Tag Archives: stocks

Balanced Investing For Balanced Living

In the market’s never-ending story, we never know how its most recent action will play out. One thing we do know is that when the market is more volatile than usual, investors who lack a personalized, long-term plan to guide their way are far more likely to make the wrong moves by the time the cycle is complete. In our opinion, every investor’s long-term plan should include embracing a buy, hold and rebalance approach to investing. This is one of the simplest and most effective ways to diversify, and it may help you prosper in various financial markets over the long term. To achieve this goal, a portfolio is initially allocated based on each investor’s needs across different asset classes, such as stocks, bonds and real estate. The portfolio mix is then maintained by periodically rebalancing. Winning investments are pared back, and underperforming investments are increased during a rebalancing. A rebalancing can occur on a specific date, such as a birthday or anniversary, or it can be done using a percentage of asset method. See my book All About Asset Allocation for a detailed discussion of rebalancing techniques. Figure 1 is an illustration of rebalancing using a 50% stock and 50% bond allocation. When stocks gain versus bonds, their percentage or allocation becomes too large. Shares of the stock investment are sold, and the proceeds are reallocated to bonds. This serves as a risk control mechanism for the portfolio. Another effective way to rebalance is to employ new dollars when they are available. For example, if you were to receive a modest lump sum of cash , you could use it to “feed” the portion of your portfolio that requires additional assets. If you were underweighted in bonds, for example, you could apply the new dollars there. This helps you rebalance, while minimizing the transaction costs involved. Figure 1: Rebalancing a 50% stock and 50% bond portfolio (click to enlarge) (Chart by R. Ferri) Some financial pundits criticize a balanced approach. They say a buy, hold and rebalance strategy is simple-minded and a relic of the past. Often, their solution is to be tactical, meaning they suggest that investors aggressively move in and out of the markets in an attempt to avoid the worst returns and capture the best ones. As it turns out, the data suggests that more than half the experts fail to time the markets correctly ; their portfolios are expected to fall short of the simple strategy they mock so much. Consider Figure 2, which illustrates the returns of a portfolio initially allocated to 50 percent in stocks and 50 percent in bonds from January 1, 2007 through August 31, 2015. The period begins just prior to the worst bear market in recent memory, and includes a surge in stock prices that occurred in the years thereafter. The proxy for stocks was the CRSP Total Stock Market Index, and the proxy for bonds was the Barclays Capital US Aggregate Bond Index. Both indexes hold broad representations in their respective markets. The 50/50 portfolio was rebalanced monthly; annual rebalancing works just as well. Figure 2: Comparing a 50/50 Bond/Stock Portfolio to Each Index (click to enlarge) (Source: CRSP and Barclays Capital data from DFA Returns Program, chart by R. Ferri) At least on paper, every stock investor lost portfolio value during the crushing bear market that began in October 2007. Prices were down nearly 60 percent from peak to trough. A 50 percent stock and 50 percent bond portfolio was down about 20 percent from the peak. Even a portfolio holding only 20 percent in stocks didn’t escape the bear, and was down about 5 percent by the time the market hit bottom in March 2009. Still, Figure 2 shows that the 50/50 diversified, rebalanced portfolio fared quite well during the bear market and the recovery that followed. The return hasn’t matched a 100 percent stock portfolio over the entire period, but the volatility was considerably lower – and volatility matters! Investors who assume the party will never end and take on too much equity risk when the markets are surging upward over extended periods run the risk of capitulating in the next bear market. They often lack a disciplined plan to see their way through, and may never fully recover the realized losses they incur after selling. Lower volatility created by a disciplined allocation to stocks and bonds helps keep you invested during all market conditions. Ideally, our crystal ball could tell us to get out of stocks before the crisis, but realistically, no one knows what the market is going to do in the future. We invest in stocks because in the long term, the returns are expected to be substantially better than those from bonds. We need this growth just to stay ahead of inflation and taxes. Patience is a virtue, though. Bear markets occur without warning; bull markets often follow on their heels with equal unpredictability. And so on, and so forth. Only those with discipline throughout can expect to build wealth according to a rational course, rather than depending on random and very fickle fortune to be their “guide.” Balanced investing is part of balanced living. A buy, hold and rebalance strategy using broad market index funds is one of the simplest and most effective ways to diversify and prosper over the long term. It helps keep us sane and our portfolios more reliably on track during good times and bad. Disclosure: Author’s positions can be viewed here .

Protecting Yourself Against The Next Bond Liquidity Crunch

By DailyAlts Staff Anyone who lived through it knows that liquidity evaporated during the 2008-09 financial crisis. In response, the U.S. federal governments imposed a series of rules and regulations designed to make financial markets safer, but instead, they’ve contributed to even more illiquidity. What can investors do about it? That’s the question explored in Alliance Bernstein’s September 2015 white paper Playing with Fire: The Bond Liquidity Crunch and What To Do About It . Trading Turnover is Down The bond market has long been considered a safe haven during times of financial stress. Historically, well-capitalized banks have stood at the ready, willing to buy bonds – particularly investment-grade and government issues – when no other buyers were interested. But due to regulatory changes, banks are hamstrung from providing this service, and as a result, turnover in both investment-grade and high-yield bonds has plummeted since the financial crisis. Increased Correlation It’s not that demand is down: New bonds are being issued in record numbers, and investors are willing to buy. The problem is that during so-called “fire-sale” selloffs – when stocks, bonds, and commodities suffer sharp declines – bond-market liquidity is drying up, and thus sellers under duress must contend with wide bid/ask spreads and lower selling prices than they bargained for. And, as a result of the policies of the Federal Reserve and other central banks, these broad selloffs are becoming more and more common. The Impact of Central Banks In the wake of the financial crisis, when liquidity dried up, central banks began forcing down interest rates by buying government bonds and other assets, thereby expanding the money supply and flooding the markets with liquidity. Their bond buys pushed interest rates down and forced yield-minded investors into riskier assets. In addition to the U.S. Federal Reserve, the U.K.’s Bank of England, the EU’s European Central Bank, the Bank of Japan, and the People’s Bank of China have all massively expanded their balance sheets since 2009. Crowded Trades With lower rates on government bonds, stocks and other riskier assets become more attractive by comparison. While 0% interest rates may have made sense as an “emergency” policy measure, nearly ten years later, rates are still pegged near zero, but it appears things are likely to begin normalizing later this year, or in early 2016. It’s widely acknowledged that the Fed and other central banks have boosted bonds and other asset prices, so the reversal of their policies is likely to have the same effect – indeed, even the Fed’s threat of scaling back its “quantitative easing” bond-buying program in 2013 led to a “fire-sale” dubbed the Taper Tantrum. The risk in 2015 and into 2016 is that yield-starved investors have crowded into too many of the same trades, and that without banks standing on guard to buy during the next “fire-sale” selloff, there may be no takers (at reasonable prices), and thus a severe liquidity crunch. What to Do About It? So what can investors do about it? AllianceBernstein’s Head of Fixed Income Douglas Peebles and Head of Global Credit Ashish Shah, authors of the white paper, provide the following list: Diversify using a broad multi-sector strategy; Be a contrarian and avoid the crowd; Keep cash handy – and don’t neglect derivatives; Do your credit homework – and expand your investment horizon; and Consider select investments in private credit. Investors should vet asset managers as part of their “credit homework.” Peebles and Shah recommend asking managers questions to gauge their acumen, such as “To what do you attribute the decline in liquidity?” and “How has your process changed as liquidity has dried up?” In closing, the authors ask investors to remember: While the financial crisis did considerable damage to markets and investors, those who kept their cool – and who didn’t rely too much on liquidity – made a lot of money. For more information, download a pdf copy of the white paper .

Can Investors Achieve Commodity Exposure Via Equities?

By Wesley R. Gray, Ph.D. This past year we examined the possibility of replicating commodity exposure via equities. The project was spurred by an insightful research report from MSCI , which showed some impressive results. Other research outfits have proposed similar concepts . The figure below, taken from the MSCI report, highlights how well the MSCI Select Commodity Producers Index replicates various commodity indices over 2010-2012: (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. We replicate these results and come to similar conclusions: Correlations for commodities and commodity-related-equities are > .8 from 2010-2012. However … and this is a big however… When we look at a longer out-of-sample period, from 1991 to 2014, correlations are much lower (the best versions of our algorithms can get the correlation in the .6-.7 range after intense data-mining). The executive summary below is from a 125-page internal report we did on commodity via equity replication. The correlation figures represent the full-sample correlations between the underlying commodities and some of our top replication techniques. Clearly, the evidence below suggests that we should be skeptical of claims that commodity exposures can be effectively replicated via commodity-related equities. Especially, when the sample period analyzed is short. (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Understanding Commodity Replication via Equities Accessing commodity exposures can be complicated. Consider oil exposure: Buy oil futures? The oil ETF? Oil stocks? Each of these option has pros and cons. Futures Futures appear straight forward, and require less margin than equities; however, these contracts trade in large notional amounts (eliminating the option for retail investors), incur transaction costs (potential roll costs and other transaction costs), and trading futures should not be viewed as a buy-and-hold investment (e.g., see research here and here ). Many investors view commodity futures like stocks, where an investor simply buys and holds over the long term and grinds out the equity risk premium. But this is not the right frame of thinking. Commodity futures aren’t equities. Futures are a traded asset class, and being active – not passive – is the only way to capture the potential risk premiums offered by commodities (e.g., term structure). ETFs that own futures One can buy an oil ETF that owns oil futures, which is simple and requires less capital, but there are management fees, and these funds still have embedded future trading costs. Stock replication One could also explore investing in stocks that are in the oil business. This approach has some huge potential benefits: tax-efficiency (i.e., deferral), simplicity, no roll risks, dividend payments, etc. However, the biggest risk is that oil stocks may not necessarily capture the exposure of oil future prices. For example, some oil producers may hedge production, thus limiting their business exposure to underlying oil price fluctuations, and thus, their correlation to the underlying commodity. In order to deal with this risk, one needs to engineer a specific portfolio and actively manage the exposures. How to Replicate Commodity Futures via Equity Portfolios In this piece, we look at different algorithms that form portfolios meant to capture commodity risk exposure via equities. To facilitate understanding, we focus on an analysis of the energy sector. In order to replicate commodity returns with stocks, we look at 3 approaches (one can mix and match or add additional techniques, but these are the big muscle movements): Identify commodity-related sectors and the associated stocks (e.g., oil sectors stocks should follow oil more than information technology stocks would). Identify % revenue generated by specific sectors (e.g., an oil stock that generates 95% of its revenue from the oil sector is better than one with 51%). Identify past correlations between stocks and commodities (e.g., an oil stock with a 90% historical correlation is better than one with a 50% correlation). In the end, we perform a variety of data-mining techniques that mix and match various elements to try and data-fit the portfolios that have the highest correlation out-of-sample. Here is an example combination approach that seems to be most effective in our research: Identify companies in a specific SIC sector (e.g., primary SIC code is energy). Confirm that the firms identified have 50%+ of their revenue from energy For firms identified in steps 1 and 2, calculate rolling past 12-month correlations with energy returns. Purchase the top 10% highest correlated firms (can equal-weight or value-weight the portfolio) Monthly re-balance. Some Example Results SP500 = S&P 500 Total Return Index future_energy_ew = equal-weighted across 6 energy futures (natural gas, crude oil, Brent crude, gasoline, heating oil, and gas oil) equity_energy_ew_12m daily corr = equal-weighted, top 10% 12-month rolling correlation using daily returns, re-balance at the end of month equity_energy_vw_12m daily corr = value-weighted, top 10% 12-month rolling correlation using daily returns, re-balance at the end of the month Results are gross of fees. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Summary Performance 1992/05 to 2014/12 (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. The correlation results are not promising – average correlation is 65-67% – a far cry from the 90%+ results we’d like to see if we wanted to replicate commodity future returns with equity. Invested Growth 1992/05 to 2014/12 (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Energy-related stocks don’t track energy sector futures that well over time. Looking inside the black box: Sample stock names as of 2014/12/31, market cap in millions (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Conclusion Based on the analysis above, replicating commodity futures via equity is mediocre, at best. In contrast to MSCI, we’re not convinced . Determining if commodity exposure is a benefit to a portfolio is a complex issue, but given that one believes in the benefit of exposing a portfolio to the commodity sector, trying to access these exposures via equity replication probably isn’t going to work that well… at least not as well as previously contemplated. Original Post