Elliott Management: We Make This Recommendation To Our Friends: If You Own US Debt Sell It Now

Wednesday, August 8th, 2012

Every now and then we prefer to sit back and let some of the smartest money speak, especially when said smart money agrees with us. In this case, we hand the podium over to none other than Paul Singer’s Elliott Management, which after starting with $1.3 million in 1977 was at $19.8 billion most recently. No expert networks, no high frequency trading, no “information arbitrage”, no crony capitalism and pseudo monopolies of scale, and most certainly no bailouts: Singer did it all the old fashioned way: by picking undervalued assets and watching them appreciate. The timing is opportune because while Elliott has much to say about virtually everything in their latest 20 pages Q2 letter, it is the billionaire’s sentiment vis-a-vis US Treasury debt that may be most critical, and may be the catalyst that resulted in today’s abysmal 10 Year bond auction. To wit: “long-term government debt of the U.S., U.K., Europe and Japan probably will be the worst-performing asset class over the next ten to twenty years. We make this recommendation to our friends: if you own such debt, sell it now. You’ve had a great ride, don’t press your luck. From here it is basically all risk, with very little reward.” There is little that can be misinterpreted in the bolded statement. And while many have taken the other side of the Fed over the past 3 years, few have dared to stand against Paul Singer because if there is one person whose opinion matters above most, certainly above that of the Chairsatan, it is his.

More deep thoughts from Elliott:

On QE and the nanny state:

• Printing money and overstaffing government offices may look like growth for a period of time, but it is actually the road to poverty, corruption and, ultimately, political upheaval.

On regulation:

• Opaque, overleveraged and vulnerable Financial Institutions which need to be propped up by the implicit or explicit guarantee of sovereigns does not make for a solid financial plumbing system for the global economy…this is a formula for power entrenchment, favoritism and shady deals behind closed doors.

On Dodd-Frank:

• Not only will it fail to make the system safer, but we believe it will likely be an actual accelerant of the next financial crisis
• Dodd-Frank was supposed to “fix” the American financial system and end “too big to fail.” Unfortunately, the law, born in a political steamroller, does the exact opposite: it will be the accelerant of the next crisis.
• The 2008 crisis was episodic and took a while to get rolling. The next one could well be a black hole, and Dodd-Frank will bear responsibility for that.

On why Americans are angry:

• The government, lacking deep understanding of these firms, wants to pretend that their gigantic efforts (most notably Dodd-Frank) actually fixed the situation. But we believe that citizens are angry at what their guts tell them (correctly, basically) about the special treatment and riskiness of Financial Institutions.

On public data reporting:

• Decades ago, the balance sheets of the Financial Institutions contained most of the information you needed to know to understand their risks. Today the picture is profoundly different, predominantly due to the growth of leverage through derivatives….As a result, there is no major Financial Institution today whose financial statements provide a meaningful clue about the risks of the firm’s entire panoply of assets and liabilities including derivatives, nor how the firm’s performance, or even survival, will be affected by market movements in the future.

On leverage:

• Including derivatives, nearly all the world’s largest Financial Institutions are levered 50-100 times (not 10-20 as reflected on their balance sheets), so the exact composition of their derivatives books is essential to an understanding of their risks and stability….no hedge fund is remotely as leveraged as the Financial Institutions, and no hedge fund actually had to be rescued during the crisis.

On European banks:

• European institutions are in worse shape than before. Not only is their leverage (including derivatives) still at pre-crash levels, but they are choking on vast holdings of questionable sovereign debt which regulators more or less forced on them with lenient risk-weightings.
• These banks are stuffed with paper that private investors would not buy, as part of the “three-card Monte” shuffle that characterizes the European banking/sovereign system today.

On “peak fragility” in the bond and stock market:

• People are still buying bonds despite pitifully low yields because, well, they continue to go up in price, albeit in a self-reinforcing process goosed by central bank and momentum buying. When these forces exhaust themselves, the reversal could and should be swift and large.
• A decade ago, stocks were overpriced, but institutions who owned them were generally happy… Stocks looked predictable and safe at the very moment that they were maximally unsafe. That is where long-term bonds of these four currency blocs (euro, U.S., U.K. and Japan) now stand.

On “safety”:

• “Safe haven” could be the two most expensive and painful words for investors in the financial lexicon this year.

On market sentiment:

• Global financial markets currently feel like they are in a period of calm before a storm, possibly centered on the European situation. The problem is that no one can foresee when the storm will make landfall, or how severe it will be.

On why Europe is making one wrong decision after another:

• Raising taxes to confiscatory levels (75% top rates are absurd and self-defeating), lowering already-too-low retirement ages, making it hard or impossible to fire people (which obviously discourages hiring them in the first place), increasing the scope of regulation and making it more complicated and subject to greater discretion by hostile, inadequately informed regulators, and making threatening noises at every turn about “the rich”, are the precise opposite of the actions and statements that policymakers should make to attract businesses and encourage expansions of existing businesses.
• Nobody is forced to locate a business in Europe, and in fact capital flight today from several countries is already large and relentless.

On the future of Europe:

• Since all of the euro bloc surprises in the last couple of years have been negative, and since the answer to every question about the ultimate cost of preserving the euro is “more than you thought yesterday,” the metaphor of a slow-motion train wreck seems quite appropriate.
• The overall situation is not going sideways or up. It is drifting down.

On Socialists – in this case in France, but applicable everywhere:

• The Socialists are unlikely to be terribly successful at preventing the destruction of jobs, but they may be all too effective, however unintentionally, at stifling job creation.

On tax policy:

• Dramatic increases in taxes and regulation, together with a repeatedly punitive tone, are understandably extrapolated by capitalists and investors as indicators of hostility toward business and profits. The societal loss from the business decisions occasioned by such signals is self-reinforcing. Businesspeople sitting on their hands leads to lower growth and more angry rhetoric and hostile actions by government.

On the lack of job creation:

• Since the top 20% of taxpayers (which includes a great number of people making less than billions and even millions) pay the overwhelming bulk of taxes, this promise to raise taxes has not exactly generated enthusiasm or jobs.

On US (small) business uncertainty:

• Under ACA and the scheduled rise in overall federal income tax rates, one of the largest aggregate tax increases in American history is scheduled for five months from now. This is occurring at the same time that several strapped large states are also raising their top tax brackets.

On shifts in paradigms:

• Businessmen are inherently optimistic, typically always looking for reasons to do business, expand and innovate.
• Historical experience shows that when established perceptions are wrong, it can take a long time for contradictory data points to accumulate before such perceptions start to adjust and to cause alterations of behavior. However, at a certain moment, shifts in perceptions and trends could be abrupt, especially given modern tools of instant communication.
• Today the hostility of the American and European governments to private enterprise, wealth and profits is used by those governments as  vote-buying tactics. The impact on growth and jobs is already visible, and capital flight (already seemingly underway in France) may accelerate unless the policies, and tone, change.

On the US welfare state:

• If [Social Security, Medicare, Medicaid and government pensions] are not reformed, such entitlements simply cannot be paid as promised, regardless of the levels of future growth or taxes on “the rich” or anyone else.
• The numbers are just too big, the result of a form of corruption: politicians made big promises in exchange for votes, not worrying about whether the promises could be fulfilled.

On the US “recovery”

• Three and a half years after the bust, the massive spending, guarantees and money printing have left America with 8.2% unemployment (which vastly understates the actual level, since millions of people have simply left the workforce, while others have migrated from receiving unemployment benefits to getting long-term disability payments), sluggish growth, $5 trillion in additional federal debt, and $3 trillion of freshly-printed dollars on the Fed’s balance sheet. This is not a success. This is a national tragedy, in a society in which the world’s greatest engine of prosperity has  historically been fueled by innovation, optimism, entrepreneurship, flexibility and opportunity.

On Congress handing over the decisionmaking process to the Fed:

• We believe that relying on monetary authorities to pick up the considerable slack in growth by printing money by the boatload is completely wrongheaded. It distorts both the price of money and the risks of holding long-term claims denominated in paper money, builds a future risk of large inflation, supports economic activity only in an oblique and unfair way, and creates something that is going to be very hard to unwind.

On the consequences of the printing money “alchemy”:

• Somehow many policymakers and citizens have come to believe that money printing is some kind of magical process, that good things can be produced literally out of thin air, and that if leaders don’t create growth from obviously-needed changes in wrongheaded policies, then poof!… printing more money will solve it. This is pathetic.
• The range of inevitable costs to societies practicing such alchemy is somewhere between “a lot” and “utterly catastrophic.” The damage is already becoming evident, particularly in the distortion between the rise in financial asset prices and the sluggishness of the real economy. When consumer prices soar across the board or there are other painful consequences, we wonder what excuses the blameworthy policymakers will make to deny their responsibility.

Finally, on what nobody wants to discuss, but could very easily be the final outcome:

• A loss of confidence in paper money could result in searing and startling inflation, evaporating life savings and turning every stolid worker into a frantic speculator.
• If that were to occur, nobody could possibly say in hindsight that the conditions for such a sorry state of affairs were not in place.
• The people who are telling us now that inflation is impossible because there is slack in the global economy, and that central banks can print trillions of dollars more without a significant risk of inflation, are the same folks who not only failed to predict the financial crisis, they did not even have a clue that a crisis of such kind was possible.

Indeed the “smartest money” is just that because it calls it how it is.

Tags: 10 Year Treasury, Arbitrage, asset class, Billionaire, Bond Auction, Crony Capitalism, Deep Thoughts, Expert Networks, Financial Institutions, Government Debt, Government Offices, Monopolies, Nanny State, Paul Singer, Political Upheaval, Printing Money, Qe, Smart Money, Sovereigns, State Printing
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Is Dodd-Frank the Death of Preferreds?

Wednesday, August 8th, 2012

by Mariela Jobson, iShares

Investors typically don’t like uncertainty, and regulatory uncertainty is no exception. So it’s not surprising that our sales team has been fielding a lot of questions from clients about the iShares S&P US Preferred Stock Index Fund (PFF). Clients are wondering what impact regulations put in place after the 2008 financial crisis might have on PFF specifically and preferred securities in general.

As the portfolio manager for our preferred stock ETFs, I spend a lot of time with our sales team and clients, helping them to understand the complexities of these products. Here, I’ve recapped the two main conversations I’ve been having with investors about the effects of these regulations on preferreds:

Q: Will regulatory changes deplete the supply of preferred stocks?

A: First, it’s important to understand what the regulatory changes are, and how they assumedly will affect preferreds. The preferred market is going through a significant transition driven by the Dodd-Frank (D-F) legislation. Under D-F, the Tier 1 capital treatment of hybrid and trust preferreds from bank holding companies will be phased out at 25% per year from 2013 until 2016. The fear is that the law will change the preferred market and could shrink the market size over the next few years. As of 8/4/12 approximately 22% of PFF’s holdings were trust preferreds that would be affected.

So what does this change really mean for preferred stocks? First, it helps to remember that the change does not actually forbid the issuance of trust preferred securities. Even after D-F goes into effect, banks may still choose to issue trust preferred shares, and they can simply opt to exclude them as part of their Tier 1 capital calculation. One reason they may choose to do this is because the interest is tax deductible.

In addition, this change is only aimed at hybrid and trust preferred securities — not the entire asset class. Companies are still issuing and should continue to issue perpetual preferred securities (see chart below). Preferreds are typically a more cost-efficient cost of capital than common equity, and as such they have been an attractive source of financing for companies.

Q: With the onset of the Dodd-Frank Act, will large volumes of preferreds be called?

A: In response to the new rules, banks can either call their preferred securities and replace them with another form of capital if needed, or they can let them continue to mature. The current low rate environment is increasing the possibility of securities of being called similar to any other security that has a call option, and in some cases, banks have the option of calling the securities even prior to normal five-year call protection.

But at this point, we believe it is highly unlikely that banks would call all of their trust preferred securities. Many of them have publicly stated their intention not to – for example, JP Morgan only plans to call half of their trust preferred issues. Instead, we believe banks will call their preferreds over time. While it is always difficult to predict what decisions management will make, we believe the chart below – which illustrates expected call dates for preferreds within PFF if prices remained at current levels and issuers were solely motivated to call based on trading prices – shows a more likely scenario.

The bottom line is that despite these regulatory changes, investors can still consider using preferred stock as part of a diversified income-oriented portfolio. While Dodd-Frank may change the treatment of trust preferred securities, we do not believe it will curtail the supply of preferreds, and as new preferreds are offered, they should continue to make their way in to PFF.

Sources: BlackRock, Bloomberg as of 6/30/12

Mariela Jobson, Vice President and portfolio manager in BlackRock’s iShares Index Equity Portfolio Management Group.

Ms. Jobson’s service with the firm dates back to 2006, including her years with Barclays Global Investors (BGI), which merged with BlackRock in 2009. At BGI, she was a portfolio manager for the index equity team, focusing on iShares and taxable accounts. She was responsible for managing U.S. and global portfolios, including preferred equity. Prior to joining BGI, Ms. Jobson worked as an equity research analyst in the asset management group at ING Investments in New York and at Wedbush Morgan Securities in Los Angeles.

 
Diversification may not protect against market risk. In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Preferred stocks are not necessarily correlated with securities markets generally. Rising interest rates may cause the value of the Fund’s investments to decline significantly. Payment of dividends is not guaranteed. Removal of stocks from the index due to maturity, redemption, call features or conversion may cause a decrease in the yield of the index and the Fund.

Tags: asset class, Bank Holding Companies, Complexities, Dodd, Financial Crisis, Ishares, Issuance, Jobson, Mariela, Pff, Portfolio Manager, Preferred Market, Preferred Shares, Preferred Stocks, Regulatory Changes, Regulatory Uncertainty, Stock Index Fund, Tier 1 Capital, Trust Preferred Securities, Trust Preferreds
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Mythbusting: Emerging Market High Yield Bond Risk

Friday, August 3rd, 2012

by Del Stafford, iShares

Emerging market high yield bonds – about as risky as an asset class can get, right? After all, emerging markets are known for carrying a significant amount of risk, and high yield bonds are one of the more speculative sectors within fixed income. Put the two together, and aren’t you doubling down on risk? I thought the same myself before researching this very topic, but to my surprise I found that is not [always/necessarily] the case.

First, most investable emerging market high yield indices contain bonds that are issued in US dollars (USD), so with these indices there isn’t additional risk from owning other currencies. Also, emerging market high yield generally includes sovereign bonds (issued by a government) and quasi-sovereign bonds (issued by an agency backed by a government), while US high yield generally only includes corporate bonds.

Corporate bonds are typically viewed as riskier than government bonds, even when they have the same credit quality rating. In times of market volatility and stress, you can see that play out in what is commonly referred to as a “flight to quality”. For example, we saw this happen during the credit crisis of 2008 when the market largely sold out of corporate bonds and bought US Treasuries.

The sovereign and quasi-sovereign exposure in emerging market high yield caused it to behave differently from other risk assets during 2007-2009. The below chart shows correlations of emerging market high yield (Barclays EM High Yield Index), US corporate high yield (Barclays US Corporate High Yield Index), emerging market equities (MSCI Emerging Markets Index) and developed international equities (MSCI EAFE Index) to US equities (S&P 500 Index) during this time period. You can see that developed international equities, emerging market equities, and US high yield increased in correlation but emerging market high yield decreased in correlation.

In addition, when you look at historical volatility in the below chart, emerging market high yield has experienced comparable levels of risk to US high yield over the past seven years.

Now, the intent here isn’t to say that emerging market high yield bonds are for everyone, but rather to challenge investor assumptions about the investment’s risk profile. Investors interested in emerging market high yield debt should still consider whether it suits their portfolio needs (Matt Tucker’s recent post may be helpful).

Source: Markov Processes International (MPI)

Del Stafford, CFA is the iShares Head of Product & Investment Consulting and a regular contributor to the iShares Blog. You can find more of his posts here.
Correlation is a statistical measure that captures the degree of the historical relationship between the returns of a pair of investments or indexes.

Correlation ranges between +1 and -1. A correlation of +1 indicates returns moved in tandem, -1 indicates returns moved in opposite directions, and 0 indicates no correlation.

Standard deviation is the statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. It is widely applied in modern portfolio theory, where the past performance of securities is used to determine the range of possible future performance, and a probability is attached to each performance.

Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Copyright © iShares

Tags: asset class, Barclays, Corporate Bonds, Correlation, Correlations, Credit Crisis, Credit Quality, Emerging Market, Emerging Markets, Fixed Income, Government Bonds, High Yield Bond, High Yield Bonds, International Equities, Ishares, Market Volatility, Markets Index, Sovereign Bonds, Time Period, Treasuries
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Solving the Global High Yield Puzzle (Video)

Wednesday, July 18th, 2012

In the hunt for income, high yield bonds continue to be of interest to investors willing to take on the extra risk.  However, there are more ways to play this asset class than simply US high yield bonds.  In this short video, Matt Tucker explores the pieces that make up the high yield puzzle and how they might fit in a portfolio.

Tags: asset class, Extra, Global High Yield, High Yield Bonds, Income Bonds, Investors, Matt Tucker, Puzzle, risk
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Is High Yield Right For You?

Saturday, July 14th, 2012

by Matt Tucker, iShares

There’s been much ado about high yield bond ETFs in the media for a while now. And with good reason – after a six month stint as the asset class of choice for yield-hungry investors, these funds have been riding a roller coaster of late, making headlines for everything from large redemptions to record trading volume. With the story changing almost weekly, I think it’s a good idea to step back and ask a more fundamental question: what role does high yield play in an investor portfolio?

It’s an interesting question, particularly because with the introduction of high yield ETFs investors now have a new way of accessing the market. High yield ETFs have brought liquidity, transparency, and access to a market that was previously opaque and difficult to access for many investors, and today have grown to thirteen funds and $26 billion in assets globally. Choice is a good thing, but as always investors should consider their own portfolio needs before investing in any asset class or sector.

So what are the considerations for investing in high yield bonds? The obvious attraction is yield, particularly for income seeking investors battling with a prolonged low interest rate environment. The iShares iBoxx $ High Yield Corporate Bond Fund (ticker: HYG) has a 30-Day SEC yield of 6.65% (as of 7/9/12) However, it’s important to note that this yield comes at a price – namely, higher credit risk than most fixed income securities, and therefore a higher risk of default. It’s this perilous reputation that earned them the moniker “junk” bonds.

Despite the negative connotations, it’s important to remember that junk bonds are still bonds, and that means that they are generally less risky than equities (see below). This simple point is often misunderstood by many investors. High yield debt issuance has a higher claim on assets than equity issuance, which means that if a firm faces bankruptcy, the bond holders get paid before the equity investors. We’ve actually seen clients shifting their dividend-paying equity allocations into high yield for just this reason, as a way to reduce risk and boost income.

Of course, more risk also equates to higher expected returns. What’s interesting to me is how these different asset classes deliver return to investors. When an investor moves from Treasury bonds to investment grade corporates, they are taking on an increasingly high level of default risk and are being compensated with higher expected yields. When an investor goes from high yield to developed market equities they actually receive a lower expected yield but a higher expected price appreciation, which results in a higher expected return.

What’s the bottom line for how investors should think about high yield? As an asset class that offers some of the largest yields in fixed income markets high yield can play a role in generating income for a portfolio, but investors should be mindful of the increased risk relative to many other fixed income sectors. High yield’s best role is as a source of income in a broadly diversified portfolio.

Source: Bloomberg

Matt Tucker, CFA is the iShares Head of Fixed Income Strategy and a regular contributor to the iShares Blog. You can find more of his posts here.


Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.
For HYG standardized performance, please click here

Tags: asset class, Bond Fund, Bond Holders, Corporate Bond, Credit Risk, Debt Issuance, ETFs, Fundamental Question, High Yield Bond, High Yield Bonds, Hyg, Income Securities, Interest Rate Environment, Investor Portfolio, Junk Bonds, Matt Tucker, Moniker, Negative Connotations, Redemptions, Roller Coaster
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When To Consider Getting Aggressive in High Yield

Thursday, July 5th, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

Here’s my take: I believe high yield bonds are close to fair value, I hold a neutral viewof the asset class and I advocate that investors generally maintain a benchmark weight.

That said, in the following three instances, I’d advocate investors consider being more aggressive buyers of high yield:

1.) If spreads widen. The spread between high yield bonds and the 10-year Treasury has generally fluctuated between 500 to 600 basis points this year, about where high yield should trade given the sluggish economic environment. However, assuming no further deceleration in the US economy, any further widening of high yield spreads back toward a premium of 650 to 700 basis points over the 10-year Treasury would represent a good buying opportunity, especially considering that many corporate balance sheets generally have been extremely strong and default rates have been low.

2.) If they have portfolios with high income needs. With a yield to maturity a little under 7% and volatility of less than 10%, a fund like the iShares iBoxx $ High Yield Corporate Bond Fund, (NYSEARCA: HYG) is an efficient way to add incremental yield to a portfolio. As such, investors may want to consider adding high yield bonds to their fixed income portfolios as their demand for income rises. For instance, while risk adverse investors may only want to hold around 10% of their fixed income portfolios in high yield, investors willing to take incremental risk to earn additional income may want to consider holding as much as 30% of their fixed income portfolio in high yield.

3.) If they are worried about rising rates. Investors who are worried about rising interest rates may also want to add high yield as a substitute for long-dated Treasuries. High yield bond funds currently have lower durations than Treasury funds, meaning that Treasuries are far more sensitive to interest rates. If interest rates rise even modestly, Treasury funds are likely to suffer larger losses than high yield bond funds.

Source: Bloomberg, iShares.com

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

The author is long HYG

 
The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com. For standardized performance for HYG, please click here.
Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Tags: 10 Year Treasury, Aggressive Buyers, asset class, Basis Points, Bond Fund, Chief Investment Strategist, Corporate Balance Sheets, Corporate Bond, Deceleration, Default Rates, Fixed Income Portfolio, High Yield Bond, High Yield Bond Funds, High Yield Bonds, Hyg, Neutral View, Rising Interest Rates, Treasuries, Treasury Funds, Yield To Maturity
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Stocks Have Their Biggest Week of the Year on Lowest Volume

Thursday, July 5th, 2012

The S&P 500 gained over 3.5% this week (with a dip-and-rip today on dismal volume). This is the best week of the year amid the lowest volume of the year (ex-holiday weeks). Gold, Stocks, Treasury yields, and the USD all recoupled from last Friday’s decoupling and limped higher, ending at the top of the day’s range today. Financials and Tech outperformed – up over 1.1% – with the majors best as financials won on the week +4.8%. Treasuries close to close were dull but intraday saw rather notable vol as 30Y yields dropped over 10bps before round-tripping back to its high yields of the day. All-in-all, broad risk assets did leak higher today but nothing like as exuberantly as stocks which was somewhat surprising into a weekend likely full of equity dilution for Spanish banks (and more burden for Spain) – or none at all. The USD rallied into the European close and sold off after for the fifth day in a row. HYG outran stocks on the day and maintained the bid (ES closed at overnight highs) but IG and HY credit lagged on the day – though are al better on the week. Cross asset-class correlations dropped notably into the close, as implied correlation dropped and VIX was very stable given the rally into the close, holding above 21% – even as S&P 500 e-mini futures ended the day more than 2 sigma above VWAP (as we suspect futures roll effects kept some out into the weekend). Lastly, this push higher today in stocks saw a major drop in average trade size – certainly not offering the kind of follow through to yesterday’s (or the week’s) gains that one would expect on a new bull leg.

Today saw ES retrace perfectly 38.2% of its last few day’s rally only to bounce and push back to close at those highs…

S&P 500 rose over 3.5% on the week, best week in six months, as volume lagged dramatically…

led by financials best week in 3 months…

But Stocks, Bonds, USD, and Gold all resynced from last week’s decoupling and limped along together…

As the S&P 500 e-mini futures closed at overnight highs and rather surprisingly around 2 sigma (light blue) above VWAP (red) with a late-day shift in peak volume (the dark blue line) suggesting we had auctioned up to retest those levels as we note some bigger blocks going through at the close…

For the fifth day in a row, the dollar strengthened into the European close and then faded after…

Charts: Bloomberg

Tags: Amp, asset class, Correlation, Correlations, Decoupling, Dilution, Fifth Day, Futures, gold stocks, Holiday Weeks, Hy, Last Friday, Majors, Rally, Sigma, Spanish Banks, Stocks Bonds, Treasuries, Treasury Yields, Vwap
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Three Universal Laws of Wall Street

Tuesday, June 12th, 2012

Guest contribution by Rick Ferri

There are three universal laws in the investment business: expected return is a function of risk, active management is a triumph of marketing, and alpha goes to the manager. If you are not already an index fund investor, you will likely become one with full understanding of these fundamental truths.

Risk and return follow natural economic law. We can’t change this. Higher returns require taking higher risks. Treasury bills are considered a risk-free investment (not counting inflation or taxes). You’ll have to put your principal at risk at least temporarily if you wish to earn a higher return than the risk-free rate. There’s no getting around it.

Trying to change the risk and return equation through active management is a high-cost poker game. There’s no evidence that active management consistently outperforms in any asset class adjusted for risk and fees (see The Power of Passive Investing for details). If an active manager claims otherwise, they’re either referring to a specific time period or they’re using the wrong benchmark for comparison.

Of course, there have been and will continue to be several winning active managers each year. While these winners argue their excess return (alpha) is the result of superior skill, the problem is proving it. There is no alpha persistence to speak of. Most past winners do not stay winners �’ they fall to the middle of the pack or worse.  The excess return they did earn for a while is eventually eaten away by management fees. Thus, the third universal law, alpha goes to the manager.

People will pay higher management fees if they’re impressed with past performance or believe there is a strong probability of out-performance in the future. That’s where marketing comes in. Good marketing beats good management every time. The more complex the message, the greater probability a manager will be able to collect a high fee. It’s the core reason why hedge funds are able to charge 2 & 20 (translation:  2.0 percent per year in management fees and 20 percent of the profits).

A friend recently asked me to check out an advisor he had an interest in. He didn’t know much about the advisor, only that their investment strategy sounded impressive.

The advisor’s website was filled with complex PhD level research and baffling industry jargon that only members in the Genius Society could understand. There were also multiple links to big-name colleges and prize winning papers written by Nobel Laureates. In addition, the firm had trademarked scientific sounding acronyms that made them seem like very smart people.

I’m not a genius and don’t pretend to be one, but I was able to figure out that at the core their investment strategy was nothing more than creating a simple asset allocation for clients, and then employing mutual funds to fill those allocations. I looked at the firm’s government filing and discovered that none of the big-name research firms or PhDs had any stake or attachment to the firm. It was all a clever marketing illusion created solely to bamboozle potential clients into believing that this firm was special and their high management fee was worth the price.

I explained to my friend that slick marketing doesn’t translate to higher returns especially given the 1.0 fee the advisor was charging. He could save a lot of money if he either self-managed after reading a few good books on index funds, or hired a low-fee investment advisor.

In summary, the three universal laws of Wall Street are 1) expected return is function of risk, 2) active management is a triumph of marketing, and 3) alpha goes to the manager.

If you’re not already an index fund investor, you’ll likely convert after learning about these three universal laws. I converted to indexing in 1996 and have never looked back. Visit Bogleheads.org for more information on low-cost investing from unbiased, like-minded and fee-sensitive investors like you.

Copyright © Rick Ferri

Tags: Active Management, asset class, Core Reason, Economic Law, Excess Return, Ferri, Free Investment, Fund Investor, Fundamental Truths, Good Management, Good Marketing, Index Fund, Index Investing, Indexing, Investment Business, Management Fees, Poker Game, Risk And Return, Superior Skill, Treasury Bills, Universal Law, Universal Laws
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The Pros and Cons of Preferreds (Koesterich)

Tuesday, May 22nd, 2012

Given the universal hunt for yield, many investors are asking me what I think of preferred stocks.

I believe that this asset class certainly has a place in yield oriented portfolios, but I wouldn’t overweight preferred equity funds at this time and would instead remain neutral. Why? While preferred funds are certainly providing a healthy, relatively high yield in a low yield environment, the extra yield comes with a lot of volatility.

Currently, preferred funds are offering a yield similar to that of a high yield bond fund, but preferred funds are also offering about 50% more volatility. For instance, the yield on the iShares S&P U.S. Preferred Stock Index Fund (NYSEARCA: PFF) is now approximately 6.5%, roughly in line with the yield of the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA: HYG). But at the same time, PFF’s three-year trailing volatility is more than 15% compared with less than 10% for HYG.  Past performance is no guarantee of future results.  For standardized performance for PFF, please click here.

To be sure, preferred stocks are generally more volatile than bonds and this makes sense given their lower place in the capital structure. However, there is another reason for the heightened volatility of preferred funds today.

The S&P U.S. Preferred Stock Index is composed of mostly financial companies. In fact, today, more than 85% of the issuers in the index are financials. This heavy concentration in the financial sector is also contributing to preferred funds’ volatility — the financial sector is now the most volatile sector in the market.

As such, preferred funds modeled on the index are essentially acting as proxies for financial stock funds, but with equity-like risk and bond-like returns. For those with a positive view on financials, this may be an acceptable risk-reward tradeoff. But as I currently hold an underweight view of global financials, I’m advocating a neutral allocation to the preferred stock asset class for now.

Source: Bloomberg

Russ Koesterich is the iShares Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

The author is long PFF and HYG.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com.

Index constituents are subject to change.

In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Preferred stocks are not necessarily correlated with securities markets generally. Rising interest rates may cause the value of the Fund’s investments to decline significantly. Payment of dividends is not guaranteed. Removal of stocks from the index due to maturity, redemption, call features or conversion may cause a decrease in the yield of the index and the Fund.  Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Tags: Acceptable Risk, asset class, Capital Structure, Corporate Bond, Equity Funds, Financial Sector, Financial Stock, High Yield Bond, High Yield Bond Fund, Hyg, Ishares, Pff, Preferred Equity, Preferred Stock, Preferred Stocks, Preferreds, Risk Reward, Stock Funds, Stock Index Fund, Volatile Sector, Volatility
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Key ETF Performance QTD and YTD

Tuesday, May 15th, 2012

by Bespoke Investment Group

The second quarter of 2012 has so far been a complete reversal of the first quarter.  As of earlier this morning, just one stock-related ETF in our matrix below was up for the quarter — Utilities (XLU).  Major US index ETFs are all down 4-5% for the quarter, while sectors like Energy (XLE) and Financials (XLF) are down 7%+.

International markets have done much worse than the US.  Brazil (EWZ), France (EWQ), Germany (EWG), India (INP), Italy (EWI), Spain (EWP) and Russia (RSX) are all down double digit percentages since the start of April, and they’re down 5%+ over the last week alone.  The only asset class that is solidly in the green for the quarter is fixed income, which many investors shunned like the plague as recently as March.  Oh how quickly things change.

Tags: asset class, Brazil, Etf Performance, Ewg, Ewi, Ewp, Ewq, Ewz, First Quarter, Inp, International Markets, Investment Group, Percentages, Plague, Qtd, Rsx, Second Quarter, Sectors, Us Brazil, Xle, Xlf
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