Category Archives: Diversification

How Am I Doing? An 8-Point Financial Checklist

How am I doing?A question that nags at many people is whether they are on track financially.  Even an average financial life can seem remarkably complex.  How does anyone know whether he or she is doing the right things?  A range of studies on how people manage their money suggests that many, if not the majority, are making choices that look decidedly sub-optimal.  Americans don’t save enough money and when they do save and invest, they often make basic mistakes that substantially reduce their returns.  More than 60% of self-directed investors have portfolios with inappropriate risk levels.  Almost three quarters of Americans have little or no emergency savings.  The solution to these problems starts with an assessment of where you are and where you need to be.

The key, as Einstein once said, is to make things as simple as possible but no simpler.  In an attempt to provide a checklist that’s in line with this edict, I offer the following questions that each person or family needs to be able to answer.

The first three questions focus on consumption and saving:

  1. Am I saving enough for to meet personal goals such as retirement, college education, and home ownership?
  2. Am I saving enough for contingencies such as a job loss or an emergency?
  3. Am I investing when I should be paying down debt instead, or vice-versa?

The next five questions deal with how you invest the money that you save:

  1. Is my portfolio at the right risk level?
  2. Am I effectively diversified?
  3. Am I aware of how much am I paying in expenses?
  4. Are my financial decisions tax efficient?
  5. Should I hire an investment advisor?

Anyone who can answer all eight of these questions satisfactorily has a strong basis for assessing whether he or she is on track. Odds are there are more than a few questions here that most of us either don’t have the answer to or know that we are not addressing very well.

Part of what makes answering these questions challenging is that the experiences of previous generations are often of limited relevance, especially when it comes to life’s three biggest expenditures: retirement, college, and housing.

For example, older people who have traditional pensions that guarantee a lifetime of income in retirement simply didn’t need to worry about choosing how much they had to save to support themselves during retirement.

The cost of educating children has also changed, increasing much faster than inflation or, more crucially, household income.  For many in the older generation, college was simply not a consideration. It has become the norm, however, and borrowing to pay for college is now the second largest form of debt in America, surpassed only by home mortgages.  Children and, more often their parents, must grapple with the question of how much they can or should pay for a college education, along with the related question of whether a higher-ranked college is worth the premium cost.

The third of the big three expenses that most families face is housing costs. Following the Second World War, home buyers benefitted from an historic housing boom.  Their children, the Baby Boomers, have also seen home prices increase substantially over most of their working careers.  Even with the huge decline in the housing crash, many Boomer home owners have done quite well will real estate.    Younger generations (X, Y, and Millenials), by contrast, have experienced enormous volatility in housing prices and must also plan for more uncertainty in their earnings.  And of course, what you decide you can afford to spend on a home has implications for every other aspect of your financial life.

In addition to facing major expenses without a roadmap provided by previous generations, we also need to plan for the major known expenses of everyday life. It’s critically important to determine how much to keep in liquid emergency savings and how to choose whether to use any additional available funds to pay down debts or to invest.  There are general guidelines to answering these questions and we will explore these in a number of future posts.

The second set of questions is easier to answer than the first.  These are all questions about how to effectively invest savings to meet future needs.  Risk, diversification, expenses, and tax exposure can be benchmarked against professional standards of practice.

What can become troubling, however, is that experts disagree about the best approach to addressing a number of these factors.  When in doubt, simplicity and low cost are typically the best choices.  Investors could do far worse than investing in a small number of low-cost index funds and choosing the percentages to stocks and bonds based on their age using something like the ‘age in bonds’ rule.  There are many ways to try for better returns at a given risk level, and some make far more sense than others.  Even Warren Buffett, arguably the most successful investor in the world, endorses a simple low-cost index fund strategy.  Upcoming posts will provide a number of straightforward standards for addressing these questions.

Investors who find these questions  too burdensome or time consuming to deal with may wish to spend some time on the eighth and final question: whether they should hire an investment advisor to guide them.  Investors may ultimately choose to manage their own finances, search out a human advisor, or use an online computer-driven advisory service.

While financial planning can seem complex and intimidating, our series of blog posts on the key issues, as outlined in the eight questions above, will provide a framework by which individuals can effectively take control and manage their financial affairs.

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Low Beta Market Sectors

With U.S. equity markets near their record highs and a bull market run that is starting its sixth year, the potential for a correction is a growing concern.  In addition, U.S. equity prices look fairly high when viewed in terms of the PE10 ratio.  Another factor that concerns some market watchers is that volatility (as measured by VIX) is at very low levels, reminiscent of 2007.  This type of complacency has historically been followed by increasing volatility, as levels return to their historical average, accompanied by a sell-off in higher-risk assets as investors adjust their portfolios to mitigate the effects of higher volatility.

Investors seeking to remain invested in equities at a target level but who want to reduce their exposure to market swings and to mitigate the impact of a rise in market volatility have historically been well-served by increasing their allocations to low-beta market sectors.  In this article, I will review the defensive value of low-beta allocations as well as examining the consistency of beta over time.

Beta measures the degree to which a security or a portfolio responds to a move in a benchmark index such as the S&P500.  A portfolio with beta equal to 80% (also written as 0.8) tends to go up 0.8% when the market rises 1.0% and vice versa.  Beta may be thought of as showing whether a security amplifies the moves in the benchmark (beta greater than 100%) or damps the moves in the benchmark (beta less than 100%).

How Beta Varies by Sector

The SPDR Select Sector ETFs provide a convenient way to break out the sectors of the U.S. equity markets by dividing the S&P500 into nine sectors.  These sectors illustrate how much beta varies.

Low Beta Market Sectors - 1

Betas and 10-year average annual returns for major sectors and indexes

The S&P500 has a beta of 100%, by definition.  Some readers may be surprised that emerging market stocks have beta of almost 140%, which means that emerging market equities tend to go up (down) 1.4% for every 1% gain (drop) in the S&P500.  Even before the market crash of 2008, emerging market stocks were high beta—this is not a new phenomenon.

There are three U.S. equity sectors with betas well below 100%: consumer staples (XLP), healthcare (XLV), and utilities (XLU).  It is often believed that low-beta equities have very low average returns.  In fact, a well-known but now widely-discounted model of equity returns (the Capital Asset Pricing Model, CAPM) assumes that beta of an equity or asset class corresponds directly to expected return.  High-beta asset classes have high expected return and vice versa.  Low-beta equities have historically substantially out-performed what would be expected on the basis of CAPM, however, and the past ten years is no exception.  These three sectors have all out-performed the S&P500 over the past ten years.  The return numbers shown here are the arithmetic averages, including reinvested dividends.

Low Beta Asset Classes in 2007-2008

The first question that is worth asking about beta is the degree to which beta corresponds to losses in really bad market conditions.  In the table below, I have tabulated beta calculated using three years of data through 2007 for each of the funds above, as well as the returns for each of these in 2008.

Low Beta Market Sectors - 2

Beta calculated through 2007 vs. 2008 returns

The three sectors with the lowest betas going into 2008 (consumer staples, healthcare, and utilities) had an average return of -22.3% in 2008, as compared to -36.8% for the S&P500.  An equity tilt towards these lower beta sectors could have reduced losses in that year.

Consistency of Beta through Time

The astute reader may notice that the betas calculated using ten years of data through May of 2014 (shown in the first table) are, in some cases, quite different from the betas calculated using three years of data through December of 2007 (shown in the second table).  Beta varies through time.  The betas calculated using three years of data through May 2014 provide an interesting contrast to the three-year betas through the end of 2007.

Low Beta Market Sectors - 3

Comparing betas for two 3-year periods

We are looking at two distinct 3-year periods, separated by almost six and a half years and, in general, low-beta sectors at the end of 2007 remain low-beta today and high-beta sectors back then are still high-beta.  The two most notable exceptions are international equities (EFA) and the technology sectors (XLK).  These changes notwithstanding, the three sectors with the lower betas in 2007 also have the lowest betas in 2014.

There are a number of factors that will determine whether any sector will weather a broad market decline better than others.  Beta is one important factor, but there are others.  In 2008, the financial sector suffered disproportionately large losses—well beyond what would have been expected on the basis of beta alone.  The underlying drivers of the 2008 market crash were most severe in the financial sector.  Small-cap stocks, by contrast, fell considerably less than the beta value of this sector would have suggested.

Low-Beta and Asset Allocation

Low-beta asset classes have historically provided some protection from market declines and increasing volatility.  There are a range of other considerations that potential investors should consider, however when creating a portfolio.  The selection of individual asset classes should be made with consideration of the characteristics of the total portfolio, including desired risk level, interest rate exposure, and income generation.  The target for total portfolio beta is primarily determined by an investor’s total risk tolerance.  A target beta level can be achieved both by choosing how to allocate the equity portion of a portfolio among sectors and by varying the balance between equity (stocks) and fixed income (bonds) investments.  Fixed income asset classes tend to have very low—even negative—values of beta.  In my next blog entry, I will explore these two approaches to managing beta at the portfolio level.

History suggests that low-beta sectors can provide some protection from market downturns.  The length of the current equity rally, and the substantial increases in equity valuations in recent years, are motivating some investors to consider their best defensive alternatives to protect against the inevitable reversal.  The question for investors to ask themselves is whether they are best-served by reducing portfolio beta by reducing their exposure to equities, by shifting some portion of assets from high-beta to low-beta sector, or both.

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REITs and the Rally of 2014

There have been a number of surprises for investors in 2014.  Bonds have markedly out-performed stocks for the year-to-date.  The S&P500 is up 2.4% since the start of 2014, as compared to the Barclays Aggregate Bond Index, which is up by 3.5%.  Even more striking, the iShares 20+ Year Treasury Bond ETF (TLT) is up by 12.5% YTD and the Vanguard Long-Term Bond fund (VBLTX) is up by 11.4% YTD.  Interestingly, REITs have been also experienced a substantial run-up in 2014 so far.  The Vanguard REIT Index fund (VGSIX) is up 16.1% YTD and the iShares U.S. Real Estate ETF (IYR) is up by 14.4% YTD.

To understand the rally in REITs, it is useful to start with an overview of this asset class.  REITs are neither stock (equity) nor bond (fixed income).  A REIT uses investor money, combined with borrowed money, to acquire real estate.  The properties that they acquire can be office buildings (BXP, SLG), apartment buildings (EQR, UDR), healthcare facilities (HCP, HCN), or even digital data centers (DLR).  The returns vary between the specific types of property owned.  REITs make money from renting their facilities out.  Please note that I am discussing only equity REITs (those which own property).  There is a secondary form of REITs that buy baskets of mortgages.  These are called mortgage REITS (mREITs).

REITs are classified as ‘pass-through’ or ‘flow-through’ entities and pass at least 90% of their taxable income to their shareholders each year.  For this reason, REITs are often favored by income-oriented investors.

REITs have their own unique measures of value and drivers of performance.  Rather than price-to-earnings ratio, a measure of the valuation of stocks, the preferred measure of valuation for REITs is price-to-funds from operations (FFO).  A notable feature of REITs is their exposure to interest rates.  In general, stocks go up when interest rates rise, while bonds fall.  When interest rates decline, the reverse tend to be true: stocks decline and bonds rise in value.  REITs tend to have a fairly neutral response to changes in interest rates, although this varies.  To the extent to which REITs need to borrow in the future due to rolling credit or new financing, their costs rise when interest rates rise.  REITs often also have the ability to raise rents, however, so that their revenue can also rise when the costs of residential or commercial real estate rise with inflation.  In addition, because REITs own a physical asset (property), the value of the assets owned by the REIT tend to go up with inflation.

An examination of the performance statistics of REIT funds illustrates their properties quite clearly.

Chart 1

REIT funds vs. major asset classes (10 years through April 2014)—Source: Author’s calculations

The returns above are the arithmetic average of returns over the past ten years, including reinvested dividends.  Beta measures the degree to which an asset tends to amplify or mute swings in the S&P500.  The betas for VGSIX and IYR show that these funds tend to rise 1.3% for every 1% rise in the S&P500 (and vice versa).  These broad REIT funds tend to do well in rising stock markets and will also tend to perform worse than the S&P500 when the market crashes.  The S&P500 fell 36.8% in 2008, for example, and IYR fell 39.9%, for example.  The high beta is only one factor that determines the returns from these REIT index funds, however.  Despite a massive decline in real estate in 2008, the average annual return for these two REIT funds has been very high over the past ten years.  The volatility levels exhibited by these REIT funds is, however, very close to that of emerging market stocks, as shown above.

The best way to understand the unique features of REITs is to look at the correlations in the returns between asset classes, bond yields, and the returns from a traditional 60/40 portfolio (60% stocks, 40% bonds).

Chart 2

Correlations between monthly returns over the past ten years (through April 2014) for major asset classes, 10-year Treasury bond yield, and the returns from a 60/40 portfolio—Source: Author’s calculations

Equity indexes tend to have positive correlations to Treasury bond yields (because yield goes up when bond prices go down, and vice versa).  This effect is evident in the table above.  S&P500 stocks (represented by SPY) have a +30% correlation to the 10-year Treasury yield.  The same relationships hold for the other major equity classes in the table above (EFA, EEM, QQQ, and IWM), with correlations to the 10-year Treasury yield ranging from 20% (EFA) to 36% (IWM).  In 2013, Treasury bond yields rose and stock indexes gained substantially.  By contrast, the returns of bond funds (AGG, TLT) are negatively correlated to the 10-year Treasury bond yield.  The returns from these funds tend to be positive when Treasury yields are falling and vice versa.

Treasury bond yields follow interest rates and inflation.  When rates or inflation rise, bond yields rise because investors sell Treasury bonds to avoid getting caught with relatively low-yield bonds in a higher rate environment.  The selling continues until the yield on the bonds is in line with new rates.  This is why returns on the two bond funds are so negative correlated to Treasury yield.  When yields go up, bond prices fall and vice versa.

VGSIX and IYR have 6% and 7% correlations to the 10-year Treasury yield—which means that these REIT funds are not highly sensitive to movements in bond yields.  While investors were betting on rising yield in 2013, opinion seems to have shifted in 2014.  If you are looking for asset classes that don’t require a bet on whether interest rates will go up or down, REITs look pretty attractive.

The correlations between the returns from each asset class and the returns from a 60% stock / 40% bond portfolio show the degree to which adding these asset classes to a simple stock-bond mix is likely to provide diversification benefits.  The higher the correlation, the less diversification benefit you can expect.  The key idea in diversifying a portfolio is to combine assets with low correlations so that when one is losing money, others are likely to be doing something different (hopefully rising in value).  As compared to the major equity asset classes, the REIT funds have a lower correlation to the 60/40 portfolio.  This, in turn, suggests that REITs can provide more diversification benefit than equities to a portfolio that currently holds stocks and bonds.

In summary, the basic narrative to explain the rally in REITs goes something like this.  REITs provide substantial income compared to bonds and equities, as well as being essentially interest rate neutral.  While REITs are a volatile asset class, the relatively low correlation between REITs and equities provides diversification benefit to a portfolio of domestic stocks and bonds, as well as providing some modest protection from rising interest rates.  REITs appear have come back into favor after being sold off during and after the so-called taper tantrum of 2013, with yield-hungry investors leading the charge.  In a slow-growth environment, with the Fed indicating that they foresee an extended period of low rates, REITs look quite attractive.  The caveat to the positive view on maintaining an allocation in REITs is that there are substantial differences between the yield, risk, and interest rate exposure and that REITs have historically been a volatile asset class.  Unless you firmly believe that you can outsmart the broader market, REITs should be thought of as a long-term income producer and diversifier.  For those investors who have maintained a strategic allocation to REITs, the gains in 2014 YTD have helped to bolster portfolio returns as equities have provided very little to investors beyond their dividends.  The downside to this positive narrative, however, is that increased prices for REITs translate to lower yields for today’s buyers.

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Understanding How Fund Performance Comparisons Overstate Returns

May 13, 2014

Every investor has, I hope, read the standard disclaimer on mutual fund and ETF performance documents that ‘past performance does not predict future performance,’ or other text to that effect. Still, when you read a fund company’s statement that ‘x% of our funds have out-performed their category average’ or that ‘x% of our funds are rated 4- and 5-star by Morningstar,’ this seems meaningful. Similarly, if you read that the average small value fund has returns ‘y’% per year over the last 10 years, this also seems significant. There is a major factor that is missing in many of these types of comparisons of fund performance, however, that tend to make active funds look better than they really are (as compared to low-cost index funds) as well as making a mutual fund family’s managers look more skillful than they might actually be.

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Is Twitter the Canary in the Coal Mine?

Investors are shrugging off the suggestion that stocks are over-valued or that the technology innovators are a one-way path to riches if the year-to-date performance of Tesla Motors (TSLA) and Facebook (FB) are any indication. Twitter’s stock (TWTR), which soared from a $45 closing price on its first day of trading (November 7, 2013) to a high of $73.30 on December 26, has fallen 32% since the start of 2014. Twitter is now trading at slightly below $45. Given the excitement surrounding the Twitter IPO less than six months ago, what does this apparent reversal of (expected) fortunes suggest? It is certainly too soon to conclude that a business model that made sense at the IPO has proven to be faulty. Does Twitter’s dramatic decline signal a shift in investors’ willingness to bet heavily on a future earnings stream that is almost impossible to predict? Continue reading

How Much Do You Need to Save for Retirement?

In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income.  The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic.  These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.

The series of articles in Money kicks off with perspectives by Wade Pfau.  Pfau’s introductory piece suggests a difficult future for American workers.  A traditional rule-of-thumb in retirement planning is called the 4% rule.  This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation.  Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years.  It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds.  The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds.  The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule.  For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds.  The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average.  High P/E tends to predict lower future returns for stocks, and vice versa.  For a detailed discussion of these relationships, see this paper.  In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement.  I also explored this topic in an article last year.

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Financial Literacy: State of the Union in 2013

April is financial literacy month.  I believe that lack of financial knowledge is one of the most critical problems that our country faces. Continue reading