also features this in its outlook, noting many of the same characteristics. Looking around the globe, European equities appear attractive over the secular horizon. In addition to the broader developments discussed, the trend toward increased dividend payout and a higher equity risk premium provide a good backdrop for superior returns. European equities offer high levels of earnings yields and valuations are lower relative to history. In its Q4 Global Economic Outlook , after frankly discussing the challenges Europe faces from the slowing Chinese economy, Deloitte offers the following observation: Despite this very volatile, challenging environment, the Eurozone has continued its recovery. In fact, this may be seen as evidence that the recovery can now weather external shocks. In this way, the Eurozone has left the “stall-speed-phase” of the recovery behind, in which it was highly vulnerable to external turbulences. Finally, with regard to the related outlook for monetary policy in Europe, Vanguard notes: Elsewhere, further monetary stimulus is highly likely. The European Central Bank and Bank of Japan are both likely to pursue additional quantitative easing and, as we noted in our 2015 outlook, are unlikely to raise rates this decade. Based on this theme, in addition to my overall allocation in developed international markets, I will include a small additional allocation dedicated specifically to Europe in my model portfolio for 2016. Theme #4: A Measured Gamble on Emerging Markets This particular item may be the most high-risk, high-reward venture within the portfolio. The picture in emerging markets is far from clear. In my research, I found comments ranging from great concern to cautious optimism. Clearly, the impact from China may be acutely felt in these economies, so could the effects of the Fed increasing interest rates in the U.S. Perhaps, the clearest example of a positive comment I saw comes from PIMCO. It acknowledges the risks but, at the same time, offers some possible reasons for optimism: Turning to emerging markets (EM), we believe that on average these sectors should outperform comparable developed market sectors over the secular horizon, but are likely to do so with higher volatility and other risks that must be considered. As in the developed markets, lower yields have been a tremendous supporter of performance for EM assets following the financial crisis. However, in the past few years, emerging markets have gone through numerous challenges that have led to generally disappointing performance. Lower growth, lower commodity prices, weak exports and a strong U.S. dollar recently have been serious headwinds. The silver lining of the recent challenges, however, is that EM assets generally offer more favorable starting valuations. EM growth, which is expected to be higher than in developed markets, also helps valuations appear attractive. Add in the higher level of investments and productivity enhancements, and we have a favorable backdrop for attractive secular returns from emerging markets. Bank of America/Merrill Lynch offers this somewhat positive view: Start of emerging markets recovery – For the first time since 2010, average annual growth in emerging markets should begin rising to 4.3 percent in 2016 from 4.0 percent in 2015. Excluding China, growth should pick up to 3.1 percent in 2016 from 2.6 percent in 2015. About three-quarters of emerging market economies could show signs of recovery by the middle of 2016, whereas Brazil could contract further to -3.5 percent as it struggles to climb out of recession. Investment likely will become the key driver of the emerging market recovery. Asset price returns of roughly 2.7 percent for external sovereign debt, 2.5 to 3.5 percent for emerging market corporate debt, and 1.0 percent for local currency debt are expected in 2016. In contrast, Vanguard cautions: Most significantly, the high-growth “goldilocks” era enjoyed by many emerging markets over the past 15 years is over. Indeed, we anticipate “sustained fragility” for global trade and manufacturing, given China’s ongoing rebalancing and until structural, business-model adjustment occurs across emerging markets. We do not anticipate a Chinese recession in the near term, but China’s investment slowdown represents the greatest downside risk. Finally, BlackRock summarizes their view of emerging markets this way: Investor sentiment is near record lows, according to the latest BofA Merrill Lynch Global Fund Manager Survey, which we view as a good contrarian indicator. Assets also are generally cheap… The same is true for companies that derive a large part of their revenues from the emerging world including China. They have severely underperformed in the past year… and now offer selected value. We are nibbling at EM assets, but not enough to fill our overall underweights. I have been watching this segment closely for some time. Given the weak pricing of this asset class, which can be graphed as being basically flat since 2009, this is going to be the biggest gamble in my model portfolio for 2016. I am going to assign it a relatively aggressive weighting of 7.5%. Theme #5: Consider TIPS As A Preferred Alternative To Bonds This theme actually caught me by surprise as I went through my research. With the prospects for inflation remaining low, TIPS have fallen somewhat out of favor of late. Interestingly, this is commented on favorably in BlackRock’s outlook: Among government bonds, only Treasury Inflation Protected Securities (TIPS) have gotten cheaper. Ten-year TIPS are effectively pricing in an average annual inflation rate of just 1.25% measured in personal consumption expenditures (PCE) terms, well below the Fed’s 2% target. Even 30-year inflation expectations have been dragged down by the oil price slump, pricing in annual PCE inflation of 1.45%. Can inflation really stay so low for so long? This sets a low bar for TIPS to outperform nominal bonds. PIMCO appears to agree with this view. Here are its comments: For the core government bond anchor in a multi-asset portfolio, we like U.S. TIPS (Treasury Inflation-Protected Securities). Not only are they an asset carrying only one risk, real rate risk (unlike nominal government bonds that carry both real rate and inflation risks), but we also view them as attractively valued relative to nominal bonds. The large amount of slack in the global economy over the past few years as well as the recent commodity price correction have resulted not only in a drop in inflation expectations (and fears of possible deflation until recently), but also in a near complete removal of inflation risk premium from the markets. Under these conditions, we think TIPS are an attractive choice for the core fixed income component of a multi-asset portfolio. Based on this theme, my allocation to TIPS will actually exceed my generic allocation to bonds in my model portfolio for 2016. In addition, my allocation to bonds will be right on the middle of the market, in terms of duration. I hope to balance the amount of income provided with overall downside risk. Theme #6: Include Some Exposure To REITs A truly diversified portfolio includes exposure to both multiple geographies as well as multiple asset classes. This can include some form of exposure to real assets . In the graphic from PIMCO featured towards the outset of this article, you will notice that, in addition to TIPS, the greatest forecasted returns over the next 10 years were featured as coming from REITs. I was happy to see this, as I include a measured weighting in REITs in my personal portfolio. What makes REITs intriguing to me is that they represent an asset class that is sort of partway between stocks and bonds. Their unique tax structure requires that they pay out at least 90% of their earnings in the form of dividends, making them in some ways similar to a bond. At the same time, a well-run REIT can also benefit from capital gains, as the value of the properties they hold can increase over time, making them in some ways similar to a stock. Based on this theme, in addition to my overall allocation for bonds and TIPS, I will include a modest additional allocation dedicated specifically to REITs in my model portfolio for 2016. Putting It All Together: The ETF Monkey 2016 Model Portfolio Based on everything that preceded it, here are the official asset allocations for The ETF Monkey 2016 Model Portfolio: Asset Class Weighting (%) Comments Domestic Stocks (General) 30.00 See Theme #2. Domestic Stocks (High Dividend) 5.00 I am going to include one ETF providing minor targeted exposure to high-yield securities, to help generate income for the portfolio. Overall, this brings my domestic stock allocation to 35%. Foreign Stocks – Developed 20.00 See Theme #2. Foreign Stocks – Emerging 7.50 See Theme #4. Foreign Stocks – Europe 5.00 See Theme #3. TIPS 15.00 See Theme #5. Bonds 10.00 REITS 7.50 See Theme #6. TOTAL 100.00 As I mentioned in the outset, look for further articles to follow. In these, I will reveal my choices for the specific ETFs with which to build this portfolio, from three different providers; Vanguard, Fidelity (with iShares funds), and Charles Schwab. Until then, I thank you for reading, and wish you… Happy Investing! Authors Note: If you like my work, I would be deeply indebted, and highly grateful, if you could be sure to follow me here on Seeking Alpha, as well as feature my work to friends, colleagues and/or relatives who may be interested in the subject matter. Other than the time you invest to read, there is no other cost for the work that I do. Your support will enable me to continue my efforts.