A Core of Mutual Funds: Part 2.

But what three?

Portfolio design

The first decision one has to make concerning the equity portion of the portfolio is whether to put it in an index fund or a managed fund.  The relative merits of managed funds versus index funds have been debated at length.  Most people are aware that the majority of managed funds underperformed their benchmark, which is usually an index.  In other words, the majority of index funds outperform the average managed funds.  That is usually true before expenses and even more frequently true after expenses.  

The simplicity of the theoretical argument has a certain appeal.  Since the index represents the average performance of the market, it represents the result of all investors.  Within that context, to a large extent, mutual funds are betting against each other.  Therefore, it is impossible for one fund to beat the average unless another underperformed the average.  When each fund then reduces performance by expenses, the average of all managed funds has to be below the average for the total market.  There is also a powerful argument that fund managers’ need to perform every quarter causes them to incur additional expenses that will reduce their total return to a figure below the annual average for the market.

Yet, one often hears that whether a managed fund can outperform index funds is related to whether market movements are the same across most stocks.  The theory goes that if different stocks are moving in different directions or at distinctly different rates, the market should provide the manager with an opportunity to pick the stocks that will perform better.  On January 24, 2014, the WALL STREET JOURNAL ran an article entitled “The Myth of a Stock-Picker's Market.”  The subtitle pretty much summarizes its conclusion:  “Active fund managers say that they'll succeed this year because stocks aren't moving in lock step. Here's why they're wrong.”

The article does an excellent job of reviewing the math and the data relevant to the issue.  It is a particularly interesting article because it compares the performance of index versus managed funds in different environments.  It looks at environments where there is a lot of volatility versus low volatility environments.  But most importantly, it compares the relative performance when all stocks are performing similarly, versus when there is a wide dispersion in the performance of individual stocks.  Its conclusion is: “For investors, the takeaway should be that no matter the environment, active managers are no more or less prone to fail or succeed.”

One index fund is included in the three fund portfolio.  It is the VanguardTotal Stock Market Index Fund.  An S&P 500 Index Mutual Fund would be an alternative.  The advantage of either one is their low cost.  The Total Stock Market Index Fund was selected because it includes small and midsize companies, as well as the largest 500 that are included in the S&P 500. 

The difference between a total stock market index fund and an S&P 500 index fund is minor.  Most (about three quarters) of the capital in a total market index will be invested in the largest 500 companies.  Nevertheless, the Total Stock Market Index Fund provides some diversification across the capitalization levels.  When capitalization levels are viewed as defining different asset categories, small and mid-cap companies tend to outperform over a long run but with greater volatility.  So, although the diversification is not extensive, it does help to define a well-balanced portfolio.

The math and the data make it pretty clear that a portion of the mutual fund portfolio should be in an index fund in order to ensure that it at least performs as well as the market.  After all, exposure to the equity market is exactly what the investor is seeking. 

Many advisers and the WALL STREET JOURNAL article cited above reach an erroneous conclusion about index funds.  It is foolish to recommend that all investment should be in an index fund.  The WALL STREET JOURNAL articles concluding statement: “Passive funds will outperform after costs,” illustrate the error.  It uses the word outperform as if it were defined.  But, there can be significant differences in how various investors define performance.  Those who only recommend an index fund are making the ridiculous assumption that everyone's sole objective, and thus their definition of performance, is to replicate the performance of the total market.  The total market performance is an important benchmark, but there is a big difference between a benchmark and an objective.  It is only for the mutual fund manager that the benchmark becomes the objective.

At this point it is impossible to avoid introducing some considerations that at first appear subjective.  It comes in the form of an assumption about objectives.  To some extent, it is a reflection of observations about the performance of investors, and it is consistent with the findings of behavioral economics.  It is also supported by empirical research about investment performance.  Consequently, despite the initial appearance of subjectivity, it is far from totally subjective.  It can be summarized by the statement: “Gains made during a bull market are only useful if they are not lost during the next bear market.”

Thus, the second fund to be included in the portfolio has a low beta and low volatility.    (Technically, low beta means it does not fluctuate with the market, while low volatility refers to the actual amount of fluctuation).  One way to consider the decision for the second mutual fund is in terms of the value stocks versus growth stocks distinction.  (The value stocks versus growth stocks distinction works because value stocks tend to have lower betas and volatility).  Each type of stock has periods (often multi-year periods) where it outperforms the alternative.  However, across those cycles, portfolios of value stocks slightly outperform the alternative.  Further, there is considerable evidence that it is possible to select a low beta portfolio of value stocks that can nevertheless perform exceedingly well. 

The fund to be included in the portfolio is the Vanguard Windsor II Fund.  An obvious alternative would be the Windsor Fund.  (The Windsor Fund was closed for a while, and that is the only reason for citing Windsor II rather than the Windsor Fund).  The important characteristics that make the Windsor funds appropriate are that they are managed to produce a lower beta, and they seek to achieve that objective by focusing on large-cap value stocks.  They also include some non-US exposure.  Non-US stocks are often viewed as another asset class.  Thus, one can view the Windsor II Fund as providing additional asset class 

diversification.

Thus far the portfolio has been constructed to focus on equities.  As mentioned in the introductory material on financial and behavioral economics, bonds constitute an important diversifier.  They are exposed to a different set of risks from equities and perform quite differently.  Thus, the third fund should include bonds. 

Bond mutual funds contain risks that are different from those of actual bonds.  The important difference between a bond fund and a bond is that a bond fund does not provide the commitment to the return of principal on a specific date.  If one wants the diversification bonds provide, then buy bonds.  A bond fund does not provide that diversification.  At the same time, there is no doubt that a bond fund is different from an equity fund and provides some bond-like diversification. 

As has been mentioned, over a long-term investment horizon one can expect better returns from equities than bonds.  Thus, one has the choice of either accepting a bond index fund that will lower overall portfolio returns or relying on a bond manager who seeks to improve on that generic performance by trading bonds. 

Since the principal purpose of the bond portion of the portfolio is diversification, it is going to be there over the long term.  It seems reasonable to assume that one can purchase that diversification by paying to have the portfolio managed in a way that seeks to overcome the tendency for bonds to underperform equities.  That effort to overcome the inherent limitations of bonds can take the form of managing the bond holdings while supplementing them with equities that, to some extent, are bond substitutes.  Consequently, the bond exposure is going to be in a managed fund that holds both bonds and equities.  In other words, it is going to be in what is called a balanced fund.

The third fund for inclusion in the portfolio is the Vanguard Wellington Fund.  A key reason for selecting the Wellington Fund is that, like the Windsor II Fund, it leans toward a value investing approach.  One would hope that the lower beta on the equities in these two managed funds would reduce the amount of bonds one would need in order to be comfortable with the portfolio's performance.  So, while bonds are represented in this portfolio, portfolio design is intended to allow a substantial exposure to equities as well.

Components Of the Portfolio

The descriptions of the funds that follow are taken from the Vanguard website and the fund prospectuses.

1.  Vanguard Total Stock Market Index Fund--Vanguard Total Stock Market Index Fund is designed to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks. The fund’s key attributes are its low costs, broad diversification, and the potential for tax efficiency. Investors looking for a low-cost way to gain broad exposure to the U.S. stock market who are willing to accept the volatility that comes with stock market investing may wish to consider this fund as either a core equity holding or your only domestic stock fund.

2.  Vanguard Windsor II Fund--Like many individuals making a big purchase, Windsor™ II Fund’s investment managers are mindful of price. While this large-cap value stock fund carries the same risk associated with the stock market, this “value” conscious approach may provide a less bumpy ride. That said, the fund may not keep up in a strong bull market. If you have a long-term investment goal and want less market volatility than might be present in a more aggressive investment, the fund could be a good fit for you.

3.  Vanguard Wellington Fund--The fund offers exposure to stocks (about two-thirds of the portfolio) and bonds (one-third). The fund tends to invest in large cap or mid-cap firms for its equity allocation.  The bonds that it holds are generally highly rated.  Thus, it is a very conservatively managed fund.  Another key attribute is broad diversification—the fund invests in about 100 stocks and 500 bonds across all economic sectors.  This is important because one or two holdings should not have a sizeable impact on the fund. Investors with a long-term time horizon who want growth and are willing to accept stock market volatility may wish to consider this as a core holding in their portfolio.

Fund Weightings and Portfolio Management.

Not surprisingly, how one weights the different funds depends upon how much volatility one is willing to accept.  They are listed in an order that corresponds to how much volatility one would expect.  However, one can get lost in trying to tailor the volatility too much.  Other considerations may be overriding.  For example, each fund has a minimum requirement of an investment of $3,000.  So, if one is only investing $9,000, an equal weighting to each fund would make sense.  In general, an equal weighting is good starting point.  One can then adjust the weights after having gained some experience with the funds.

It is also worth noting that the $3,000 minimum is less than the contribution limit for an IRA in any given year.  Thus, one could begin an IRA by acquiring one fund the first year.  In the second year, it would be possible to build the full three fund portfolio.  Using that approach, the Wellington Fund would be a logical first fund for a conservative investor, but an aggressive investor who is confident in the market may want to begin with the Total Market Index Fund.  The logic of starting with the Wellington Fund is that there is a lower chance of experiencing a significant immediate downturn that would interfere with establishing the three fund portfolio in the second year.

In general, the portfolio is designed to be close to a set-it-and-forget-it portfolio.  If one starts with an equal weighting for the three funds, rebalancing should not be needed for many years.  Just in terms of investment return within the portfolio, one could fix a percentage variation from equal weights as a guide for rebalancing.  However, that is largely unnecessary.

Many discussions of portfolio management proceed as if the portfolio is the only consideration when deciding how to allocate assets.  In reality it is far more likely that events that occur totally independently of the portfolio will provide more compelling reasons to adjust the balance. 

To illustrate, a young investor who holds the portfolio in equal weights is assigning about a 10% weight to bonds (the Wellington fund is 1/3 of the portfolio and about 1/3 of the Wellington fund is in bonds, 1/3 of 1/3 = 1/9).  That is a very reasonable starting allocation for a young investor.  As the portfolio grows over time, one would expect the equity investments to grow more than the bond investments.  Consequently, one would expect the bond weighting to fall.  The theory of life cycle investing would argue that the bond weighting should be increased.  However, the investor’s reality is often quite different and justifies a different approach. 

At the same time that the bond weighting is falling, the total wealth of the individual investor will be increasing as the portfolio rises.  It is also quite likely that the investor’s income is rising, both from higher wage or salary income, and from the returns on the investments.  Further, the investor may acquire other bond-like assets such as a home or vesting in a pension.  That should enable them to accept a bit more volatility in the mutual fund portfolio.  Since they are able to accept more volatility, they can let the bond portion of the portfolio fall.

Probably the most important consideration is one that financial economics often totally overlooks.  More than one posting on this blog has advocated using the total dollar value of an individual investment as criteria for deciding whether to rebalance.  That approach seems particularly appropriate for the three fund portfolio.
 

Basically, make the investments in thirds and then just let the relative weights of the different investments vary over time.  Postpone any rebalancing until one of the mutual funds has a dollar value that the investor finds uncomfortable in terms of their income.  For example, when the mutual fund becomes equivalent to the dollar value of the investor’s income or some multiple of the investor’s income, subsequent investments could be targeted toward one of the other mutual funds or into a totally new category of investment.

The three fund portfolio is fine as a standalone investment approach if one does not want to branch into more adventuresome investments.  But even if one has branched out, it can still be a useful core holding.  If one pursues the three fund portfolio and makes regular additions as well as letting the gains compound, setting a dollar limit will almost guarantee that at some point the investor will have to branch out. 

If one understands the logic of fund selection (i.e., remembers why one bought the thing in the first place), the three fund portfolio can be adjusted quite readily.  For example, a young retiree whose pension and Social Security more than covers their living expenses could drop the need for the balanced fund (i.e., the Wellington Fund).  If the retiree was going to be totally dependent upon the portfolio for income in retirement, he or she could increase the holdings in the low beta large-cap value fund (i.e., Windsor II) and balanced fund (i.e., Wellington Fund) in order to reduce the chance that he or she would have to take any withdrawal when the fund portfolio was down.

This portfolio is highly versatile.  It can be THE core holding or a core holding.  It can be a very large portion of one's total investments, or it can be used as a place to park money while waiting for other investment opportunities.  More than likely, over one's investment career, it will fulfill different roles.  

The Hedged Economist, as stated in various postings, favors selecting individual holdings.  Nevertheless, this portfolio has been a core holding for a very long time.  For the last few years, as discussed in the posting of January 31, 2014, “An Alternative to TradingBonds,” alternatives to holding bonds have seemed more appealing.  There is no doubt, that the alternative involves a little bit more risk, hopefully more return, and certainly a lot more time than just holding the Wellington Fund.  For a long-term investor who prefers the simplicity of mutual funds, a three fund portfolio such as the one discussed in this posting should be THE core holding.

A Core of Mutual Funds: Part 1.

Three is really enough.

Why is the portfolio limited to three funds?   There are reasons grounded in financial economics, strong behavioral economic foundations as well as important practical considerations.  Each will be addressed.  Part 2 of this posting will describe the considerations relevant to the selection of the funds.  Then there will be a description of the three funds, which will be followed by a discussion of how much to invest in each fund and how to adjust the weights over time.

Financial economics.

Most mutual fund families and most 401(k)s will offer at least three good mutual funds.  In fact, most offer a lot more.  For the long-term investor, the broader variety is based upon the assumption that diversification across asset types allows one to achieve a better risk-adjusted rate of return.  It is always possible, in hindsight, to show that that could be true.  The general problem with the approach is that extensive diversity of asset classes will work well under normal circumstances.  It draws heavily on applying Modern Portfolio Theory (MPT) to the mix of assets.  It assumes that the investor is applying a trading algorithm to try to maintain the risk-return level continuously.  That algorithm may be as simple as rebalancing once a year, or it may be as complicated as the most sophisticated computerized trading system.

Asset allocation can be made to sound as complicated as possible.  However, it is actually a lot simpler than advocates of Modern Portfolio Theory make it sound.  The problem with the more complicated applications of Modern Portfolio Theory is that it is based upon faulty assumptions.  To be successful, it depends upon asset correlations (i.e., technically, the covariance matrix between all asset classes).  It assumes those covariances are stable.  Nothing demonstrated the fact that the covariances are not stable better than the recent financial crisis.  So, the theory works well under normal circumstances, and it results in a theoretical improvement in returns for any given level of risk.  When put into practice, any improvement in return is very, very slight, and, as the saying goes, “It works as long as it works and then it doesn't work.”

One does not have to understand the role of asset correlations in order to see the limitations and prudent use of the idea behind Modern Portfolio Theory.  Another way to envision the role of asset allocation is by looking at the performance of different asset classes over various periods.  A common way to show that data is a quilt chart.  If one analyzes a quilt chart, it becomes apparent that the biggest difference in performance is between bonds (or cash) and all other assets.  When there is a major market dislocation (a market collapse) or a major economic decline, all assets except bonds (or bonds and cash) have negative returns.  That exception is important.  The threshold between positive returns and negative returns is extremely significant mathematically and psychologically.

Behavioral economics.

Modern portfolio theory has been around since the 50s.  It is a very good theory if you assume that individuals’ risk tolerances are consistent over time.  However, there is considerable evidence that individuals do not have stable risk tolerances.  Further, people are not good at accurately judging their own risk tolerance, much less forecasting it. In addition, behavioral economists have shown that an abundance of options does not necessarily lead to better decisions, and the number of options influences one's perception of risk.

So, the three fund restriction may theoretically involve taking a little more risk.  In actual practice, most non-professional investors do perfectly well with the more restricted diversification of asset classes.  It may be that selecting fewer options requires them to acknowledge the risk involved in any investment.  Thus, they may be less likely to misdiagnose their own risk tolerance.  It may also be that fewer options actually anchor the risk tolerance at a higher level of both risk and return.  

It also would seem logical to assume that the more mutual funds selected the more likely it is that the investor will pick at least one mutual fund that is poorly run.  Having that blooper in one’s portfolio undoubtedly has some effect on one's risk tolerance.  Behavioral economists have pretty much been able to confirm that witnessing poor performance lowers one's risk tolerance.

Practical considerations.

First, the idea that one needs to hold a large number of mutual funds in order to be diversified into multiple asset classes is nonsense.  There are individual funds that invest across multiple asset classes.  Some try to assess an individual's risk tolerance and then adjust the asset mix to maintain that risk profile.  They may do it by periodically adjusting the mix across asset classes, or they may do it continually.

An example of the first type that periodically adjusts the asset mix would be one of the many target date funds.  Their assessment of the risk tolerance is based upon the individual’s age as reflected in the target date the individual selects.  The notion that all individuals of a given age should be exposed to the same risk, regardless of health, wealth, or disposition, does not make sense.  Despite the fact that it is absolutely absurd to assume that one's age is the only determinant of the appropriate risk, target date funds are very popular.

Their popularity seems to originate from the fact that they are simple.  Further, the periodicity with which they rebalance assets to their target mix is largely arbitrary.  It may be that their benefit is that they relieve the individual of having to make any asset mix decisions.  However, there is absolutely no reason to think that they make the right asset mix decision for any particular individual.

At the other extreme are the funds that continually adjust to a target asset mix.  As explained above in this posting, they suffer from the assumption that any individual can measure a different individual’s risk tolerance. Further, any improvement in performance from such an approach is so slight that many funds that pursue this approach have to take on leverage in order to realize a large enough yield benefit to justify their management fees.  The best examples of such an approach are some of the hedge funds (e.g., Long-Term Capital Management) that have blown up spectacularly.

Even though funds that over-diversify and try to determine the appropriate amount of risk have shortcomings, that does not mean that funds cannot provide some benefit of asset diversification.  Rather, these funds illustrate that multiple funds are not required in order to get asset diversification.

Every mutual fund has a minimum amount that has to be invested.  Further, some have charges that are steeper in percentage terms on smaller holdings.  If the amount of capital to be invested can only justify holding one mutual fund, a target date fund will provide asset diversification.  That diversification will result in less volatility.  However, in many cases,  where the amount to invest only justifies one mutual fund, strong arguments can be made for the need for the investor to expose themselves to greater volatility in the form of equity holdings beyond what would be characteristic of a target date fund.

In general, when considering mutual funds, the trick is for the investor to select funds that provide the appropriate amount of asset diversification for that unique individual.  It is also important to ensure that, once that desired level of diversification is achieved, it remain stable unless the investor chooses to intentionally change it.  Further, as discussed above in this posting, the most important aspect of diversification is exposure to both equities (stocks) and debt (bonds).  However, bonds only represented a diversifier and a source for funds when equity markets turned down.  Over the long-run, equities are going to outperform bonds.

The Three Fund Portfolios.

Less control, but more simplicity.

This will be the first of three postings on the use of mutual funds.  The next posting will address a core portfolio of mutual funds.  It will be followed by a posting on how to use mutual funds to supplement domestic (US in this case) stocks.  However, this posting has to first address the decision whether to buy stocks and bonds directly or use mutual funds.

So far this year, previous postings addressed managing a portfolio that holds actual stocks.  Many people believe it is easier to pick a mutual fund than a few stocks.  It is hard to understand why people think it is easier to pick a manager for a mutual fund than to recognize a few good businesses.  Nevertheless, that is the case for many people.

When one first starts, the total amount of the portfolio may not seem large enough to justify the purchase of a number of stocks.  A mutual fund may provide diversification that would not otherwise be available. In some cases, mutual funds are the only accessible option for the individual.  For example, many people have 401(k)s that restrict them to mutual funds.  Perhaps they are forced to become comfortable with mutual funds. 

Regardless of why people prefer to build portfolios of mutual funds, they do. Consequently, a portfolio of mutual funds is worth discussing .  An April 20, 2011 posting entitled “Investing PART 13: Mutual funds” discussed issues related to mutual funds, as well as some legitimate uses of mutual funds, but it never addressed constructing a portfolio of mutual funds. 

Nothing that follows should be taken as an endorsement of mutual funds.  As stated in the posting cited above, “They are an extremely inefficient, hard to analyze, and risky way to invest in certain asset classes that should be the major focus of individual investors.”  Despite their limitations, if used carefully and used with an understanding of their limitations, mutual funds can play an important role in an investor's portfolio. 

They can be used to achieve diversification with less capital.  They also can be used to achieve diversification into areas where the investor does not feel comfortable making individual investment decisions.  Further, they can be used to acquire assets that would otherwise be unappealing (e.g., due to their tax treatment) or difficult for the investor to acquire.

Finally, as discussed in the January 24, 2014 posting entitled “What is to be learned about stock acquisition?” managing a portfolio like the widows’ and orphans’ portfolio can involve anywhere from 2 to 6 trades in a year as decisions have to be made about what to do with dividends.  Obviously, it also requires selecting the stocks to put in the portfolio in the first place.  That can involve selecting 10 to 15 stocks.  That may be more than many people want to do.  A mutual fund portfolio can involve fewer decisions about where to invest and fewer decisions about when to trade.  For many people, that alone would justify the mutual fund portfolio.  The ability to achieve diversification with only one decision has tremendous appeal to many people.

 

The mutual funds available to each investor depend upon whether the investments are in or outside of a 401(k).  If it is within a 401(k), offerings will be restricted to only selected funds offered within that 401(k).  If they are outside the 401(k), technically, the investor could pick any mutual fund but often feels constrained to those offered by a particular broker or mutual fund company.  So, in the next two postings references to individual mutual funds should be taken as illustrative examples of the appropriate type of mutual fund.  (In order to facilitate the use of the named funds as an illustration, the posting includes descriptions of the funds).

Important consideration in any mutual fund is the expenses that the mutual fund charges the investor.  The examples referenced in the next posting are all Vanguard funds.  Vanguard places a lot of emphasis on low management costs.  Consequently, Vanguard was a convenient source for examples of how to construct a simple mutual fund portfolio.  That should not be taken to imply that the same could not be done with bonds from other fund management companies.  Therefore, funds offered by Fidelity will be used in the third posting in this series.

 

 

 

An Alternative to Trading Bonds.

Trading bonds substitutes.

During the financial crisis, clearly bonds represented an exceptional opportunity.  Not surprisingly, during the liquidity crisis, people were liquidating bonds at prices well below normal.  However, if one purchased bonds during the financial crisis, by about 2011 a well-constructed bond portfolio had appreciated so much in value that there was little incentive not to take the capital gain.  Interest rates were so low that holding bonds was a waste of one's capital.  The likely outcome was a loss of purchasing power over the remaining life of the bond.   Furthermore, with the Fed manipulating the entire yield curve, it was impossible to assess the risk of continuing to hold the bonds. 

Consequently, for the last few years, utilities, Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) were viable alternatives.  However, just as bonds experienced substantial appreciation coming out of the financial crisis, REIT and MLP valuations have risen significantly since 2011.

MLPs presented an unusual opportunity when the President decided to postpone the decision on the Keystone pipeline for political reasons.  By acting counter to the economic pressure, the Administration guaranteed that the economic pressure would surface in the form of higher returns to alternative energy transportation options.  Alternative pipelines or pipelines that could benefit from the absence of Keystone were guaranteed to experience an increase in demand.  That greatly reduced the risk associated with selected other pipelines.  Those pipelines could be purchased as a bond substitute with very little downside risk and dividends substantially above the interest rate on bonds.  

In the MLP space, pipelines provide a potential substitute for bonds.  There near-monopoly on transportation along their routes insulates them from competitive pressures over a fairly long term.  It takes a long time to build a new pipeline, as Keystone illustrates.  Further, the decision on Keystone created a unique opportunity to select MLP pipelines.  It is not MLP structure that makes pipeline MLPs a potential bond substitute; it is the combination of their specific business and the MLP structure.  Consequently, mutual funds that are composed of all types of MLPs whether pipelines or not, are a poor substitute for bonds.  Individual MLPs would seem to be a more reasonable bond substitute because you can restrict it to pipelines and you know they yield.

Some of those pipelines would have served as a successful temporary bond substitute.  For example, Enbridge Energy Partners (EEP) provided a nice dividend, and that was about it.  However, as occurred with bonds coming out of the financial crisis, other pipelines would have appreciated to the point where there were substantial capital gains.  For example, between the end of 2011 and May 2013, the gain in Plains All American Pipeline (PPA) was almost 100% without including dividends.  By mid-2013 the logic of holding either was greatly diminished to the point where they no longer justified the additional tax complexity associated with MLPs.  Generally, the yield on MLPs had fallen.  Those that retained the high-yield did so because they became more risky.

For many years REITs were what the name implies: Real Estate Investment Trusts.  Thus, during the financial crisis and coming out of the financial crisis, REIT mutual funds represented a way to diversify into real estate.  The popularity of that shift, however, attracted firms that stretched the definition of real estate to the breaking point.  Consequently, by 2011, one had to pick individual REITs in order to ensure that the investment was really a real estate investment.  The security of real estate holdings is one of the reasons that REITs served as a potential bond substitute.  The other reason is the cash flow.

Among REITs, as long as it is real estate, no specific industry stands out as a natural substitute for bonds.  Most real estate can be replaced much faster than a pipeline.  Consequently, all real estate industries are more competitive than pipelines.  So, market considerations in the industry of an individual REIT are more important.  

One type of REIT that has some characteristics which make it a good candidate for a bond substitute is a REIT that specializes in “triple net” properties.  (Triple net properties generally have long-term leases where many variable expenses are shifted from the real estate owner to the occupant).  If the REIT has broad geographic exposure and a diversified base of renters, it takes on additional bond-like characteristics.  One does need to be careful about the amount of leverage on the REIT’s balance sheet.  That is particularly true of new REITs, but it is less of an issue with the larger REITs that have existed for a number of years.

The least specialized triple net REITs are concentrated in retail.   I have a large number of tenants.  The tenants may be entirely different retail segments, and they often have very broad geographic coverage. National Retail Properties, Inc. (NNN) provided a pretty good substitute for bonds from 2011 to 2012.  However, early in 2013 its valuation got way out of line as the stock appreciated in value.  A very popular triple net lease REIT is Retail Income Corp. (O).  Its monthly dividend structure appeals to many investors.  However, the appeal of that monthly dividend structure has resulted in higher valuation for Retail Income Corporation than National Retail Properties.  Its price followed a trend similar to National Retail Properties.  Of the two, National Retail Properties seemed to provide a better bond substitute.  But in both cases, by early in 2013, the valuation spikes justified exiting the positions.  If their prices fall off a bit more, National Retail Properties could be a very good bond substitute.

Another appealing area within the REIT space is healthcare REITs.  The demand for healthcare is reasonably stable.  Consequently, occupancy rates, an important metric in real estate, are fairly stable.  The risk in healthcare REITs is the stability of payment streams that result from government payments for health services (Medicare and Medicaid reimbursement rates).  However, it is possible to select healthcare REITs that are not extensively exposed directly to the whims of politicians regarding prices.  Basically, a REIT that owns the property and is dependent upon rents is more stable than one that both owns and operates the properties.  National Health Investors, Inc. (NHI) is one such REIT.  It has the added advantage that many of its hospitals and other facilities operate under a triple net lease.

A purchase of National Health Investors at any point during 2011 would allow one to currently exit with a capital gain, as well as the dividend stream.  That is true despite a price spike in May of 2013, and the subsequent decline.  But the combination of the run-up in the price of National Health Investors and then the price spike provided ample opportunity to adjust one's holdings in such a way as to end the year with holdings in this bond substitute at almost no cost.  LTC Properties (LTC) was formally known as Long-Term Care Properties and is another healthcare REIT.  Like Retail Income Properties, LTC pays a monthly dividend.  It displayed a price time path similar to National Health Investors.   Of the two, National Health Investors is the better bond substitute. 

An unfortunate side effect of monthly dividends is that the REITs attract investors whose only concern is the cash flow.  Consequently, REITs that pay monthly dividends tend to have higher valuations, and, other things being equal, they tend to be more risky.  Thus, while both National Health Investors and LTC Properties have been acceptable bond substitutes until their price spiked, National Health Investors was the only REIT that was worth retaining as a bond substitute after the price spike.  Its a ration seems more reasonable.

Other REIT sectors such as commercial space also provided a bond substitute.  However, unlike those cited above, commercial space REITs often have more limited geographic focus.  During the period from 2011 into 2013, a number of commercial space REITs were good bond substitutes.  However, because of their geographic focus, that ability to substitute is more ephemeral.  It depends upon too many factors: the quality of the REIT management, the performance of the local economies, and conditions in the local commercial real estate market.  Thus, it is not surprising that they are temporary holdings. 

Both the REITs and the MLPs as bond substitutes do not require expert timing although timing was more important with the REITs.  REITs seem to have been more influenced by the chase for yield.  However, the price spikes that preceded their decline provided the investor with a warning.  Their price decline was almost a mirror image of the spike.  However, for both the MLPs and REITs, an investor who is still holding those assets has not lost principal.  Not losing principal is an important requirement for a bond substitute.

As mentioned in “Rebalancing in a Manipulated Interest-Rate Environment,” utilities are the traditional equity substitute for bonds.  Thus, not surprisingly, there were opportunities to substitute utility stocks for bonds during the period from 2011 through 2013.  

When looking utilities, it is worth remembering that Verizon (VZ), which is sometimes considered a utility, was included in the widows’ and orphans’ portfolio.  One might ask whether Verizon belongs in the utility sector at all.  The question is legitimate given the importance of its unregulated businesses.  The point, however, is that Verizon retains enough regulated landline business to make it unnecessary to consider telecom utilities for a bond substitute. 

Electric utilities, which are often thought of as the prototypical utility, are so much of a regulatory crapshoot and had so many industry-specific risks, that they were not a good bonds substitute.  Although with the hard to find the data to prove it, electric utilities seem to suffer the most from regulatory whims.

Two gas utilities provided an excellent opportunity to substitute equity positions for bond holdings.  Both have the advantage that they operate in a number of subsectors of the gas industry.  AGL Resources Inc. (GAS) has been an excellent bond substitute for number of years.  It is to the point where it is almost a core holding, but only to the extent that one might hold bonds on a regular basis. 

The other, National Fuel Gas Company (NFG), was far less of a pure bond substitute.  It would have been totally inappropriate previous to 2012.  However, at the beginning of 2012, National Fuel Gas seemed to be priced based totally on its non-utility operations.  Consequently, one could acquire the company and get gas utility exposure almost for free.  That type of sum-of-parts analysis is usually not required to identify a utility is a bond substitute.  However, in the case of National Fuel Gas, it was essential since National Fuel Gas did not pay a high enough dividend to justify considering it as a bond substitute based on its dividend alone.  National Fuel Gas may continue to be an excellent investment opportunity, but by the end of the year it could no longer be justified as a bond substitute.  It could be sold and the proceeds used to purchase a more traditional bond substitute or held as cash.

The final area where it may be possible to find bond substitutes among the utilities is water utilities.  American Water Works Company Inc. (AWK), and Aqua America Inc. (WTR) are the two largest.  Water consumption is obviously extremely stable and insensitive to the economy.  One might conclude from that stability that water utilities would be a natural substitute for bonds.  However, both companies suffer from lower dividend rates than one would want in a bond substitute.  Despite that, Aqua America looks like an attractive bond substitute going into 2014.  The lack of sensitivity to the market and the economy is true of both the company’s business and its stock price.  Thus, it is a reasonable place to park money absent some more compelling bond substitute.

Interestingly enough, after having made that decision and purchased additional shares of Aqua America, an article in BARON’S on January 25, 2014, “Dow Slides 3.5% in a Global Retreat From Risk,” referenced the stock as attractive.  One might expect to find a reference to water utilities in an article talking about a stock market decline.  The rationale for holding Aqua America is that it is almost totally impervious to stock market fluctuations and economic cycles.  Fortunately, the stock did not jump after the reference in that article.  So, the stock is still an attractive investment.  A reasonable plan for 2014 is to add to the holdings of Aqua America as long as the price remains stable.

In summary, going into 2014, positions in National Health Investors, AGL, and Aqua America currently serve as bond substitutes.  However, it is reasonable to assume that during the year other stocks will have to fill the role bonds usually play. 

One other passing note, because of the repression of the interest rates, the period 2010 through 2013 and going into 2014 is one of the few times where holding more cash than normal made sense.  The cash needs to be available as opportunities arise to purchase bond substitutes.  The rationale behind the approach of holding cash and using bond substitutes that embody slightly higher risk was discussed in a posting on September 30, 2011 entitled “The Fed Cannot Force Investors toShift to a Different Risk-Return Profile.”

   

 

 

Rebalancing in a Manipulated Interest-Rate Environment

A continuing issue for 2014.

Rebalancing, in the broadest sense, just means selling an asset that is inappropriately large for a portfolio and using the proceeds to buy other assets.  Rebalancing in that broad sense was discussed in this blog on December 4, 2010, in a posting entitled “Investing PART 1:Background music.”  That posting was about diversification and asset allocation in general.  It presented a number of tools and data (e.g., guilt chart and asset class correlation matrix) relevant to the issue.

Rebalancing was specifically the target of a posting on December 12, 2010.  It was entitled “Investing PART 2: Adjust the treble and base.”  It was discussed again on December 31, 2010 in a posting entitled “Investing PART 7: “To every thing there is a season.”  Between them, those postings present reasonable strategies for rebalancing, as well as limitations.  This posting addresses some issues related to rebalancing that are particular to the financial environment over the last few years.

Most often rebalancing is discussed in connection with the mix of bonds and stocks.  However, as was discussed in connection with the previous postings this year, it also applies to equity holdings within a portfolio.  In many respects, for the last few years, rebalancing within the equity holdings has been easier than rebalancing between bonds and equities. 

The oft-quoted argument for a fixed portion of bonds within the portfolio is based upon the assumption that the unpredictability of equity markets creates a need for potential liquidity at any point.  Also, the return on bonds tends not to be correlated with the return on equities.  Consequently, rebalancing involves selling bonds when their returns have been high, on the assumption that that would be when stocks have had low returns or have gone down.  However, that argument rests on an assumption about the investor’s time horizon.

Bond holdings are, in many respects, always problematic.  There are major shortcomings of bond mutual funds.  Specifically, they defeat the principal purpose of bonds, which is to ensure a return of a specific amount at a specific time.  Even holding individual bonds presents a problem, mainly because they historically have a lower return than equities.  Thus, a reasonable approach is to only hold bonds with maturity dates designed to coincide with the investor’s need for liquidity. 

For the last few years, the Federal Reserve has completely undermined the logic and desirability of bond holdings.  Not only have they manipulated short-run rates, but through operation twist and quantitative easing, they are manipulating the entire yield curve as well as the spread between treasuries and mortgage-backed securities.  The net effect is what is known as financial repression.  It is worth noting that the repression focuses on fixed income investors.

One should keep in mind that every investment, even money (which always has a negative real return during periods of inflation), carries certain risks while hedging others.  As the Fed expanded its rate manipulation to include longer maturities, negative real returns became characteristic of bonds as well as money.  A logical response to the Fed's policy has been to look for substitutes for bonds. 

As mentioned in the postings cited above, one's investment options are not static.  New options arise over time.  Some of those new options can be used to hedge some of the same risks that bonds would hedge.  It is also possible to pick investment options that provide some return characteristics similar to bonds.  Options that are currently far more accessible to investors than they were a decade ago are Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), and Limited Liability Partnerships (LLPs) in general.  Those options now trade like the shares of other companies.

One similarity with bonds is that they are backed by specific assets.  Granted, the claim on those assets is a lower priority than with senior secured bonds, but there is a claim, and, in many cases, that claim is on an asset that is more liquid than those of many corporate bonds.  Further, like bonds, the return on investment is the cash flow from the asset.  Some bonds’ only asset is the discounted cash flow from other financial assets they hold.  Thus, in some instances, one might judge an equity position in a REIT or MLP as better secured than some bonds. 

Interest rate risk manifests itself in a different way.  With a bond, one can always hold it until maturity, at which point it no longer has any interest rate risk.  There is no equivalent maturity date for equity positions in REITs or MLPs.  A rise in interest rates can be secular or long-term.  In which case, one cannot wait out the impact of the interest-rate change.  However, REITs and MLPs can raise their dividends to offset the impact of an interest rate increase.  Bonds offer no similar option.  Consequently, the cash flow from an investment in a REIT or MLP has a different profile from that of a bond.  One has to weigh the risks associated with the two differently structured cash flows and judge the degree to which the REIT or MLP is an acceptable substitute.  The same is true of utilities which were the traditional bond-like equity investment.

The Fed's policy has killed bond holdings as a conservative investment that could be held to maturity and rolled over.  As will be explained in the next posting with examples, bonds and bond substitutes have become more of a trade than an investment.  That is particularly true of bonds where fluctuations in the value of the bond can easily be a multiple of the interest earned over any period of time short of its full maturity.  The need to trade potential substitutes for bonds is partially a result of interest rate manipulation, but it is also related to other features of the substitutes.

Perspectives on management

The relationship between corporate management and portfolio management.

The previous postings about managing an equity portfolio (starting with “2013 Was a Very Educational Year”) intentionally minimized references to the financial analysis or technical analysis that supported the portfolio adjustments discussed in the postings (especially in “What is to be learned about stock acquisition?”).  The purpose of that approach was to demonstrate that investing can be done without extensive sophisticated analysis. 

Lest that comment be misunderstood, the point is not that one should throw darts at the financial page in order to construct a portfolio.   Once one has identified what looks like an appealing adjustment, additional analysis can be used to confirm that it is legitimate.  The amount of additional analysis one requires is really a matter of taste and there are numerous scores of guidance from textbooks to websites.

The approach works because the widows’ and orphans’ portfolio has a logic and an objective.  An important component of the logic behind the portfolio is to restrict portfolio holdings to well-respected companies that produce well-respected products.  One can learn a lot about the quality of a company from an analysis of the reputation of its products.

Another important criterion for inclusion in the widows’ and orphans’ portfolio is what for lack of a better term might be called robustness.  Robustness implies companies with reputations for conservative financial management and market leadership.  Buffett likes to say that he likes to invest in businesses that are so simple that they could be run by idiots, because sooner or later they will be.  Robustness does not have to originate from simplicity.  Robustness may originate from an ingrained corporate culture, unique assets, natural monopolies, strong brands, exceptional management or a variety of other factors.

Among those factors that contribute to robustness, the most fleeting is exceptional management, especially senior management.  It is easy to over-emphasize senior management's role.  They get paid a lot, so one might assume they must be doing something important.  The media likes stars, so they focus on senior management.  Most investors do not get exposure to other than the most senior managers.  However, the corporations in the widows’ and orphans’ portfolio are huge.  Any senior manager’s impact on the company is a lot like the impact of the helmsman of the supertanker.  Changes in the fortunes of the company only occur slowly.  Consequently, monitoring the quality of senior managers provides an opportunity for the long-run investor. 

The investor’s greatest challenge associated with using judgments about the quality senior management is deciding whether senior management's impact will be lasting.  In most cases, the portfolio is designed to include firms that can outlast weak management.  But, weak management provides an alternative opportunity.

Johnson and Johnson provided an example when it was run by Weldon.  He made a series of mistakes including ill-advised acquisitions that resulted in some embarrassing product recalls.  It was clear that he was overly focused on empire building to the detriment of the company's reputation for quality products.  At the time, a decision had to be made as to whether to abandon Johnson & Johnson as an investment or hang on in the belief that it would survive Weldon's mistakes.  If one judged that Johnson & Johnson would survive Weldon, when he was finally replaced it bdecame an excellent opportunity to acquire additional Johnson & Johnson stock.

If one felt that his management would have lasting impact, the response could been to shift to an alternative drug company.  Somewhere in between, there is a strategy that involves buying a different drug company with the intention of shifting the capital into Johnson & Johnson when Weldon was replaced.  One could also just accumulate the Johnson & Johnson dividends and wait for the opportunity to invest them.  If the widows’ and orphans’ portfolio is as well-designed as intended, the alternative was to hold onto Johnson & Johnson stock, and to use the dividends from the stock to purchase an alternative drug company.  Then, when Weldon left, some of the stock in the alternative drug company could be sold to purchase Johnson & Johnson shares. 

One should not misinterpret these comments about Johnson & Johnson during Weldon's management term.  Weldon did not achieve his position by chance.  He is a capable executive with a lot to contribute.  However, his talents were not what Johnson & Johnson needed at the time of his term.  Further, one suspects that some of the mistakes that were made could not have occurred without substantial support, perhaps encouragement, from some members of the Board of Directors.

That example is looking backward.  Looking forward, a review of the portfolio reveals that currently there may be similar opportunities among the holdings.  Empire building is not the only vice that sometimes afflicts bright people.  Very talented managers may just have the wrong skills for the particular challenges the company is facing.  One of the most dangerous situations is when a very talented senior manager cannot recognize his or her own managerial limitations.  That can originate from a variety of motivations from hubris to an evangelical commitment to a particular object.  It is extremely rare for it to be incompetence.  More often than not, it is a failure of senior managers to structure their environment in a way that capitalizes on their talents.  That structuring can be anything from delegation to divestitures.

Pepsi is a good example.  The business has been unable to realize its full potential.  The entire food group has not performed spectacularly, but Pepsi seems to be suffering more from self-inflicted constraints than the overall performance of the industry.  This situation has been going on for a number of years and has reached the point where there are now calls for separating the beverage and snack food businesses.  Pepsi's market position and size pretty much guarantee that it can survive such underperformance.  Therefore, its problems did not justify abandoning the stock.  At the same time, those same factors eliminated any urgency to address the problems.

Under the circumstances, Pepsi can perform reasonably, but not well, for a long time.  It has done just that.  Over the last few years, Pepsi's lack of a catalyst for a performance improvement provided an incentive to delay any investment in Pepsi.  Such underperformance generates increasing pressure on management.  It may be that 2014 is the appropriate time to begin reinvesting dividends in anticipation that the pressure will force some change. 

Previously, investing dividends from Pepsi in other firms in the industry, or similar industries, made sense.  Pepsi's relatively poor performance within the portfolio means that some step had to be taken to restore an appropriate weighting to the food and beverage industry component of the portfolio.  In that respect, it provided an opportunity to diversify into a broader representation of the total industry.  One could acquire a non-snack food firm like General Mills.  One also might consider other beverage companies less heavily represented by sugary beverages.  It seemed like a perfect time to have a beer.  Once a catalyst for improvement in Pepsi's performance can be identified, those stocks and/or their dividends can be used to enhance the holding in Pepsi.

General Electric has represented even more of a problem for the portfolio.  Almost from his first day, it has been apparent that Immelt was unable to control GE's future.  He walked into a period when GE faced significant challenges from the events of 9/11 and then the financial crisis.  However, his willingness to blame those external events for GE's performance made it quite apparent that he was not up to the task of controlling GE's future and ensuring its success.

The rationale for including GE in the portfolio included the statement that the company is sufficiently robust to survive a bad manager.  Thus, there is no reason to abandon the company.  It will prosper and perhaps 2014 will be when that begins.  However, over the last few years there was no rationale for adding to the position in GE.  In presenting the widows’ and orphans’ portfolio, United Technologies was mentioned as an alternative.  Given the situation at GE, investing GE’s dividends in United Technologies has made sense for over a decade and may continue to be the case.

Procter & Gamble was mentioned as the consumer nondurables component of the widows’ and orphans’ portfolio.  However, as was noted, Kimberly-Clark, Colgate-Palmolive, and even Clorox provide alternatives.  Thus, Procter & Gamble's management problems and the consequent underperformance of the stock make the consumer nondurables component of the portfolio the natural place to diversify away from the core into other comparable companies.  For example, one opportunity to diversify was mentioned in a posting on March 30, 2010.  The posting, “Wall Street doesn’t run the world,” mentioned an opportunity in one of the alternatives, Kimberly-Clark.  It was not until last year that Procter & Gamble’s stock was able to keep pace with the companies peers.

The underlying philosophy behind the widows’ and orphans’ portfolio is that it will provide a core, but not the totality, of one's equity positions.  Adding new positions might occur in response to a change in one of the portfolio holdings.  For example, when Pepsi spun off Yum Brands, it made sense to hold Yum Brands’ or add exposure to replace Yum Brands business in fast foods. 

If the basic portfolio holdings are durable, management problems represent a different kind of opportunity.  They present an opportunity to acquire non-core holdings or accumulate the dividends. Those non-core holdings can be used to expand the industry coverage of the holdings.  An example would be adding a non-snack food producer to supplement Pepsi's snack food business or adding a paper company like Kimberly-Clark to the nondurables.  In some cases, the supplemental company will be a competitor of the core holdings for some or all of its lines of businesses.  For example, United Technologies competes with General Electric in some business lines.  But between them, the two companies represent more business lines than either alone. 

In most cases, the additional stocks can be selected so as to strengthen the overall portfolio and enhance the performance over the long run.  However, it is the long-run portfolio objective, industry mix, and emphasis on quality holdings characterized by the core holdings of the widows’ and orphans’ portfolio that stay the same.

As with the other postings in this series, this posting was done without any reference to the financial statements of the corporation or technical analysis of the stock.  One should not conclude that a review of the financial statement is irrelevant to an assessment of management.  That is hardly the case.  Financial statements, especially the balance sheet, but also the cash flow statement, say a lot about management.  The income statement, which seems to receive the most press, probably says the least about management of the company.  They were ignored in order to show that sophisticated financial analysis and technical analysis are not required in order to identify investment options.