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The Big, Bad Floating NAV Is Coming Your Way

Summary Prime money market funds are going to be reporting their net asset values on a floating basis due to recent SEC rules. The effect will be to render these funds costlier, both on an accounting and a tax basis, and might lead to an outflow from these funds. However, the weighted average maturity of these funds, one measure of their riskiness, is well within SEC guidelines. The big, bad floating NAV is coming your way In 2014 the SEC adopted amendments to rules that govern certain types of money market funds. In particular prime money market funds – those that invest in corporate debt securities will have to report floating Net Asset Values (NAVs) instead of posting fixed NAVs as has hitherto been the case. Thus at any given time, capital appreciation or depreciation will have to be reported, leading to a move towards money market funds with a Treasury or municipal bond focus. Instead of assuming a fixed NAV of $1.00, investors will have to confirm the posted NAV price. There will also be liquidity management issues, since the use of these money market funds for intra-day liquidity management will be much diminished, given the uncertainties about the NAVs for these funds. Companies would have to monitor the marking-to-market value of these funds on their balance sheets. Finally, all sales of money market fund shares would become taxable events. Rule 2A-7 risk limiting provisions amended Traditionally SEC’s Rule 2A-7, adopted in 1983, allowed money market funds to use amortized cost to value the funds so long as they kept within very strict parameters. Since money market funds are not insured by the FDIC, they have traditionally had to keep within limits about the three primary risks they face. Of course, the first was interest risk, credit risk and liquidity risk (the risk that a borrower will not pay its obligations when due). Of course, the first two kinds of risks do not affect money market funds which invest in Treasuries or municipal bonds. But all three risks affect prime money market funds. With a fixed NAV based on amortized cost, investors did not need to track their capital gains and losses, since all of the return of a money market fund is paid out in dividends. In addition, a stable NAV allowed these funds to offer such services as check-writing and the other general features available to deposit accounts, while allowing investors to have access to some upside features. The daily dividend on the fund is based on the accrued interest based on amortized cost. At least that was the situation before the recent amendments by the SEC. On Weighted maturities and interest rate sensitivities. Given the above mentioned advantages of the stable NAV for money market funds, it was imperative to keep the funds within certain risk bounds. One way to do this was to limit the maximum weighted average maturity (WAM) of the funds. An increase in interest rates would decrease a fund’s shadow price. One measure of the sensitivity of any fund with respect to a change in interest rates is the fund’s weighted average maturity (the WAM). The WAM is the measure of the average maturity of the bonds in the fund’s portfolio, and the SEC rules provided that funds, in order to use amortized cost, could have a maximum WAM of 60 days. The higher the WAM, the more sensitive the shadow price of the fund would be to changes in interest rates. When redemption of funds is high, especially in times of crisis, (as was the case between 2007 and 2008), then shadow prices will fall below $1, and the WAM is especially helpful to understand the riskiness of these funds. Recent measures of WAM show relatively low riskiness. Money market funds are obligated to disclose their net assets, 7-day interest rates and WAMs on a monthly basis. Extracting some of this data from the SEC web site for four representative prime money market funds (those of BMO, BNY Mellon, Legg-Mason and Fidelity) show that all of these funds have WAMs well below 60 days. The shadow prices (not shown) are $1 for BMO and BNY Mellon, $1.002 for Fidelity and $1.0001 for Legg Mason in the period shown. Legg Mason, with a WAM over the period for its prime funds of 6 days, carries a 7-day rate on average of .23%. (The figures below come from the N-MFP disclosures on the SEC website). Does this mean there is no cause for concern? The above-mentioned trends do not mean that there is no cause for concern. Shadow prices of these funds are notoriously resistant to reflecting trends in markets. In September of 2008, 90 percent of prime money market funds had shadow prices within 5 basis points of $1, as reported by the ICI. Nevertheless, when floating NAVs become part of the investor’s framework, it is likely that they will not be as volatile as feared if current trends in the weighted average maturity are any indicator. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Portfolio Risk Contributions: Practical Examples

Portfolio risk contribution of an investment tends to differ from its portfolio weight. In some cases intuition may be misleading – a good example is the traditional 60/40 portfolio. It is paramount to assess the impact from each position in a portfolio. It is no secret that portfolio risk contribution of an individual security almost always differs substantially from its portfolio weight. However, investors frequently overlook this simple truth and tend to focus on notional dollar amounts invested. I have compiled a few examples that clearly illustrate why risk contributions matter. Let’s start with the traditional 60/40 portfolio, where SPDR S&P 500 ETF (NYSEARCA: SPY ) is used as a proxy for equities and iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) for bonds. Analyzing this portfolio on InvestSpy Calculator with 1 year historical data, we get the following results: The table above tells us that even though TLT had a slightly higher annualized volatility than SPY (which is an interesting fact in itself), its risk contribution to the total portfolio volatility was only 21.4% – way below TLT’s portfolio weight of 40%. And the difference would only get wider if we used shorter duration bonds for the fixed income component. So even though an investor may intuitively feel well diversified between stocks and bonds, almost 80% of portfolio risk comes from the equities component. Big discrepancies between portfolio weights and actual risk contributions can arise in equities-only portfolio as well. I came across the next example while writing a recent article about the ‘Fab Five’ stocks. Assuming a simple hypothetical portfolio where 50% is invested in SPY ETF and 50% in Google (NASDAQ: GOOG )(NASDAQ: GOOGL ), risk contributions from each position are far from even: This gap between risk contributions is primarily factored by the fact that GOOG is by far a more volatile security than SPY. The third example I would like to present is a portfolio that includes emerging market stocks. Investors are frequently reminded of a home country bias in their allocations and encouraged to include international stocks in their portfolio. So if a US investor allocates 20% to Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) with the remainder sitting in SPY, the risk profile of such a portfolio looks as follows: The risk contribution of the VWO position appears to be fairly close to its portfolio weight. Interestingly, the annualized volatility of the portfolio is only a tad higher than that of SPY’s in isolation despite the fact that VWO is significantly more volatile security. This is a direct result of the diversification effect. Therefore, the addition of emerging market stocks to diversify a portfolio of US stocks looks like a sensible decision. I hope the examples above give the readers a bit of a flavor how risk contributions work and why they are important. It is crucial to look beyond notional amounts invested in each position to assess if your portfolio is balanced the way it was intended. You will be surprised in some cases. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The MnM Portfolio Supplement – I Want To, But Can’t Purchase A Water Utility

Summary I outline my preference for water utilities. I review my analysis of the five water utilities listed as Dividend Champions on David Fish’s monthly publications. The current prices, yields, and historical dividend growth rates are unattractive as compared to other opportunities. A little background When I look over my MnM portfolio, last written about here , one of the key considerations I make is sector diversification. As I have built out the portfolio this year, it has come to my attention that I do not have any exposure to several sectors, including, but not limited to: utilities, telecoms, and financials (excluding REITs and insurers). I have been tempted to add positions in these sectors to round out the portfolio a little more. I hope to potentially do so in the coming year. That being said, I wanted to look a little bit deeper into utilities, as when I look at the overall utilities sector, represented by the Dow Jones Utility Average (^DJU), I see that it’s trailing the broader S&P 500 this year. (click to enlarge) Source: Yahoo Finance, 11 September 2015 It’s important to note that there are various types of utilities in the U.S. There are those that provide electricity, those that provide natural gas, those that provide water services, and some that provide a blend of these services, or others. A Quick summary of the regulated utility industry I am well versed with the regulated utilities environment, having grown up with a parent who worked in the industry, and spending some time in it myself. For those unfamiliar with how these companies work, a simple explanation is that utilities work with state and federal utility commissions to get rates approved to charge customers (end users of the electricity, gas, water, etc.) based upon a cost plus margin model. The utilities generally have to justify their capital expenditures to the commissions in seeking to be reimbursed for the costs (and consequently their margin). This model exists as utilities generally have a monopoly of service for their territories, meaning that other utilities are not able to offer up competing services. It’s too cost prohibitive. End users generally have only one provider option. As noted above, I do not currently hold any utility stocks, but if I were to purchase one down the road, my preference would be towards water utilities. Why do I have a preference for water utilities? When I take a step back from the fundamentals and technicals, I question whether in 25 years (or shorter) our current electric utilities will still operate in the same way. For example, if you were to tell me in 1995 that we would be seeing a huge shift away from coal within 20 years, I might have laughed at you. When I went to Germany back in 2012, to visit the country and experience Oktoberfest, I couldn’t help but notice that virtually every roof was covered in solar panels. As we speak we’re seeing a transformation in the US in terms of solar being increasingly cheaper, more available, and installed in a distributed (vs. centralized) manner, even as far north as where I live where we see weekly articles of the local utility Xcel Energy (NYSE: XEL ) fighting with solar providers over the size of solar gardens. Don’t get me wrong, I’m not calling for the death of utilities as we know it, but I do think that technological change will put pressure on the current distribution model, and could be a major challenge to growth (i.e. higher electricity sales). Now, there are obviously counters to these concerns, such as expanding populations and increasingly more powered devices (such as cars) across the US, but you cannot deny that things are changing. Some might argue that you could thank the EPA for that. To get back to my point, water is one thing provided by current utilities that I do not feel faces the same kind of technological threats to growth that the other utilities face. We will always need it, and it seems like climate change (whether you believe it or not) is negatively impacting the supply as well, as demonstrated by the droughts in California. Given all of this, water to me, is the most defensive, and thus the one resource I would most like to consider investing in. Why haven’t I bought in already? I looked through David Fish’s U.S. Dividend Champions list for Water Utilities and found there to be five within the dividend champions. Not a bad number. These include American States Water (NYSE: AWR ), California Water Service (NYSE: CWT ), Connecticut Water Service (NASDAQ: CTWS ), Middlesex Water Co. (NASDAQ: MSEX ), and SJW Corp (NYSE: SJW ), and they boast some impressive dividend streaks. (click to enlarge) Source: Price, P/E and Yield metrics courtesy of FASTgraphs.com, closing prices as of 10 September 2015. Dividend growth metrics courtesy of David Fish’s U.S. Dividend Champions spreadsheet updated 31 August 2015. When I took a look through their fundamentals, I have to stop my analysis right there. What disappoints me the most is that for the most part, the dividend increases have been barely above, or even less than the assumed 2% level of inflation, and not just over the last five years, but over the last ten years. American States Water, which has shown superior growth, is just too expensive to buy right now. Further, I personally have a mental “4% yield” requirement for both Utilities and REITs, meaning that is generally the minimum yield I want in order to enter into these securities. This is especially true as we enter a rising rate environment. None of them even come close right now. I would throw in a FASTgraph, but it doesn’t seem warranted. Conclusion I like water utilities in principle, and would love to have a more defensive play in my portfolio; but I just can’t justify owning one right now at their current multiples and stodgy dividend growth. The valuations on these stocks don’t seem to justify the lack of growth. I will keep tracking the securities, as I would like to own one at some point, but I need prices to come down and to see some more accelerated growth before I would jump in. Right now it seems that I could likely do much better with a telecom, such as Verizon (NYSE: VZ ), which is trading at a much lower multiple, pays a much higher distribution, and has grown dividends at a much higher clip. I have my eyes on Verizon, and hope to initiate a position in it at some point in the future. (click to enlarge) Source: FASTgraphs.com, closing price as of 10 September 2015 Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.