Why You Should Not Hold Bonds to Maturity

Posted On June 22, 2015 By Admin In Portfolio Management /

If you own individual bonds, as opposed to bond funds, you have the option to sell your bonds rather than holding them to maturity. There are a number of reasons why you might sell a bond before it matures, but we’re going to focus on an important opportunity bond investors have today to enhance returns through roll yield.

In recent years, short-term interest rates have been very low, which causes a steep yield curve. A corporate bond might have a yield to maturity of 3-5% when it has 5-10 years to maturity, but a similar bond with only one year before maturity may yield only 1-2%. Bond yields and prices have an inverse relationship, so as bonds near maturity, their yields shrink and the prices of those bonds increase.

Here’s an example: Let’s say we purchase a 5-year bond with a 5% coupon at par ($1000). One year later, the bond has four years remaining, and let’s say that similar bonds have a yield to maturity of 4%. The price of our 5% bond is now $1036. If we sell the bond after one year, we will have received $50 in interest, and we will made $36 in capital gains, for a total increase of $86, or 8.6%. The $36 gain is the roll yield, and it nicely enhanced our return from 5% to 8.6% for just one year.

When you buy most bonds, it’s not likely that the price of the bond will stay the same until maturity. Because of the steepness of today’s yield curve (low short-term rates), bond investors can benefit from selling bonds above par before maturity. If we go back to our example of a 5% coupon bond, let’s fast forward a couple of years to when the bond has just one year left to maturity. If the yield on 1-year bonds is 1.5%, our bond would be worth $1034. We could sell for $1034 today versus waiting a year to get back $1000. And while we’d miss out on the final $50 in interest payments, we could use our $1034 to buy other bonds further out on the yield curve. Also, given that the $34 gain would be treated as a capital gain (at a 15% tax rate for many investors), whereas the $50 bond interest would be treated as ordinary income (25%, 28%, 33%, 39.6% or higher), the after-tax return of selling a year early is almost the same as holding until maturity.

Generally, we advocate a laddered approach to individual bonds, but for the last several years, low interest rates have made it possible to sell bonds a couple of years before maturity to take advantage of roll yield. If your bonds are priced with a yield to maturity of 2% or less, it is definitely worth a look to see if you might benefit from selling rather than holding to maturity. This type of active management takes a bit of work, and frankly, we don’t see a lot of other advisors providing this level of service.

We typically suggest using bond funds for portfolios under $1 million dollars, because it is difficult to achieve a satisfactory level of diversification on smaller portfolios. The managers of your bond fund are likely looking closely at roll yield as well as other reasons to buy or sell bonds, to take advantage of the current interest rate environment. This is one of the reasons that it may be easier for fixed income managers to have a better chance of outperforming their benchmark than equity managers. While 65-80% of equity managers typically underperform their benchmark over five years, according to S&P, only 41.09% of intermediate investment grade bond funds were beaten by their benchmark from 2010 through 2014.

Equities tend to get all the attention, but many of our clients have 30 to 50 percent of their portfolio in fixed income. It’s important that investors do a good job selecting and managing both their equity and fixed income holdings. If you currently have a portfolio of individual bonds, bring me a statement for a complementary portfolio review. I’ll analyze your portfolio and suggest which bonds to keep and which ones to sell and replace. Or if you’re trying to decide between individual bonds or bond funds, please give me a call.

Fixed Annuities in Place of Bonds?

Posted On June 15, 2015 By Admin In Portfolio Management /

Today’s low interest rate environment is challenging for investors. Cash is paying virtually nothing, and even the 10-year Treasury has a yield of only 2.3% to 2.4%. If you do invest in longer-dated bonds, you have the risk of falling prices if interest rates begin to rise.

Low interest rates have pushed many investors to seek out higher yielding securities. But, there is no free lunch, as higher bond yields come with lower credit quality, heightened risk of default, and increased volatility.

Treasury bonds are a good tool for portfolio construction, because they have a very low correlation to equities. However, if investors replace those very safe (but low yielding) Treasuries with high yield bonds, they are increasing the probability that both their equity and fixed income positions will be down at the same time.

In 2008, for example, as equities tumbled, the iShares High Yield ETF (HYG) was down more than 17% for the year. Although high yield bonds have a place, investors need to understand that junk bonds may not provide much defense when the stock market takes a dive.

Cautious investors have been hiding out in short-term bonds, which might be yielding 1% or less. And while that will limit losses if rates rise, no one knows how long we will be stuck with today’s low rates. If low rates persist for years, short-term bonds aren’t providing much return to help you achieve your investment goals.

As an alternative to taking the risks of chasing yield, or the opportunity cost of hiding in short-term bonds or cash, some investors might want to consider a Fixed Annuity. These come in a variety of formats, but I am only suggesting annuities with a fixed, multi-year guaranteed rate. These are sometimes compared to CDs, but it is very important that investors understand how annuities differ.

Here’s the attraction: we can offer up to 3.25%, principal and interest guaranteed, on a 5-year Fixed Annuity today. And that’s the net figure to investors, which is fairly compelling for a safe yield. It’s more than 1% higher than the SEC yield on a US Aggregate Bond Index fund, like AGG.

Here are five key points to help you understand how annuities work and determine if an annuity is a good choice for you.

Tax-deferral. Annuities are a tax-sheltered account. While you don’t get an upfront tax deduction, an Annuity will grow tax-deferred until you withdraw your money. When withdrawn, gains are taxed as ordinary income, and do not receive capital gains treatment.
Like an IRA, withdrawals from an Annuity prior to age 59 1/2 are considered a pre-mature distribution and subject to a 10% penalty. This is an important consideration: only invest in an Annuity money that you won’t need until after age 59 1/2. This is obviously easier for someone who is in their 50’s or 60’s compared to younger investors.
Limited liquidity. Annuity companies want investors who can commit to the full-term and not need to access their principal. They may impose very high surrender charges on investors who withdraw money before the term is completed.
At the end of the term, investors have several options. You can take your money and walk away. You can leave the money in the annuity at the current interest rate (often a floor of 1%). You can roll the annuity into a new annuity and keep it tax deferred. If the annuity is an IRA already, you can roll it back into your regular IRA brokerage account. Or lastly, you can annuitize the contract, which means you can exchange your principal for a series of monthly payments, guaranteed for a fixed period, or for life. I don’t think very many investors annuitize – most will walk away or reinvest into another annuity.
Annuities are guaranteed by the issuing insurance company, and that guarantee is only as good as the financial strength of the company. Similar to how CDs are insured the by the FDIC, investors in Annuities are protected by your state Guaranty Association (Texas Guaranty Association). Since coverage for annuities in Texas is only up to $250,000, I would never invest more than this amount with any one company.

What I like about the annuity is that it can provide a guaranteed rate of return and price stability, unlike a bond fund. An annuity also can reduce a number of types of portfolio risks, such as interest rate risk, default risk, and will have no correlation to equity returns.

Is an annuity right for you? You should be able to invest the funds for at least 3-7 years and have ample money elsewhere you can access in case of an emergency. You can invest money from an IRA or a regular account, but either way, should not plan on withdrawing money from an annuity until after age 59 1/2. And we’re only using money that would have otherwise been allocated to bonds, CDs, or cash in your investment portfolio. If this describes you, please give me a call at 214-478-3398 and we can discuss Fixed Annuities and their role in your portfolio in greater detail.

Please note that as an insurance product, an annuity will pay the issuing agent a commission. Clients are not charged an AUM fee on monies invested in Annuities. We aim to disclose all conflicts of interest and provide transparency on how we are paid.

Should You Hedge Your Foreign Currency Exposure?

Posted On May 25, 2015 By Admin In Portfolio Management /

When you invest in foreign stocks or bonds, you’re really making two transactions. First, you have to exchange your dollars for the foreign currency and only then can you make the purchase of the investment. Over time, your return will consist of two parts: the change in the price of the investment and the change in the value of the currency. In 2014, foreign stocks – as measured by the MSCI EAFE Index – were up 6.4% in their local currency, but because of a strong dollar, the index was actually down by 4.5% in US dollar terms.

This nearly 11% disparity of returns has made for one of the fastest growing investment segments in 2015: currency-hedged Exchange Traded Funds. These new funds invest in a traditional international index, but then hedge the foreign currency, so US investors can receive a similar return to investors in the local currency. Obviously, a currency hedging strategy has worked well over the past year, but is it a good idea going forward?

As you might imagine, there is no free lunch with currency hedging. There are two important caveats for investors to understand. First, when you hedge, you are making a directional bet that the dollar will strengthen. If the dollar weakens instead, a hedged international fund will under perform a non-hedged fund, or even lose money. Hedging adds an additional element to the investment decision making process, which can increase the possibility of under performance. After all, the most appealing time to hedge will be after the currencies have already made a big move, but in many cases, that will also be too late!

Having foreign denominated investments can provide investors with diversification away from the US dollar. If the dollar were to decline, foreign denominated positions would rise. Having that currency diversification could help investors over time by potentially smoothing returns and providing a defensive element. If you hedge your foreign positions, a declining dollar would negatively impact both your domestic and foreign holdings, which means you may have actually increased your portfolio’s correlations and risk.

The second caveat is cost. Currency hedged funds have a higher expense ratio than regular ETFs, and those management costs do not even include the actual cost of purchasing the hedges. If currencies are relatively stable over a longer period, hedged products will likely lag non-hedged funds due to their higher expenses.

Given these two caveats, I have been reluctant to recommend currency hedged ETFs for long-term investors. Today, however, there are some reasons to believe that the US dollar’s strength may continue. If we look at central bank policy, the US Federal Reserve has been discussing when and under what conditions they will begin to raise interest rates. Compare this to Europe or Japan, where the central banks are looking to create new stimulus and quantitative easing programs. The expectation is that the money supply will increase in Europe and Japan, while the US money supply will be more stable. That’s bullish for the dollar for the near term.

We shouldn’t expect 2014’s nearly 11% difference between hedged and un-hedged indices to continue, but currency trends or cycles can last for several years. I will be talking with our investors to discuss hedging a portion of their international exposure, provided they can make those trades in an IRA. We prefer to make the trades in an IRA to avoid any capital gains on a sale today. Also, we consider the currency-hedged funds to be tactical rather than strategic, meaning that at some point in the future, we will probably want to trade back into the traditional, un-hedged index.

There are also currency hedged ETFs for Emerging Market stocks, but we recommend investors steer clear of those funds. The cost of hedging is tied to short-term interest rates in the foreign currency, so it’s very cheap to hedge Euros or Yen today, but fairly expensive to hedge emerging market currencies where interest rates may run 6-8% or more. And that explains why currency hedged Emerging Market funds are not showing the same out performance we see with currency hedged funds in developed markets, even though the dollar has strengthened in both cases.

Have questions on how to implement this in your portfolio? Please don’t hesitate to call me at 214-478-3398 or send me an email to [email protected] for help!

Fixed Income: Four Ways to Invest

Posted On April 28, 2015 By Admin In Portfolio Management /

Fixed Income is an essential piece of our portfolio construction, a component which can provide cash flow, stability, and diversification to balance out the risk on the equity side of the portfolio. Although fixed income investing might seem dull compared to the excitement of the stock market, there are actually many different categories of fixed income and ways to invest. As an overview, we’re going to briefly introduce the various tools we use in our fixed income allocations.

1) Mutual Funds. Funds provide diversification, which is vitally important in categories with elevated risks such as high yield bonds, emerging market debt, or floating rate loans. In those riskier areas, we want to avoid individual securities and will instead choose a fund which offers investors access to hundreds of different bonds. A good manager may be able to add value through security selection or yield curve positioning.

While we largely prefer index investing in equities, the evidence for indexing is not as conclusive in fixed income. According to the Standard & Poor’s Index Versus Active (SPIVA) Scorecard, only 41% of Intermediate Investment Grade bond funds failed to beat their index over the five years through 12/31/2014. Compare that to the 81% of domestic equity funds which lagged their benchmark over the same five year period, and you can see there may still be an argument for active management in fixed income.

2) Individual Bonds. We can buy individual bonds for select portfolios, but restrict our purchases to investment grade bonds from government, corporate, and municipal issuers. The advantage of an individual bond is that we have a set coupon and a known yield, if held to maturity. While there will still be price fluctuation in a bond, investors take comfort in knowing that even if the price drops to 90 today, the bond will still mature at 100. It’s difficult for a fund manager to outperform individual bonds today if their fund has a high expense ratio. You cannot have a 1% expense ratio, invest in 3% and 4% bonds, and not have a drag on performance.

Those are the advantages of individual bonds, but there are disadvantages compared to funds, including liquidity, poor pricing for individual investors, and the inability to easily reinvest your interest payments. Most importantly, an investor in individual bonds will have default risk if we should happen to own the next Lehman Brothers, Enron, or Detroit. Bankruptcies can occur, and that’s why we only use individual bonds in larger portfolios where we can keep position sizes small.

3) Exchange Traded Funds (ETFs). ETFs offer diversified exposure to a fixed income category, but often with a much lower expense ratio than actively managed funds. ETFs can allow us to track a broad benchmark or to pinpoint our exposure to a more narrow category, with strict consistency. Fixed income ETFs have lagged behind equity ETFs in terms of development and adoption, but there is no doubt that bond ETFs are gaining in popularity and use each year.

4) Closed End Funds (CEFs). CEFs have been around for decades, but are not well known to many investors. Closed End Funds have a manager, like a mutual fund, but issue a fixed number of shares which trade on a stock exchange. The result is a pool of assets which the fund can manage without worry about inflows or redemptions, giving them a more beneficial long-term approach. With this structure, however, CEFs can trade at a premium or a discount to their Net Asset Value (NAV). When we can find a quality fund trading at a steep discount, it can be a good opportunity for an investor to make a purchase. Unfortunately, CEFs tend to have higher volatility than other fixed income vehicles, which can be disconcerting. We don’t currently have any CEF holdings as core positions in our portfolio models, but do make purchases for some clients who have a higher risk tolerance.

Where fixed income investing can become complicated is that within each category (such as municipal bond, high yield, international bond, etc), you also have to compare these four very different ways of investing: mutual funds, individual bonds, ETFs, or CEFs. They each have advantages and risks, so it’s not as easy as simply choosing the one with the highest yield or the strongest past performance. And that’s where we dive in to each option to examine holdings, concentrations, duration, pricing and costs.

There are other ways to invest in fixed income, such as CDs, or annuities, and we can help with those, too. But most of our fixed income investing will be done with mutual funds and ETFs. In larger portfolios, we may have some individual bonds, but will always have funds or ETFs for riskier categories.

Investors want three things from fixed income: high yield, safety, and liquidity. Unfortunately, no investment offers all three; you only get to pick two. Where we aim to create value is through a highly diversified allocation that is tactical in looking for the best risk/reward categories within fixed income.

Our Investment Process

Posted On April 1, 2015 By Admin In Portfolio Management / 1 Comment

Growth Versus Value: An Inflection Point?

Posted On March 30, 2015 By Admin In Portfolio Management /

Over time, Value stocks outperform Growth stocks. There are a number of reasons why this has held true over the history of the market. Value stocks may include sectors which are currently out of favor and inexpensive. Investors, on the other hand, are sometimes willing to pay too much for a sensational growth story rather than a boring, blue chip company. Often, those great sounding stocks flame out rather than shooting higher as hoped. The result is that the long-term benefit of value strategies has persisted.

Although the “Value Anomaly” is a historical fact, it hasn’t worked in all periods, and we’re at such a point in time now. Growth has actually outperformed value over the past decade. Even though growth beat value in only 5 of the past 10 calendar years, the cumulative difference is notable. Over the past 10 years, the Russell 1000 Growth fund (IWF) has returned an annualized 9.18% versus 7.10% for the Russell 1000 Value (IWD). And so far this year, Growth (IWF) is up 5%, whereas Value (IWD) has gained only 0.63%.

The last time growth showed a marked divergence from value was the 90’s. And at that time, we saw the valuations of growth companies rise to unsustainable levels. This largely occurred in the tech sector, where for example, we saw Cicso trade for more than 200 times earnings, and become the most valuable company in the world in 2000. Eventually, growth corrected with the bursting of the tech bubble, and we saw value stocks return to favor. These are the cycles of the market, as inevitable as the seasons, although not as consistent, predictable, or rational!

I don’t think we’re in bubble territory for the market today, but some popular growth names have certainly started to become expensive and value is looking like a relative bargain. Looking at the top 10 stocks in the both indices, the growth stocks have an average PE of 27, versus 17 for the 10 largest value companies. Some of that difference is Facebook, #4 on the Growth list, with a PE of 75. However, the difference in valuation is across the board. Two of the largest value companies, Exxon Mobil and JPMorgan Chase have a PE of only 11.

So, what are the take-aways from the Growth/Value divergence?

Growth has outperformed value in recent years. This will not continue forever.
Our portfolios are diversified, owning both growth and value segments. We have a slight tilt towards value, which we will continue. When value returns to favor, this will benefit not only pure value funds, but will also likely help dividend strategies, low volatility ETFs, and fundamentally-weighted funds.
As the overall market becomes more expensive, I would expect to see that we will move from a unified market, where all stocks move up or down together, to a more segmented market, where stocks move more based on their valuation and fundamentals. Global macro-economics have been the primary driver of stock prices in recent years, but this should abate somewhat as the recovery continues.

We won’t know if we’ve reached an inflection point, where value will overtake growth, until well after the fact. Growth can’t outperform indefinitely, and as investors become more cautious, value stocks will start to look more and more attractive. That’s what we’re seeing in the market today and why we started to increase our value holdings in 2015.

Source of fund data: Morningstar, through 3/27/2015

Get Off the Sidelines: 3 Ways to Put Cash to Work

Posted On February 9, 2015 By Admin In Portfolio Management /

I know there are many investors who have a lot of cash on the sidelines. They may have raised cash fearing a pullback in 2014. Or maybe they made contributions to their IRA and didn’t invest the money because the market was at or near a high. Others sold positions once they reached their price targets and have been sitting in cash ever since.

Looking at today’s valuations, it’s a lot tougher to find bargains that seemed plentiful a few years ago. Unfortunately, holding cash cost investors plenty last year, when the S&P 500 Index was up more than 13%. And that’s the problem with trying to time the market with your purchases: you can miss a lot of upside by being on the sidelines, even if you’re out for a relatively short period.

If you have a significant level of cash in your portfolio that will not be needed in the next couple of years, it probably makes sense to put your cash to work. And while there’s no guarantee (ever) that the market will be higher in a month or a year from now, that’s the uncertainty that we have to accept in order to make more than the risk-free rate over time.

I can understand that putting a lot of cash to work at once is daunting when the market is up like it is today. So rather than thinking in black and white terms of all-in or all-out, let’s consider three strategies to help you get that excess cash invested prudently.

1. Dollar Cost Average. We invest in three tranches, 90 days apart, investing 1/3 of the cash position each time. This gives us the advantage of getting an average price over time. If prices drop, we can pick up more shares at a lower price.

Dollar Cost Averaging worked well in the second half of 2014, as we had cash to invest in October when the market was down 7%. Of course, there are also times when the market rises, and the lowest prices were available at the first trade date. In that case, Dollar Cost Averaging can increase your average cost basis.

2. ETF Limit Orders. One of the advantages of Exchange Traded Funds (ETFs) compared to Mutual Funds is the ability to use limit orders. If you believe there might be a pullback in 2015, place a limit order to buy ETFs at a set price or percentage below the current values.

For example, if you think there might be an 8% correction, we could set limit orders that are 8% below the current price of each ETF. This way we have a plan in place that will automatically invest cash if the market does in fact drop. Even though there is no guarantee we will have such a drop, this is still a much better plan than saying “Let’s wait and see what happens”, because when the market is down, people don’t feel good about making purchases. And recently, any corrections in the market have been short-lived, so there has been only a small window of opportunity.

3. Use “Low Volatility” ETFs. If the primary concern is market volatility, there are Low Volatility products can help reduce that risk today. These are funds which quantitatively select stocks from a broader index, choosing only the stocks which are exhibiting a lower level of fluctuations and risk. Low volatility funds are available in most core categories today, such as large cap, small cap, foreign stock, and emerging markets.

Over time, a Low Volatility index may be able to offer similar returns to a traditional index, but with measurably lower standard deviation of returns. These ETFs have been available for only a couple of years, so this belief is largely based on back testing, and there’s no guarantee this strategy will work in the immediate future.

We should also note that a Low Volatility strategy is likely under perform in Bull Markets (think late 90’s, or 2009), and could lag other strategies for an extended period of time. Additionally, Low Volatility does not prevent losses, so the strategy could certainly lose money like any other equity investment in a bear market.

With those caveats in mind, I am happy to use Low Volatility funds if they give an investor some more comfort with their equity positions and the willingness to put cash to work. Time will tell if these funds are successful in achieving their stated objectives, but in my opinion, Low Volatility funds are among the more compelling ideas offered to investors in the past several years.

Each of these three strategies has advantages and disadvantages, and there is no magic solution to the conundrum of how to get cash off the sidelines today. My role is to work with each investor to find the best individual solution to move forward and have a plan to accomplish your personal goals. Luckily, we have a number of tools and techniques available to help address your concerns.

Indexing Wins Again in 2014

Posted On February 2, 2015 By Admin In Portfolio Management /

2014 was another strong year for Index funds. According to the Wall Street Journal, only 13% of actively managed large cap funds exceeded the 13.7% total return of the S&P 500 Index for the year. It seems like each year, when index funds outshine active managers, we hear different excuses why. This time, market breadth was blamed, as a high correlation of returns meant that there were few stand-out stocks for managers to make profitable trades. In previous years, we heard managers complain about a “junk rally”, or that “our style is out of favor this year”. And of course, each year, we also hear why the new year is going to finally be a stock pickers market.

We use index funds as the core of our Good Life Wealth model portfolios. Indexing works. I think the misconception about indexing is that it means settling for average returns or that it’s a lazy approach. The reality is that using index funds actually increases your chances of achieving good performance. Index funds outperform 60-80% of actively managed funds over the long-term.

Of course, some actively managed funds do beat the indices. Why not just select those funds? Unfortunately, past returns are not a reliable indicator of future performance. We know this is true – and not just my opinion – through the Standard and Poors Persistence Scorecard, which rigorously measures the persistence of fund performance. Updated in December, the Persistence Scorecard found that of 421 domestic equity funds in the top quartile (top 25%) over five years, only 20.43% remained in the top quartile for the subsequent five-year period.

Top Quartile funds based on 5-year performance (as of September 2009). Over the next 5 years, through September 2014:

20.43% of the funds remained top quartile
19.95% fell into the second quartile
22.33% dropped into the third quartile
27.09% sunk to the bottom quartile
10.21% of the funds were merged or liquidated

If long-term performance was a reflection of manager skill, why are so few funds able to continue to be above average? The results above suggest that instead of high-performing funds remaining at the top, their subsequent returns are almost randomly distributed. In fact, top quartile funds are more likely to be at the bottom (27%) than to remain at the top (20%). And surprisingly, 10% of those top funds don’t even exist in five years. Unfortunately, buying that 5-star fund that has been killing the market often turns out to be a poor decision in a few years time. Then the investor switches to a new hot fund, and the cycle of hope and disappointment begins again.

Indexing avoids these pitfalls. It’s a smart way to invest. And when you look at the tax efficiency of index funds compared to active funds, indexing looks even smarter. (Don’t even ask about the tax consequences of trading mutual funds every couple of years.) But using index funds isn’t a once and done event. We carefully create our asset allocation each year in consideration of valuations, risks, and potential returns for the year ahead. Even when we don’t make any changes to the portfolio models, we still monitor client portfolios and rebalance annually to make sure your holdings stay in line with our target weightings. Perhaps most importantly, the indexing approach allows investors to focus their energy on saving and planning decisions, rather than monitoring managers or searching for the next hot fund.

Are Equities Overvalued?

Posted On January 5, 2015 By Admin In Behavioral Finance, Portfolio Management /

In last week’s blog, we reviewed the fixed income market and discussed how we are positioned for the year ahead. Today, we will turn our attention to the equity portion of our portfolios. Perhaps the top question on most investors’ minds is whether the 5-year bull market can continue in 2015. At this point, are equities overvalued or do they still have room to run?

I don’t think it’s useful to try to make predictions about what the market will do in the near future, but I’m certainly interested in understanding what risks we face and what areas may offer the best value for our Good Life Wealth model portfolios. We use a “Core + Satellite” approach which holds low-cost index funds as long-term “Core” positions, and tactically selects “Satellite” funds which we believe may enhance the portfolio over the medium-term (12-months to a couple of years).

The US stock market was a top performer globally in 2014. The S&P 500 Index was up over 13% for the year, and US REITs (Real Estate Investment Trusts) returned 30%. Those are remarkable numbers, especially on the heels of a 32% return for the S&P in 2013. With six years in a row of positive returns, valuations have increased noticeably for US stocks. The S&P now has a forward P/E (Price/Earnings ratio) of 18, slightly above the long term average of 15-16.

While US stocks are no longer cheap, that doesn’t automatically mean that the party is over. With a strong dollar, foreign investors are continuing to buy US equities (and enjoyed a greater than 13% gain in 2014, in their local currency). The US economic recovery is ahead of Europe, where growth remains elusive and structural challenges are firmly in place. Compared to many of the Emerging Market countries, the US economy is very stable. Emerging economies face a number of economic and political issues, and struggle with declining energy prices, often their largest export.

US Stocks remain the most sought-after. While today’s P/E is above average, “average” is not a ceiling. Bull Markets can certainly exceed the average P/E for an extended period. And given today’s unprecedented low bond yields, it’s tough to make a comparison to past stock markets; equities are the only place we can hope to find growth. Current valuations are not in bubble territory, but it seems prudent to set lower expectations for 2015 than what we achieved in the previous five years. And of course, stocks do not only go up; there are any number of possible events which could cause stocks to drop in 2015.

Given the current strength of the US market, you might wonder why we own foreign stocks at all. They certainly were a drag on performance in 2014. In Behavioral Finance, there is a cognitive error called “recency bias”, which means that our brains tend to automatically overweight our most recent experiences. For example, if we did a coin-toss and came up with “heads” four times in a row, we’d be more likely to bet that the fifth toss would also be heads, even though statistically, the odds remain 50/50 for heads or tails.

Checking valuations is a important step to avoid making these types of mistakes. Looking at the current markets, Foreign Developed Stocks do indeed have better value than US stocks, with a P/E of 15.5 versus 18. And Emerging Market stocks, which were expensive a few short years ago, now trade at an attractive P/E of 13. We cannot simply look at which stocks are performing best to create an optimal portfolio allocation. Diversification remains best not just because we don’t know what will happen next year, but because we want to buy tomorrow’s top performers when they are on sale today.

Our greatest tool then is rebalancing, which trims the positions which have soared (and become expensive), to purchase the laggards (which have often become cheap). So we’re making very few changes to the models for 2015, because we want to own what is cheap and want to avoid buying more of what is expensive, even if it does continue to work. We will slightly reduce International Small Cap, and add the proceeds to US Large Cap Value. US Small Cap has become quite expensive, but small cap value now trades at a bit of a discount (or is less over-valued, perhaps), so that is another shift we will make this year.

Each year, I do an in-depth review of our portfolio models and I always find the process interesting and worthwhile. This year, looking at relative valuations in equities reminds me that our best path is to remain diversified, even if owning out-of-favor categories appears to be contrarian in the short-term.

The Dangers Facing Fixed Income in 2015

Posted On December 30, 2014 By Admin In Portfolio Management /

Although returns were largely positive, 2014 did little to ease the risks in Fixed Income, and in some categories, made the situation decidedly more precarious. Looking at the funds and ETFs I follow, municipal bonds, foreign bonds, and long-term treasuries saw their yields fall, with prices markedly higher. Bonds with the longest duration experienced the greatest change in price.

We are now several years into a low interest rate environment which central banks, like the Federal Reserve, manufactured through their interest rate policies and quantitative easing (bond buying) mechanisms. The market consensus was that these depressed interest rates were like a coiled spring, ready to shoot higher and eventually cause bond investors to endure painful losses. The flip side of some bonds gaining 10-20% in value this year is that if interest rates were to increase by 1-2% in 2015, those same investors could potentially see 20% or higher losses in their positions.

A strong return in 2014 creates a challenging situation – if those categories were overvalued before, they’re even more expensive now. Although the potential for interest rate risk is now higher than ever, the market is beginning to recognize that without increased signs of inflation, we might be stuck with these low rates for an unprecedented number of years. While the yield on the US 10-year Treasury is around 2.2% today, the equivalent 10-year government bond yields less than 1% in Germany, Japan, and a number of other countries. To accept such a low rate suggests that deflation remains a greater concern than inflation for investors in some locations.

Investors positioned defensively in short-term bonds, floating rate, high yield bonds, or TIPS, all lagged the Barclays Aggregate Bond Index in 2014. How should we position for 2015 then? In our Good Life Wealth model portfolios, we are taking a three-prong approach.

1) We don’t try to predict interest rates or speculate on bonds. The role of Fixed Income in our portfolios is to mitigate the risk of our Equity positions. We are looking to have lower interest rate risk (“duration”) than the overall bond market. This means we will make less if interest rates continue to fall, but we will also lose less if or when rates eventually rise.

2) We will underweight areas where yields are too low to compensate for the potential risks. For now, this means we avoid foreign and US treasuries and TIPS. We keep cash to a minimum, to 1% or the amount required for 12 months of withdrawals.

3) We consider each Fixed Income category in terms of its potential rewards and risks. For example, a fund with an SEC yield of 3 and a duration of 3, would have a ratio of 1; a fund with a yield of 2 and a duration of 4, would have a ratio of 0.5, which is less desirable. That’s not to say that we can simplify our selection process to a single step, but it does help inform how quickly we would recover from potential losses, so we can be better positioned if interest rates were to rise.

Although bond prices can be volatile in the short-term, the beauty of bonds is that their Yield to Maturity is a very strong predictor of how the bonds will behave over their lifetime. Our primary focus then is on the opportunity each bond category will provide over time rather than what might occur in the short-term.

With US Stocks sitting at or near all-time highs, bonds may be an after-thought for some investors. And with today’s paltry yields, it’s no wonder. However, bonds have an important role in protecting our portfolios and creating income to contribute to our total return. We’re not going to ignore the risks in bonds, so you can count on our Fixed Income allocation to continue to be tactical in the years ahead.