The Widows’ and Orphans’ Portfolio and US Banks

Regulatory Risk.

The “widows’ and orphans’ portfolio” introduced in the January 9, 2011 posting entitled “Investing PART 9: One version of the ‘Unfinished symphony” is intended to be a long-term investment portfolio.  The type of adjustments that one would expect were summarized in the January 24, 2014 posting entitled “What is to be learned about stock acquisition?”  Generally, they should be adjustments in portfolio weights.  However, as mentioned in the January 26, 2014 posting entitled “What is to be learned for 2014 planning?” when a portfolio objective cannot be achieved by adjusting portfolio weights, there is always the possibility of adding a new holding.

The possibility of not being able to achieve portfolio objectives by adjusting weights was made in connection with a restatement of the portfolio objective:  “Stability, simplicity, profitability, and low risk are not the only objectives of the portfolio.  As the name widows’ and orphans’ implies, dividends are an important consideration in the design and objectives of the portfolio.  Dividends interact with stability and low risk, but the more important point is that, for this portfolio, they are an objective in-and-of-themselves.”

“…one would want to … increase the average yield of the portfolio....  Hopefully, that can be done within the portfolio.  If that is not possible, some additional companies could be added to the portfolio.”

Currently, the objectives of stability, low risk, and dividend yield necessitate a significant change in the portfolio.  As the title of this posting implies, it concerns the US bank held as a part of the portfolio.  When the portfolio was initially introduced, the Bank of New York Mellon (BK) was identified as a core holding.  As explained below, that posture is no longer sustainable.

One should not misinterpret this shift in the portfolio.  As was stated in an earlier posting “…the Bank of New York Mellon is particularly well situated going into 2014.”  However, as it also has been noted, “…it has one of the lower yields of the portfolio holdings.”  Consequently, from the perspective of portfolio management, “…one would have to be very confident that it will be able to increase its dividend in order to justify anything more than just automatic dividend reinvestment.” 

It is with respect to increasing its dividend that the problem with holding Bank of New York Mellon as a core holding first surfaces.  However, the problem is broader than just the dividend.  As the subtitle, “regulatory risk,” implies, the US government has introduced a new dynamic into planning any investment in a US bank. 

First, just from the perspective of dividend increases, Bank of New York Mellon is not going to be able to increase its dividend based upon its own assessment of its business.  That is a problem in the short run and totally unacceptable over the long run.

In April it will undergo a round of stress testing supervised by the government.  Based on how pleased the government is with the results, the regulators will determine how much the Bank of New York Mellon dividend can be increased.  A good guess is that the government will allow the Bank of New York Mellon to increase its dividend (or stock buybacks) by somewhere around 20%. A 20% dividend increase is not to be dismissed lightly.  But even with a 50% increase, Bank of New York Mellon would still have one of the lower dividends yields in the portfolio.  Thus, in the short run, the Bank of New York Mellon cannot achieve the dividend yield appropriate for the portfolio.

Over a longer period of time, the dividend will increase, but it will be based upon political considerations to an unacceptable extent for the widows’ and orphans’ portfolio.  The Hedged Economist has worked with regulators and banks for much of his career.  That experience makes one thing very clear: regulators are no better at forecasting and scenario analysis than banks.  What is even more concerning is that the current administration seems to be regulating by whim.  It is unlikely that regulators are sufficiently independent to avoid being drawn into the process of regulation by whim.  The widows’ and orphans’ portfolio should be made up of financial investments, not a political bets.

With respect to the dividend, both the process by which the dividend will increase and the amount of the increase justify looking for an alternative bank investment.  If the dividend were the only issue, supplementing the Bank of New York Mellon holdings with another bank would be a viable strategy (e.g., Wells Fargo—WFC-- was mentioned when the widows’ and orphans’ portfolio was first introduced). 

Second, dividends are only a part of the objectives of the portfolio.  Stability and low risk are also important considerations.  The Bank of New York Mellon had traditionally been a relatively stable bank because of its dependence upon fee-based services like trust management.  Those fee-based services tended to make the earnings and the stock price relatively stable.  In the current environment, that is no longer the case. 

An administration that acts upon whims does not facilitate the stability or low risk sought for the widows’ and orphans’ portfolio.  The Bank of New York Mellon has become a high beta stocks relative to the rest of the portfolio.  In fact, by some measures it is the most volatile stock in the widows’ and orphans’ portfolio, and although its stock may appreciate, on a risk-return basis it cannot justified as a portfolio holding.

Third, lawsuits designed to extort money from the banking system seem to have become extremely stylish.  Led by the state and national regulators who find banks an easy mark, the legal profession has come to realize that all they need in order to make fat legal fees is someone to play the role of plaintiff.  The widows’ and orphans’ portfolio appreciates stylishness, but it missed the memo indicating that wearing a target was stylish.  Put differently, investing in a large US bank involves assuming considerable headline risk, a risk the portfolio does not need.

Fourth, regardless of how one feels about all or any specific regulations that have been enacted, one cannot deny that they have added complexity.  From the very start of this blog, The Hedged Economist has pointed out that complexity creates its own risk.  Thus, the regulations themselves are creating new risks.

At the Federal Reserve's annual policy conference in Jackson Hole, Wyoming on August 31, the Bank of England's Director of Financial Stability, Andrew Haldane, made a presentation entitled "The Dog and the Frisbee."  The speech and the supporting research provide evidence that as regulations become more complex, they also become less effective.  The research also points out that much of the reason large banks are so difficult for regulators to comprehend is because regulators themselves have created complicated metrics that cannot provide accurate measurements of a bank's health.  So, the additional regulations are not necessarily reducing risk.  At the same time, the regulations are making it harder to identify what risks do exist.

For a brief summary of the speech consult the WALL STREET JOURNAL of September 13, 2012.  The article was entitled “Complexity and Risk Management.”  For an updated discussion of the topic, consult the December 20 WALL STREET JOURNAL article entitled “Andrew Haldane: The Banker Who Cried 'Simplicity’.”  It is based on an interview of Mr. Haldane.  For a non-technical discussion of why the metrics developed by regulators are often counterproductive, consult the January 4, 2013 WALL STREET JOURNAL column by The Numbers Guy.  The article entitled  “Don't Let Math Pull the Wool Over Your Eyes” makes the case that many people, including holders of graduate degrees and professional researchers are too easily impressed by math.  Behavioral economists have been able to show that is true when applied to financial decisions.  However, their focus has been narrower than the generalized statement of the article. 

If one wants a fuller explanation and longer history of how regulation has created risk in the banking system, one might want to read FRAGILE BY DESIGN: THE POLITICAL ORIGINS OF BANKING CRISES AND SCARCE CREDIT by Charles W. Calomiris and Stephen H. Haber.  Despite the title, the thesis of the book is not that regulators intentionally design an unstable system.  Rather, they focus on the political motivations that lead to regulations that have unintended and largely unanticipated consequences.  If history is any guide, the regulators are creating risks that they do not understand.

The net effect of regulation by whim and the regulatory landslide that has occurred is that all US banks now contain a level of uncertainty totally unrelated to the economy or their operation.  A quote from the conclusion in a previous posting is appropriate: “… about the nature of the relationship between politicians and Wall Street. It isn’t always easy to tell who is using whom. That implies that avoiding situations with Washington-based headline risk is an effective risk reduction strategy for most investors.”

The unavoidable conclusion is that Bank of New York Mellon has to be replaced in the portfolio.  To summarize in terms of the objectives: 1) Dividend yield --The dividend yield is too low and the company's performance cannot be relied upon as a basis for increasing the dividend.  2) Stability-- The price of the stock has become far less stable and is exposed to considerable headline risk.  3) Low risk-- The Company is exposed to significant new risks, some of which are identifiable and others are not even known.

From a portfolio perspective, finding a suitable replacement is problematic.  While many of the arguments for dropping Bank of New York Mellon applied to any US bank, not all banks have experienced the effect to the same extent.  For example, Wells Fargo, mentioned when the widows’ and orphans’ portfolio was first introduced, has been more successful at maintaining its dividend, and the price of the stock has been more stable (e.g., it has a lower beta).  If it were used as the banking component of the portfolio, dividend reinvestment might be all that would be required.  However, that would still leave the portfolio exposed to regulatory risk.  Put differently, it is impossible to guess when our government or a group of trial lawyers will decide that Wells Fargo would be a nice target for extortion.

Fortunately, an investor does not have to be exposed to the types of risks that have been introduced into the US banking system.  Our northern neighbor, Canada, has a far more stable banking system than the US.  Thus, Canadian banks provide excellent candidates for substitution for the Bank of New York Mellon.  Further, many of the Canadian banks have US subsidiaries.  Consequently, the investor does not have to give up exposure to the US economy totally in order to reduce the exposure to regulatory whim and legal extortion.

One of the nice things about focusing on Canadian banks is that there are not too many of them.  One can fairly quickly narrow the field of consideration down to two or three banks.  The Hedged Economist’s screens narrowed the field to The Royal Bank Of Canada (RY) and Toronto Dominion (TD).  As stocks, both pay healthy dividends, have histories of raising the dividends, and have betas that are lower than Bank of New York Mellon.  Both have healthy financials and strong businesses.

For the widows’ and orphans’ portfolio, Toronto Dominion was selected.  Its dividend is slightly lower, but not significantly lower.  By contrast, its beta is significantly lower, and that is an important consideration for this portfolio.  Both are financially strong banks, but TD Bank seems to be more successful at building a strong brand around the “America's most convenient Bank” theme.

Investing in any company that operates in multiple countries involves some currency risk.  That is true of the TD investment.  It would also be true of an investment in the Royal Bank of Canada.  A totally domestic US bank would not involve currency risk to any appreciable extent.  However, any large bank whether US or Canadian embodies some currency risk because of the nature of the assets it holds.  Thus, it would be easy to overestimate the extent to which the purchase of TD Bank increases the portfolio’s currency risk.  When compared to the currency risk involved in the investments in the other multinationals held in the widows’ and orphans’ portfolio, the currency risk embedded in TD is acceptable.

In order to acquire the Toronto Dominion shares, all shares of Bank of New York Mellon were sold.  In addition, the small position in Newmont Mining, discussed in a previous posting as primarily held as an indicator, was also sold.  The combination of the two sources provided adequate funds to achieve a more desirable dividend yield for the portfolio (2.5%) and brought banking as a portion of the portfolio (4.9%) closer to the desired level.  At some future date, dividends from the portfolio will be used to bring both the dividend flow and portion of the portfolio completely up to the desired levels.

The effect of this trade is to bring the portfolio much closer to balance.  Only minor adjustments should be required for a fairly long time.  The stock portion of the portfolio is summarized in the table below.  The first column is the stock symbol.  The second column is the portion of the portfolio represented by that stock.  The third column is the dividend yield (i.e., the rate at which dividends are paid based on current prices).  The third column shows the portion of the total dividends derived from the specific stock identified in column 1.

	PERCENT		PERCENT
NAME	OF VALUE	YIELD	OF YIELD
PPG	20.9%	1.3%	10.6%
JNJ	10.2%	2.8%	11.3%
BA	14.4%	2.2%	12.4%
PEP	8.6%	2.9%	9.8%
VZ	5.1%	4.6%	9.3%
MMM	13.1%	2.6%	13.4%
XOM	9.5%	2.7%	10.0%
GE	4.5%	3.4%	6.0%
PG	8.8%	3.0%	10.3%
TD	4.9%	3.6%	7.0%

The price appreciation in PPG has brought it to a level that some investors view as an upper bound for a portfolio weight.  By contrast, PPG is not overly represented as a portion of the dividend yield.  The inverse situation is characteristic of Verizon (VZ).  As a portion of the portfolio, Verizon shares do not represent a very large portion of the holdings.  However, because of its higher dividend rate its contribution to dividends is about appropriate.  GE and TD Bank are the two portfolio holdings where both the portion of the portfolio and the contribution to dividends need to be enhanced.  Unless something unanticipated arises that will be a principal focus for the balance of the year.

A disclosure, as mentioned in “A Core of MutualFunds: Part 2,” a number of mutual funds are also held as a core portfolio.  Thus, the portion of the portfolio and the portion of dividends attributable to any individual stock are both allowed to fluctuate within fairly large bands.  However, in keeping with the idea that the portfolio is a source of income, the portion of dividends attributable to any individual stock is more tightly monitored than its portfolio weight. 

However, since some people prefer stocks and others prefer mutual funds, in The Hedged Economist’s postings, core portfolios of either are presented as standalones.  When that is not the case, it will be quite explicitly stated (e.g., “Funds for Asset Class Diversification”).  When the discussion is about acquiring or selling non-core holdings, there will be no reference to how they fit in a portfolio (e.g., “Without the Glitter, An Alternative to Trading Bonds”).  It should also be understood that references to a position as core or non-core should be viewed as relating to a portfolio.  A non-core holding referenced in a posting may be held for multiple years (e.g., the Kimberly-Clark stock purchased for reasons discussed in “Wall Street doesn’t run the world” has been held continuously since March of 2010) or it may be sold very shortly after acquisition (e.g., some of the alternatives to bonds mentioned in “AnAlternative to Trading Bonds”).

A Word of Explanation.

Pick a mutual fund for your purpose.

Last month's postings on mutual funds all referenced open-end funds (“The Three Fund Portfolios, A Core of Mutual Funds: Part 1 and Part 2, Funds for Asset Class Diversification”).  The use of open-end funds was consistent with the focus of the postings. 

Often, much is made of the distinction between closed-end versus open-end funds, open-end funds versus Exchange Traded Funds(ETFs), and index funds versus managed funds.  Each type of fund is appropriate for a particular investment objective. 

Most people have no problem understanding that when the decision is between a bond fund versus a stock fund.  By contrast, when they focus within the stock fund universe, both investors and financial commentators lose sight of the fact that each type of mutual fund has a purpose.  They often get absorbed by recent relative returns or short-run projected returns.  

The investor ultimately has to select a type of fund that is consistent with his or her objective for the fund investment.  For example, last month’s postings make quite clear that the selection between index funds and managed funds had nothing to do with short-run projected returns or historical relative returns.  The selection criteria were based on the portfolio objective.

However, just stating what the portfolio objective is and pointing out funds that meet that objective does not automatically rule out alternatives.  Consequently, why other alternative types of funds were not appropriate for last month’s portfolio discussion is worth addressing.  One of the advantages of such a discussion is that it provides an opportunity to identify when those alternatives would be appropriate.

In last month’s discussion of mutual funds, the importance of low fees was pointed out.  Thus, a legitimate question is: Why were ETFs, which often have lower fees than open-end funds, not used instead of index funds?  The March 1, 2014 WALL STREET JOURNAL ran an article entitled “Do ETFs Turn Investors Into Market Timers?”  For those who did not already know, it documents how ETFs’ primary advantage, that they can be traded easily, is far from a blessing. 

The research cited in the article includes a Vanguard study that summarizes why ETFs were not mentioned in last month's postings: “The individuals owning ETFs were more than twice as likely to fall outside the "buy and hold" category than those who owned open-end share classes….”  Since the postings were about a buy-and-hold strategy, open-end funds seemed more appropriate. 

The fact that Vanguard’s ETF investors were not pursuing a buy-and-hold strategy does not mean an ETF could not be used in a buy-and-hold strategy.  Theoretically one could purchase an ETF and use it in exactly the same way as the postings recommended using open-end funds.  However, that does not seem to be what happens in practice.   The theoretical possibility is interesting, but what really matters is actual investor experience.  By applying a statistical model that relates frequency of trading to various investor characteristics, the Vanguard study hints at something more fundamental being at work.  People with the same investor characteristics seem to behave differently when they own ETFs instead of open-ended funds.

That impression is supported by data from the largest brokerages in Germany. The researchers found that performance deteriorated for the average investor after he or she began investing in "easy-to-trade index-linked securities" such as ETFs.  Further, the deterioration in performance was related to trading.  "Bad market timing" that the typical investor engaged in after investing in ETFs was identified as the source of lower returns.  While the Vanguard study used statistical techniques to isolate the impact of ETFs versus open-end funds, the study by the German brokerage firm looked at behavior over time.

Yet additional support for the impression comes from the experience of investment advisers.  A Hulbert Financial Digest study monitored 23 advisers who maintain both a model portfolio of ETFs as well as one focusing on open-end funds. The ETF portfolios over the past five years trailed their non-ETF fund portfolios by an average of 2.5 percentage points on an annualized basis.

The research is inconclusive, but in truth, one hardly needs the research results.  All one has to do is listen to the marketing pitch for ETFs: it is quite clear that trading convenience is their primary selling point.  Clearly, if one’s objective is to trade a particular asset class, an ETF may be appropriate vehicle.  By contrast, if one just wants to participate in the long-run performance of a particular asset class, an open-end mutual fund may be the more appropriate vehicle despite slightly higher expenses.

Similarly, closed-end mutual funds can be very useful investment vehicles.  However, the biggest return in closed-end mutual fund investing results from trading activity rather than a buy-and-hold strategy.  How successful one is at investing in closed-end mutual funds depends upon timing the trades. 

Successful closed-end fund traders are navigating two sets of timing variables as well as the basic issue of portfolio composition characteristic of any mutual fund.  First, those timing variables included cycles in the relationship between each fund’s price and its net asset value.  The second time variable involves cycles in the asset prices of the particular sector or country in which the closed-end fund invests.  Needless to say, those two timing variables interact.

There is a further complication with closed-end mutual funds: one cannot assume that selecting a good fund manager is the most important decision.  A truly good fund manager of a closed-end mutual fund will have an impact upon the relationship between the price of the mutual fund and its net asset value.  As a consequence, the fund manager’s ability to select the right investments may be totally offset by the fact that the fund has to be purchased at a premium; the premium being a price above the net asset value of the fund’s holdings.  Thus, the fund may hold the right assets, but the investor is overpaying for them.

One further consideration with closed-end funds is whether their charter allows them to take on leverage.  When it does, the leverage can be a major consideration.  Analyzing the leverage (how much, what duration, what rates, etc.) is not a trivial task.

As a consequence, closed-end mutual fund investing is a discipline in-and-of-itself.  People who are good at it can make a substantial trading profit.  It is a discipline quite different from portfolio management and long-term investing.  The Hedged Economist has generally found it easier to select individual stocks for a portfolio than to time purchases of closed-end funds.  Any diversification needed to supplement the stock portfolio can easily be purchased using open-end funds.  Achieving that additional diversification was the focus of last month's postings.

Both ETFs and closed-end funds are useful trading vehicles.  However, as such, they were inappropriate for last month's postings about buy-and-hold strategies.  Theoretically one could argue that the lower expenses of an ETF justify using it in a buy-and-hold strategy instead in an index fund.  The theory is nice,  but it is not what happens.  Similarly, one could argue that the closed-end fund if purchased when it trades significantly below its net asset value is a reasonable substitute for a managed open-end fund.  However, with a closed-end fund one cannot avoid the timing issue involved in determining an adequate discount to the net asset value.  One of the advantages of the strategies discussed last month is that for the long-term investor timing is irrelevant.

Without the Glitter.

Gold as an investment

Gold is a speculative commodity.  It hedges very little.  It has not been a good long-term investment.  Mining gold can be a profitable business, however it is extremely cyclical.  Gold miners have learned to adapt to the speculation in their output.  Consequently, there are times when the stocks of the gold miners are attractive investments. 

Current supply and demand conditions in the gold market, as well as the response of the mining companies to recent market conditions, suggest that now may be an appropriate time to investigate the stocks of gold miners.  This posting discusses the issue and summarizes the Hedged Economist’s response.  However, the more important take away is that now is a good time for any investor to review his or her exposure to precious metals.

In previous postings on The Hedged Economist, both gold and gold mining stocks have been mentioned.  The April 5, 2010 posting on gold entitled “Gold: Be sure you know what you’ve hedged,” focused on debunking many myths that surround gold.  In many peoples’ minds it has taken on almost magical investment qualities.  As the posting pointed out, those magical qualities do not and never have existed. 

The May 16, 2010 posting entitled “Gold again” pointed out: “In the long run it isn't a very good investment, but as a short-run speculation, it has its moments.”  The August 20, 2010 posting, entitled “Worthrepeating and, yes, gold again,” compared the return on gold to other investments.  The comparison was made for a number of different time periods.  It showed that it is very hard, if not impossible, to find any periods where gold was other than a short-term speculation.

Gold miners are businesses.  Any investment related to gold has to be done with considerable caution.  However, gold and gold miners are two different investments.  Gold miners are businesses and regardless of the speculative component that influences the demand for their product, they produce a product that is subject to supply and demand.  They have costs.  They have financials.  They have stock prices.

The posting on May 5, 2011 entitled “Up, up and away in my beautiful balloon, or is it abubble?” discussed both gold and gold miners. The business of any miner can be evaluated using fundamental analysis just like any other business.  However, given the speculative component in the demand for their product and the lackluster performance of sector, is there any justification right now for putting in the effort to analyze individual mining stocks?

The answer is yes there are reasons to investigate the sector.  The first, and always the most important consideration, is how gold miners’ stocks fit into the investor’s portfolio.  The mining sector should be represented in a portfolio.  However, extractive industries are highly cyclical, and precious metals constitute very small portion of the sector.

As was mentioned in the posting cited above, The Hedged Economist can see no justification for holding much exposure to precious metals.  An average exposure of a couple of percent seems reasonable, but contrary to many prescriptions usually advanced when the price of gold has rising, there is no justification for a constant exposure of more than that.

If one holds a couple of percent exposure, the poor performance of gold miners, both in absolute and relative terms, will have reduced that exposure below the desired threshold.  The Hedged Economist has maintained a portfolio weight between less than 1% and up to 5% with the average being closer to 1% than five. 

There is no effort to maintain a stable exposure.  Rather, the exposure fluctuates within that range based upon the cyclical performance of the metal and the miners.  Often when the prices of the metal or the mining stocks advance, that exposure is reduced in order to take advantage of the price increase. 

The other side of the portfolio management, and the current situation, is that when the exposure falls because of a fall of the price of the metal or the price of the miners stocks, additional purchases are considered.  When prices are down, that is the time to consider additional purchases.  Thus, the portfolio suggests that it is a good time to consider investing in the sector.

Another reason involves the demand for gold.  Of course one has to guess, but it appears that a good deal of the speculative demand for the metal has abated.    It is only a guess, but there number reasons for making that guess.

First, the amount of gold being held to back the gold ETFs has decreased as their price decreased.  Gold held to back ETFs is definitely gold held on speculation.

Second, that guess or interpretation is consistent with warehouse inventories at theComex.  Thus, it appears that less gold is being held to meet the demand of speculators that trade on the Comex. 

Third, warehousing of metals is less appealing to banks in the current regulatory environment.  Banks are themselves speculators, and they hold inventory to facilitate the trading of other speculators. 

Fourth, that interpretation is consistent with the performance of gold versus certain gold mining stocks.  The Hedged Economist has held a small position (less than one percent of the portfolio) in Newmont Mining (NEM) for many years and has come to believe that certain divergences between the price-performance of gold and Newmont’s stock provides some information about the amount of speculation embodied in the price of gold. 

The bottom line is that there are reasons to believe that further downward pressure on prices from speculators reducing positions has stopped. 

By contrast, the physical demand for the metal has held up or increased.  Some of the demand is being repressed.  For example, import restrictions in India (one of the major consumers of gold jewelry) have kept the price of gold high in India.  There are estimates that the price of gold in India has been as much as $100 above the world market.  That sort of government intervention indicates that prices could increase in India without reducing the physical demand.  Elsewhere the demand for gold coins and jewelry has held up or increased as prices fell.

It is always good to remember that there is a huge physical inventory of gold in central bank vaults and warehouses.  Whether central banks add to those inventories is a wildcard in any demand projection.  It is also important as it relates to the third reason that now is an opportune time to investigate gold miners’ stocks. 

The third reason for believing that now is an opportune time to consider the stocks of gold miners concerns the supply of gold.  If central banks began to divest themselves of their gold, they could easily flood the market with far more gold than the miners produce.  There is no reason or announced plans for major gold-holdings central banks to sell their gold.

Another positive development regarding the supply is that gold miners have become more disciplined in their response to gold prices.  Developing a mine has very long lead times.  Consequently, often mines that were started during periods of high prices would come online when prices were depressed.  The consequent oversupply would further depress prices.  However, during the recent price decline gold miners have delayed or halted development projects in response to the price decline.

Part of that new discipline regarding supply reflects better management.  But part of it reflects the demands of the financial markets.  Some mines had to be delayed or halted in order to avoid further declines in specific company stocks.  That decline could reflect a market reaction by owners of the stock or by the company’s financial need to dilute their shares in order to secure adequate financing to pursue their expansion.  The result is that it does not look like gold miners will flood the market for the metal.

The same market reaction that has restrained the development of new mines has forced management to more carefully manage their balance sheets.  Consequently, one would expect some gold miners to be in good financial shape to expand production, take market share, and avoid pressure on their margins.

One can also apply technical analysis to the price of gold miners’ stocks.  In fact, BARON’S on February 12, 2014, posted just such a technical analysis in their Getting Technical feature.  The article was reprinted in the weekend edition as “More Support for Gold: Charts Take Bullish Turn.”

Aficionados of technical analysis may want to check out that article.  The Hedged Economist purchased shares in a gold miner (Gold Corp.  – – GG) on February 3 before the article was published.  The fundamentals and portfolio considerations rather than technical analysis were the driving influence.  However, given the advance in gold and gold miners’ stocks since February 3, some readers may find the technical analysis reassuring.  The Hedged Economist, not being an aficionado of technical analysis, is more reassured by the relative performance of miners versus the metal, and both miners and the metal relative to the overall stock and credit markets.

The confirmation that the markets have provided is extremely important.  Keep in mind, any decision related to gold is subject to revision at any time.  That is especially true of a decision that increased the portfolio weighting for gold mining stocks to 2%.  Two percent is above The Hedged Economist's normal portfolio weighting.  Nevertheless, for now, some gold miners look like reasonable investments.

Funds for Asset Class Diversification

Supplementing an equity portfolio with mutual funds

One of the appropriate uses of mutual funds is to gain exposure to asset classes where the investor does not feel comfortable making decisions on individual holdings.  In some cases, the investor may simply be choosing to focus his or her attention on other asset classes.  In other cases, it may be very difficult, to the point of almost being impossible, for the investor to acquire individual assets in the class.  In other cases, there may be tax advantages to holding the assets indirectly through a mutual fund rather than directly. Rather than trying to distinguish between the potential reasons for using mutual funds, this posting starts from an assumption about what category of assets holds directly.

Areas where supplements may be needed.        

                                

Specifically, this posting looks at mutual funds as a supplement to a portfolio of bonds and large-cap equities.  The actual mutual funds discussed in this posting are designed to provide asset class exposure outside of those two categories.   

Part 1 of the previous posting (“A Core of MutualFunds: Part 1”) discussed the logic and limitations of diversification across asset classes.  Therefore, this post is will proceed on the assumption that the pros and cons of diversification do not need to be addressed.

There are three areas where mutual funds seem like a convenient way to supplement the portfolio of stocks and bonds.  (1) Since they are supplementing a large-cap US equity portfolio, small and mid-cap stocks are a logical focus.  (2) Further, since the portfolio is US equities, international exposure seems appropriate.  (3)  Finally, international exposure to developed economies can be achieved in ways different from that of emerging markets.  Therefore, emerging markets can, and should, be addressed separately from developed markets.

Cost considerations

As with any mutual fund investment, costs are an important consideration.  Mutual funds specializing in these three asset classes tend to have higher costs:  Markets may not be as liquid which can lead to higher trading costs.  Different markets may be governed by different regulations and trading conventions which have to be researched.  Further, the information on individual companies may have to be verified.  At the extreme, this requires significant travel, especially for managed funds that focus on fundamental analysis involving meeting the management of the company.  Consequently, research costs are often higher for these fund categories.  Those higher costs are reflected in higher fees. 

There are some fees that can be ignored given the role assigned to these mutual funds as a part of a total portfolio.  Often funds in all three areas have charges associated with short-term holding periods.  There are such fees on all three of the funds used as illustrations in this posting.  However, as discussed here, one would anticipate holding the supplemental funds for the long-term, as long as one is holding the large-cap US equity portfolio.  Thus, the cost imposed on short-term trades of the mutual funds can be ignored.  The supplemental funds are not being purchased as short-term trades.

Fund selection

One has to decide between index funds versus managed funds.  As discussed in a previous posting (A Core of Mutual Funds: Part 2), index funds outperform the average managed funds after costs.  That places a particularly heavy burden on managed funds in the relevant categories because of their tendency to have particularly high costs. 

Further, the objective of the supplemental funds is to expose one to the relevant markets.  Consequently, a managed fund that specifies an objective different from the performance of the overall market is inappropriate.  In the case of the supplemental funds in these three categories, the performance of the market is the objective.

For an index fund to truly represent a market requires that the market be fairly liquid under normal conditions, and it requires a market that has enough listings so that the index is not totally dominated by a single company.  In other words, a market that can be represented by an index has to exist.  Those two requirements are clearly met by the US small and mid-cap market and by the market for stocks of companies from developed economies. 

Using index funds totally eliminates the disadvantage of higher costs discussed above.  Index funds that focus on small and mid-cap companies have fees that are comparable to index funds for large-cap US stocks.  The same is true of index funds focusing on the developed economies other than the US.  Thus, index funds are an appropriate way to address those two asset classes.

Similar arguments are not robust when applied to the stocks of companies operating in emerging economies.  The stock markets in emerging economies can be highly illiquid under normal conditions, and what liquidity there is can be very fragile.  Also, because the stock markets are operating in smaller economies with fewer listed firms, they can be dominated by a single company.  It is not at all unusual for the market of an emerging economy to be dominated by a single industry.  Consequently, the rationale for using index funds does not fit emerging markets.  Thus, a managed fund is used as a representative fund addressing emerging markets.

Portfolio components

The previous postings on a core portfolio used funds from Vanguard.  So, just for balance, this posting on supplemental mutual funds uses examples of funds available through Fidelity.  The selection of one fund family or the other is just a matter of convenience, and clearly, funds from other fund families could be used.  What is important is the description of the funds’ objectives and approach.  However, all the funds used as illustrations meet the requirement that they manage costs effectively.

Spartan Extended Market Index -- The first fund included in the portfolio is the Spartan Extended Market Index. It seeks to provide investment results that correspond to the total return of stocks of mid- to small-capitalization United States companies.  It normally invests in common stocks included in the Dow Jones U.S. Completion Total Stock Market Index.  That index represents the performance of stocks of mid- to small-capitalization U.S. companies. It excludes companies in the S&P 500® Index.

Spartan International Index Investor Class -- It seeks to provide investment results that correspond to the total return of foreign stock markets in developed economies. Normally it invests in common stocks included in the Morgan Stanley Capital International Europe, Australasia, Far East Index.  Spartan International Index Fund seeks to provide monthly results, before expenses, that match the returns and characteristics of the MSCI® EAFE® Index as closely as possible. It includes large- and mid-cap companies in 21 developed countries, excluding the U.S. and Canada.

Lazard Emerging Market Equity Blend Portfolio -- This fund is offered through Fidelity, but is not managed by Fidelity.  It is a managed emerging markets fund. The investment seeks long-term capital appreciation. The fund invests primarily in equity securities, including common stocks, ADRs and GDRs, of non-US companies.  Under normal circumstances, it invests in equity securities of companies whose principal business activities are located in emerging market countries. The fund may invest in companies of any size or market capitalization.

Portfolio management

Portfolio management is always a matter of taste.  For some reason, people find that easier to accept when it involves what stocks to own in what proportion.  When it comes to asset diversification across the capitalization sizes and international boundaries, they somehow lose sight of that fact.  Consequently, a substantial portion of this section is devoted to debunking many of the myths concerning allocating investments across these asset classes.  Many of the myths and recommendations are totally irrelevant and, in some cases, highly destructive.

The most silly and destructive allocation is based upon the capital market sizes.  The logic goes that the US market constitutes X percent of all market capitalization and therefore the investor should be investing no more than X percent in the US market.  People advance this argument without realizing how silly the underlying assumptions are.  It is surprising that people who make this argument are taken seriously.  To illustrate how destructive and silly the approach is, two shortcomings of the approach are highlighted below.

First, a global capital market is a nice theoretical construct. Unfortunately, the world does not work that way.  There are barriers between capital markets.  What is even more important is that the theoretical construct is totally irrelevant to individual investors.  It assumes that the investor is that proverbial “man with no country.”  Every investor, even an investment corporation, has a tax residence.  For the individual investor, the residence is much more than just where they are taxed.  Global capital markets and the global economy are not what the individual experiences.  The individual lives in his or her own personal economy.  Their investment decisions should be a response to that personal economy.  They invest to address their own personal need.

Data about “home country bias” (the tendency of investors to hold assets in their native currency and local economy) are interesting and informative.  However, the very name, home country bias, implies a misinterpretation of the phenomena.  It is not a bias in any sense.  It is a rational response of investors to their own personal financial needs.  Research that attributes it to naive nationalism or ignorance about foreign economies, displays its own arrogance and ignorance.

Second, allocating one's capital based upon market capitalization would be highly destructive.  The basic reason for allocating capital to different asset classes is that their values move somewhat independently.  When prices go up in a market, the capitalization of that market will increase.  Using capitalization as a guide one would be increasing one's investment in that market as prices increase.  Similarly, when prices go down in the market, the capitalization of that market will decrease.  Using capitalization as a guide the investor would sell holdings in a depressed market.  Buying when markets are up and selling when they are down is not a very constructive process.

The bottom line is that investors should ignore anyone who recommends allocating investments based upon the capitalization of different markets.  It is irrelevant and destructive.

Another supposed guideline for allocation is economic growth.  This rationale is often heard in connection with emerging market investments.  The argument goes that emerging market economies are growing faster.  Therefore, stocks in those markets will appreciate more than that of stocks of companies in developed economies.  While not as destructive as capitalization, it is largely irrelevant.  The ECONOMIST published a very interesting article on the issue in the February 15, 2014 edition.  The Buttonwood feature had an article entitled “The Growth Paradox.”  The conclusion is fairly well summarized by the subtitle: “Past economic growth does not predict future stock market returns.”

The article points out the weakness of any correlation between previous economic growth and stock market performance.  It looks at the issue from a number of different perspectives.  It also provides some interesting insights into why that is the case.  Ultimately, the reader is left with the inevitable conclusion that forecasting emerging market countries’ stock markets is just like forecasting any other stock market.  The fact that there emerging market countries is largely irrelevant.

A surprisingly large amount of chatter about allocation across these segments circulates in the financial media and research publications in financial economics.  Much of it is based on a firmer footing than those who naively use capitalization or previous economic growth rates.

While capitalization is irrelevant, how stock markets fluctuate (i.e., their variance and the timing and their fluctuations) is relevant.However, if one looks at the data used to support allocation schemes based upon variations in the performance of different markets, it only adds to the confusion.  The conclusions are highly dependent upon the periodicity of the data used for the analysis and the historical period covered.  They are also sensitive to the assumptions made about trading frequency.  Finally, some research explicitly makes reference to trading costs and currency risk while others completely ignore them. 

Also, the conclusions are sensitive to how the analysis treats trends in the error terms.  That is especially true of the international asset allocation.  There is a theoretical argument that the benefit of international allocation is dependent upon the degree to which the global economy is integrated.  An interesting aspect of that issue is the periodic debates about "decoupling" (e.g., whether emerging market countries have economic and stock market cycles independent of the developed economies). 

What is interesting about those debates is that they are questioning the basic assumption behind the rationale for international asset allocation.  They are questioning whether the assumption of stable asset correlations is valid.  Without explicitly stating it, one side in such debates is implicitly stating that the entire basis for Modern Portfolio Theory no longer applies.

One does not need to take a side in the theoretical arguments or become immersed in the empirical research.  The very existence of such issues makes it apparent that there is no single scheme that is optimal for the long-term investor.  Compound that with the existence of different investment objectives among investors, and it becomes apparent that the allocation is largely a matter of taste.

As if that were not enough, the assumption that identifies these three asset classes as candidates for mutual fund investment is that the investor is comfortable picking individual holdings in other asset classes.  The assumption that investments in direct holdings are restricted to large-cap equities and bonds need not be absolute.  A large-cap investor may select global firms located in another country.  Similarly, once one begins analyzing equities, holdings other than large-cap may become appealing.  An individual’s international holding or stock of a smaller company would influence how much of each mutual fund is appropriate.

As a consequence, one can make a reasonable argument for viewing investments in each of these three supplemental mutual funds as comparable to any other holding.  Usually an investor restricts individual holdings to a much smaller portion of the total portfolio than is frequently advocated for investments in these asset categories. 

Restricting the investment in any individual supplemental mutual fund to a level comparable with other individual holdings has been The Hedged Economist’s approach.  Each of these mutual funds hedges certain risks.  They are useful, but they are not the only way to address those risks.  Other assets can address some of the same risks while yielding a higher return.  Mutual funds are often viewed as a convenient way to get diversification.  Consequently, it may seem counter intuitive, but there are times when one wants to diversify away from the holdings in mutual funds.  Alternative ways to accomplish the same objective are worth searching out when the holding in any particular mutual fund becomes uncomfortably large.