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Macro Themes And The Implications: Time To Pay Attention To U.S. High Yield Bonds

By Dr. Chenjiazi Zhong Key Macro Themes and the Implications Low inflation : Inflation is low but it does not mean inflation is zero. The slow growth in global economy keeps inflation subdued even as CPI slowly rises. Global policy divergence : Fed continues to normalize slowly as other central banks pursue stimulus policies. Investors should expect yields to rise modestly. Supply-side weakness : Across developed countries, the low productivity and growth in labor force will ultimately cap longer-dated yields. Strength in U.S. economy : U.S. economy remains resilient; recession risks are being overpriced for 2016, which indicates a good environment for high yield bond. Gradual recovery in Europe : The expansion in Europe is on track; monetary policy is a key factor that will support EU stocks and credit markets. Japan – beyond Abenomics : The economic risk in Japan is becoming more binary; the asset returns will be more geared to fiscal response. Emerging markets rebalancing : The stats of emerging markets implies that the environment is stabilizing and the valuations are undemanding. The short-term risks exist but investors can expect the conditions will improve in 2016. China in transition : That China is shifting from resources to services will continue to weigh on global trade. U.S. High Yield Bonds In an environment of full valuation, fragile investor sentiment, favorable relative valuations of credit over equity, slow but positive growth with limited recession risk that is priced in, high yield credit that offers equity-like returns is an attractive proxy for stocks. U.S. High yield credit spreads widened the most since 2011. U.S. high yield bonds offer lower volatility than equities due to their coupon income. In down markets, a larger coupon for high yield bonds helps to offset market declines; in up markets, high yield bonds usually correlate to rising equities. Moreover, high yield bonds are generally not impacted by modest rise in interest rates; spreads are more a reflection of market expectations for future default rates rather than expectations for higher interest rates. Furthermore, high yield bonds managers charge lower fees as compared to the hedge funds specializing in distressed debt. Despite U.S. high yield bonds offer equity-like return, investors need to adjust or discount the asset class for its potential for downside losses, liquidity constraints, sector risks, and other realities: The high yield bonds market is characterized by asymmetric risk whereby the potential for downside losses outweighs upside capital appreciation. Asymmetric risk exposure is a situation in which the potential gains and losses on an investment are uneven. The high yield bonds are traded over the counter, which highly depends on dealer capital. Additionally, the majority of high yield bonds do not trade on a daily basis, which means there may be a significant difference between trade prices and broker quotes. Independent fundamental analysis is paramount. The market generally anticipates upgrades and downgrades long before the actual rating changes. The difficulty in estimating defaults is defaults are not correlated to the severity of recessions. For instance, the 2008-2009 period was not the worst for defaults but it was dramatic to other asset classes. The key to long-term success in investing in high yield bonds is managing credit risk, avoiding dangerous concentrations and minimizing defaults in the portfolio. In addition, in harvesting carry across extended credit markets, security selectivity becomes even more crucial . Investors shall stay engaged, know the securities; do not be afraid of sentiment. The increase in volatility is creating numerous opportunities for fundamental, bottom-up investors. With more movement in the market, there is a wider range of possible outcomes, some of them lost, but some of them gained. While the downside increases, so does the upside. As with any investment, the riskier it is, the greater the possible return is. Furthermore, a contrarian stance, backed by a comprehensive understanding of companies’ long-term fundamental prospects, will provide a strong foundation to withstand as well as profit from a world of rising volatility.

Hedge Funds – Misunderstood, But Still Not Worth It

Cliff Asness has a wonderful new piece on Bloomberg View discussing hedge funds. He basically argues that: Hedge fund criticism has been unfair largely due to false benchmarking. Hedge funds should hedge more. Hedge funds should charge lower fees. These are fair and balanced statements. And they’re worth exploring a bit more. The first point is dead on. The media loves to compare everything to the S&P 500, which is ridiculous. The S&P 500 is a domestic slice of 500 companies in a global sea of millions of companies. It neither represents “the stock market”, the “global stock market” nor anything remotely close to “the financial markets”. I have pleaded with people at times to stop comparing everything to the S&P 500. But no one listens to me, so it’s not surprising that this continues. 1 Hedge funds are treated particularly unfairly here, because, as Cliff notes, they’re not even net long stocks on average. The average hedge fund is only about 40% net long stocks. The portfolio is also comprised of bonds and alternatives, making classification difficult to average out. But the point is that the S&P 500 is absolutely not a good comparison. 2 I would argue that the proper benchmark for all active managers is the Global Financial Asset Portfolio , which is the true benchmark for anyone who actively deviates from global cap weighting (which is everyone, by the way). The second point is also clearly true, as hedge funds have become increasingly correlated to the S&P 500 over time. Differentiation is what makes alternative asset classes valuable. Unfortunately, you don’t get much differentiation in hedge funds, and I don’t think this can reasonably change as the industry grows, because, as assets under management grow, the managers will inevitably start to look similar, since there are only so many assets that can be held at the same time. The paradox of active management is that the more active everyone becomes, the more all this activity starts to look like the same thing (minus taxes and fees). The last one is my major point of contention. A globally allocated 40/60 stock/bond portfolio earned about 7.5% per year over the last 40 years. And this was in an era when that 60% bond piece averaged about 6.3% per year. Those days are long gone. I think it’s safe to assume that balanced portfolios will generate lower returns simply due to the fact that the bonds cannot generate the same returns in a 0% interest rate environment. Either that, or the stock piece will probably expose the portfolio to more risk, resulting in similar but riskier returns, on average. I’ve discussed this in some detail, and we even have some historical precedent for this when bonds generated about 2.5% returns from 1940-1980 during a period of low and rising rates. So, the question becomes: In a world of low returns, how can hedge funds justify charging something like 2 & 20, which cuts the total return by almost 50% assuming benchmark returns? Hedge funds have a huge hurdle to overcome on the fee side, and the arithmetic of the markets shows us that they can’t all do it. That arithmetic is clearly coming into play in an environment where aggregate returns have been fairly weak. At the same time, many people clearly benefit from having an investment manager. Vanguard has shown that a good advisor/manager can be worth as much as 3% per year (which I suspect is high), and the average investor has been shown to do far worse than they do when someone like an advisor consistently slaps their hand away from making persistent changes. The value-add of a manager is largely subjective and always personal, but I have a hard time believing people should pay more for an asset manager than they do for doctors, accountants, lawyers, etc. In my mind, portfolio managers and advisors are more like personal trainers – they’re a luxury for people who know they’re not knowledgeable or disciplined enough to build and maintain a proper plan. But personal trainers shouldn’t cost you an arm and a leg. I like Cliff’s points, and there’s some good takeaways in there. But I still think point three is really difficult to overcome. Hedge funds simply charge too much. In a world where you can now mimic a hedge fund index for the cost of 0.75% , it’s very hard to imagine that there’s any rationale for fees being higher than that, on average. And I suspect that, like most high-fee active managers, these sorts of funds won’t benefit investors in the long run anyhow. 3 1 – This is not an entirely true statement. My wife listens to me on rare occasion, but has good reason to ignore most of what I say, since it mostly involves rants about things like quantitative easing and other things almost no one cares about. My dog listens to me roughly 90% of the time, though she selectively ignores me, such as late last night when she got sprayed in the face by a skunk because she did not properly respond to my commands. My chickens do not listen to me at all. I am not sure if it’s because they are geniuses or idiots. Probably geniuses, as they’ve clearly evolved to be unable to hear the Cullen Roche voice. By the way, if you’re still reading this, you should probably be questioning your own evolutionary development. 2 – Part of what’s exacerbated this problem is that Warren Buffett made a public bet with some hedge fund managers who decided it was smart to benchmark their performance to the S&P 500 on a nominal basis. I can only assume that Buffett drugged them before getting them to agree to this deal, since only someone on drugs would benchmark hedge funds to the nominal return of the S&P 500. 3 – Yes, I know this is not a perfect hedge fund replicator, but it’s close enough.