Tag Archives: portfolio-strategy

Indexing Doesn’t Win When It’s Implemented Via A High Fee Advisor

I’m a big advocate of indexing strategies because they’re low fee, tax efficient and diversified approaches to allocating one’s savings. But I see a worrisome trend in the asset management business – high fee advisors endorsing low fee indexing and selling it as something different from “active” management. We should be very clear here – these high fee advisors are not much different than their high fee active brethren. The asset management business has experienced a huge shift in the last 10 years. Trillions in fund flows have moved from high fee mutual funds into low fee ETFs and index funds. The evidence behind low cost indexing has become virtually irrefutable at this point. You don’t get what you pay for.¹ In fact, in many cases you get what you don’t pay for. Unfortunately, as fund fees have declined the average management fee at the advisor level has remained relatively high. Over the last 10 years we’ve seen a huge shift in the way asset management firms generate revenue. As mutual funds grew in popularity in the 90’s many of these firms used to charge commissions or advisory fees (usually in excess of 1%) and the fund company charged you an expense ratio on top of that (also 1% or more). Most investors in a mutual fund housed at a big brokerage house were seeing 2% or more of their total return sucked out in fees. Investors in a closet index fund housed at a discount broker were still seeing a 1%+ drag on their returns. As the indexing revolution has swept over these firms the high fee closet indexing mutual funds have been increasingly swapped out for the low fee index funds. But the high fees are still there. They’re just lower high fees than the outrageous 2%+ fees that were once there. Unfortunately, what we’re seeing across the business today often involves an advisor who charges the same 1%+ fee that the mutual fund charged, but they’re selling it within the “low fee indexing” pitch. So, what you actually end up owning is a low fee indexing strategy wrapped inside of a high fee asset management service. In other words, you end up with a fee structure no different than the investor who owns the high fee mutual fund in their own discount brokerage account. The chart above shows the impact of a diversified portfolio with an average annual return of 7% in a low fee index relative to the same portfolio with a 1% and 2% fee drag. Over the course of 20 years your $100,000 investment is a full 40% lower after the 2% fee drag and 18% lower with the 1% drag. In other words, over a 20 year period you’re handing over upwards of $100,000 for a service that is now being done by truly low fee advisors like my firm, Vanguard, Schwab and the Robo advisor firms. It’s true, as Vangaurd has noted , that a good advisor can contribute up to 3% per year in added value, but in a world of low cost “good” advisors you should still be cognizant of the cost of an advisor. And to be blunt, this 1% fee structure is an antiquated fee structure and it won’t continue. To be even more blunt – investors should be revolting against it given their options. We can’t control the returns we’ll earn in the financial markets. But we can control the taxes and fees we pay in those accounts. As the investment landscape shifts and you review your 2016 finances don’t find yourself in a backwards service paying high fees for something that is now being done by a multitude of firms in a truly low fee structure. ¹ – Shopping for Alpha – you get what you don’t pay for , Vanguard

Do Historical Comparisons Matter? Strong Similarities Between 1937 And 2015

The case for the continuation of the U.S. bull market heavily rests on the shoulders of steady economic growth and low interest rates (on an absolute basis). Many believe that, as long as these circumstances exist, stocks will provide venerable results. Market participants might want to consider a similar period in history – a time when the 10-year Treasury offered paltry yields, GDP grew at a reasonable clip and the Fed tightened monetary policy. The case for the continuation of the U.S. bull market heavily rests on the shoulders of steady economic growth and low interest rates (on an absolute basis). Many believe that, as long as these circumstances exist, stocks will provide venerable results. However, market participants might want to consider a similar period in history – a time span when the 10-year Treasury offered paltry yields, gross domestic product (GDP) grew at a reasonable clip and the Federal Reserve tightened monetary policy. In late 1936, GDP had been growing steadily and the 10-year yield averaged 2.6%. The Fed chose to modestly compress the money supply after years of extraordinary stimulus. Indeed, the 1929-1932 “Great Depression” seemed as though it had been been vanquished. Unfortunately, by the second quarter of 1937, investors became alerted to signs of economic deceleration. Risky assets began to falter. The Fed quickly reversed course from tightening to easing, even engaging in market-based asset purchases. To no avail. An insipid recession occurred in spite of the central bank’s rapid policy reversal. Before all was said or done – by the time the 1937-1938 bear had finally ended – stocks had already plummeted 51.5%. Here in 2015, we have experienced steady economic growth for six-plus years with GDP expanding at approximately 2.2% per year. It has been an anemic recovery, but an expansion nonetheless. ( Indications of economic deceleration abound .) Meanwhile, the U.S. stock bull has been remarkably robust, both in duration and magnitude. One researcher estimates that the current bull market period has been more powerful (since 3/09) than 90% of the preceding rallies since 1900. (See chart below.) Similar to the circumstances in late 1936, when the economy appeared relatively healthy, stocks performed admirably, and the Fed started to tighten monetary policy after a long hiatus, the 2015 Fed recently embarked on its first overnight lending rate hike. Those who ignore the similarities say that it is only 25 basis points; they believe that members of today’s Federal Reserve are smarter than their predecessors and that they would not endeavor to normalize borrowing costs unless the economy were strong enough to withstand the shift. Me? I am skeptical. Here are three additional similarities between 1937 and right this moment: 1. The Last Time Stocks, Bonds, And Cash Did Not Work . Asset allocation is not working . Granted, the iShares S&P 500 (NYSEARCA: IVV ) is up 3% through December 2009, with 1% coming on today’s (12/29) price jump and the rest of it coming from dividends. Yet the iShares Mid-Cap ETF (NYSEARCA: IJH ) that tracks mid-sized corporations in the S&P 400 logged -0.5% through 12/29 and the iShares Russell 2000 (NYSEARCA: IWM ) that tracks small-cap stocks registered -2.3% through 12/29. The more that one diversifies, the worse things get. Add foreign stocks via iShares All-World excluding U.S (NASDAQ: ACWX ) for -4.0%. Inject iShares High Yield Corporate Bond (NYSEARCA: HYG ) for -5.2%. Dare to emerge with Vanguard FTSE Emerging Markets (NYSEARCA: VWO ) for -14.7%. In fact, Bloomberg tracked 35 ETFs that invest in different asset types to uncover a median loss (-5.0%). Even the all-in-one solution via iShares Core Growth Allocation (NYSEARCA: AOR ), which offers 60% in stocks and 40% in bonds, served up a negative result (-0.7%). According to research compiled by Bianco Research LLC in conjunction with Bloomberg, you have to go back to 1937 to find a 12-month run where asset allocation performed as poorly. Coincidence? Could be. Or perhaps investors in 1937 struggled with the same concerns about a return OF capital as opposed to a return ON capital. 2. Overvaluation Then, Overvaluation Now . Nobel laureate in economics, James Tobin, proposed that the combined market value of all companies listed on the exchanges should be roughly equal to their replacement costs. He then developed the “Q Ratio,” which divides the total price of U.S. stocks by those replacement costs of corporate assets. Tobin’s Q hit 1.1 earlier this year, suggesting that stocks traded 10% above the value of companies’ assets. Not so bad? That reading has only been surpassed by the year 2000. Moreover, if one assumes the year 2000 was a moment of ridiculous dot-com euphoria, you’d have to go back to 1937 to find a reading that suggests similar overvaluation. Keep in mind, this ratio has only surpassed the 1.0 threshold on one-tenth of trading sessions, most of which occurred in the late 1990s. The average (mean) Q ratio is approximately 0.68. 3. “Spread Spike” For High Yield Bonds . Back in May of 1937, the high-yield bond spread rocketed 85 basis points. Here in 2015? We have two occasions where high-yield bond spreads have spiked by more than 1%. Normal market fluctuations? Hardly. When investors abandon the credit markets, they are concerned about a wave of corporate defaults. And they’re not just worried about energy defaults either. High yield corporate credit is struggling clear across all sectors of the economy. (See Bloomberg chart below.) Are the circumstances in 2015 identical to those in 1937? Of course not. Every well-read market participant recognizes that history has a habit of rhyming, not repeating. Nevertheless, keeping a higher allocation to cash than you might otherwise keep is sensible in this late-stage stock bull. Disclosure : Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Low-Risk Tactical Strategies Using Volatility Targeting

Summary In this volatility targeting approach, the allocation between equity and bond assets is varied on a monthly basis based on a specified target volatility level. Low volatility is the goal. Two strategies are presented: 1) a moderate growth version and 2) a capital preservation version. 30 years of backtesting results are presented using mutual funds as proxies for ETFs. For the moderate growth version, backtests show a CAGR of 12.6%, a MaxDD of -7.4% (based on monthly returns), and a return-to-risk (CAGR/MaxDD) of 1.7. For the capital preservation version, CAGR = 10.2%, MaxDD = -4.9%, and return-to-risk (CAGR/MaxDD) = 2.1. In live trading, ETFs can be substituted for the mutual funds. Short-term backtesting results using ETFs are presented. I must admit I am somewhat of a novice at using volatility targeting in a tactical strategy. But recently, the commercially free Portfolio Visualizer [PV] added a new backtest tool to their arsenal, so I started studying volatility targeting and how it works. Volatility targeting as used by PV is a method to adjust monthly allocations of assets within a portfolio based on the volatility of the assets over the previous month(s). In this case, we are only looking at high volatility equities and very low volatility bonds. To maintain a constant level of volatility for the portfolio, when the volatility of the equity asset(s) increases, allocation to the bond asset(s) increases because the bond asset has low volatility. And when the volatility of the equity asset(s) decrease, allocation to the bond asset(s) decreases. In PV, you can specify a target volatility level for the portfolio. Since I wanted an overall low volatility strategy with moderate growth (greater than 12% compounded annualized growth rate), I mainly focused on very low volatility target levels. I ended up using a monthly lookback period on volatility to determine the asset allocations because monthly lookbacks produced the best overall results. I quickly came to realize that high-growth equity assets are desired for the equity holdings, and a low-risk (low volatility) bond asset is preferred for the bond fund. In order to assess the strategy, I used mutual funds that have backtest histories to 1985. This enabled backtesting to Jan 1986. In live trading, ETFs that mimic the funds can be used. I will show results using the mutual funds as well as the ETFs. The equity assets I selected were Vanguard Health Care Fund (MUTF: VGHCX ) and Berkshire Hathaway (NYSE: BRK.A ) stock. Either Vanguard Health Care ETF (NYSEARCA: VHT ) or Guggenheim – Rydex S&P Equal Weight Health Care ETF (NYSEARCA: RYH ) can be substituted for VGHCX in live trading. BRK.A is, of course, a long-standing diversified stock. These two equity assets were selected because of their high performance over the years. Of course, these equities had substantial drawdowns in bear markets, something we want to avoid in our strategy. But in volatility targeting, as I have found out, it is advantageous to use the best-performing equities, not just index-based equities. Of course, it is assumed that these equities will continue to perform well in the future as they have in the past 30 years, and that may or may not be the case. For the low-risk bond asset class, I used the GNMA bond class. The selection of the GNMA bond class was made after studying performance and risk using other bond classes such as money market, short-term Treasuries, long-term Treasuries, etc. The GNMA class turned out to be the best. I selected Vanguard GNMA Fund (MUTF: VFIIX ) for backtesting, so that the backtests could extend to Jan 1986. There are a number of options for ETFs that can be used in live trading, e.g. iShares Barclays MBS Fixed-Rate Bond ETF (NYSEARCA: MBB ). Moderate Growth Version (CAGR = 12.6%) A moderate growth version is considered first. VGHCX and BRK.A are the equities always held in a 66%/34% split; VFIIX is the bond asset; and the target volatility is 6%. The backtested results from 1986-2015 are shown below compared to a buy and hold strategy of the equities (rebalanced annually). (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) It can be seen that the compounded annualized growth rate [CAGR] is 12.6%, the maximum drawdown [MaxDD] is -7.4% (based on monthly returns), and the return-to-risk [MAR = CAGR/MaxDD] is 1.7. There are three years with essentially zero or very slightly negative returns: 1999, 2002 and 2008. The worst year (2008) had a -1.6% return. The monthly win rate is 74%. The percentage of VFIIX varies between 1% and 93% for any given month. The Vanguard Wellesley 60/40 Equity/Bond Fund (MUTF: VWINX ) is a good benchmark for this strategy. The overall performance and risk of VWINX are shown below. It can be seen that the CAGR is 9.1%, while the MaxDD is -18.9%. These performance and risk numbers are quite good for a buy and hold mutual fund, but the volatility targeting strategy produces higher CAGR and much lower MaxDD. VWINX Benchmark Results: 1986-2015 (click to enlarge) Capital Preservation Version (MAR = 2.1) For this version, the target volatility was set to a very low level of 3.5%. This volatility level produced the lowest MAR. The results using PV are shown below. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) It can be seen that the CAGR is 10.2%, the MaxDD is -4.9%, and the MAR is 2.1. Every year has a positive return; the worst year has a return of +0.4%. The monthly win rate is 75%. Limited Backtesting Using ETFs To show how this strategy would play out in live trading, I have substituted RYH for VGHCX and MBB for VFIIX. The second equity asset is BRK.A as before. Backtesting is limited to 2008 with these ETFs and the BRK.A stock. The backtest results are shown below. (click to enlarge) (click to enlarge) The ETF results can be compared with the mutual fund results from 2008 to 2015. The mutual fund results are shown below. (click to enlarge) (click to enlarge) It can be seen that the overall performance over these years is lower than seen over the past 30 years. The CAGR is 9.7% from 2008 to 2015 for the mutual funds and 9.3% for the ETFs. Although this performance in recent years is less than earlier performance, it is still deemed acceptable for most retired investors interested in preserving their nest egg while accumulating modest growth. The good quantitative agreement between mutual funds and ETFs between 2008 and 2015 provides some confidence that using ETFs is a viable option for this strategy. Overall Conclusions The tactical volatility targeting strategy I have presented has good potential to mitigate risk and still provides moderate growth in a retirement portfolio. The moderate growth version has a CAGR of 12.6% and a MaxDD of -7.4% in 30 years of backtesting. The capital preservation version has a CAGR of 10.2% and a MaxDD of -4.9% over this same timespan. The return-to-risk MAR using target volatility is much better than passive buy and hold approaches, especially in bear markets when large drawdowns may occur even in diversified portfolios.