Tuesday, September 24, 2013

Just Say No To Fixed Allocations

I got a real interesting question the other day from someone who wanted to know if Utility stocks were a good thing to buy if you expected a market crash.  Basically, if the market is going to crash would utility stocks do less bad than other areas of the stock market.  In a world where people have fixed allocations to stocks regardless of what is happening in the market this is a great question.  If you have to be invested in the market it makes sense to find those areas that will be hurt the least in a market crash.  But, why do you have to be invested in the market?  If the market does crash, which it will eventually because it always does every once in a while, then why try to find areas that will lose the least?  The better idea is to get out of stocks entirely and into cash or Treasuries and wait until the market starts going back up.

I am seeing the same thinking in the bond market these days.  Everywhere you turn there are articles on areas of the bond market that will be hurt the least when interest rates rise.  I saw one article that recommended short term Treasury ETFs like iShares 1-3 year Treasury (SHY).  A quick look on CNBC.com shows that SHY is yielding .27%, that's not even worth the effort it takes to push the enter button to enter a sell order.  The question should not be which area of the bond market to get into, it should be if you are getting out of bonds what do you buy instead?

Saturday, September 14, 2013

Mutual Funds Try Hard to Hide One Statistic

An RIA we work with shared a short article about how mutual funds try very hard to hide their maximum drawdowns which then makes it impossible to calculate their MAR ratios.  Maximum drawdown is your maximum peak to trough loss.  For example, lets say you put $100 into a mutual fund in January, in August it was worth $200, and then in December it was worth $110.  You actually made money for the year, you started with $100 and ended with $110, but it doesn't feel like it.  In August you had $200 and in December you had $110, you had a $90 drawdown which was 45%.  We have long believed that risk should be measured by maximum drawdown, not nebulous figures like standard deviation, but I have never seen anywhere where you can find drawndown numbers on mutual funds.  We even subscribe to the most sophisticated analytic package Morningstar has, we can run over 500 statistics on mutual funds, but I have never seen it report on maximum drawdown.

Why don't mutual  funds want you to know what their maximum drawdowns are?  Because the numbers look ugly.  From October 2007 to March 2009 the S&P 500 had a 60% drawdown.  Since most equity funds don't beat the S&P 500 it stands to reason that many were much worse.  It is much better marketing for them to show risk measures like standard deviation because most people don't understand that anyway, but they do understand a peak to trough of 60%.

In evaluating any investment the maximum drawdown can be used to calculate the MAR Ratio.  The MAR Ratio is simply the average annual return divided by the maximum drawdown.  For the past 10 years ended 9/13/13 the S&P 500 has an average annual return of about 7.36% with a maximum drawdown of 60%, that gives us a MAR ratio of .12.  If you were evaluating an investment that could return 7.36% on average but could also drop 60% at any time you probably wouldn't take those odds.  MAR ratios should be 1 at a minimum, so if an investment had a 60% drawdown it should have a 60% average annual return.  Now you understand why mutual funds don't want you to know about maximum drawdown and MAR ratio.

Monday, September 9, 2013

How Is This News?

Investors Bet on Battered Emerging Markets

The WSJ ran a story this morning quoting some large emerging market funds who are bullish on emerging markets.  What would you expect them to say?  If investors want to invest with style box money managers that is their choice but don't let what they say about their investment sector sway you in any way.

Money does go where it is treated best and it hasn't been treated well in emerging markets this year.  That being said, if this rally continues then at some point the US is going to start looking overvalued vs. emerging markets and you will see them catch up.  If the rally doesn't continue then emerging markets could get hammered some more.

Tuesday, September 3, 2013

Your Goals Don't Matter Agility Does

If you have ever talked to a financial planner before the process usually goes something like this:

Step 1:  Determine your goals

Step 2: Determine your risk tolerance

Step 3: Create a portfolio, within your risk tolerance, that is designed to achieve your goals.

Step 4: Help you stick with your portfolio through periodic re-balancing and telling you to hang on during market declines.

This sounds fine in theory, you have a goal or goals that you want to achieve and if you can design a portfolio that will give you the best chance of achieving them then what is wrong with that?

What is wrong of course is that the market doesn't care about your risk tolerance or your goals, it will do what it is going to do.  For example, lets say it is the year 2000 and you are 55 and want to retire in 10 years.  Some simple math tells you that you need to average 10%/yr in your portfolio to reach your retirement goal.  Anyone can design a portfolio for you that would have returned 10% over the past 10 years but that is meaningless for what it is going to do over the next 10 years.  In fact, you probably would have reached 2010 with about the same amount of money you started with, if you were lucky.  So in effect you are getting an asset allocation that a financial planner is guessing might have a chance to earn 10%, you are re-balancing to that allocation, and being advised to stick with it during market downturns.  

Agility Is What Matters

Would you ever write a business plan and stick with it no matter what?  No.  New opportunities and new threats always pop up, your business plan needs to be constantly updated to keep up with reality.  Why would you ever design an investment plan and stick with it?  In the above example, since I have no way of predicting what mix of assets will return 10%/year the best solution is to earn as much as possible while taking a risk level that you are comfortable with.  This requires agility and the willingness to respond to new opportunities like Bull Markets, and new threats, like Bear Markets.