Advisor Blog

A recent New York Times article by Tara Siegel Barnard titled "Why Panic? A couple's Nest Egg Better Left Alone" discusses the experience of a typical retired couple during the market plunge of 2008-2009.  It makes a number of good points and it is particularly interesting to us because the retired couple in the article are the parents of a long-time friend and colleague at DFA, Mark Gochnour.  Mark was the guy who happened to answer the phone when I first called DFA a dozen or so years ago. 

Among other things, the article discusses the importance of disciplined savings, choosing a portfolio with characteristics that fit within your risk tolerance, and being able to draw income from stable high-quality bond funds during periods of stock market stress.  At a conference a couple of weeks ago, I got to see how some planners have referred to this as the portfolio's "liquidity ratio", to borrow a term from balance sheet analysis.  Essentially, this is how many years of expenses can be covered without selling equity positions in the portfolio.  For retirees that choose to work with us for financial planning/wealth management, this is typically many years - more than enough time for the stock market to recover from even a serious decline. 

“It is really the simple things that I call the blocking and tackling of investing,” Mr. Gochnour said. “And you have to stay disciplined and stick with your plan, not only in good times but in more challenging times as well."  As the author points out, it also helps to turn off the television.

The past year reminded investors that they should hope for the best, prepare for the worst, and be thankful when reality does not match their fears. Investors entered 2011 with hopes that the world economy would continue recovering from a long and painful deleveraging process. Equity markets had posted two straight years of positive performance, central banks remained committed to pro-growth monetary policy, and major developed nations were focused on reducing debt.

Another great article from Weston Wellington at DFA in his "Down to the Wire" column:

Equity investors around the world had a disappointing year in 2011 as thirty-seven out of forty-five markets tracked by MSCI posted negative returns. The US did well on a relative basis and was the only major market to achieve a positive total return, although the margin of victory was slim. Total return for the S&P 500 Index was 2.11%, and the positive result was a function of reinvested dividends—the index itself finished the year slightly below where it started.

Led by the excellent performance of US stocks, global equity markets posted strong returns in the quarter. Those returns, however, were not sufficient to overcome a dismal third quarter and most markets had negative returns for the year.

• Quarterly returns for the broad US market, as measured by the Russell 3000 Index, were 12.12%. Asset class returns ranged from 15.97% for small cap value stocks to 10.61% for large cap growth stocks. The strongest sectors in the quarter were energy and industrials, while the weakest one was telecommunication services. For 2011, the strongest sectors were utilities and consumer staples, while the weakest ones were financials and materials. Value outperformed growth in the quarter, but not in 2011.

• In US dollar terms, the quarterly returns for developed non-US markets were over 3%, above the historical average but far behind the US. For 2011, however, developed international markets as a whole lost over 12%. As in most of the past few quarters, there was much dispersion in performance at the individual country level. Greece, which remains at the center of Europe’s sovereign-debt woes, was by far the worst performer in the quarter and the year. At the other end of the spectrum, Ireland, the Scandinavian countries, and Australia were the top performers for the quarter.

• In US dollar terms, emerging markets gained about 4% in the quarter, in line with the historical average, but not enough to overcome their very poor performance of the third quarter. As a result, emerging markets lost almost 20% in 2011. Malaysia and other smaller emerging markets in Asia and Latin America such as Thailand and Peru posted double-digit returns in the quarter. At the other end of the spectrum, India, Turkey, and Egypt had double-digit negative returns in the quarter. 

In a prior article, we discussed the role of fixed income in a portfolio and the performance of our fixed income allocation during periods of stress in equity markets.  The fixed income portion of our portfolios has continued to do exactly what it is designed to do - limit volatility at the portfolio level.

There are several factors that we take into account when selecting a fixed income strategy that work together to insure that it serves this purpose.  First, we keep the duration short - that limits the volatility due to interest rate changes.  Next, we keep the credit quality extremely high - almost all in the upper half of the investment grade range.  This limits volatility due to credit/default risk.  We diversify globally to limit risk from exposure to any particular economy.  In each economy, we only take on term risk when the yield curve is positive and there is enough additional return for assuming that risk.  No decisions are made based on forecasting of interest rate changes.  Statistically, short-term high credit quality fixed income has a very low or negative correlation with equities.  This means that they tend to move "out of sync" with each other - exactly what you'd want to see when equities are performing poorly.  Finally, we hedge out exposure to foreign currencies.

Why does it usually make sense to hedge foreign currency risk in global bond allocations?  Remember that the purpose of the bond allocation is reduction in portfolio volatility.  Exposure to foreign currency risk in the global bond holdings would add volatility.  It's relatively inexpensive to eliminate currency risk by purchasing rolling one-month forward currency contracts.  In addition, exposure to currency risk has no expected rate of return.  Currencies simply fluctuate when measured against the value of each other and there is no evidence that these fluctuations are predictable.  When a particular currency is under pressure, as the Euro has been lately, hedging away currency risk pays off.

We typically use a combination of DFA's global fixed income funds to achieve this, although we may use other funds in portfolio designs for some clients that have specific goals/needs.  DFA won the award for best fixed income funds from Investment News in 2008 during the previous period of extreme equity market stress.  The strategy has worked very well during the most recent volatile period in the equities markets, too. 

What is the best signal for investors worried about the risks posed by investing in sovereign bonds? Does one look at the relative size of countries' debt, the nature of their borrowings or their credit ratings? Or is the market itself the best guide?

With the strained balance sheets of governments in the Europe and US the focus of so much media and market attention in recent times, it is understandable that investors would fret about the risks of putting their money into sovereign bonds. Alongside the sheer size of the liabilities being accumulated by many governments, the often reckless behavior of politicians of all stripes on either side of the Atlantic in seeking to deal with these policy issues hardly inspires confidence.

For example, how does a country like France, with total government debt of nearly 70 per cent of its economic output, maintain a top tier 'AAA' bill of health from all the major credit rating agencies—Moody's, Standard & Poor's and Fitch?

Correspondingly, how does a country like Japan, with an even bigger proportionate debt load (184 per cent of GDP) than beleaguered Greece (148 per cent), maintain a superior credit rating (AA/AA–) to the junk paper of the Greeks (CCC/CC)?

And how does the United States—supposedly the safest of all safe havens—hold a AAA/AA+ credit rating when it has the biggest nominal debt load of any country at nearly $US15 trillion or just over 60 per cent of its economic output?

So what should we pay attention to: The nominal debt, the proportionate load, the interest bill or the credit rating? And if we decide the credit rating is the best guide, whom do we believe: Moody's, S&P or Fitch? For instance, while S&P recently downgraded the US to AA+ with a negative outlook, Fitch later confirmed the US as AAA. It's confusing, isn't it?

Listening to the Market

But there is an alternative, and that is the market price. Specifically, there is a very large market in a form of derivatives called 'credit default swaps' or CDS. These are a form of insurance policy that some investors take out against a loan default. There are CDS for corporate borrowers and for sovereign borrowers. This very liquid market serves as a useful guide to how the market views the relative risk of default among various sovereign borrowers. And it is clear that risk as judged by the market and the risk as judged by credit rating agencies are not necessarily the same.

For example, seven months before it defaulted in 2008, Ecuador was rated 'BBB' by Standard & Poor's. Yet, its bonds were yielding around nine percentage points above those of US Treasury bonds, which implied a risk associated with a 'CCC' rating, according to a report by the International Monetary Fund. And, this isn't a one-off quirk. Chart 1 below maps the prices of credit default swaps (the vertical axis) for 26 different sovereign borrowers (the horizontal axis). Marked against the individual chart points are the average credit ratings—based on the three major agencies—for the individual countries.

Broadly speaking, the higher the price of default insurance for each sovereign borrower, the greater the market sees the risk of investors not getting their money back.

Not surprisingly, the most expensive CDS—as of August 2011—were those for Greece, which also happened to be the lowest rated country in this sample. The least expensive CDS were for Norway, a AAA-rated borrower with a low debt burden. So far, so good.

But now look at the US, which was downgraded by S&P, but whose cost of default insurance was lower than that of France, which maintained a AAA rating at time of writing. Or compare Mexico, with the lowest investment grade rating of 'BBB', whose default insurance actually cost less than AA-rated Spain.

The point of this is that the market believes the US, while fiscally challenged, retains sufficient flexibility to raise funds if needed. On the other hand, some of the European borrowers—locked into the monetary settings and debt constraints of the European Union—were seen by the market as having less flexibility.

Now look at the second graphic, Chart 2, below. This charts the total debt-to-GDP ratios (vertical axis) of seven countries in our sample with the price of their individual credit default swaps (horizontal axis).

Again, Greece was the most expensive country to insure and Norway the cheapest when we took this snapshot. But then look at Japan, whose total debt in proportionate terms is the highest of them all, but whose CDS were only marginally more expensive than those of Chile (the least indebted of all the nations in our sample). Incidentally, Australia—also one of the least indebted sovereigns in the developed world—was judged by the market as actually a higher credit risk than the US.

So, which offers the best signal: the credit rating agencies, the economic fundamentals or the market? The answer to that question is that no one knows for sure, because no one has found a way of correctly and reliably forecasting the future. But in pricing risk, it is usually better to give greater weight to market signals—if for no other reason than the price represents the combined wisdom of millions of market participants staking real money on the outcome.

While credit ratings and debt-to-GDP ratios are important, the market ultimately judges sovereign risk on both the perceived ability of sovereign borrowers to find new sources of revenue as needed and the perceived willingness of those borrowers to repay.

So while the US undoubtedly is stretched, it is perceived by the market as having the capacity to fund its liabilities relatively easily through tax increases and/or additional spending cuts. It also has the advantage of being able to borrow in its own currency in capital markets and is less reliant than the Europeans on bank funding. Markets incorporate all these pieces of information—economic variables, credit ratings, risk perceptions, willingness to pay—and put a price on them.

Sovereign risk is called as such because it is a risk, like any other. Countries can and have defaulted. As recently as 2010, Jamaica defaulted on its debt. Others to default in the past decade have included Ecuador (2008), Belize (2006), Dominican Republic (2005), Uruguay and Nicaragua (2003), Moldova (2002) and Argentina (2001).

Summary

The way to deal with those risks are the tried and true methods of working with the market, diversifying broadly, taking risks only when there is a demonstrated reward for doing so and basing one's strategy on a long-term, scientifically proven research and a consistent philosophy.

The size of a country's debt—both in nominal and proportional terms—is one input to this process, as is its credit rating. But also important is the market's perception of a country's ability and willingness to raise new revenues, reduce outlays and pay back its debt. Ultimately, all this information is reflected in market pricing.

I read a great article last week that was written by an active manager about different portfolio management strategies and his opinions about them.  It was particularly interesting to me to read what he thought about what is, essentially, our strategy:

A passive investment strategy has been promoted as an intelligent strategy for two reasons. The first is that the strategy acknowledges that markets are relatively efficient and that it's very difficult to consistently price assets more effectively than the market mechanism. The second reason flows from the first: The significant costs associated with asset value analysis and the active management of an investment portfolio (management fees, transaction costs, etc.) make it even harder to outperform the returns obtained by passively accepting market prices.

He's exactly right, so far - and, he goes on to say:

Contrary to popular belief, the fatal flaw with this paradigm is not that it assumes that markets are relatively efficient. If anything, this assumption constitutes a great advantage of this investment strategy. For it would be quite absurd indeed to assume that the average individual (or portfolio manager) will consistently be able to price assets more effectively than the market mechanism. And it is a mathematical impossibility for the majority of people to outperform the overall market.

So, now he has admitted that the underlying methodology is correct, but let's examine his conclusion:

The problem with the passive investment strategy derives from an entirely different aspect of human nature that is distinct from analytical capacity: emotions. Constant exposure to markets means that passive investors will be subjected to intermittent episodes of hair-raising volatility. And the fact of the matter is that very few have the sort of emotional makeup that would allow them to sustain such a strategy over time.

The herding instinct is powerful. Very few individuals are emotionally equipped to stay the course and hold their positions -- much less buy -- when everyone around them is selling in a panic. The strategy of passive investing may be theoretically sound on its own terms. However, in practice, it tends to fail because most people are emotionally unable to sustain it.

Fortunately, our experience has been quite different. Why?  I think that there are several reasons, but the most important is that we use a process of measuring a client's risk tolerance and constructing a portfolio that adds high quality short duration global fixed income to the equity allocation.  This very effectively dampens the portfolio volatility to a level that the client should be able to tolerate.  In addition, we do our best to educate clients about what they should expect from capital market behavior.  And, looking back over the past 10 years, our portfolios have achieved outstanding risk adjusted rates of return for clients that stayed the course - even through two major rough spots in the market (2000-2002 and 2007-2009). 

The current renewed volatility in financial markets is reviving unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good.

At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets.

So, developed world equities, oil and industrial commodities, emerging markets, and commodity-related currencies like the Australian dollar are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold, and Swiss francs.

It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.

As to what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.

• Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor's of the US government's credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.

• Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that's another way of saying expected returns are higher. And while the media headlines proclaim that "investors are dumping stocks," remember someone is buying them. Those people are often the long-term investors.

• Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive of months of gains totalling almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

• Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.

• Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving. A globally diversified portfolio takes account of these shifts.

• Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.

World Economic Outlook, IMF, April 2011.

Last week we came across an "Economic and Policy Watch" update prepared by a major investment bank that reviewed recent government proposals to address the nation's funding crisis. Titled "It Just Gets Worse," the report chided policymakers for actions that "look like a poor cover for loose money, rising inflation, and fiscal problems," and warned that "government financing needs are corrupting monetary policy." As a result of these ill-advised tactics, the bank had turned "more negative" on the outlook for financial stability and saw "little hope of improvement in the inflation/currency mix."

Amidst the barrage of news coverage from dozens of sources probing the US debt/default/downgrade issue, such a conclusion might seem unremarkable. We found it of interest because the focus of the report was not the US Treasury but the government of Indonesia, and it appeared over a decade ago, on July 16, 2001.

Indonesia's sovereign debt rating at that time placed it firmly in the "junk" (non-investment grade) category: B3 from Moody's and single-B from Standard & Poor's. Although Moody's upgraded Indonesia to a B2 rating in 2003 and to Ba1 in early 2011, at no time over the past decade was Indonesia deemed to merit an investment grade rating.

What has been the experience of equity investors in Indonesia since this report was published? The Jakarta Composite Index closed at 415.09 on January 16, 2001, while the Dow Jones Industrial Average finished that day at 10,652.66. On Wednesday, the Jakarta Composite closed at 4,087.09 and the Dow at 12,592.80. If the Dow Jones Average had kept pace with Indonesian stocks over the past decade, it would be over 104,000 today.

Investors in Indonesia have had their share of ups and downs over the years, and markets fell even harder than the US during the financial crisis, with a peak-to-trough loss of nearly 60%. But the recovery was sharper as well: The Jakarta Composite recouped all of its losses by April 2010, and the all-time high on July 22 this year was 45% above the high-water mark of early 2008.

For the ten-year period ending June 30, 2011, total return as computed by MSCI was 29% per year in local currency and 33% in US dollar terms. At no point throughout this period did Indonesia have an investment grade rating for its sovereign debt, and outside observers continue to find fault with the country's troublesome level of corruption, primitive infrastructure, and unpredictable regulatory apparatus.

We are not suggesting that investors should dismiss the effects of a US government credit downgrade. US Treasury securities are so widely held around the world that any potentially destabilizing event is worrisome. Nor are we suggesting that investors focus solely on countries with low credit ratings. Just as a broadly diversified portfolio includes companies with high and low credit quality, investing in countries with both high and low ratings is equally sensible.

Some might say the strong performance of Indonesian stocks over the past decade was at least partly attributable to the nation's improving credit profile, even if it remained at a relatively low level. The US, in contrast, appears to be deteriorating. Our point is that a low credit rating in and of itself is not necessarily a death sentence for equity investors. Citizens of triple-A countries behave much like those living in single-B territory—they eat, drink, shop, get stuck in traffic jams, chatter on mobile phones, and check their Facebook pages. (Indonesia claims the second-largest number of members in the world.) Companies doing business in either location generate cash flows, and investors do their best to evaluate what those cash flows are worth. A triple-A sovereign debt rating is no guarantee of superior equity market returns, and a "junk" rating is no assurance of failure. A diversified strategy will have exposure to both.

Ray Farris, "It Just Gets Worse," ING Barings Economic and Policy Watch, January 16, 2001.

"Global Credit Research," Moody's Investors Service, March 2004.

"Missing BRIC in the Wall," Economist, July 21, 2011.

Securities data provided by Bloomberg.

Yahoo! Finance, finance.yahoo.com (accessed July 25, 2011).

We frequently hear from investors that want to know why we prefer to use bond funds instead of purchasing individual bonds.  Usually, it's about the concept of holding the individual bonds to maturity in order to know the rate of return and be assured of not losing money.  In reality, however, there is a lot more to the decision and there are some significant benefits from investing in a bond fund.

First, let's consider how bonds fit into our asset allocation.  We view bonds as volatility reducers and not as income generators.  Our portfolios are designed for efficent total return and utilize a variety of investments that have varying degrees of correlation with each other.  By adjusting the asset allocation, we create a portfolio that has volatility characteristics that coincide with an investor's risk tolerance.  The majority of our clients have long time horizons and are most concerned with maximizing growth, so it is appropriate for their portfolios to have a significant allocation to equities.  These portfolios have very good long-term return potential, but will exhibit short-term periods of extreme volatility (it's a common lament in the world of financial economics that "there is no free lunch" - in other words, you can't have a high rate of return with low volatility).  Investors with high risk tolerance, a long time horizon, or both are willing to endure the volatility in order to achieve a high rate of return over time.

But, not everyone is well-suited for a volatile portfolio, even
though it may maximize expected return.  Some investors must rely on their portfolio to supply their living expenses or to meet a large financial obligation in the near future and a short-term drop in the value of their portfolio could be harmful.  These investors generally choose to have a greater allocation to bonds because bonds are much less volatile than equities.  From a practical standpoint, creating an income stream from the entire asset allocation with regular rebalancing of the portfolio meets the client's withdrawal needs.  The total return approach also shifts a meaningful portion of the tax liability to long-term capital gains (which are taxed at a lower rate than interest income), creating increased tax efficiency. 

A common myth about owning individual bonds is that you don't have to worry about losing money or having the bonds depreciate.  As usual, the truth is more complicated.  All bond prices move in response to changing interest rates, credit conditions and other variables.  It's quite possible for a long-term bond's price to drop by a couple of percentage points on a really bad day.  If you need to liquidate that position, you would suffer a capital loss.  Of course, if you plan to hold the bond to maturity, this short-term decline would not be an issue.  But, this only matters if you assume that the distributions from the portfolio must be generated from investment income and not from total return.  More often than not, the appearance of added safety is a function of not looking at the value of the bond over time, whereas bond mutual fund prices are calculated every day.  In reality, bond funds benefit more quickly from the higher prevailing yields that create a price decline.  So, although you may not have a simple and easily defined terminal value to expect, the evidence shows that bond funds will likely outperform individual bonds or a laddered portfolio of bonds over longer time periods.

Bond funds also provide superior diversification, more efficient reinvestment of interest payments, transaction cost advantages, and the ability to dynamically manage term and/or credit risk.  Owning the right bond funds can also be very inexpensive.  The funds that we use for most portfolios have expense ratios of less than 0.25% per year versus the 0.72% average for bond funds.¹

So, if laddered portfolios of individual bonds are not preferable to owning a bond fund, why do most of the salespeople at Morgan Lynch Barney BS Fargo Jones & Company do it?  Because it makes it look like they are doing something that adds value.  It doesn't really matter if it actually does or not.  Like far too many things in this business, it's all about creating a perception instead of about doing what's right for the client.

1. ICI Research Perspective, March 2011

The recent spate of bad economic news seems to have caused a sudden reversal in the average investor's appetite for risk.  Fund flows into bond mutual funds have returned to the same levels that we saw last year.  According to The Economist, "in the week ending on May 18th bond funds collectively recorded their largest inflows since late October 2010".

A couple of months ago, I was constantly hearing from people that were worried about their bond portfolios and the effect of rising interest rates, usually in response to something that they had heard on CNBC or read in the financial media.  Two things are pretty clear.  First, most investors don't really understand the relationship between bond prices and yields or what makes a bond portfolio more or less sensitive to interest rate changes.  Second, most investors don't understand the right way to use bonds in constructing a portfolio.

Bond prices and bond fund share values decline as interest rates rise.  This inverse relationship is easy to understand.  Think of it this way.  If you own a bond that pays an interest rate of x and there is a new bond issued with similar credit and term characteristics that pays an interest rate of more than x, then who would pay the same price for the bond you own that pays a lower interest rate?  The price of the bond has to be discounted to a point that the buyer would realize the same return as the newly issued bond.  Thus, the price of existing bonds falls as interest rates rise.  But, by how much?  The sensitivity of the existing bonds, or bond portfolio, to interest rates is determined by the duration (technically, the "modified duration") of the bond or portfolio.  Duration is a calculated number and it is based on many factors, but the most important is the remaining time (number of coupon payments) until maturity.  Lower duration bond or bond funds are less sensitive to interest rate changes.

As duration increases, so does the volatility of a fixed income position or portfolio.  At some point, it approaches the same level of volatility that we observe in equity portfolios.  But, and this is an important point, without the same rate of return.  So, chasing yield in the bond allocation of a balanced portfolio does two bad things - it increases risk and increases correlation with equities.  There is a good chart on page 27 of the Talis Investment Philosophy presentation that illustrates this concept. 

Credit quality also matters.  During the equity market meltdown in 2008, we saw many portfolios designed by competitors that contained allocations to high yield (aka "junk") bonds that had suffered almost as much as equities.  All the while, our fixed income portfolio was delivering positive returns, offsetting losses in equities exactly as it was designed to do. 

So, the lesson is pretty simple.  Short-term and high credit quality fixed income does a good job of dampening the volatility of a portfolio and allowing risk to be taken in asset classes with more efficient return characteristics.  How much risk is appropriate in the fixed income allocation and how it's managed are subjects for a future article.  And, what about the "bond bubble" that now seems to be forgotten with the recent round of lackluster economic news?  No doubt, most investors will be worrying about it again at some point in the future. 

Dalbar is an independent research firm that evaluates mutual fund investor returns on an annual basis.  The research uses data from the Investment Company Institute (ICI), Standard and Poor's and Barclays Capital Index Products to compare mutual fund investor returns to an appropriate set of benchmarks.  The annual Quantitative Analysis of Investor Behavior (QAIB) covers the time period ending December 31, 2010.

For the 17th year in a row, the study shows that both equity and fixed income investors underperformed the broad indices.  For 2010, equity investors trailed the S&P 500 by almost 1.5% and fixed income investors underperformed the Barclays Aggregate bond index by more than 3.5%.

Why do average investors underperform broad indices by such significant amounts?  The primary reason is investor behavior - reacting to market movements and news results in never staying invested long enough to derive the benefits of a long-term strategy.  Retail investors, in particular, tend to abandon investing at the most inopportune times, often in response to bad news or market corrections.

Behavioral finance experts have identified psychological factors that help explain why investors often make buy and sell decisions that contradict best practices.  These include:

• Loss aversion – expecting high returns with low risk.  Searching for investments that don’t exist, resulting in taking no action or selling at an imprudent time.

In order to achieve desirable results, investors must manage the behaviors that destroy long-term success.  Working with an advisor can often be helpful in this regard.  It is also important to understand your risk tolerance and construct a portfolio that does not exceed the level of volatility that you are comfortable with.  Taking excessive risk often leads to decisions to exit the market at exactly the wrong time. 

One of my clients sent me a New York Times article from last Sunday's front page in which Charles Biderman, chief executive of a funds research company, stated that "people have lost a lot of money over the last ten years in the stock market, while there has been a bull market in bonds."

It is ce
rtainly true that a lot of people did lose money in the stock market over the past ten years.  In fact, if you invested a dollar in the S&P 500 on August 1, 2000 that dollar would have been worth about 93 cents as of the end of July 2010.  And, that's assuming you could invest in the index at no cost.  This certainly seems to support the conclusion that the stock market has had a "lost decade."  But, what happens when we take a closer look?

What if you had invested in a globally diversified portfolio of stocks in a portfolio that emphasizes exposure to value and small cap companies?  That's exactly what our Talis 100 equity portfolio does.  So, how did it perform over the same time period?  The dollar that you invested on August 1, 2000 would be worth $2.13 and that's after all of the fund expenses and the highest advisory fee that we charge.  This also assumes that all distributions are reinvested.

So, what if you had been prescient enough to have gotten out of the stock market on August 1, 2000 because you somehow saw this coming?  And, what if you had taken advantage of the "bull market in bonds" by investing in an intermediate bond index?  Again, assuming that there are no costs involved in doing this, a dollar invested in the Lehman (now Barclay's) corporate/government intermediate bond index would be worth $1.81.  We should also point out that most bond funds failed to beat this index.

So, why does the New York Times fail to mention any of this?  First, the media always feels the need to "dumb down" any analysis.  Apparently, they don't think that their readers are capable of understanding a more informative article.  And, it's easy to write a story that makes a very simple point - stocks are risky and dangerous, bonds are safe!  Considering the attention span of many readers, that might be right.  However, for investors that understand capital market behavior and the factors that actually contribute to returns, the past decade has been a very different experience.

To learn more about the performance of the Talis portfolio series, see comparisons to benchmark indexes, and access disclosure information click here.

With interest rates near historical lows, some investors may be anxious about a possible rate climb and its potential impact on their fixed income investments. Rising interest rates typically cause existing bonds to lose value. While investors might hold short-term instruments to manage this risk, an interest rate decline could spoil this strategy by forcing investors to reinvest in lower yields when their short-term instruments mature.

Rate movements in either direction affect portfolio returns. This is true in any market environment, regardless of the current rate level. The larger question is how to manage the risk. As you read the financial headlines and evaluate your current fixed income exposure, it may be helpful to consider these principles about fixed income investing:

Interest rate movements are unpredictable.

Academic research offers strong evidence that the bond market is efficient, and that bond prices and interest rates are not predictable over the short term.¹ This uncertainty is reflected in the often-contradictory interest rate forecasts offered by economists, analysts, and other market watchers.²

Even when the experts share similar views on the direction of the economy and credit markets, reality often proves them wrong. Last year’s Wall Street Journal forecasting survey offers a recent example.³ Among fifty economic forecasters surveyed in 2009, forty-three expected the ten-year US Treasury note yield to move higher over the next year, with an average estimate of a 4.13% yield. Only two respondents predicted rates to fall below 3.00%. The ten-year Treasury yield slumped to 2.95% on June 30, 2010, and rates on thirty-year mortgages fell to their lowest level since Fannie Mae began tracking them in 1971.

Today’s bond prices already reflect expectations for tomorrow’s business conditions and inflation, and these expectations can change quickly in response to new information. This new information is unknowable. Investors who accept market efficiency should not be surprised when the credit markets foil the experts. If prices were easy to forecast, you should find a host of fixed income managers with market-beating returns. But most of them underperform their respective benchmarks over longer time periods.⁴

Since no one has a reliable method for determining whether interest rates will rise or fall in the near future, investors should avoid making fixed income decisions based on a forecast, media coverage, or their own hunches.

 Pursuing higher expected returns requires more risk taking.

The strong link between risk and return appears in all properly functioning capital markets. When investing in stocks, bonds, or other assets, investors must accept more risk to pursue a higher potential return.

In the fixed income markets, earning a return above short-term government instruments is usually a function of assuming more term and credit risk. Term risk refers to a bond’s maturity, and credit risk refers to the creditworthiness or default potential of the borrower. Bonds with longer maturities and lower credit quality are usually considered riskier and have offered higher yields and returns to compensate investors for higher risk.

On the term side, investors who commit their capital for longer periods of time are exposed to the amplified effects of changing interest rates. Bond prices and interest rates move in the opposite direction: When rates rise, the value of an existing bond declines; when rates fall, bond values rise. The market adjusts the price to match the yield available on a new instrument. The longer the bond’s maturity, the greater the price adjustment for a particular interest rate change. A long-term bond is more exposed to rate changes than a short-term instrument, and usually (but not always) offers a higher yield to compensate investors for the extra risk. Also, lower-coupon bonds are more affected by interest rate changes than higher-coupon bonds. For example, if rates move 1%, a bond that pays 3% will experience a greater gain or loss than one paying 5%.

On the credit risk side, the government is considered the strongest borrower in the market, so it has a lower cost of capital relative to other issuers. The most creditworthy companies are considered relatively safe, but they must still offer a higher rate than the government to compensate investors for taking more default risk. The weaker a corporate borrower’s financial condition, the more it must pay in yield to attract investors. Investors seeking higher returns on the credit spectrum must bear a higher risk of default.⁵

Investment strategy should drive fixed income decisions.

Investors may hold fixed income securities for a variety of reasons—for example, to reduce portfolio volatility, generate income, maintain liquidity, pursue higher returns, or meet a future funding obligation. Each objective may involve a different portfolio approach, or a combination of strategies to manage tradeoffs. For example, investors who want to maximize current income may not be strongly concerned with the effects of short-term price volatility. They may extend maturity or accept slightly lower credit quality when the market offers a yield premium for doing so. On the other hand, investors seeking long-term wealth appreciation may commit most of their portfolio to equities and keep their fixed income investments short term and high quality to buffer the volatility of stocks.

Regardless of your approach, you should know the difference between controlling risk and avoiding it. You cannot eliminate risk, but you can manage your exposure by diversifying across maturities, industries, countries, and currencies to reduce the impact of rates, inflation, currency fluctuations, and other risks. Your decision to take more term and default risk may depend on the current state of the yield curve and credit spread.

Many factors influence the direction of interest rates and performance in the bond markets, and these are too complex for anyone to reliably predict. Rather than placing your faith in the experts or reacting to economic news, manage your fixed income component from a portfolio perspective. Your strategy should reflect your overall investment goals, risk tolerance, and other personal financial considerations. This is a solid approach to managing your portfolio in an uncertain interest rate market.

Endnotes

¹ Eugene F. Fama, “The Information in the Term Structure,” Journal of Financial Economics 13, no. 4 (December 1984): 509-528. Also: Robert R. Bliss and Eugene F. Fama, “The Information in Long-Maturity Forward Rates,” American Economic Review 77, no. 4 (September 1987): 680-692.

² Mark Gongloff, “Two Treasury Forecasts: a Grand Canyon-Size Gap,” Wall Street Journal, April 10, 2010.

³ Wall Street Journal Forecasting Survey, www.wsj.com, accessed July 7, 2010.

⁴ Christopher R. Blake, Edwin J. Elton, and Martin J. Gruber, “The Performance of Bond Mutual Funds,” Journal of Business 66, no. 3 (July 1993): 371-403. Also see Standard & Poor’s Indices Versus Active (SPIVA) Scorecard for the US, Canada, Australia, and Europe (http://www.standardandpoors.com/indices/spiva/en/us).

⁵ The yield curve plots the current relationship between rates and maturity, and the credit spread plots the risk-return relationship across the range of credit qualities. The curves offer a current snapshot of how markets are pricing term and credit exposure.