Tag Archives: mutual funds

Savers double up without reward

An addendum to Gary’s News Tribune column from January 6. Cash equivalents may be zombie investments but investors still favor them.

TrimTabs, a tracker of cash flows to bank and investment accounts released information January 13 demonstrating that Americans deposited $889 billion into bank checking and savings accounts from January 2011 through November. That’s more than eight times more than the $109 billion that flowed into stock and bond mutual funds and exchange-traded funds.

In an interview with AdvisorOne, TrimTabs Executive Vice President David Santschi said the bank flows are more than double the $335 billion 12-month average flows since 2000, and closely approach the record flow into savings and checking accounts in the 12 months ended November 2009.

“The Fed is doing almost everything it can to get people to speculate but retail investors aren’t taking the bait,” Santschi said. “If you want to know where the real money is going, it’s all going into savings vehicles.”

More details in this article:

http://www.advisorone.com/2012/01/13/investors-flee-stocks-and-bonds-stuff-cash-in-matt

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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High-yield bonds may not be junk

High-yield corporate bonds have built a big edge in income yield over Treasury bonds over the past few months. Some people prefer the perceived safety of Treasury bonds and accept the lower income stream (even if it means a negative return after accounting for inflation). The fear is that high-yield corporate bonds have a higher default rate. But according to Fidelity Investments, in order for high-yield bonds not to perform better than Treasury bonds over the intermediate term, default rates would have to rise from currently between 1 and 2% all the way to 10%.

According to a recent market analysis from Charles Schwab, Moody’s projects a peak high-yield default rate of 9.4% in the case of severe recession. Going back to November 2009, corporate bond defaults peaked at 14.5%. The Moody’s stress test uses an unemployment spike to over 13% and a dramatic rise in the cost of high-yield debt (to the levels seen in 2008–2009).

Schwab’s Rob Williams (Director of Income Planning) and Kathy Jones (Fixed Income Strategist) wrote: “We’re nowhere near either of these possibilities at the moment, in our view. Unless we see a severe economic downturn, yields north of 9% for high-yield bonds—where they are currently on a broad index—may be enough to compensate for volatility and defaults for more risk-tolerant investors. Bottom line: Adding yield when spreads compared to Treasuries widen, in our view, can make sense for investors interested in corporate bonds now that yields have risen.”

High-yield bonds collectively have average yields over 8%.

Certainly, if recession returned, conditions would change but at this point, concern of recession has eased. We find that using multi-sector bond mutual funds where the managers have flexibility to shift to the most relatively attractive segment of the global bond markets, is a good way to gain exposure to high-yield bonds.

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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What we look for when picking a mutual fund

In theory, picking a good mutual fund should be easy. Just find a fund with an experienced portfolio manager who has consistently outperformed the fund’s relevant benchmark and buy some shares. Then repeat in each portion of the market so that you have a well-diversified investment mix.

In reality, while it’s possible to evaluate past performance and choose from funds that have peer-beating records, the more difficult job is to identify funds that have a high probability of continuing that performance. Performance is fleeting. Even funds that have performance among the best in their category may have built good returns on a small number of incredibly well-timed investments. Alternatively, some very good funds could have excellent long-term performance and good future positioning skewed by the impact of one or two investments that didn’t work in their favor.

Identifying funds with a repeatable process to add value beyond just buying the whole market is an ongoing and involved task.

A lot of things can change about a manager or a fund from year to year. We work to learn as much as we can about the manager or fund, so we are comfortable with its stability and understand how it will fit into our clients’ portfolios.

Important questions that we ask include:

  • How much of rising market returns does the manager earn and how much does the fund participate in declining markets? (Ideally, actively managed mutual funds capture most of – if not more than – a climbing market’s return and are able to avoid the full extent of downturns.)
  • How much flexibility does the manager have? (When we choose mutual funds, we generally prefer managers who are not constrained to invest only in a specific portion of the market regardless of whether it is in or out of favor at the time. We use exchange-traded index funds to get this inexpensive broad diversification instead.)
  • Have there been any changes to the manager or management team recently?  If so, how have those changes influenced the fund’s investment outlook or process?
  • How are decisions made to buy and sell a stock or bond?
  • Does the fund invest only in long-only positions in stocks or bonds or does it use derivative products to emphasize or de-emphasize certain exposures in the fund? (We’re not against fund managers who use of derivatives to some extent as long as the process and purpose are very transparent.)
  • Has the manager’s investment philosophy changed recently?
  • How much new money has been invested in the fund lately and has that affected either the number or the quality of holdings in the fund?
  • What have been the recent trends of the manager for underperforming or outperforming the fund’s relevant benchmark?  Why has this underperformance or outperformance occurred?
  • Have there been any changes to the basic characteristics of the fund?  Expense ratio, portfolio turnover, number of holdings, risk measures, etc.?
  • Does the fund have an institutional share class available so that we don’t have to pay the higher retail share class management fees? Or, can we aggregate client accounts to get into funds that otherwise would have an unapproachable minimum investment?
  • How will this fund fit in with the other funds in a client’s portfolio?  Are there other funds that could do a better job?
  • Is there a low-cost passively managed investment like an exchange traded fund that could be used in place of this fund which would provide similar investment returns?

How do we get this information?  Mostly through conference calls with the manager, reading annual and semi-annual reports for the fund, reviewing analyst’s reports and other third-party reviews.

This process doesn’t guarantee selection of the best future performance. In fact, we guarantee that in hindsight you will find better performers in every category over various time periods. But if the fund advances through our decision tree and we have high conviction in its expected returns compared to its known risks, then it makes the cut.

The worst thing we could do would be to constantly turn over our list of preferred funds in pursuit of the absolute best performance. It would create unnecessary reach for fractionally better results and drive up transaction costs.

That is not to say that we are not searching for new funds that offer attractive expected returns with better risk management. We certainly make changes. We just are not inclined to do it on a whim because a certain fund’s holdings were more in favor last quarter or last year.

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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The total return picture for bonds when interest rates rise

Extending our thoughts from the 2-part Bond Market Conundrum post of December 22, here is a good visual representation of the fact that total return (income + price appreciation) is important to evaluate bonds and bond mutual funds.

When interest rates climb and negatively impact bond prices, the income paid by the bonds largely offsets the problem, usually keeping bonds in positive territory.

This chart, produced by our friends in the advisor consulting group at Russell Investments, tracks the total return components of the Barclays Capital U.S. Aggregate Bond Index since 1994.

Bond market total returnAs long as interest rates don’t rise much faster than expected, bond mutual fund managers should maintain a good ability to manage the changes.

There is a rule of thumb approach to measuring the negative impact of interest rate changes on bond funds. Bonds can be expected to decline by a multiple of the percentage change in interest rates times the duration* of the bond(s).

Here is an example using data from the Barclays Aggregate Bond Index at the end of 2010.

Let’s assume interest rates over the next year rise by 0.5%. The duration of the Barclays Aggregate Index on 12/31/2010 was 4.98 years.

0.5% x 4.98 = 2.49

You could expect a bond’s price to decline by 2.49% over this time. The average income yield of the Barclays Aggregate Index at the end of 2010 was 4.24%. Add that to the negative 2.49% price decline and the total return of the index would be 1.75%.

If rates happen to climb by a full 1.0% in a year, then total return would be lightly negative.

Unless unemployment declines, home prices regain value and inflation grows significantly, there doesn’t seem to be much pressure to raise interest rates very swiftly.

*The longer the duration, the higher sensitivity to interest rate changes. This explains why long-term bonds are impacted more by interest rate moves than short-term bonds.

~ Brooks, Hughes & Jones — Partners in Wealth Management — Tacoma, WA

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Stocks are “cheap,” investors prefer bonds

Jeremy Siegel is a finance professor at the University of Pennsylvania’s Wharton School of Business. His research and book, Stocks for the Long Run, have documented investment returns and performance patterns back into the 1800s.

On a conference call with advisors October 18, he communicated his bullish thoughts.

“Relative to bonds, I’ve never seen a cheaper market,” Siegel said.

He acknowledged that the economic recovery is slow and will continue to be. He focuses, though, on earnings expectations for publicly traded companies. Even after being revised downward, expectations for 2011 earnings are still at all-time highs. Combine that with low interest rates and Siegel says, “Stocks are a buy by every principle we know in finance.”

While earnings are the most important element of stock performance, they certainly aren’t the only one. There are other positive factors as well but they are presently outweighed by investor sentiment. “Risk aversion is the only thing holding the market back,” Siegel said.

Cash flow, the contrary indicator?

Risk aversion is clear when you look at cash flow into and out of mutual funds.

More money is flowing into bond funds than did into stock funds during the euphoria of 1999-2000. This trend has significantly changed the overall mix of assets that average investors hold.

Recent work from Ned Davis Research indicates that as of the end of June 2010, bonds as a percentage of assets for households and trusts were 20.7%. The 55-year average is 13.0%. That means ownership of bonds in the average family’s mix of assets has risen 59% above the long-term average. The 13.0% long-term average has climbed slowly over the past 25 years as only three years in the past 25 have featured bond ownership less than the 13% average.

Now, here’s an interesting view from the flip side. Institutional investors (sometimes referred to as the “smart money”) have decreased their bond holdings over the same period. Public and private pension funds as of June 30, 2010 held 24.5% of their assets in bonds, down from a 55-year average of 40%.

While individual investors increased bond holdings 59%, institutional investors reduced bond exposure by 39%. It’s important to note that the bond reduction by institutions doesn’t translate directly to an increase in stock exposure. A lot of institutional money has moved to alternative assets such as natural resources, private equity, and other non-traditional investments.

Bonds still key to portfolio diversification

While we believe bonds still have a strategic role to play in almost all portfolios, the characteristics that have attracted individual investors (less fluctuation, better returns relative to stocks) are not likely to continue to the same extent forever.

New issuance of high-quality corporate bonds has produced record low income payments. Microsoft set a U.S. record in September with a 3-year bond offering paying just 0.875%. This beat IBM’s 1% bond issue in August. To receive better income returns, investors are seeking bonds with lower credit quality and higher yield.

Low bond yields also make dividend-paying stocks more attractive. With quality stocks paying attractive dividends, you may get higher income than from bonds and have the opportunity to participate in stock price appreciation essentially for free. This creates a better total return. Of course, this comes with stock market risk.

Two other primary reasons not to overload your portfolio with bonds:

  • When interest rates climb from their all-time low, bond prices will decline.
  • With the government flooding the marketplace with cash stimulus (and apparently more to come in November), noticeable inflation will return, eroding the purchasing power of income from low-yield bonds

We think it is best to diversify bond exposure broadly, including foreign bonds, inflation-protected bonds and floating rate bonds, all of which can be expected to fare better than U.S. government agency bonds when interest rates and inflation grow.

~ Brooks, Hughes & Jones, Partners in Wealth Management — Gary Brooks, CFP®, Allyn Hughes, CFP®, CLU, ChFC, Nancy Jones, CFP® — Tacoma, WA

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The Paradox of Choice

In an ideal world, your life goals and financial resources would lead you down a path where you have to choose route A or route B from time to time, but, for the most part, the options and expected outcomes are understood.

Of course, financial planning and investing is more complex than coming to a Y in a country road and making a simple decision. Instead, occasionally it’s as if you were dropped in the middle of an unknown metropolis where freeways intersect and on and off ramps intertwine with directions that aren’t clear.

Given the multitude of investment options (401k, IRA, 403b, 529, mutual funds, ETFs, etc.) and the infinite possibilities for combining investments into a coherent money management strategy, it’s no surprise that people often struggle to make choices.

As Barry Schwartz wrote in The Paradox of Choice, “there is a cost to having an overload of choice.” It leads to three effects:

  1. Decisions require more time and effort (How much is your time worth to you? Do you find it to be a valuable use of your time to evaluate and monitor investments?)
  2. Mistakes are more likely (With more choice comes less certainty in the outcome of any specific choice.)
  3. Psychological consequences of mistakes are more severe (We beat ourselves up for failures more than we celebrate successes.)

Often, fear of choice leads to missed opportunity or the assumption that no decision is better than the wrong decision.

One aspect of a good financial advice relationship is the development of confidence in your direction. A good advisor uses insight to make actionable decisions, filtering out the noise in the pursuit of financial security.

The primary focus of our client relationships is to help people shine a light on their goals, identifying things that require planning, money and time to accomplish. Then, we narrow down the choices for how to proceed and make personalized recommendations. The paradox is answered with conviction for a plan that is actionable, effective and monitored by professionals.

You will continually be presented with transitions in life. Many options will be presented for how to address each step from the dual perspective of your goals and your financial resources. Getting guidance about each will help you overcome the paradox of choice.

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Should you follow the money into bonds?

Gary’s monthly column in The News Tribune was published today. It reviews cash flow into and out of mutual funds and what that tells us about investor psyche. Despite a rapid global stock market rally, dollars are still flooding out of stock funds and into bond funds. Investors lured by the returns of the past decade for bond funds may be disappointed going forward.

You can click on the image here to read a bigger version.

TNT article Dec. 17, 2009

Trimmed from the story was this quote from Ibbotson and Chen about performance expectations for stocks vs. bonds:

“stock returns over the past 40 years were virtually in line with the long-term historical average. On the other hand, bond returns were not only much higher than their historical averages, but also higher than their current yields. This high bond return is due to higher interest rates in the 1970s and a subsequent declining interest-rate environment. This scenario for bonds is very unlikely to repeat in the future, given today’s low-interest rate environment. Investors hoping that bonds will outperform in the coming years will likely be disappointed.”

 

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