Huge change in market conditions and what it means for fund fees

newsletter imageFees charged by fund managers have come under attack, and this is especially true for “active” funds that try to beat an index. In recent years, they have struggled to perform better than much-cheaper “passive” funds that simply match their benchmarks, so their higher fees have been harder to justify.

From this, some observers have concluded that active management has proven to be pointless and all investment in the future will be passive – that is, nobody will even try to beat a benchmark anymore. This is a wild exaggeration, to say the least. Active management will have its moment in the sun again, and, as we will see, that moment may be coming soon.

Critics also accuse active managers of barely deviating from their benchmarks anymore. If that is true, they provide little, if any, added value or diversification, and therefore they are charging too much for a job they are not even performing.

There is some validity to the claim that active managers have not been very “active” in recent years. But there is more to this than meets the eye.

We measured the correlation between some popular large-cap mutual funds and the S&P 500, and found credible evidence that after the financial crisis “active” funds indeed became more “passive”, i.e. more correlated with the index. The group we studied, which includes funds large and small, clearly provided much less diversification or additional value over the S&P 500 from 2008 to today.

graph one

But it may be incorrect to conclude that managers have simply become too lazy to do their job. A deeper look at market dynamics suggests that scaling back their efforts to outperform the market was a rational response to a significant change in market conditions.

When we looked at the characteristics of this group over 20 years, we found that regardless of size, the funds least correlated with their benchmarks performed better than the ones that followed their benchmarks more closely. In other words, the ones that were more “active” reaped the largest returns.

But the last 9 years of so show a very different picture: the closer those funds matched the index, the better they performed. Trying to produce returns different from the index was not a successful strategy. What changed?

graph two

The simplest explanation, and the one that much of the financial media has embraced, is that managers have indeed gone lazy or “lost their touch.” In our view, it is quite unlikely that a whole industry of professionals could have somehow become incompetent almost overnight.

The more likely explanation is that a change in market dynamics made it much more difficult for them to beat their benchmarks. If this is so, then we need answers to three questions: what kind of change took place; did managers respond to that change correctly; and is that change temporary or permanent. The answers to these questions yield a much more favorable picture of active managers than the financial media has been willing to paint.

After the financial crisis, individual stock price changes became highly synchronized, making it very hard to identify which stocks would deliver above-average returns without increasing portfolio risk beyond prudent levels. There is plenty of evidence that this is the case.

graph three

Trying to squeeze extra returns from assets that move close together is a losing strategy. Margins are slim, and whatever a manager may be able to extract is likely to be wiped out by trading costs, behavioral biases, and mistakes. In such an environment, the rational response for a professional portfolio manager is to embrace the benchmark. Interpreting this as a sign of laziness or ineptitude is too harsh. In our view, active managers came to a realistic admission that they cannot beat the market through stock-picking when stock correlation goes through the roof.

The opposite is true when correlation drops. When the spread between outperforming and underperforming stocks widens, the reward for choosing the “right” basket of assets is much higher. Leaving aside the much-debated question of whether it is actually possible to identify such basket, the fact is that in low-correlation markets, such basket in principle exists and its potential payoff is much higher.

A high-correlation environment became prevalent after the financial crisis, but it is finally coming to an end. In the last few months, inter-asset correlations have dropped noticeably and, remarkably, the group of funds we studied has itself become less correlated with the index. Active management seems to have been doing its job all along – decoupling with the index when correlations were low and hugging the index when correlations were high.

The decline in inter-asset correlations has important consequences. First, it argues against the premise that in the future all investing is destined to become passive (i.e. merely index-following). As stock picking becomes once again a likely source of excess returns, the attraction of active funds will grow. Second, it bodes well for the market as a whole. Lower correlation is usually accompanied by a drop in volatility, which is a key component in bringing back the retail demand for equities, which has been weak in the wake of the financial crisis. All this supports our view that the mid- to long-term outlook for risky assets such as stocks has significantly improved, and that the bull market is far from over.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at achieving steady, long-term returns while managing downside risk.

You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Contact Path Financial here.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Falling number of shares a key factor behind the market rally

By: Raul Elizalde
today's photoWhen a stock pays a dividend rate higher than the interest at which the company can borrow money, it makes sense for that company to issue debt and buy back its own stock. This is exactly what happened as interest rates fell to historic lows. We believe that the retirement of equities is a key factor in the stock market rally, making them look “expensive” when compared to traditional measures of value, but not when considering their shrinking supply.

We measured changes in the number of outstanding shares of about 350 stocks with an aggregate market capitalization of $17.4 trillion (the total market is currently around $28 trillion). We found that since the beginning of 2011, the number of shares dropped by about 8%. If those shares had not been retired, this group would have a $1.7 trillion larger market capitalization. This extrapolates to a $2.8 trillion shortfall for the total market of US equities due to corporate buybacks.

image 1This estimation is remarkably similar to the $3.0 trillion retired equities calculated by the Federal Reserve. In addition, the Fed tallies the value of shares retired due to mergers and acquisitions, which adds up to another $2.3 trillion, for a total of $5.3 trillion in that period. This was only partially offset by $2.9 trillion of new issues coming to market. On balance, therefore, corporate America retired $2.4 trillion of equities value, which is on par with the GDP of the United Kingdom.

image 2This has vast implications. Stock prices go up disproportionately to the number of shares retired, meaning that a 1% reduction in supply causes a price appreciation much larger than 1%. More precisely, the marginal change in price due to the marginal change in supply is very high. This effect is not easy to isolate and measure, but it is undoubtedly present, and we believe that it is an important factor behind the market rally.

It also helps explain why equities seem expensive against traditional measures of value, such as P/E ratios. A corporation finds value in buying its own stock if it reduces its cost of capital, regardless of what those indicators show. The fact that top management compensation is often linked to the price of their stock may also play a role in a company’s decision to repurchase stock.

As long as this activity continues, the market will continue to seem “expensive”, and it may become more so if the Trump administration’s attempts to reduce the corporate tax rate eventually succeed.

Many US corporations with profitable global operations have not brought back those funds because they are subject to taxation once they come in. According to Moody’s, non-financial US companies hold close to $2 trillion abroad. If a corporate tax cut persuades companies to bring back their overseas profits, the likelihood is that they will be used to repurchase company stock. It is quite doubtful, as proponents of the tax cut argue, that they will be invested in their respective lines of businesses. Given that businesses have easy access to historically cheap credit, money sitting abroad does not seem to be a hindrance to financing any investments that seem promising.

Most recently, both our numbers and the Fed’s numbers show a slight decline in the pace of equity retirement. It could be “noise”, or it could be due to the modest interest rate rise of late last year.

It is reasonable to assume that if interest rates or equity prices go up much further, the economic benefits of retiring shares will end. The danger of higher rates is small, in our view, because it is difficult for the Fed to justify lifting rates much more when inflation has been falling further and further away from its target. As much as the Fed wants to “normalize” monetary policy, hiking rates when inflation is falling is risky.

On the other hand, earnings-per-share have been climbing, both on a trailing and (especially) on a forward basis. Moreover, Europe looks stronger and global GDP projections have improved. These fundamental factors support higher equity prices everywhere, regardless of the impact of corporate demand for equities.

These fundamental factors could make equities seem less expensive in the medium term when compared to traditional measures of revenue and earnings, and could well spur a new wave of demand from retail investors who, because of low interest rates, have few other places to go for returns. The market rally will end one day, but the combination of corporate demand, improving fundamentals, benign outlook for rates and a potential for growing retail demand are pushing that day further into the future.

What now?
We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at achieving steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Why trying to beat the market is a very bad idea

path-1The usual investor experience is a recurring cycle of euphoria and disappointment. Fortunately, there is a better alternative that can put an end to the emotional and financial rollercoaster that is all too common in traditional investing. This alternative requires a serious examination of what are the right priorities that should drive the portfolio management process.

One of the most dangerous goals individual investors have embraced is trying to “beat the market.” This objective can cause tremendous damage to their portfolios.
Here is why: Beating the market (i.e. “getting a better return than the index”) does not accomplish much when the market goes down in a big way. A portfolio that declines by 30% when the index goes down 40% beats the market handily, but it hardly qualifies as “success.” This issue became clear during the market crash of 2008-2009.

Another reason is that for a portfolio to beat the return of an average basket of stocks, it has to be more aggressive than the basket itself. If the market goes up, a portfolio heavy on conservative assets is unlikely to show higher returns than the market. That means that it needs to be over-exposed to aggressive stocks, which magnifies losses when the market sooner or later takes a turn for the worse. This is what happened to investors who loaded up on dot-com stocks during the late 90s, only to see them crash back to earth after the internet bubble burst.

Another issue is that “beating the market” is a pointless goal by itself. An elderly individual with many millions of dollars in the bank, modest expenses, and no legacy goals is much better off with hyper-conservative investments to protect his or her savings rather than with a stock portfolio. Equity exposure is inherently risky, and potential returns would offer no marginal benefit to a portfolio that has already achieved the investor’s goal of paying all living expenses many times over.

These three reasons – limiting the downside, determining the risk/return portfolio profile, aligning risk to goals – have a common thread: managing risk is more important than targeting returns. As a bonus, concentrating on risk rather than returns may actually lead to stronger portfolio performance.

Chasing returns often leads to this kind of unsatisfying experience:
path-2In the last twenty years alone, investors have been badly bruised by several legs of bull and bear markets that leave them disappointed with their investment results. This is one of the reasons why the current bull market, although one of the strongest ever, has been called “the most hated rally in history.” Many investors are still stuck on the “I should have bought earlier”/“I still don’t trust it” phase, or have finally entered in the last 18 months, only to witness a market largely trapped in a range.

Ironically, this dispiriting cycle reinforces the idea that beating the market is a do-or-die goal. As the thinking goes, eking a market-beating return while the market goes up may well be the only way to cushion the downside when the cycle inevitably turns. Compounding this mistake, most investors think they will be able to identify the early stages of a bear market and exit early enough to prevent a big loss.

A much better approach is to focus on managing risk using a systematic, disciplined approach. This can result in a much more satisfying pattern that may require investors to accept lower returns than the market during a bull run in exchange for a considerably gentler experience during times of crisis.

path-3At Path Financial we specialize in designing portfolios intended to provide such smoother experience. It requires a dynamic management of positions to ensure that the level of targeted protection is consistent with the market cycle. Most importantly, it focuses on risk management over return targeting as a source of investment performance.

As an example, we tested how a hypothetical portfolio of mutual funds would perform under some of our process rules. We chose mutual funds that have been around for a long time in order to cover many market cycles of boom and bust, and selected a group representing a broad array of domestic and foreign equity, bond, and commodity baskets.

path-4As the graph shows, this hypothetical portfolio managed according to our risk-based approach could provide a much smoother long-term ride than the stock market, or than a more typical 60% stocks/ 40% bonds mix. It captures a positive return when the market goes up, and drastically cuts the downside in times of crisis. The process focuses on controlling risk over producing high returns, and yet it delivers a comparable performance than a much riskier all-equity exposure over the long term.

To achieve these results investors must take a long-term view and turn their focus away from trying to find market-beating positions, which is a largely impossible task other than by luck. Once they embrace the idea that risk management alone can produce much more stable long-term returns, they will be in a far better position to leave behind the frustrating cycle of euphoria and disappointment they often experience.

What now?
We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return. We implement this process for our clients and we tailor it for their specific circumstances. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of our most recent whitepaper describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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You May Not Be As Diversified As You Think

onionsDiversification is the key element when managing a portfolio. If you want to smooth the ups and downs of individual assets, combine them in a basket. The less correlated those assets are, the steadier the basket’s performance.

Implementing this simple concept effectively, however, is not easy. One major reason is that asset correlations change over time, both in magnitude and direction. For example, when interest rates fall, bond prices go up but stocks can go up or down, depending on whether investors think that lower rates as a stimulus for the economy, or that they are a sign that the economy is slowing down. Because the relationship between stocks and bonds changes over time, the “optimal” proportion of both in a portfolio changes as well.

It is very difficult to forecast changes in correlations. That’s why a common approach is to assume that they will remain constant – which is where the advice that a portfolio must contain a 60% stocks/40% bonds comes from. The assumption is that such pre-set allocation will be good enough to smooth volatility and produce positive results, even if at times it is not the “best” mix for achieving the sometimes opposite goals of maximizing returns and minimizing volatility.

Is it possible to obtain better results by actively managing a mix of assets instead of fixing it at some arbitrary level?

This question is sometimes dismissed out of hand because it sounds like asking whether it is a good idea to “time the market”, an activity that is generally thought to reduce portfolio returns. Indeed, many studies show that portfolio results tend to decline when trading activity increases. The reason behind this is not clear. Some studies blame transaction costs associated with more frequent buying and selling, while others blame behavioral biases – chasing winners; holding on to losers far too long; fear and greed, etc. that are absent when a portfolio is left alone. Regardless, it is not difficult to show how simple active strategies can outperform a passive approach.

For example, it is possible to improve returns over a simple 70% stock/30% bond strategy with the following rebalancing rule: if stocks outperform bonds in any six-month period, change the mix to 90% stocks/10% bonds for the following six months. Otherwise, change it to 50%/50%. In other words, give an extra 20% to the asset class that did better in the prior six months. This “momentum” rule clearly outperforms the “passive” allocation for any base mix of stocks and bonds –70%/30%, 20%/80%, or any other.

image 1Notably, the rule only improves results starting in the early 1990s, making little difference over the “base” allocation before then. This is because there was a substantial change in the correlation between interest rates and stock returns that started around that time. This phenomenon became clear in hindsight, and many of the papers that describe it were published many years after the fact. An investor dedicated to building portfolios on the basis of responding dynamically to shorter-term correlation changes could have achieved higher returns much sooner.

It seems plausible that looking at diversification in more dynamic terms can yield better results, and in fact dynamic techniques have spread widely in the last few years. This approach has been at the center of our practice since we started managing clients’ portfolios, and we focus on developing, improving, and implementing these techniques for individual investors.

While simple strategies like the one described can be effective over the very long term, their benefits over much shorter periods may be less apparent. This is important, because the usual life of an individual’s investment portfolio is often measured in years, not decades. One consequence of this is that for retirement portfolios controlling volatility becomes more important than maximizing returns. This is because pursuing higher returns exposes a portfolio to more risk, which can get in the way of protecting a savings portfolio so it can fund future living expenses. While a static allocation designed to reduce risk must reduce its expected returns, a dynamic allocation tries to find a way to capture more of the upside while keeping risk low..

The main goal of managing diversification dynamically is to provide a better trade-off between higher returns (more risk) and lower volatility (less risk) than a static portfolio mix. This is best achieved over the long term, since fixed allocations can, and do, outperform dynamic management over shorter periods. The process used to improve this trade-off is often a differentiating factor among portfolio managers who pursue the same goal.

What now?

We believe that our portfolio management process, focused on measuring risk, can be very effective at managing the trade-off between risk and returns. We implement this process for our clients, tailored for their specific circumstances, and we can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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Are You Financially Literate?

classroomIn 2009, the Financial Industry Regulatory Authority, or FINRA, started a periodic survey of the financial capabilities of US adults, measuring the skills, judgment and resources needed to manage their financial well-being. Questions range from credit-card behavior (are you paying just the minimum due?) to home equity (do you owe more on your mortgage than your home is worth?).

The study was repeated in 2012 and 2015. Results are encouraging: resources and judgment show a steady improvement over six years. But when it comes to skills, results are disappointing. More and more adults fail to demonstrate a basic level of financial knowledge.

First, the good news. As labor conditions improve, fewer individuals spend more than they make: 20% in 2009, 19% in 2012, and 18% in 2015. The Affordable Care Act had a strong impact on reducing the number of people with overdue medical bills: 26% in 2012 versus 21% in 2015 (the question was not asked in 2009). Similarly, more people have rainy day funds (35% in 2009, 40% in 2012, and 46% in 2015) and fewer pay just the minimum on credit card balances (40% in 2009, 34% in 2012, 32% in 2015). And as home prices recovered, just 9% report having a home underwater in 2015 (i.e. with a mortgage balance higher than the value of the home) versus 14% in 2012.

The data paints a much improved picture. In fact, when asked directly if people are satisfied with their personal finances, the percentage saying “yes“ has gone up to 31% in 2015 from 24% in 2012 and 16% in 2009.

Unfortunately, the opposite is true of financial literacy. Study participants were asked five questions about basic aspects of economics and daily-life finances regarding inflation, interest rates, mortgage debt, and investment risk. In 2009 the percentage of respondents with 3 or less correct answers was 58%. This went up to 61% in 2012 and again to 63% in 2015.

This is a worrisome development because, as FINRA notes, “individuals need at least a fundamental level of financial knowledge” to make sound financial decisions.

Even more worrisome for us at Path Financial is that in 2015 Florida scored second-worst in the nation, at an average of 2.89 correct answers out of five (Texas was worst, at 2.81). You can take the five-question quiz here.

An even more worrisome fact is that, despite their poor performance in this quiz, Americans tend to see themselves as highly versed in financial matters. In 2015, 76% gave themselves a “high” assessment of their own financial knowledge. And while the proportion of “high” self-scoring went up in each of the study years, the public’s ability to answer basic questions correctly went down every time.

Furthermore, when asked to evaluate their math skills, less than two-thirds among the 79% of respondents who gave themselves a “high score” could estimate compound interest correctly in the context of debt.

The disconnect between people’s perceived and actual financial skills is alarming, because it is contributes to making bad decisions regarding savings, investments, and debt.

Understanding risk and avoiding fraud, specifically, are two key areas that are difficult to handle without basic financial knowledge. Even securing conflict-free advice can be challenging without some level of financial literacy: for example, many “seminars” aimed to the public, usually involving a free meal, are aimed more at selling products preying on financial illiteracy than on actually enlightening the public.

This does not mean that everyone who is not a financial expert is doomed to investment failure. But a basic set of skills is necessary to identify those “too good to be true” situations that we all encounter at some point.

A good place to start is an adult-education course offered by a community college, although you may not be able or willing to commit to classroom training. If you want to hire a financial advisor to help you instead, you can screen his or her record beforehand at the Investment Advisor Public Disclosure website. Watch for “disclosures,” which alert the public to client disputes or regulatory violations involving the advisor or firm you want to check out.

Another excellent resource is FINRA’s “protect your money” site. One of the links will take you to a “scam meter” that asks a few questions about investments you might be considering. See, for example, if you identify with these statements:

– I learned about an investment at a free investment seminar

– I cannot clearly articulate what the investment is

– I am not sure what license the person selling the investment has

– The investment is guaranteed

These four answers earn four red flags in the “scam meter”. This is a useful tool that will not analyze a specific investment but can alert you to potential dangers when considering one.

The bottom line is that it would be great for individuals to have better investment skills, but the numbers show little improvement on that front. Also, free tools that can help people avoid serious investment mistakes remain under-utilized. In the meantime, well-crafted investor protection regulations will have to fill the gaps.

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Best Practices for Updating Revocable Trusts Explained in Free Seminar

Raul Elizalde Raul Elizalde, president and chief investment officer of the financial advisory firm Path Financial, is presenting a free seminar, open to the public, covering essential concepts of legal and financial protection of family assets through revocable living trusts, with an emphasis on best practices for strategically updating existing trusts. Guest speaker will be Sarasota attorney David G. Bowman Jr., Esq, of Bowman, George, Scheb, Kimbrough, Koach & Chapman, P.A. Elizalde will join Bowman to discuss specific strategies for assessing and mitigating financial and investment risks within portfolios, including trusts. The seminar is offered Thursday, January 21 at 2 p.m., at 1990 Main Street, Suite 750, downtown Sarasota; building parking is complimentary and refreshments will be provided. To register, call 941-366-5510.

The seminar will include discussions on tax law changes, Florida domicile, and particular circumstances such as second marriages, changed relationships with trustees or beneficiaries, and more. Other topics will include how trusts may help cut tax bills, and how to protect and grow investments, while minimizing exposure to risk.

David Bowman, Jr., is a partner with the Sarasota law firm of Bowman, George, Scheb, Kimbrough, Koach & Chapman, P.A. His practice is focused in the areas of estate planning and administration, as well as real estate and corporate law.

Elizalde is a contributing columnist for Oxford World Financial Digest, and has a national reputation for financial insights and analyses that are published online by some of the most respected financial media in the country, including Morningstar, Motley Fool, the Street and Yahoo! Finance. In 2014, he was a featured expert panelist during National Financial Advisor Week in New York City, and in 2012, was named among the country’s most respected and innovative money managers in Max Isaacman’s 2012 book, “Winning with ETF Strategies: Top Asset Managers Share Their Methods for Beating the Market,” published by Financial Times Press. Elizalde is a current member and past chair of the Asset Management Committee for the State College of Florida Foundation.

Path Financial is a Florida-registered investment firm rated “A+” by the Better Business Bureau, and is located at 1990 Main St., in Sarasota, Florida.

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Junk-Bond Wake-Up Call Column Quotes Raul Elizalde of Path Financial

herald tribune logoIn his newspaper column in today’s Sarasota Herald Tribune, contributing columnist Ernest “Doc” Werlin quoted Path Financial President and Chief Investment Officer Raul Elizalde on the topic of the current challenges facing the junk-bond market. Drawing from Path Financial’s Dec. 15 article for investors, “Junk Bond Troubles Could Be the Tip of the Iceberg,” Werlin noted Elizalde’s comment that “it’s too soon to say the worst is over for investors….It took over a year for the earliest signs of serious problems in the mortgage bond market to metastasize into the collapse of Lehman Brothers and a full-blown financial crisis.” Werlin also quoted Carl Icahn’s Dec. 12 appearance on CNBC where Icahn “warned that a lack of liquidity could cause the high-yield market — otherwise known as the junk-bond market — to implode and contribute to a broad market crisis.”

Read Werlin’s full column here.

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Junk bond fund failures may be the tip of the iceberg

Junk bond fund failure iceburgSigns of distress are mounting in the high-yield bond market.

Last week, the mutual fund company Third Avenue Management blocked redemptions in its $790mm junk-bond oriented Focused Value fund. Another company, Stone Lion Capital, did the same in its $400mm distressed debt hedge fund. And Lucidus Partners close its high-yield oriented fund and returned all money to investors.

Third Avenue’s fund, like all mutual funds, permitted daily redemptions; however, it invested in illiquid, hard-to-price, low-quality debt. As the fund’s losses mounted investors liquidated shares, forcing the fund to sell its most liquid assets first. Left with assets for which few buyers existed, management ended up erecting a “gate” to prevent a fire-sale of its remaining positions.

This turned all holders into “beneficiaries of a liquidating trust.” It is unlikely that any of the mutual fund’s holders ever contemplated the possibility that their money would be locked without any clarity on how much they would get back, or when.

The problems in the high-yield world extend to popular ETFs. Since the beginning of the year, the price of the two largest ones in that category, JNK and HYG, lost enough money to wipe out three years of dividends and price gains. Franklin Templeton’s High Income, a $5bn junk bond mutual fund, has had an even worse fate (see graph).

Junk bond failures graph 1All corporate bonds, including high-yield, are measured by their yield “spread” over US Treasuries. This is simply the additional interest that investors demand for accepting a risky bond. The riskier the bond, the larger the spread. The spread can also widen because of a demand/supply imbalance if buyers are hard to find.

Analysts are currently debating whether current junk-bond market woes are due to these technicalities, or whether something worse is going on.

There is no doubt that liquidity in the bond market has deteriorated after the ability of investment banks to trade and warehouse bonds was curtailed by regulations created after the financial crisis of 2008. Despite this, corporate bond issuance exploded in response to high investor demand as interest rates fell. Corporate treasurers were eager to issue debt at low rates, which they used not only to finance operations but also to buy back their own stocks. The latter resulted in savings because of lower dividend distributions, improved equity metrics such as earnings per share, and propped up equity prices to which corporate management’s compensation is linked.

The explosion of debt issuance raised few alarms until recently. As we discussed in a recent newsletter (This is where the next crisis will come from, 8/21/2015), the current run-up of corporate debt is the largest and fastest in history, and comes in the wake of a crisis that was due precisely to a huge increase in private sector indebtedness (see graph).

Junk bond failures second graphAn important challenge to the creditworthiness of some of the new debt is the decline in oil prices. Originally seen as a boon for consumers, it quickly became too-much-of-a-good-thing when investors started questioning the ability of some of the most leveraged companies in the oil business to repay their debts in the wake of collapsing revenues. If defaults rates rise, a contagion effect on those who lent to the oil industry will become an additional worry. And all is taking place in the context of a Federal Reserve intent on jacking up the cost of debt.

So are the high-yield fund troubles a sign that a market crash is near? Many bond-fund managers don’t seem to think so. They point out that since only a quarter of outstanding junk bonds are in the hands of mutual funds, there few reasons to believe that problems could spill over to other parts of the corporate bond market, let alone stocks.

That may be so. But it is interesting to note that for the last 12 years there has been a mirror relationship between high-yield bond spreads and the stock market: when spread fell, the stock market rallied and vice versa. This relationship has not held in the last year or so, as the stock market completely shrugged off the dramatic widening of bond spreads (see graph).

Junk bond fund failures third graphFor this relationship to come back in line, bond spreads would have to come down substantially, creating fabulous gains for high-yield bonds. It would also come back in line if stocks crashed in a big way.

A third option, of course, is that the two asset classes have decoupled and will move independently from now on. This is possible; in a more distant past, the relationship between them was different. Entering a new period of higher rates also may play a role in breaking the familiar link.

So, it is early to say whether the junk-bond fund failures are isolated events or warning signs that big troubles are brewing. After all, past market anxieties like Greece, a US credit downgrade or the Japan tsunami did not have any lasting impact on a relentlessly climbing market. Still, it may be foolish to completely dismiss mutual fund failures as being of no importance. After all, the financial crisis was preceded by the demise of two Bear Stearns funds and the troubles of a handful of money market funds in 2008.

The Investment Company Institute reports that mutual funds currently own $300bn of high-yield debt – twice the level of 2007. This is worrisome, because mutual fund investors can and will sell their shares quickly if sentiment worsens, leaving managers to figure out how to liquidate holdings in an environment of much-reduced liquidity. This could well lead to more fund failures and a down-spiral of investor confidence.

Many times, portfolio management is about making a decision to buy insurance rather than positioning a portfolio to capture uncertain returns. Investors may need to look at this tradeoff closely and decide whether insurance, in the form of reduced exposure to risk, is a wise purchase given the current challenges that the high-yield bond market currently faces.

What now?

Our clients want to make sure that their investments are managed efficiently and prudently, and that they partner with an advisor who helps them cut through the market noise. We look at their specific situations and use quantitative techniques and solid execution expertise to build and maintain investment portfolios that are suitable for their needs. We try to identify when to buy or sell different asset classes, with a focus on controlling downside, seeing through the haze of short-term volatility, and looking at what securities are priced favorably at various times. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more

 

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As we were saying – “Fed should wait with liftoff to see firm inflation signs: IMF note” [Reuters]

“The U.S. Federal Reserve should wait to see firm signs of rising inflation as well as a stronger labor market before hiking benchmark interest rates, an International Monetary Fund paper said on Thursday.” (November 12, 2015)

This is according to Reuters, and agrees broadly with our October newsletter, “Low inflation should keep the Fed on hold.” (October 27, 2015). Inflation remains low, and yet the market seems convinced that the Fed will hike rates soon, and Fed officials seem poised to do just that. We remain unconvinced that this is the right move.

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Two conditions keeping investors on edge

In case you haven’t noticed, the S&P 500 has been breaking records since April 2013. Just this week it crossed the psychological 1900 level for a brief moment. But while this is happening, aggressive stocks like small caps are losing a lot of ground to far more conservative large caps. The same is happening to the consumer discretionary sector, which has performed dismally against consumer staples.

There is little evidence – actually, none – in the last 14 years that a market rally like the one we are experiencing can take place without aggressive stocks being at the forefront of performance. To pessimists, this is a clear warning that the market is heading for trouble. Are they right? (Read more)

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