Sure, it’s always easier to simply ignore the long-term issues and plan to deal with them later in life.  As humans, we have an enormous behavioral bias to focus on the now and not on the future.  In his recent Ted talk, Shlomo Benartzi estimates that only 11% of Americans are saving enough to meet their future financial needs. This is, in my opinion, a disaster in the works.

What are we thinking?

Benartzi explores the ways that our innate behavioral biases allow us to ignore the looming crisis. He frames the question of how and why people make consistently bad decisions in a range of example, like taking out a mortgage you can’t afford. Using a series of lab experiments, he explains how we seem to have some hard-wired (neurological) biases that tend to make us totally discount our future needs in favor of current consumption. To quote Benartzi:

“Self-control is not a problem in the future. It’s only a problem now when the chocolate is next to us.”

Another speaker on Ted, economist Daniel Goldstein, characterizes this problem as the conflict between our present and future selves.  His main thesis is that we have an incredibly difficult time actually envisioning future outcomes.  Because we cannot see our future selves, we are less likely to save on his or her behalf. Our choices today are implicitly a conflict between our own interests and the interests of some other person—meaning our future selves. Our future self is someone that we don’t even know—some old, gray-haired stranger.

The fundamental issue here is that consumption is instantly gratifying while denying ourselves in the present is not. Denying our impulses to consume requires effort, whereas consuming is both easy and pleasurable. Yet, there are plenty of people who manage to train themselves to eat healthy, to exercise, or to save for retirement. The problem is how we, as a society, motivate more people towards making better, and (sometimes harder) decisions.

The Implications of Poor Financial Choices

When society does not teach high school students that their choices about what they spend on a college education are directly tied to a potential substantial debt that their future selves will have to repay, it is no wonder that so many young people take on such enormous debt burdens without grasping the personal implications.

When mortgage brokers and realtors talk homebuyers into a larger house that they can’t afford (or even that buying as large a house as possible is a good investment, which they have been known to do) we cannot be surprised when they take on an unsustainably large mortgage. The thought here is that it does not take a lot of convincing to get someone to make a choice that they want to make in the first place.

The field of behavioral economics is fascinating and I hope it will help policy makers figure out new ways to motivate people to make better financial decisions. The problems of inadequate savings and the propensity to take on too much debt, have enormous implications for our society. The research into why it is easier (or perhaps more natural) to make bad financial decisions does not alleviate that individual responsibility.

We all have to choose the harder path of consuming less and saving more.

Related Links:

• The Most Common Mistake Investors Make
• Why Mutual Fund Managers May Not Act in Your Best Interest
• Financial Literacy is the Issue of the Month? Try Issue of the Century.

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

And this year is no exception. 

The QAIB examines the real returns earned by investors in equity mutual funds, bond mutual funds, and asset allocation mutual funds.  Over the past twenty years, the average investor in an equity mutual fund has under-performed the S&P 500 Index by an annualized 4.3% per year. The S&P 500 returned an average of 7.81% for the 20-year period through 2011, but the average equity fund investor generated only 3.49% per year. 

And unfortunately, the news just gets worse: In 2011 alone, the average equity fund investor generated -5.7% vs. the S&P 500 which generated 2.1% return (an under-performance of 7.85%). Investors in bond funds did far worse. Compared to the Barclays Aggregate Bond Index which has a trailing 20-year annualized return of 6.5% per year, the average investor in a bond fund gained an annualized return of only 0.94% per year over this same period. Investors in bond funds underperformed their benchmark index by -5.56% per year. 

Investors Still Buy High and Sell Low

These results are astronomically bad and the results from the 2011 DALBAR QAIB is just one more piece of evidence that investors are not making the right choices. Sure, fund expenses are part of the problem, but for the majority of individual investor’s the underperformance can be blamed on bad timing decisions. This is nothing new to professionals who study investor behavior: Investors invariably get out of the market after a decline and jump back in after a rally. In other words, they tend to buy high and sell low.  

I wrote my summary of these issues back in May 2008, almost exactly four years ago.  At that time, I estimated that the average loss due to bad timing by investors was 3% per year for an investor with a portfolio made up of 60% equities and 40% bonds. Over the most recent five-year period, the DALBAR QAIB reports that the average equity fund investor has trailed the S&P 500 by -1.96% per year. The average bond fund investor has trailed the bond index by -5.55% per year. 

If we take the equivalent proportions (60% equity and 40% bonds) and estimate an aggregate underperformance over the past five years, we get 3.4%.  The closeness of this number to my estimate is, no doubt, partly coincidental. In my 2008 article, I noted that the range of evidence suggested that bad timing was a major culprit in the poor performance experienced by retail investors. Individual investors buy equity funds when they are optimistic and sell when they are worried, and DALBAR’s annual QAIB surveys are an ongoing validation of that observation. The average mutual fund equity investor holds a fund for an average of 3.3 years. For bond fund investors, the average holding period is less than 3 years. The DALBAR QAIB report shows that the flow of investor money into or out of the market is timed poorly. 

Buy and Hold Investing: Don’t Throw in the Towel

Many investors have simply thrown in the towel on the idea of buy-and-hold investing because they believe that buy-and-hold has failed as a strategy. This is simply not true.  A buy-and-hold investor in Vanguard’s S&P 500 Index Fund (VFINX) has an annualized return of 10.6% per year since its inception in 1976. Vanguard’s Total Bond Market Index (VBMFX) has returned an average of 6.8% per year since its inception in 1986. 

These returns do not, of course, mean that these funds or their underlying indexes will return anything similar to these levels over the coming years. And I am not saying that buy-and-hold is the only right strategy. What I am saying is that the pundits who say that buying and holding a low-cost portfolio has historically been an unsuccessful strategy are simply looking at shorter time horizons. Using data in the QAIB report, for example, we see that the S&P 500 has an annualized return of 2.92% for the last 10 years and 7.81% per year for the last twenty years.  And this tells the story.  Nobody will be complaining if the market returns 8% going forward, but even if that is the case, how many investors could stomach another decade of returns below 3% along the way?

What’s the Take-Away Here?

First, I want to reiterate that there are many ways to create successful investment strategies, and individual investors’ efforts to time the market have been a notable and horrendously expensive failure. This does not mean that there are no successful ways to change allocations as a function of market conditions (this is called “tactical asset allocation”). The DALBAR results do not mean that investors should simply hold a stock index fund and a bond index fund. While this approach has delivered attractive returns over sufficiently long periods, we cannot simply assume that we will be the fortunate recipients of high returns rather than low returns.

Perhaps more specifically, even if the long-term future average return of the S&P 500 is 8%, we must understand that we might still be the unlucky recipient of returns far below this level over decade-long periods. Investors twenty years ago did not have any assurance that their investments in stocks would average out to close to 8% per year.  Even given our uncertainty with regard to the future returns from equities, there are several things we can do to improve our future prospects and perhaps the most important is to make a strategy and stick to it, avoiding jumping out of the market  because we are feeling panicked or jumping in because the market appears to be rallying.

Related Links:

• Stocks and Shocks: What to Do?
• Financial Literacy is the Issue of the Month? Try Issue of the Century!
• Sell in May? 9 Trillion Reasons to Say “No”

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

Clearly, investors nearing retirement didn’t understand the levels of risk they were taking by investing in 2010 TDFs.  It has also been widely noted that the percentage of assets invested in equities in 2010 TDFs varied dramatically among funds, which in turn meant that there was little commonality among TDF fund manufacturers as to how much risk investors at or near retirement should have in their portfolios.  Both the lack of investor understanding regarding risk in these funds, and the wide variability in risk levels between funds are substantial issues that have received considerable discussion in the press.  However, there is another issue that has gotten almost no attention that I want to raise here.

Examining Risk in Target Date Funds

A standard approach to examining the risk level in a TDF is to compare the percentage of the fund that is invested in bonds and cash to the percentage invested in equities. As we all know equities tend to be riskier than bonds, and the percentage allocated to equities vs. bonds is commonly used as a proxy for risk. A higher allocation to bonds equates to a less risky portfolio (and vice versa). For many, this approach provides an intuitive and simple metric to use in their portfolio planning. Unfortunately, the approach is also a poor predictor of risk and investors who use it as their guide to build a conservative portfolio as they get closer to retirement can be in for a terrible shock.

The chart below shows the percentage of each 2010 TD mutual fund that is allocated to bonds and cash vs. the fund’s risk level, as measured by the trailing 3-year volatility. Each point on the chart is a different 2010 TDF.

2010 Target Date Funds: Risk vs. Asset Allocation (Source: Author)

The Bad News for Investors

What we expect to see is that 2010 TDFs that have higher allocations to bonds and cash are less volatile (e.g. less risky) and vice versa. And we do, indeed, see a downward-sloping trend to the data that conforms to the idea that more bonds and cash in an allocation equates to less risk.

Now for the bad news.

The analysis above was performed for all 2010 TDFs using data available through the end of April of 2012. What it shows us is that these 2010 TDFs have annualized volatility levels ranging between about 4% and 12%. (As a simplified rule of thumb, I find that the maximum 1-year loss that investors should expect from a portfolio is around twice its volatility). Using this rule of thumb, this means that the potential loss for 2010 TDFs range (approximately) from -8% to -24% in a single year.

The first piece of bad news for investors nearing retirement is that this is a huge range of potential loss.  The second piece of bad news—and the main theme that I want to focus on here—is that while the percentage allocated to bonds and cash (as opposed to equities) is a reasonable proxy risk measure for investors to use in their portfolio planning overall, there are enormous differences in risk levels between individual funds with (almost) identical allocations to cash and fixed income.

For example, look at the TDFs in the chart above with between 50% and 55% allocated to bonds and cash. One would assume that these TDFs would have similar risk levels. However, the trailing volatility for these funds range between 8.1% and 11.7%. To put this another way, the riskiest TDF in this group (the fund with 11.7% of trailing 3-year volatility) is 44% riskier than the fund with the least risk (8.1%). What’s really interesting to note here is that there is only a 0.2%difference in the allocation to cash and bonds between these two funds.

There are also two 2010 TDFs with about a 60% allocation to bonds and cash (look at the two portfolios very near to the 60% value on the horizontal axis) with an even larger spread in their risk levels.

What these results mean is that investors, advisors, and plan sponsors using the percentage allocation to bonds and fixed income as a proxy for risk—a common practice for many—may be comparing funds that are, in fact, vastly different in terms of risk exposure. Folio Investing raised this issue in a comment letter to the SEC in 2011.

Using Historical Volatility to Gauge Risk

The good news here is that the solution to this problem is pretty straightforward. In a 2010 article in Workforce Management, Lori Lucas (the head of Callan Associates Defined Contribution plan practice) proposed that:

“…one of the best ways for plan sponsors to understand the trade-offs of target-date fund structures is to use forward-looking simulations to project possible outcomes.”

This is exactly how we designed the Target Date Folios at Folio Investing. Short of the use of forward-looking simulations, however, an examination of historical volatility is very useful   One of the challenges for the use of forward-looking simulations to understand portfolio properties such as risk is that there are differences between models and there is no single standard that is universally accepted.  Historical risk levels are available from sites such as Morningstar, and there are standard approaches to calculating historical risk.  Morningstar uses trailing three-year volatility as a standard risk measure and my own calculations of trailing three-year volatility match Morningstar’s estimates perfectly.

My conclusion overall is that anyone examining possible portfolios (such as different TDFs) must drill down to look at risk levels (at least historical risk) and not simply look at an over-simplified proxy for risk such as the percentage allocation to bonds and cash.  Without doing so, investors have little hope of understanding how much risk they are actually taking on in a Target Date Fund.

Related Links:

• Why Warren Buffett Was Right: “Diversification is Protection Against Ignorance”
• Long Live Diversification!
• The Changing American Workforce: Can They Still Retire?

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

Speculation vs. Supply and Demand

By contrast to much of the focus on speculators as being the cause of high prices, The Economist makes the argument that the current price of oil is due to a far more benign cause: the balance of supply and demand.  Lower productivity of oil wells combined with soaring demand for energy in the developing world have resulted in higher demand relative to production with the inevitable result that prices are higher.   The demand for oil in the Asia/Pacific region has climbed fast and steadily over the last decade, and the demand has proven remarkably insensitive to variability in price.  These data aside, however, Exxon’s CEO recently stated in testimony before the U.S. Senate that oil prices would be around $60-$70 per barrel on the basis of supply and demand.

Finance professor Craig Pirrong, director of the Global Energy Management Institute at the University of Houston, has focused on the role of speculators in commodity markets in his research.  He concludes that speculators play a relatively small role in determining the price of oil.  Pirrong cites the current very low price of natural gas, for example, as demonstrating that speculation is not somehow uniformly raising commodity prices.

Making Sense of the Issue

Despite the fact that I worked on the trading floor of an energy commodity trading firm and also for a consulting firm serving these markets, much of the current debate around this topic baffles me.  Nobody likes to pay $70 or more to fill up their car’s tank, but it is entirely possible that we simply need to reconcile ourselves to a new global reality.

Despite having a much better-than-average grasp of the mechanics of energy markets, I do not feel confident that I understand the role of speculators in determining the price of a barrel of oil or a gallon of gas.  Given the rapid growth in demand in the developing world, however, I am of the opinion that oil prices will be higher in the future than we, in the United States, have become accustomed.  That said, I certainly don’t have the expertise to debate with Exxon’s CEO over his assertion that the ‘fair price’ of oil is far below where it is today.

Workable Solutions

Since I am inclined towards pragmatism, I tend to look for simple solutions to complex problems.  We need to drive less, buy cars which get better mileage, insulate our homes better, and look for other ways to reduce energy consumption and, particularly, our national dependence on foreign oil.  This is the no-regrets solution to the problem of higher gas prices.

From an investment standpoint, the issue can seem overwhelming.  The simplest solution is that investors need exposure to commodities and/or companies that produce oil and other commodities as part of their portfolios.  This is not so much a bet on oil prices specifically as a way to ensure that long-term portfolio purchasing power keeps up with inflation.

Related Links:

• Why Mutual Fund Managers May Not Act in Your Best Interest
• Jeremy Grantham, Investing, Natural Resources, and Retirement Planning
• The Five Biggest Financial Issues for People with Children at Home

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

How do we avoid walking into a “left hook” in the markets? That was the discussion this week during a client review.

“Can’t you see them coming and avoid them?” he asked. Well maybe some folks can, but the issue of investing with possible shocks as an outcome is a very difficult one.

“Do you position for the worst outcome?” If yes, you would never invest in anything.

“Is there a middle road?” We think so and that is why we use a combination of ETFs and bonds and recommend diversifying risk among several asset classes.

Below this introduction is a partial list of upcoming potential shocks. As readers will note, we can see the potential shock relatively clearly. Scott MacDonald of MC Asset Management calls them “dangerous seas ahead.” His maritime metaphors sequence the Titanic and Lusitania. Lehman-AIG and the meltdown were the Titanic. “This leaves us to wonder if the U.S. economy is not like the Lusitania, operating in a high risk environment, but felt to be safe from prowling German U-boats in the North Atlantic.” ponders Scott.

Of course, we cannot know the result of a potential risk before it happens. We cannot know the outcome and the policy shift. Therefore, the anticipatory period preceding the risk and the aftermath (if as and when the risk is realized) are not symmetrical. In other words, you are investing in asymmetry. Knowing this in advance allows for an asset-allocation rebalancing as the circumstances and probabilities change. In other words: reassess, reassess, reassess risks and rebalance, rebalance, rebalance.

Some of the discussion in our new book addresses these types of asymmetries. See Amazon.com, From Bear to Bull with ETFs or visit Cumberland’s website. In the book, we actually show the comparison with the ten sectors of the S&P 500 index and the relative performance of each sector in the bear and in the subsequent bull market.

Now let’s get to some potential shocks and comment about them:

• Possible Shock Number 1: The Fed will cease “Operation Twist” on June 30. They confirmed the policy shift as recently as this last meeting and Bernanke’s statement. What will a twist cessation bring to bond yields? Will it change home mortgage interest rates? Delay a housing market recovery? Alter the steepness of the yield curve? Or the flatness of the yield curve? What happens to bond credit spreads? Pricing of repo collateral? Maybe the whole thing will pass as a non-event. Nobody knows.

• Possible Shock Number 2:The so-called “fiscal cliff” is approaching at year-end. Strategas’ Dan Clifton and Jason Trennert have hammered this theme. Their summary identifies three elements:“… roughly one-third of the entire tax code expiring at the end of the year, the spending sequester beginning on January 2, a debt ceiling increase needed in the six weeks after the election and before the end of the year.”How much will markets anticipate these outcomes? How deep is fiscal drag? Is there a fiscal drag? Is Ricardian equivalence dead? How large is the policy shift danger to our country from the Congress? From this President? From next year’s President (re-elected or new)? All of these tax-spend-borrow outcomes are probable in the present-day realm of American politics. That puts our American destiny in the hands of a class of people who are very unpopular and despised by the majority of American citizens. Our politicians have become the scurrilous, scatological scoundrels that we elect and send to Washington. (We include both political parties in this opprobrium). Jack Bittner asks if we should limit all pols to a single term.

• Possible Shock Number 3: The Bank of Japan has leaped to the top of the G4 central banks when it comes to balance-sheet expansion. BOJ announced an increase in the rate of asset purchases and an extension of the duration of the Japanese sovereign debt it will buy. Initial market reaction was that this plan is “not enough.” BOJ is trying to get Japan’s inflation rate UP! They have not succeeded in the past. Is this time different? What will be the impact on the foreign exchange markets? Will the yen weaken? If so, which currency will strengthen? We have written in the past that FX market adjustments are quite distorted when the G4 central banks are all maintaining their policy interest rates near zero.

• Possible Shock Number 4:The FDIC limit on non-interest-bearing demand deposit insurance is scheduled to revert back to the pre-crisis level at the end of this year. We quote from the FDIC website:“From December 31, 2010 through December 31, 2012, at all FDIC-insured institutions, deposits held in non-interest-bearing transaction accounts will be fully insured regardless of the amount in the account. For more information, see the FDIC’s comprehensive guide, Your Insured Deposits.”What will be the impact in the money-market end of the yield curve? Will there be an extension of the termination date if markets begin to tighten? What will happen to repo rates? Repo collateral pricing? How closely is the Fed watching this development, since the Fed has been providing the market with more repo collateral (T-bills) through its Operation Twist? Is there a relationship, or will there be one? Can the banking system withstand larger withdrawals of zero-interest deposits if corporate agents deem deposits to be insecure without FDIC insurance coverage? (Note that the FDIC just closed five more banks this week. In the case of the Bank of Eastern Shore, Cambridge, Maryland, the FDIC has not found a buyer or merger partner, and the uninsured depositors are at risk of loss. Readers who are still worried about the safety of their bank deposits may check the FDIC website for the current rules).

• Possible Shock Number 5: Watch the price and futures prices of Brent crude. Many are sanguine about oil and energy pricing and the gasoline price. We are not. Libyan production is not coming back in a hurry (hat tip to Barclays for superb research on the risk of Libyan civil war). Geopolitical risk is high in the Persian Gulf (Iran) and in Nigeria (see the developing news story of turmoil in this important oil-producing country). Worldwide demand for oil inexorably rises. U.S. energy policy still fails to accelerate our move to energy independence. Despite Energy Secretary Salazar’s protestations, the fact is that the Obama Administration has a failed energy policy and continues to pursue it. We do not drill, we do not encourage the use of natural gas in an accelerated and proactive way, and we do stymie new production and exploration. We do have pipelines running in the wrong directions, and we do have distorted domestic oil pricing because of excess inventories in Cushing, Oklahoma. At Cumberland, we remain attentive to this sector even as the market has become sanguine about it. We continue to hold our oil-energy-exploration and oil-service positions. The range of forecasts of the oil price is a mile wide. We have seen a low of $40 a barrel within two years and a high of $175. We lean to the higher price, not the lower one.

Reassess and Rebalance

I will stop now with the list of possible shocks and leave it to the reader’s imagination to complete this compendium with thoughts about Europe or China slowing or future inflation risk. Here is how we see the portfolio management decision. Remember this is today. It could change tomorrow, next week, next month or next year. The operative structure is reassess, reassess, reassess, rebalance, rebalance, rebalance.

Cumberland continues its fully invested approach using ETFs. We have been in that mode since the bear-market bottom of October 3. We think the bull market that started on October 3 is only half over as to price change and only one-third to one-fourth over as to time. Of course, any shock could derail this forecast. Our bond portfolios are slowly repositioning to a hedged or defensive mode. We have time. The process of moving from the present very low interest rates will require years and be volatile but gradual. Interest rates cannot go below zero. To get them above zero and into a more normal relationship, the G4 central banks must neutralize over four trillion dollars equivalent of excess reserves. Collectively they are still enlarging this position and are a long way from extraction from it.

Two items are recommended:

• Read “Death of a Theory,” by St. Louis Fed president James Bullard, in the March-April/2012 monthly bulletin of that bank.
• For analysis of last year’s bear market and the ensuing bull market, readers may wish to consult our new book, From Bear to Bull with ETFs. We thank readers for their responses so far. For the first time in our life, we have had a three-week-running best-selling book. All links to book distribution will be constantly updated on Cumberland’s website.

(Disclosure: The views and opinions expressed here are those of the author(s) and do not necessarily reflect the views of the Portfolioist. Cumberland Advisors is unaffiliated with FOLIOfn Investments.)

About David R. Kotok:

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. Mr. Kotok’s articles and financial commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent guest on financial television including Bloomberg Television, CNBC and Fox. He also contributes to radio networks such as NPR and media organizations like Bloomberg Radio, among others.

Related Links:

• Understanding France’s Credit Rating Downgrade
• Sell in May? 9 Trillion Reasons to Say “No”
• Chasing Yield: Is the Flow into Munis and High Yield Bonds Rational?

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

A mutual fund manager makes decisions on behalf of his or her fund’s investors.  In the parlance of economics, the manager acts as an agent working on behalf of the investors (the meaning here is similar to the use in the term real estate agent).  The financial agent generates income by acting to assist the client and represents the interests of the client.  There are invariably potential conflicts of interest between agents and clients.  Agents often have incentives to make decisions that are in their own best interests but which are not necessarily in the clients’ best interest. 

A Herding Mentality

In Grantham’s essay, he focuses on the most innocent of all agency problems in mutual fund management, but one that is enormously financially significant nonetheless. Grantham proposes, following famed economist John Maynard Keynes, that a fund manager’s biggest risk is career risk, the risk that he substantially underperforms compared to the fund’s benchmarks or to other funds that are classified as peers and loses his job as a result.  If the fund loses a lot of money when all of its peers also lose a lot of money, that is less likely to result in a change of fund manager, than if a fund manager takes a conservative stance and misses out on a big market rally.  This situation leads to herding among fund managers.  There is less career risk for fund managers to make decisions similar to one another.  Grantham asserts that market volatility levels are so much higher than the variability in fundamental variables such asGDP because of this herding behavior. 

Standard Client Patience Time

Grantham describes a related agency issue that does not get as much as attention as manager herding.  He calls this standard client patience time.  This is the amount of time that a client is likely to stay with a fund manager if the fund’s performance does not meet the client’s expectations.  A fund manager who makes investment decisions that are substantially different than his peers runs the very real risk of being wrong for some period of time. 

How many of the fund’s clients will lose patience with the fund and sell their shares? 

It is crucial to remember that a fund’s income depends on the total amount of money being managed and not directly on the performance of the fund.  If investors dump their shares, assets under management drop, and the fund’s income drops.  It is, in fact, fascinating that Keynes described this exact scenario:

“What Keynes definitely did say in the famous chapter 12 of his General Theory is that “the long-term investor, he who most promotes the public interest … will in practice come in for the most criticism whenever investment funds are managed by committees or boards.” He, the long-term investor, will be perceived as “eccentric, unconventional and rash in the eyes of average opinion … and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.”

-GMO Quarterly Letter for April 2012

The entire problem is beautifully summarized in the same paragraph of Keynes’ General Theory from which Grantham draws his quote:

 ”Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

 –John Maynard Keynes, General Theory of Employment, Interest, and Money

A Fund Manager’s Core Dilemma

This single sentence perfectly summarizes the core dilemma for a mutual fund manager.  If you, the fund manager, have a big allocation to Apple (AAPL) when most of the other funds in your category also have big allocations to Apple, and Apple stock drops substantially, you are probably okay from a career standpoint.  The media will report that Apple disappointed investors in its latest earnings and you don’t get singled out.  On the other hand, if you load up on a stock because you believe that the evidence is that this stock is incredibly undervalued and that bet does not pay off, then you look like a bad fund manager.  And, if your bet on that stock turns out to be correct, some people will be impressed but many others will attribute your success to luck (which may or may not be the case). 

The “Agency” Effect

The key take-away to remember here is that a fund manager is faced with an agency problem.  He or she wants to make the best investment decisions, but also knows that investors have a relatively short patience time (investors hold mutual fund shares for much shorter periods than they used to) and that the evidence suggests that you have more to lose (assets under management or, at the extreme, your job) by following your beliefs if they go against the crowd than you have to gain if you turn out to be correct. 

The agency problem that Grantham is tackling in his excellent piece, is something that every investor should care about and Grantham discusses examples from his own experiences managing money at GMO.  You cannot fault investors with bailing on fund managers who are underperforming, nor can you fault the fund managers whose choices are influence by the desire to keep their jobs. 

What Investors Can Do

What can investors do to minimize the effects of this agency problem on their portfolios?  There are several solutions.  The simplest default solution is simply to focus on a low-cost diversified portfolio of index funds.  When you invest in index funds, you are not paying a manager to make decisions that will make or break his career.  The much harder solution is to identify and invest with managers who do, indeed, follow their own convictions when it comes to the best investment decisions.

Related Links:

• Financial Literacy is the Issue of the Month? Try Issue of the Century.
• Be Entertained by the Stories; Trust Only the Data
• Financial Services for the Masses

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

All month long, I have been trying to think of how to write a post that can express the depth of my conviction that the lack of financial knowledge is at the core of some of the biggest problems that we, as individuals (and as a nation) are facing.

There are so many areas in which we can see the enormous problems created by a lack of financial literacy that, frankly,  I don’t even know where to start. In fact, the Wall Street Journal just ran an article about college graduates who have little hope of ever being financially secure given their enormous levels of student loan debt. (Even President Obama isn’t exempt: he admitted today that he paid off his student loans just 8 years ago.)

This is a big problem.

We know, of course, that retirement savings are woefully low and that credit card balances are frighteningly high for this general population.

This is another huge problem.

Making Poor Financial Decisions

The financial straits facing many Americans (while not entirely due to financial illiteracy) are certainly related to the way that we make financial decisions:

•  The average household with credit card debt has a balance of $16,000.
•  The personal savings rate (the fraction of after-tax income that is not consumed) is a mere 3.7%.
•  Less than 20% of investors know how much they pay in mutual fund expenses.
•  Many investors pay high fees for their mutual funds when they could own functionally identical fund for far less.
•  60% of households have savings and investments totaling less than $25,000 (this excludes the value of their primary residence and any traditional retirement plans–defined benefit–not 401(k) and related plans).
• Only 33% of workers (or their spouses) have any type of traditional pension from a current or previous employer (but 56% of workers expect to receive a traditional pension in retirement).
• 56% of workers have not even tried to calculate how much money they need to save for retirement.
• The average student loan debt for college students  who took out loans to pay for their education, is $25,000 at graduation (and 2/3 of students take out loans).

This list goes on and on … and each one of these facts is its own financial disaster in the making.

As a whole, these and other related statistics suggest that a vast number of Americans have made financial decisions that are ruining their hopes of a secure financial future, as well as shaping the ability of their children to build one of their own.

Now, it may be tempting to attribute financial problems to the bad economy and certainly the economy in recent years has certainly not helped. But, frankly, this is only part of the problem. Consumer spending, (driven by auto sales) has been rising faster than real income, while savings rates plummet.

The Housing Bubble: A Prime Example

The role of financial literacy is perhaps nowhere as well illustrated than in the growth of the housing bubble and its subsequent collapse that left 24% of homeowners owing more on their mortgages than what their houses are actually worth.

How did this happen?

People who did not understand the real risks involved with the housing market were more than willing to be sold mortgages that allowed them to take massively leveraged bets on housing–even as housing prices had risen far beyond any rationally-grounded values. (In fact, the news is still grim. Read the latest data released yesterday from the S&P/Case-Shiller Home Price Indices.)

So, whose fault was this?

Certainly there were unscrupulous mortgage practices, however, we live in a society that assumes that adults are competent to make binding financial commitments.  And this is why financial literacy is so crucial.

We’re Left with Only Three Choices

Going forward, it appears to me that we have three choices:

1) Simply live with the status quo in which people are consistently making financial decisions that are harmful to them and to their families.

2) Expand the regulatory reach of the government in order to protect people from making bad decisions.

3) Make a real societal commitment to improving financial education.

The first of these options is simply unacceptable. That’s why the road ahead must include both improved regulatory oversight and a serious commitment to financial literacy in our society.

Related Links:

• Sell in May? 9 Trillion Reasons to Say No
• Housing Prices and the Economy: Is There Any Good News?
• The Biggest Unknown in Financial Planning

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

The old adage “Sell in May and go away” was good guidance for stock markets last year.  The market peaked on April 29 and bottomed out on October 3.  For a detailed discussion of this period and the subsequent bull-market recovery, see our new book From Bear to Bull with ETFs.  The eBook (ten bucks) is now available on Amazon.com.  Paperback by month end and other channels of distribution like iBook and Nook are coming.  Please note that profits from this book will be donated to the Global Interdependence Center, www.interdependence.org.

History shows that ‘Sell in May and go away’ has applied when the Federal Reserve was in a tightening mode during the six-month span from May to November.  If the Fed was actively raising interest rates, withdrawing or constricting credit, imposing additional reserve requirements, or taking an action that was of a tightening mode, stock markets were usually punished in that six-month period.

When we did the study we examined what the Fed did, not what it said.  We used actual changes in the Federal Funds rate to determine whether the Fed was tightening, easing, or neutral.  Once the Fed took the interest rate to zero at the end of 2008, the historical data series lost its power for forecast purposes, since the Fed cannot take the rate below zero.  However, we believe the concept is valid even if the present measurement problem exists.

What happens in the May-November period when the Fed is not tightening?  That is a different matter.  Other factors tend to drive the stock markets.  Last year, the market tanked from a fear of recession, not tight money.

We examine this in our book and discuss what it means to discount a recession and then not get it.  As the book documents, investors who bought into the recession scare suffered.  Those who used sensitive economic outlook models to guide them and concluded it was a slowdown and not a recession have profited.  The book explains the down cycle (April 29-October 3 bear market) and the subsequent up cycle since the October 3 final selling climax (bull).  At Cumberland, a hat tip goes to our colleague, Bob Eisenbeis, for keeping us out of the recession forecast trap.  Bob, 1400 Cumberland separate account clients thank you.

What do we know about the Federal Reserve for the rest of 2012?

We know that the members of the Federal Open Market Committee (FOMC) are divided in their views.  Five of the twelve Federal Reserve Regional Bank Presidents have articulated concerns about additional quantitative easing (QE).  David Hale discussed this in detail in his recent economic commentary.

A few presidents favor additional QE.  They seem to be in the distinct minority.

Lastly, we know that the folks who drive the majority and, hence, the FOMC decisions are on hold.  One of them is the FOMC vice-chair and New York Federal Reserve Bank President, Bill Dudley.  Dudley’s position carries the only permanent regional-bank vote.  The other eleven regional bank presidents rotate, with only four voting at any time.

It is clear that Fed Chairman Ben Bernanke and Board of Governors Vice-Chair Janet Yellen also favor a holding pattern.  They are not ready to do more, and they are not ready to withdraw any stimulus.  So when it comes to Fed policy, the best way to describe it is (1) a continuation of “Operation Twist” until June 30th, and then (2) the Fed will be on hold, unless there is some negative shock.

Remember, Bernanke is willing to tolerate dissenting voters.  As a chairman, he has pressed forward with this policy approach when three of the ten voters opposed him.  As long as the five sitting Governors and Dudley are aligned, Bernanke starts with a majority vote in the FOMC.  The division of the remaining eleven presidents means he will probably get one or two or even three to join him.  Therefore, Bernanke will set the policy, all the Fed rhetoric notwithstanding.

“Sell in May and go away” is a difficult prescription to accept when the Fed is on hold and there is no recession.  The Fed has created a very large amount of excess reserves in the banking system and is maintaining the short-term interest rate near zero.  One cannot describe that as a tightening policy.

Significance of G4′s Common Policy

Even more important is to view the collective actions of the four large central banks.  They are the Federal Reserve (Fed), the Bank of Japan (BOJ), the European Central Bank (ECB), and the Bank of England (BOE).  All of them are maintaining a near-zero interest rate policy, so the short-term interest rate on cash equivalents, whether denominated in dollars, yen, euros, or pounds, is the same throughout the world.

These four currencies combined represent approximately 85% of the capital markets of the world when you add to them those markets in which the currencies are linked to one of the G4.  For example, the Hong Kong dollar is linked to the U.S. dollar.  The Swiss franc is linked to the euro.  Therefore, the capital markets of the world are driven by this near-zero short-term interest rate maintained by the collective G4 central banks.

The significance of the G4’s common policy is critical.  We will get to it, but first let us dissect the four banks.

At Cumberland, we track the combined G4 central bank balance sheets, their assets, their liabilities, and their aggregate size.  You can find this data on our website at    http://www.cumber.com/content/misc/G4_Charts.pdf.

In that chart stack, you will find the aggregate of the G4 on top.  Then you will see the breakdown of each of the four banks’ assets and liabilities.  Note that the size of the collective G4 has set a new, all-time record high at a 9-trillion USD equivalent.  The driving force to raise the total to that collective number did not originate in the Federal Reserve; 9 trillion was reached with the help of the ECB and its recent monetary policy actions (LTRO).  It was also helped by the BOE.

In fact, the Fed’s balance sheet has actually declined by a slight amount.  The Fed is busy twisting the yield curve, but it is not expanding the size of its balance sheet.

The BOJ continues to be somewhat passive.  However, one can begin to expect that to change.  David Hale carefully noted the political construction in Japan that could lead to a more dovish monetary policy board.  We agree with Hale.  We think the BOJ is headed towards much more expansive central bank activity as it attempts to weaken the yen, fight deflation, and bring on some inflation, if it possibly can do it.  Please note that the GIC has a meeting planned in Tokyo in early December so we can discuss this issue in detail.  Call GIC for details, 215-238-0990.

We expect the size of the G4 central bank balance sheets to grow to $10 trillion before this unprecedented process is over.  Watch for changes in Japan to gauge the pace of G4 collective central balance sheet expansion.  The ECB will face extreme pressure to launch another round of LTRO.  Spain, Italy, Portugal debt pricing suggests this may come sooner, not later.

Remember, central banks have only this tool.  Worldwide, national fiscal policies are too austere and too extended to be of any value in the attempt to encourage risk taking and economic growth; it all falls on the central banks.  They have taken their rates to zero.  They have twisted the yield curves where they can.  All they have left is an expansion of QE in one form or another.  Summarize: Fed on hold, BOE and ECB expanding, Japan likely to expand, all four at zero interest rate policy (ZIRP).

By this historically unique policy, the central banks have also disoriented the clearing mechanism between and among currencies.  When four different currencies all pay a zero interest rate, the market has no way to anchor shorter-term arbitrage among them.  It is the interest-rate differentials among and between currencies that allow for forecasts of changes in the FX market.  Foreign exchange trading and the derivatives that hedge these transactions depend on these interest-rate differentials.

The Importance of the Carry Trade

Another element is the carry trade.  Loosely interpreted, it means “I borrow in one currency at a very low interest rate.  I convert the currency, with some form of currency risk hedge in place, to some other currency, and then I deploy the other currency in some investment asset.”  We are now seeing some stock market exchange-traded funds that are designed to allow investing in a foreign market with a currency hedge, so that the investor can play a country’s stock portfolio without the currency risk.  More and more sophisticated instruments of this type are being used in global investment management and construction.  We use them at Cumberland.  Remember, at very low interest rates, the currency hedging costs are low because the interest rate differentials are so tight.

What this means is that the collective central bank expansion is very important.  It drives financial markets.  With the entire G4 at a zero interest rate boundary, they collectively continue to expand their balance sheets.  They acquire additional holdings of sovereign debt securities from the G4 member countries.  Thus, the Fed may be on hold, but global monetary policy is not on hold.  It is still easing.  Moreover, it is likely to be easing for some time, given the events in the world.

Under these circumstances, we believe ‘sell in May and go away’ will prove incorrect this time.  With worldwide monetary policy so stimulative, stock prices have an upward bias.  We believe that they will continue to have an upward bias as long as this policy continues to be expansive.  We expect that to be the case for many more months and perhaps several more years.

Bond markets are a different matter.  Bond markets try to foresee the time when this policy will change.  Bondholders are worried about rising interest rates if and when the collective policy eventually changes.  You see that in the changes in credit spreads and in the changes of interest-rate spreads among and between high-grade bonds.  We track the most important ones and update them weekly on our website.

Sell in May and Go Away? Not This Year.

The conclusion is this: Sell in May and go away. Nope.  Not this year.  There are 9 trillion reasons not to do it.

Caveat, caveat, and caveat:   Change your mind at once if the central banks stop expanding their balance sheets in this collective fashion.  Yes, move rapidly once you see signs of tightening.  To see it you have to observe the central banks moving away from the zero boundaries.  Otherwise, stay the “risk on” course, because financial assets will rise in price as long as the collective central banks remain as is.

As we have said before and will say again, at Cumberland, we could change our position rapidly – in one day, one week, one month, or one year.  Our ETF strategies allow us this flexibility.  The book will help explain it.

We are fully invested today and have been that way since the bull market started.  We believe the bull market has made only half of its move, which started on October 3.  Note that 3% to 7% corrections can happen at any time in ongoing bull markets.  We are in one right now.  They may be scary.  They are buying and reallocation opportunities.

From the longer-term view, we are in the most uncertain times for investors.  We are in uncharted waters when it comes to worldwide monetary policy, and we are dealing with sovereign debt issues of a monumental and challenging size and scope.  The chapters of the new academic textbooks are being written before our eyes.  Meanwhile, we stay in May.  There are 9 trillion reasons why.

Our new book was released on April 9.  I suspect we are going to need a second edition.  Enjoy.

(Disclosure: The views and opinions expressed here are those of the author(s) and do not necessarily reflect the views of the Portfolioist. Cumberland Advisors is unaffiliated with FOLIOfn Investments.)

About David R. Kotok:

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. Mr. Kotok’s articles and financial commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent guest on financial television including Bloomberg Television, CNBC and Fox. He also contributes to radio networks such as NPR and media organizations like Bloomberg Radio, among others.

Related Links:

• Chasing Yield: Is the Flow of Money into Munis and High Yield Bonds Rational?
• Sell in May?
• Risk, Return and Low Beta Stocks

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

There is also evidence of money flowing into ETFs that focus on preferred shares. The ETF Industry Association reports that two high-yield bond ETFs were included in their list of the ETFs with the highest inflows for the year-to-date (Note: readers can access data on ETF inflows and outflows here). 

 What I want to know is: Are these flows simply evidence of investors chasing yield?The flow of money into these asset classes is clearly driven by their yield. The iShares iBoxx High-Yield Corporate Bond fund (HYG), yields 7.36% and the iShares S&P Preferred Stock Index (PFF) yields 6.04%. Now, munis have a much lower yield, but my sense is that people perceive munis as a “safe” way to boost yield. The iShares S&P National Municipal Bond Fund (MUB) has a yield of 3.2%.  The Powershares National Insured Municipal Bond ETF (PZA) has a current yield of 4.36%.  The yields on munis are considerably higher than the current 10-year Treasury yield at 2.02%. 

 The standard criticism of the flow of money into these asset classes (high-yield bonds in particular) is that investors are simply chasing yield and are not properly accounting for the increased risks of these higher-yield asset classes. This is probably a fair assertion.  What measures might be used to compare risk levels among these asset classes?

Quantifying the Yield vs. Risk Trade-Off

The table below shows the trailing 3-year volatility, a standard measure of risk, as calculated by Morningstar.  Because the trailing three-year period does not include the very big market swings of 2008, I have also included my own results for trailing 4-year volatility. In addition, I have included Monte Carlo simulations for risk levels on a going-forward basis.  The table also shows current yields.

 (Source: etrade.com.)

Taking a Rational Look at Risk vs. Return

When add the additional risk information, we can rationally look at the yield vs. risk provided by each of these asset classes. To further simplify, we might start by looking at the ratio of yield to risk for each of these, and ranking them according to each risk level. 

 In the table below, I show the ranking of yield / risk: 

 Ranking of Yield/Risk Ratio (1=highest, 8=lowest.)

It should not be surprising that the aggregate bond index, AGG, looks most attractive on a stand-alone basis because it has the benefit of diversification across a number of fixed income classes. Preferred shares, despite having a substantial yield, look unattractive on a standalone basis. The intermediate-term Treasury fund (IEF) looks quite unattractive as well.  The Insured National Muni fund (PZA) is the second most-attractive asset class on a standalone basis and the High-Yield Bond fund is the third. 

The individual risk/yield ratios are of interest, but they are not the ultimate measure.  I ran an optimization using the Monte Carlo simulation results. The goal of the optimization was to create a portfolio with maximum yield for a risk level no higher than the risk level of the aggregate bond index (AGG). AGG has a yield of 2.75%. The optimized portfolio has a yield of 4.6% and risk equal to that of AGG.  The components are shown below: 

 (Optimized yield portfolio with projected risk equal to AGG.)

The Surprising Results

 The results above may surprise some readers.  If Treasuries are so unattractive, why do they comprise almost 36% of this portfolio?  The answer lies in the correlations between these asset classes. Treasury bonds are contributing risk mitigation due to their very low correlation to high-yield bonds. Granted, this result is driven by the forward-looking projections. To stress test this result, I ran the optimization using trailing 4-year volatility rather than projected volatility, with the same goal of maximizing yield, but with the constraint that trailing 4-year risk of this portfolio could be no more than that of AGG.  The resulting portfolio, with a yield of 3.47%, is shown below: 

 (Optimized yield portfolio with trailing 4-year risk equal to AGG.)

Because of the substantial increase in correlations between asset classes during the big market declines in 2008, the portfolio optimized using historical 4-year risk depends more on municipal bonds and less on high-yield bonds. There remains, however, a meaningful allocation to high-yield. 

Shedding a Different Light on Munis and High Yield

The results above shed a different light on the relative attractiveness of municipal bonds and high-yield bonds for income investors. Using various measures of risk, it seems perfectly rational for investors to hold meaningful allocations to high-yield bonds and muni bonds.  For those with higher risk tolerance, it may make sense for income-oriented investors to consider replacing some portion of their equity portfolios with high-yield bonds. 

It is entirely possible—even probable—that many investors are adding allocations to high-yield bonds and muni bonds without properly weighing the risks. As my calculations show, high-yield bonds and muni bonds are markedly riskier than an aggregate bond fund. 

 Investors who ignore the spread in risk are making a big mistake.  For those who account for the risk differences, there are still good reasons to hold high-yield and muni bonds.  Default rates in the high-yield space are low and a number of analysts expect them to remain low. 

The same is true for munis.

Related Links:

• The Biggest Unknown in Financial Planning
• Beyond VIX: The Outlook for Market Risk
• The Big Retirement Downshift: From Saving Up to Drawing Down

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.