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How To Look At Negative Yields Inside A Portfolio

Negative yields on bonds are no longer unicorns. In Switzerland, Germany, Denmark and several other European countries, government bonds are trading at negative nominal yields. Recently, the Bank of Japan announced it is adopting negative interest rates. For investing, there are four potential reasons that can illustrate trade-offs between different investment strategies as a result of negative interest rates. First and foremost, negative yields could simply be a consequence of active monetary policy (with the expressed goal of stimulating economic activity) in a world where bond supply and demand is not balanced. Central banks in major developed economies have amassed close to $12 trillion in government bonds since 2004, and still remain a source of demand of close to $3 trillion a year. Meanwhile, the net issuance of government bonds of about $2.5 trillion has been on the decline since 2013. This demand mismatch is likely one of the reasons there are $6.3 trillion in government bonds outstanding trading at a negative yield. This represents about 10 percent of total outstanding government debt worldwide, estimated by McKinsey to $58 trillion. Second, negative yields could potentially be correctly forecasting a sharp economic slowdown, which, as a consequence, could lead to an increase in defaults (both corporate and sovereign) in the future. Paying up now and receiving less nominal money in the future can be profitable if the price of goods has fallen sufficiently. Third, negative yields could also be a consequence of the ecology of current market participants. Choosing to not own these government bonds as an active allocation decision can (even with good cause due to their negative yields) carry risk for certain investors – e.g., the potential for higher tracking error to their benchmark or underperformance versus their peers. That said, as government bonds have an increased representation in many bond indexes that are used as benchmarks, holding these bonds to stay close to the benchmark also carries a cost: lower absolute returns due to a portfolio with an increasing component of negative return. Fourth, certain investors who have a preferred investment horizon may require a meaningful risk premium to buy bonds with maturities outside their preferred habitat. For instance, when investors with a shorter horizon are faced with short-term yields in negative territory, the steep slope of the yield curve and longer-maturity bonds might provide the inducement to buy longer bonds. Because they join other investors who invest regularly in longer maturities as part of their own preferred habitat, the ensuing higher demand could be a reason for negative yields on longer-maturity bonds, as was recently the case in Switzerland and Japan. And lastly, negative interest rates cause currency volatility and capital flight. By adopting a negative rate to weaken the currency, the true goal is to apply a haircut to government debt that is unsustainable as GDP growth stays anemic. The result is negative interest rates lead to one currency appreciating to super strength, namely the US dollar, while the rest of the world’s currencies depreciating by central banks printing money. The result of negative rates is the opposite from what it was intended; instead of a stimulus, it has led to deleveraging debt. The effect was first through the energy sector by causing distress in high yield markets that has now spread more broadly. ​ Portfolio Strategy If one believes negative yields are primarily due to demand from passive or indexed investors, then an active investment strategy should tolerate the tracking error and take the other side of the indexing herd. Despite the profit uncertainty of investing in negative yielding bonds, there is a logical approach to constructing robust portfolios. First, control exposure to risk factors where the uncertainty of outcomes may be the most severe, for instance, by adjusting overall portfolio duration. Second, tilt portfolios in directions where relative asset valuation is more attractive, e.g. equity and bonds of companies with solid fundamentals. Third, look for sources of diversification, where the ultimate and eventual resolution of the negative yield conundrum is likely to create large trends and market movements. And finally, in very broad terms, aggressive central bank intervention with negative interest rates continues to underwrite risk taking. At the same, negative rates also cause volatility, currency depreciation and deleveraging of debt. So as more central banks jump on the bandwagon to drive rates more negative, an appropriate asset allocation of conservative, higher quality credit risk, floating rate exposure, and maintaining high liquidity remains prudent. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Smart Beta ETFs That Stood Out Amid Market Volatility

The ‘smart beta’ rage has lately taken the charge of the ETF world. Simply put, the days of plain vanilla ETFs or market-cap weighted ETFs are gone and products with several winning attributes are coming on stream. By now, investors are quite familiar with what the smart-beta concept actually is. As the name suggests, this approach calls for a strategic procedure rather than a plain vanilla market-cap oriented method of portfolio construction. Smart beta funds normally follow the passive investment strategy but with a slight twist which enables it to generate market-beating returns. Many people call it an enhanced investing strategy. A survey conducted by Create-Research shows that smart beta ETFs make up for around 18% of the U.S. ETF market. Another survey pursued by FTSE Russell reveals that 68% of financial advisors are eyeing smart beta ETFs while 70% are focusing on multiple strategic beta techniques. Investors dream of sweeping off the market and scooping up capital gains through this approach. The love for smart beta products was best reflected when renowned investment house Goldman Sachs recently forayed into the ETF industry with a host of smart-beta products (read: Can Goldman Dominate the Smart Beta ETF Industry? ). Below we have highlighted five ‘Smart Beta’ options that outperformed the broader U.S. market ETF SPDR S&P 500 ETF (NYSEARCA: SPY ), which has lost about 1.7% so far this year (as of March 4, 2016) (read: How You Can Beat the Market with Dividend Aristocrat ETFs ). PowerShares DWA Utilities Momentum ETF (NYSEARCA: PUI ) As bond yields fell on a flight to safety triggered off by global growth concerns and oil price declines at the initial part of the year, rate-sensitive sectors like utilities soared. The sector is known for its relatively high dividend payout and defensive but capital-intensive nature. As a result, a low-yield environment is a winning backdrop for it. While all utilities ETFs performed well in the stormy first two months of 2016, PUI – comprising utility companies that are showing relative strength – fared better. PUI is up 8.2% in the year-to-date frame (as of March 4, 2016). PowerShares S&P 500 High Dividend Low Volatility ETF (NYSEARCA: SPHD ) The drive for high current income along with focus on low volatile stocks has made this high dividend low volatility ETF a winner this year. The underlying index of the fund looks to track the performance of 50 securities selected from the S&P 500 Index that have historically provided high dividend yields with lower volatility. The fund yields 3.47% annually and is up 7.1% so far this year (as of March 4, 2016) (read: 3 Safe High Dividend ETFs to Beat the Volatile Market ). ALPS Emerging Sector Dividend Dogs ETF (NYSEARCA: EDOG ) The fund benefited from the return of the emerging markets and investors’ lure for dividends. The underlying index of the fund picks five stocks in each of the 10 sectors that make up the S-Network Emerging Markets which offer the highest dividend yields. The fund is equal-weighted in nature. The fund yields 4.48% annually and is up 12.3% so far this year (as of March 4, 2016) (read: Emerging Markets Back On Track: 5 Outperforming ETFs ). IQ Global Resources ETF (NYSEARCA: GRES ) Since commodities have enjoyed a phenomenal run in the year-to-date frame, this fund has found a place in the top-performers’ list. The IQ Global Resources ETF focuses on momentum and valuation factors to identify global companies that function in commodity-specific market segments and whose equity securities trade in developed markets, including the U.S. These segments include the major commodity sectors, plus Timber, Water and Coal. The fund has added 11.3% so far this year (as of March 4, 2016). The fund yields 2.60% annually. PowerShares S&P Mid-Cap Low Volatility ETF (NYSEARCA: XMLV ) As volatility spiked to start 2016, this mid-cap low volatility fund gained considerable investor attention. The fund measures the performance of 80 of the least volatile stocks from the S&P MidCap 400 Index over the past 12 months. XMLV is up over 3.4% and yields 1.83% annually. Original Post

The Statistical Support For Long-Term Return Regimes Is Compelling

By Rob Bennett The last three columns examined a recent article by Michael Kitces (“Should Equity Return Assumptions in Retirement Projections Be Reduced for Today’s High Shiller CAPE Valuation?”) that advances the highly counter-intuitive and yet entirely accurate claim that, “The ideal way to adjust return assumptions… [may be] to do projections with a ‘regime-based approach to return assumptions. This would entail projecting a period of much lower returns, followed by a subsequent period of higher returns.” This changes everything that we once thought we knew about how the stock market works. The old (and still dominant) belief was that stock prices fall in the pattern of a random walk because price changes are caused by economic developments. If what Kitces is saying is so (I strongly believe that it is), prices do not fall in a random walk at all. They play out according to a highly predictable long-term pattern. For about 20 years, valuations rise (with short-term drops mixed in). Then, for about 15 years, valuations drop (with short-term rises mixed in). It is investor emotion that is the primary determinant of stock price changes. Investors can reduce risk dramatically, while also increasing return dramatically by adjusting their stock allocations in response to big valuation shifts, and thereby keeping their risk profile roughly constant as one “regime” is replaced with another. This is hard to accept. We are always living through either a high-return regime or a low-return regime. The regimes continue long enough to convince us that they are rooted in something solid and real and permanent, not in something as loosey-goosey and vague and seemingly ephemeral as investor psychology. When sky-high returns were being reflected on our portfolio statements in the late 1990s, we adjusted our understanding of our net worth. But improperly so! A large portion of the oversized returns were the result of the regime we were living through. Those returns were fated to disappear in the following regime. And the poor returns of today’s regime (which began in 2000) will also disappear when we enter the next return-boosting regime. The strategic implications are far-reaching. If there really are high-return regimes and low-return regimes, it makes no sense to stick with the same stock allocation at all times. If there are two types of return regimes that last for 15 or 20 years, there are two types of stock markets that last for 15 or 20 years. Decisions that make sense for one of the two types of regimes cannot possibly make sense for the other type of regime. Buy-and-hold is a mistake. We should be going with higher stock allocations in high-return regimes and with lower stock allocations in low-return regimes. There’s a rub. What if the data that Kitces is taking into consideration in forming his conclusions is the product of coincidence? Can we really be sure that the two-regime world will remain in place? If it doesn’t, and if we invest on the belief that it will, we will be underinvested in stocks while waiting for today’s low-return regime to play out (the historical reality is that no low-return regime has ever ended until the P/E10 level dropped to 8 or lower, a big drop from where it stands today). Negative consequences follow for an investor who abandons buy-and-hold for valuation-informed indexing in the event that Kitces’ regime concept turns out to be an illusion. The most convincing case that I have seen that it is not an illusion is the case put forward in a book by Michael Alexander, titled Stock Cycles: Why Stocks Won’t Beat Money Markets Over the Next Twenty Years . Please note that the claim made in the subtitle was widely perceived as crazy at the time it was made (the book was published in 2000), and yet, has proven prophetic – stock returns over the past 16 years have been far smaller than the returns that were available in 2000 through the purchase of super-safe asset classes like Treasury Inflation-Protected Securities and iBonds. Buy-and-holders would have said at the time that a prediction of 16 years of poor returns was exceedingly unlikely to prove valid. And yet, Alexander knew something (or at least thought he knew something) compelling enough to persuade him to put his name to that claim in a very public way. Alexander engaged in extensive statistical analysis to determine whether stock price changes really do play out differently in different long-term regimes. He concluded that: “The effect of holding time on stock returns in overvalued markets is the opposite of what it is for all markets. Normally, holding stocks for longer amounts of time increases the probability that they will beat other types of investments such as money markets… In the case of overvalued markets (like today), holding for longer times, up to twenty years, does not increase your odds of success.” We don’t today know everything there is to know about how stock investing works. We are in the early years of coming to a sound understanding of even the fundamentals. We need to be careful not to jump to hasty conclusions based on limited research. That’s what I believe the buy-and-holders did. Many of their insights were genuine and important, and have stood the test of time. But the claim that it is safe for investors to ignore price when buying stocks has not stood the test of time. The Kitces article is pointing us in a new direction. I hope it generates lots of debate. My guess is that we will not see that debate immediately, but that many will be giving the Kitces article a second look following the next price crash, when we will all be seeking to come to terms with what we have done to ourselves by too easily buying into the idea that the stock market is the one exception to the general rule that price discipline is what makes markets work. Disclosure: None.