Tag Archives: volatility

Investing: What the heck is a Larry Portfolio?

PortfolioGuest post by Contributing Editor, Matthew Amster-Burton, Mint.com.

Recently, I wrote a three-part series on how to start investing.

Today, I want to look at an advanced topic. Generally, I avoid advanced topics in investing, for two reasons:

  1. Most people don’t even have a grasp of beginner-level investing yet.
  2. The vast majority of “advanced” investing techniques can’t beat a simple, diversified portfolio over time.

Today, I want to look at a possible exception. It’s called the Larry Portfolio, developed by a guy named (you guessed it) Larry Swedroe and presented in his short and readable new book, Reducing the Risk of Black Swans, cowritten with Kevin Grogan.

Like momentum investing, which I explored last week, the Larry Portfolio is a way to attempt to capture more return from your portfolio without taking more risk—the holy grail of investing. Spoiler alert: it’s a promising idea that may or may not be appropriate—or possible—to implement in your own investments.

This is fairly technical stuff, although I’ll leave the math out of it. If you’re interested in investing as a hobby, read on. If you just want a simple portfolio that will beat your stock-picking friends, that’s fine. Go back to my original series.

One kind of risk

Smart investors like to take smart risks.

Investing in just one company is a dumb risk. That company might go bankrupt in any number of unexpected ways. Investing in lots of companies (aka diversification) is a smart risk: you’re no longer exposed to the risk of one company flaming out.

You’re still exposed to the risk of the market as a whole, and that’s the risk that investors can expect to get paid for over time.

Investors call this total-market risk beta. Beta measures the volatility of the stock market as a whole. Generally speaking, to get more return, you have to take more risk: Treasury bonds have low beta and low expected returns; stocks have high beta and higher expected returns. A total stock market portfolio has a beta of 1. (Let’s talk about low-beta stocks another time, please!)

So you might imagine that the best possible portfolio would look something like this:

  • Low-risk bonds (Government bonds from stable governments, high-quality corporate bonds, CDs)
  • A total world stock market fund

Mix them in whatever proportion suits your risk tolerance. One popular formula is 60/40: 60% stocks, 40% bonds.

Many kinds of risk

Then, in the early 1990s, two professors at the University of Chicago, Kenneth French and Eugene Fama, took another look at the data. They found that beta couldn’t explain all of a portfolio’s returns.

Two other factors seemed to be important, too. A portfolio taking these factors into account could, some of the time, beat a total-market portfolio without being riskier. These factors are:

Size. Small company stocks tend to have higher returns than large company stocks.

Value. “Value” stocks, essentially stocks with low prices, tend to have higher returns than growth stocks. How do you decide which stocks are value stocks? Use a measure like price-to-earnings ratio.

Value stocks are essentially stocks in mediocre, boring companies. This seems like an odd way to make money, but it’s a highly persistent effect. (Value is believed to be a stronger effect than size.)

You can now easily buy mutual funds concentrating on small or value stocks, and many investors choose to “tilt” their portfolios toward these factors, hoping for bigger returns without bigger volatility.

It’s a reasonable hope, because beta, size, and value have low historical correlation. When you have multiple stocks in your portfolio that are exposed to different risks, we call that diversification. The same can be said for having multiple factors in your portfolio.

The Larry Portfolio

Now, what if the stock portion of the portfolio was made up of entirely small value stocks?

That would give plenty of exposure to beta (because small value stocks are still stocks, and correlate with the wider stock market), and also maximum exposure to the small and value premiums. It’s also reasonably well-diversified, because there are thousands of stocks that fit the profile.

This sounds like a risky stock portfolio, and it is: high risk, high expected return.

Larry Swedroe’s insight was: what if we mix a little of this very risky (but intelligently risky) stock portfolio with a lot of very safe bonds? Say, 30% small value stocks and 70% bonds?

The result is the Larry Portfolio, a portfolio with similar expected return to to 60/40 portfolio I described, but lower risk, because the portfolio is mostly bonds—the kind of bonds that did just fine during the Great Depression and the recent financial crisis.

Swedroe warns in the book that there are no guarantees in investing. “[A]ll crystal balls are cloudy—there are no guarantees,” he writes. The research behind the Larry Portfolio may be sound, but “we cannot guarantee that it will produce the same returns as a more market-like portfolio with a higher equity allocation.”

Is it for you?

I took a look at my portfolio. It looks almost exactly like the portfolio Swedroe describes in the first part of the book, a diversified 60/40 portfolio with plenty of exposure to beta but no exposure to the size or value premiums.

So I asked him the obvious question: should I have a Larry Portfolio?

“There is no one right portfolio,” Swedroe told me via email. “The biggest risk of the LP strategy is the risk called Tracking Error Regret.”

Tracking Error Regret is a nasty thing. Here’s what it means.

Inevitably, the Larry Portfolio will sometimes underperform a 60/40 portfolio. If the stock market is soaring, it might underperform it for years at a time. A Larry Portfolio holder might look around and say, “Dang, everyone is making a ton of money but me. This portfolio sucks.”

Then you jump off the Larry train and back into a 60/40 portfolio—probably right before a market crash that decimates your stock portfolio. (That’s the Black Swan in the book title.) “Oh no—Larry was right!” you conclude, and buy back in, but it’s too late: now you’re selling cheap stocks to buy expensive bonds.

There really isn’t any cure for Tracking Error Regret. You can write an investment policy statement (IPS) to remind yourself that you’re a long-term investor and shouldn’t be watching the market too closely, because it’ll only raise your blood pressure.

The worst way to address the problem is to assume that you’re too smart or tough to experience it.

Can we build it? Maybe we can

Finally, there’s one other reason the Larry Portfolio might not be for you: it requires using mutual funds that might not be available in your retirement plan.

If most of your money is in a 401(k) plan, and that plan doesn’t have a US small value fund and an international small value fund, you can’t really build a Larry Portfolio. You might be able to build a watered-down version, but it won’t have the same risk-return characteristics as the real thing.

I haven’t decided yet whether the Larry Portfolio is for me. If you’ve read this far, however, you’ll probably enjoy Swedroe’s book. And if you already use a Larry Portfolio or are considering one, please let me know in the comments.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Mint.com is not affiliated with Folio Investing or The Portfolioist.

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Goodhart’s Law

Goodhart's LawGuest post by Leo Chen, Guest Contributor to Cumberland Advisors.

Goodhart’s Law

“When a measure becomes a target, it ceases to be a good measure.”

-Charles Goodhart

When it was first introduced in 1975, Goodhart’s Law focused mainly on social and economic measures. Since then, many financial market indicators have lost their forecasting power and succumbed to Goodhart’s Law. Nevertheless, Goodhart’s Law in no way depreciates the value and importance of market indicators; it simply means that investors are unlikely to be able to consistently generate abnormal returns over time using popular measures that are publicly available to the entire market. A clear example is what has happened to the CBOE Volatility Index, or VIX.

The Volatility Index

The Volatility Index (VIX) was a groundbreaking product when the Chicago Board Options Exchange (CBOE) released it in 1993. Also referred to as the fear index, VIX measures the expected underlying volatility in the S&P 500 over the next 30-day period on a real-time basis. Using various measures of VIX such as the two-week mean, the 30-day rolling standard deviation, etc., VIX traders and portfolio managers developed strategies that were initially profitable. However, over time it has become extremely difficult to profitably forecast the market by simply observing the movement in VIX.

While the history of the VIX demonstrates how a market gauge lost its predictive power once it caught investors’ attention, the CBOE Low Volatility Index, LOVOL, provides an even better illustration of how an indicator can lose its forward-looking power very quickly. CBOE began calculating the Low Volatility Index on March 21, 2006, and started disseminating LOVOL data on November 30, 2012. The forecasting ability of LOVOL immediately plunged to almost zero within a month. In fact, Goodhart’s Law has captured nearly all of the CBOE volatility indexes as prisoners. These fallen angels are no longer useful tools for forecasting purposes.

Another prominent index, developed in the late 1960s, that uses extremes in its value to signal that a market may soon change direction is the Arms Index (TRIN). As predicted by Goodhart’s Law, while technical indicators such as TRIN were able to successfully predict market returns in the past, their loss of forecasting power was only a matter of time when every technician used these ratios for trading purposes. Even the Federal Reserve was no exception. The pre-FOMC announcement drift was found to explain the equity premium puzzle in 2011. But this 24-hour window disappeared soon after the research was published.

Investors Beware

On one hand, Goodhart’s Law teaches us that a smart investor should not rely on any single factor known by the general public to be “powerful”; on the other hand, it does not negate the significance of any indicator.

The following figure is a ratio brought up by Chairman and Chief Investment Officer David Kotok of Cumberland Advisors. The CBOE SKEW Index measures S&P 500 tail risk, while the VXTH Index hedges “black swan” events such as Black Monday in 1987. Lagging and scaling both indexes by the lagged VIX, we are able to track the daily SPX with a correlation that can top 90%, comparable to the correlation between the S&P 500 and GDP. Nonetheless, a high correlation is not necessarily equivalent to strong forecasting power. While one could use this chart for long-term investing strategy, the accuracy of using these daily ratios to predict the daily market movement is approximately 51%, not economically significant enough for forecasting purpose.

3-5-2015

Figure 1. Correlations between SPX and Volatility Indexes

Conclusion

The list of captives of Goodhart’s Law is clearly longer than just the indicators mentioned above. High-quality research should be able to produce positive abnormal returns as long as there is information that can be exploited; however, superior research alone is no longer synonymous with outperformance – time is also of the essence. Because of technological innovation in financial markets, the time frame in which Goodhart’s law operates today is much shorter than it was in earlier decades. Just as Moore’s Law predicts that chip performance will double every 18 months, investing methodologies must continually evolve in order to remain profitable, due to Goodhart’s Law.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with Folio Investing or The Portfolioist.

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Oil, Markets, Volatility

Guest post by Contributing Editor, David R. Kotok, Cumberland Advisors.

Oil, Markets, VolatilitySharply lower oil prices have occasioned a huge discussion about their impact. We see it play out daily in newspapers, on TV and radio, at websites, on blogs, and in market letters. The range of forecasts runs from one extreme to another.

On one side, pundits predict a recession resulting from a US energy sector meltdown that leads to credit defaults in energy-related high-yield debt. They predict trouble in those states which have had high growth from the US energy renaissance. These bearish views also note the failures of Russian businesses to pay foreign-denominated debt held by European banks. And they point to sovereign debt risks like Venezuela.  These experts then envision the geopolitical risk to extend to cross-border wars and other ugly outcomes.

Geopolitical high-oil-price risk has morphed to geopolitical low-oil-price risk. That’s the negative extreme case.

The positive forecasts regarding oil are also abundant. American’s Consumer Price Index (CPI) drops robustly due to energy-price ripple effects of $50 oil. We are still in the early stages of seeing these results in US inflation indicators. There is a lot more to come as the lower energy price impacts a broad array of products and service-sector costs.

A big change in the US trade balance reflects the reduced imported oil price. We are also seeing that appear in the current account deficit plunge. In fact, both of those formerly strongly negative indicators are reaching new lows. They are the smallest deficits we have seen in 15 years. Action Economics expects that the current account deficit in the first quarter of 2015 will be below $80 billion. That is an incredible number when we think about gross flows history.

Remember that the current account deficit is an accounting identity with the capital account surplus.  Net $80 billion goes out of the US and turns around and comes back.  These are very small numbers in an economy of $18 trillion in size.

Think about what it means to have a capital account surplus of $80 billion, driven by a current account deficit of $80 billion. That means that the neutral balancing flows into the United States because of transactional and investment activity are now small. Therefore the momentum of US financial markets is driven by the foreign choices that are directing additional money flows into the US.

In the end the equations must balance. When there is an imbalance, it affects asset prices. In the present case, those asset prices are denominated in US dollars. They are desired by the rest of the world.  They are real estate, bonds, stocks, or any other asset that is priced in dollars and that the world wants to accumulate. In the US, where the size of our economy is approaching $18 trillion, the once-feared current account deficit has become a rounding error.

How bad can the energy-price hit be to the United States? There are all kinds of estimates. Capital Economics says that the decline in the oil price (they used a $40 price change, from $110 to $70 per barrel) will “reduce overall spending on petroleum-related liquids by non-oil-producing businesses and households by a total of $280 billion per year (from $770 billion to $490 billion).” Note that the present oil price is $20 a barrel lower than their estimated run rate.

That is a massive change and very stimulative to the US non-energy sector. The amount involved is more than double the 2% payroll-tax-cut amount of recent years. In fact it adds up to about 3/4 of the revised US federal budget deficit estimate in the fiscal year ending in 2015.

Let me repeat. That estimate from Capital Economics is based on an average price of $70 a barrel in the US for all of 2015. The current price of oil is lower. Some forecasts estimate that the oil price is going much lower. We doubt that but the level of the oil price is no longer the key issue.  It is the duration of the lower price level that matters.  We do not know how long the price will fall, but there is some thought developing that it will hover around $55 to $60 for a while (average for 2015).

There is certainly a negative impact to the oil sector. Capital spending slows when the oil price falls. We already see that process unfolding. It is apparent in the anecdotes as a drilling rig gets canceled or postponed, a project gets delayed, or something else goes on hold.

How big is the negative number? Capital Economics says, “The impact on the wider economy will be modest. Investment in mining structures is $146 billion, with investment in mining equipment an additional $26 billion. Altogether investment in mining accounts for 7.7% of total business investment, but only 1% of GDP.”

At Cumberland we agree. The projections are obvious: energy capital expenditures will decline; the US renaissance in oil will slow, and development and exploration will be curtailed. But the scale of the negative is far outweighed by the scale of the positive.

Let’s go farther. Fundstrat Global Advisors, a global advisory source with good data, suggests that lower oil will add about $350 billion in developing-nation purchasing power. That estimate was based on a 28% oil price decline starting with a $110 base. The final number is unknown. But today’s numbers reveal declines of almost 50%.  Think about a $350 billion to $500 billion boost to the developing countries in North America, Europe, and Asia. Note these are not emerging-market estimates but developing-country estimates.

It seems to us that another focal point is what is happening to the oil-producing countries. In this case Wells Fargo Securities has developed some fiscal breakeven oil prices for countries that are prominent oil producers. Essentially, Kuwait is the only one with a positive fiscal breakeven if the oil price is under $60 per barrel. Let’s take a look at Wells Fargo’s list. The most damaged country in fiscal breakeven is Iran. They need a price well over $100 in order to get to some budgetary stability. Next is Nigeria. Venezuela is next. Under $100 but over $60 are Algeria, Libya, Iraq, Saudi Arabia, and the United Arab Emirates.

Let’s think about this oil battle in a geopolitical context. BCA Research defines it as a “regional proxy war.” They identify the antagonists as Saudi Arabia and Iran. It is that simple when it comes to oil. Saudis use oil as a weapon, and they intend to weaken their most significant enemy on the other side of the water in their neighborhood. But the outcome also pressures a bunch of other bad guys, including Russia, to achieve some resolution of the situation in Ukraine.

There are victims in the oil patch: energy stocks, exploration and production, and related energy construction and engineering. Anything that is tied to oil price in the energy patch is subject to economic weakness because of the downward price pressure. On the other hand, volumes are enhanced and remain intact. If anything, one can expect consumption to rise because the prices have fallen. Favoring volume-oriented energy consumption investment rather than price-sensitive energy investment is a transition that investing agents need to consider. At Cumberland, we are underweight energy stock ETFs. We sold last autumn and have not bought back.  We favor volume oriented exposures, including certain MLPs.

We believe that the US economic growth rate is going to improve. In 2015, it will record GDP rate of change levels above 3.5%. Evidence suggests that the US economy will finally resume classic longer term trend rates above 3%. It will do so in the context of very low interest and inflation rates, a gradual but ongoing improvement in labor markets, and the powerful influences of a strengthening US dollar and a tightening US budget deficit. The American fiscal condition is good and improving rapidly. The American monetary condition is stabilizing. The American banking system has already been through a crisis and now seems to be adequately protected and reserved.

Our view is bullish for the US economy and stock market. We have held to that position through volatility, and we expect more volatility. When interest rates, growth rates, and trends are normalized, volatilities are normalized. They are now more normal than those that were distorted and dampened by the ongoing zero interest rate policy of the last six years.

Volatility restoration is not a negative market item. It is a normalizing item. We may wind up seeing the VIX and the stock market rise at the same time. Volatility is bidirectional.

We remain nearly fully invested in our US ETF portfolios. We expect more volatility in conjunction with an upward trend in the US stock market.

High volatility means adjustments must be made, and sometimes they require fast action. This positive outlook could change at any time. So Cumberland clients can expect to see changes in their accounts when information and analysis suggest that we move quickly.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with FOLIOfn or The Portfolioist.

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Investing Implications of Trends in Household Wealth

Shifting Wealth

A new study released by the Russell Sage Foundation analyzes trends in household wealth over the last twenty years, with a focus on the years surrounding the ‘great recession’ of 2008.  The study examines changes in household net worth for the median household, as well as for the 95th percentile of households by wealth (the richest 5%), the poorest 25% of households (the 25th percentile) and tiers in between.

7-30-2014

Source: Russell Sage Foundation

The results, adjusted for inflation (values are shown in 2013 dollars), show that the median U.S. household remains substantially poorer in terms of total net worth than it was before the recession and is actually now poorer than it was in the mid 1980’s.  What’s more, median household net worth has not recovered at all since the great recession.  The same trends are evident even for the wealthiest quarter of households (the 75th percentile), although the gains in wealth by this tier of households in the 80’s, 90’s, and early 00’s were sufficiently great that the top quarter of households by wealth is more than 25% wealthier today than in the mid 80’s.

The most striking feature of this chart is the spread in wealth levels.  While the median and 25th percentiles of households by wealth are substantially poorer today than they were twenty years ago, the wealthiest 10% (the 90th percentile) and the wealthiest 5%, in particular, are substantially richer today.  The increasing spread between the percentiles through time is evidence of growing inequality.  The study concludes that much of the divergence between wealthier and poorer households reflects the proportion of their wealth held in homes vs. stocks and bonds.  Housing prices remain well below their previous peaks in 2007, while the equity markets have regained their previous levels.  For poorer households, homes represents the vast majority of their net worth.  This is not the case for wealthier households.  The results of this study are consistent with other analysis—this is confirmation rather than being surprising.  Nonetheless, each new set of results that are consistent adds weight.

Implications for Investors

The implications of the trends in the table above are substantial.  If the median household is seeing declining or stagnant wealth levels—with more extreme declines for poorer households—this will ultimately reduce their capacity to buy and consume goods and services.  Indeed, the Russell Sage study concludes that declining household wealth shows that poorer households, unable to support their current consumption with income, are gradually depleting their assets.  At the other end of the spectrum, the wealthiest 10% of households has seen a substantial decline in net worth as well, even though this tier enjoyed huge gains in the past twenty years.

Aside from the fact that declining household wealth reduces the ability to spend, there is also the problem of the wealth effect.  Households that have disposable income are less likely to spend it if they feel less wealthy and even the 95th percentile of households by wealth is less wealthy than it was just five years ago.

The simplest interpretation of these data are that mid-market retail products and retailers are going to suffer, while the budget products and retailers and the luxury markets will perform relatively better.  So, for example, Family Dollar stores (FDO), WalMart (WMT), Costco (COST) and other discount retailers should do well.  More broadly, however, the declining disposable incomes for the middle tier of investors suggests that the companies that provide the basic products and services that people depend upon are good bets.  Utilities (IDU), oil companies (IGE), and pharmaceutical companies (JNJ, BMY, GSK, PFE) are fairly well insulated from changes in wealth distribution.

The more challenging questions involve discretionary goods and services that are higher-priced and easier to do without or that can be displaced by lower-cost competitors.  Companies like Bed, Bath, and Beyond (BBBY), Whole Foods (WFM), Abercrombie and Fitch (ANF), and Express (EXPR) sell products for which there are cheaper and largely indistinguishable alternatives.  The winners in this mid-market business are those companies that provide fairly low-cost products while retaining brand appeal to wealthier customers (SBUX, CMG, NKE).

Another theme that looks promising is consumer products that are expensive relative to peers but that represent a low-cost substitution as compared to other types of conspicuous consumption.  Apple (AAPL) has successfully capitalized on this trend.  The new iPhone may be expensive compared to other phones, but it is fairly cheap as a prestige object.   Smart phones also provide low-cost entertainment via product offerings such as Facebook (FB).  People who spend their time surfing Facebook or watching Netflix (NFLX) are likely to see cable TV as expensive.  This realization is already expressed in the high prices of these firms relative to their earnings, however.

The Take-Away

The latest data on growing wealth inequality add support to the conclusion that the middle tier of American families is getting squeezed.  The long-term implications for how people spend their money are worth considering.  The ultimate losers will be companies that sell fairly high-cost goods or services to the middle class for which there are low-cost alternatives and for which there are up-market competitors that appeal to wealthier families.  One class of winners will be low-cost ‘prestige’ brands such as smart phones and Starbucks coffee.  It is hard to imagine the average urban millennial substituting his iPhone for generic pay-as-you-go hardware or rushing to the office with a cup of gas station coffee rather than the iconic Starbucks cup.  As discretionary wealth gets tighter for the middle tier, low-cost mobile entertainment looks like a winner at the expense of cable and satellite TV.

The discount retailers and providers of basic goods such as fuels and pharmaceuticals are likely to hold up well simply because changing wealth distributions will have little impact on their businesses.

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REITs and the Rally of 2014

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

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

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

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

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

Chart 1

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

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

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

Chart 2

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

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

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

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

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

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

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