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Do Rising Rates Spell Doom For REITs?

westloop — Tue, 22 Jul 2014 14:50:54 +0000

As we have discussed many times, much of the conventional wisdom on investing is simply wrong. For our purposes, we can define conventional wisdom as those ideas that are so commonly accepted that they go unquestioned. Today, we’ll look at the idea that rising interest rates would doom returns to real estate investments, specifically the returns from real estate investment trusts (REITs). This assumption – that returns from REITs would indeed tank if interest rates rose – is one I’ve been hearing a lot about lately as people speculate on the future actions of the Federal Reserve, its bond-buying program and the projections for short- and long-term rates.

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The Long And Short Of The Low-Volatility Anomaly

westloop — Tue, 22 Jul 2014 14:48:26 +0000

As far back as the early 1970s, research has shown that the lowest volatility stocks have provided better returns than the highest volatility stocks. These findings run counter to economic theory, resulting in the low-volatility anomaly. The academic research, combined with the 2008 bear market, has led to low-volatility strategies becoming a darling of investors. For example, as of July 3, 2014, five low-volatility ETFs had reached at least $1 billion in assets under management:

PowerShares S&P 500 Low Volatility Portfolio (SPLV): $4.1 billion
iShares MSCI USA Minimum Volatility Index Fund (USMV): $2.6 billion
iShares MSCI Emerging Markets Minimum Volatility Index Fund (EEMV): $2.0 billion
iShares MSCI All Country World Minimum Volatility Index Fund (ACWV): $1.2 billion
iShares MSCI EAFE Minimum Volatility Index Fund (EFAV): $1.2 billion

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Does Taking Corporate Credit Risk Add Value?

westloop — Mon, 14 Jul 2014 15:48:10 +0000

Earlier this week, we looked at whether adding credit risk in the form of lower investment-grade municipal bonds was an efficient approach to improving returns. The evidence is clear that this isn’t the case. In fact, taking more credit risk resulted in worse relative performance. Today, we’ll apply the same approach to determine whether adding corporate credit risk, again in the form of lower investment-grade bonds, is an efficient way to improve returns.

Each of our two examples will cover the 30-year period from 1984-2013. The first example compares returns from a typical 60 percent equity and 40 percent bond portfolio using investment-grade bonds to returns from a portfolio that limits its bond holdings to Treasuries.

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Do Lower Investment-Grade Municipal Bonds Add Value?

westloop — Mon, 07 Jul 2014 16:47:43 +0000

The Federal Reserve’s zero-interest rate policy is now well into its fifth year, probably far longer than most – if not all – investors were expecting. This persistence of low interest rates has pushed many investors to stretch for greater yield from their bond investments. One way to achieve higher yield is to take on more credit risk through the purchase of lower-rated bonds. Many argue that higher-yielding bonds also provide some diversification benefits. While this is true, the low average correlation between lower-rated bonds and stocks has a nasty tendency to dramatically increase at exactly the wrong time, such as when equity risk shows up. As my colleague Jared Kizer and I discuss in our book, The Only Guide to Alternative Investments You’ll Ever Need, this should come as no surprise because high-yield bonds are basically hybrid securities. Some of the risk in high-yield bonds is unique, but much of it can be explained by certain types of risk in common with equities and Treasury bonds. In other words, credit risk is mostly equity risk in disguise. If investors were unaware of this, 2008 should have provided ample instruction.

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The Role Of Credit Risk In Exchange-Traded Notes

westloop — Mon, 07 Jul 2014 16:46:54 +0000

The financial crisis of 2008 underscored the role that credit risk plays in many investments. And while counterparty risk has been in the spotlight with such derivatives as credit default swaps, comparatively little attention is paid to its impact on exchange-traded notes (ETNs), a type of tracking product.

ETNs are relatively new — but rapidly growing — financial vehicles generally issued by a single bank as senior, unsecured and unsubordinated debt securities. As such, they are backed only by the full faith and credit worthiness of the issuer. Because ETNs are unsecured promissory obligations, ETN holders are directly exposed to the issuer’s credit or default risk. Unfortunately, many individual investors mistakenly ignore this risk. A possible explanation for this oversight is that investors may wrongly lump ETNs together with exchanged-traded funds (ETFs), which don’t entail credit risk because they hold the underlying assets of the index they are designed to track.

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Why We Love Premium Bonds And You Should Too

westloop — Mon, 07 Jul 2014 16:45:28 +0000

A common error made by many bond investors is to avoid purchasing premium bonds – bonds that trade above their face value (or par, typically 100). A bond will trade at a premium when the coupon (stated) yield is above the current market rate for a similar bond of the same remaining term to maturity.

Many investors avoid premium bonds because they don’t want to buy a product that they believe comes with a guaranteed loss built into the price. You pay above par, yet receive only par at maturity. This is a major mistake. In fact, the higher annual interest payments received for premium bonds offset the amortization of the premium paid. So when building individual bond portfolios, we at Buckingham – where I am director of research – don’t try to avoid premium bonds. We generally prefer them because they offer a number of excellent advantages over discount or par bonds.

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The Hurdles Are Getting Higher For Active Management

westloop — Mon, 23 Jun 2014 15:22:59 +0000

The goal of actively managed funds is to generate alpha – returns above the appropriate risk-adjusted benchmark. We might add here that the alpha should also be sufficient to compensate for the increased idiosyncratic risks active managers take by failing to fully diversify, and that the only way to generate alpha is to hold a different/less diversified portfolio than the benchmark.

As economist William Sharpe pointed out in his famous paper, “The Arithmetic of Active Management,” before costs active management is a zero sum game, and after costs it’s a negative sum game: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.” In other words, for active managers to be successful they must have victims that they can exploit. Who exactly are these victims?

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Do Day Traders Evidence Skill?

westloop — Mon, 23 Jun 2014 15:22:17 +0000

Professors of finance Brad Barber and Terrance Odean have done extensive research on the performance and habits of individual investors. Among their findings is that, on average, individual investors lose money from trading – and not all of the losses can be explained by trading costs. They’ve found that individual investors can have perverse security selection abilities – for example, buying stocks that earn sub-par returns and selling stocks that earn strong returns. They also have found that women produce better results than men, and that those who trade the most have the worst risk-adjusted returns. And demonstrating that more heads aren’t necessarily better than one, the average investment club lagged a broad market index by almost 4 percent a year. Adjusting for risk, their performance was even worse. Clubs would have been better off never even trading during the year.

How significant are the costs of underperformance? In a study on the Taiwanese market covering the period from 1995-1999, they found that the aggregate losses of individual investors exceeded 2 percent of the country’s annual gross domestic product.

The body of evidence demonstrates that even the most skilled investors have a hard time generating alpha (risk-adjusted excess returns) after all expenses are accounted for.

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Does Private Equity Deliver Alpha

westloop — Mon, 23 Jun 2014 15:20:44 +0000

The term private equity – PE – is used to describe various types of privately placed (non-publicly traded) investments. It has grown tremendously over the past 30 years – thanks largely to America’s pension funds as they search for alternatives to public equity markets that might help them meet their return objectives.

Frank Jian Fan, Grant Fleming, and Geoffrey J. Warren, authors of the study “The Alpha, Beta, and Consistency of Private Equity Reported Returns,” which appears in the Fall 2013 issue of the Journal of Private Equity, examined the performance of both buyout and venture capital – VC – funds through 2011. Their study adds to the literature on private equity by incorporating the factors of size and value – instead of benchmarking returns to a single broad market index. They also benchmarked returns against investable index funds, rather than just the index itself (which doesn’t have costs). In addition, they considered whether the reported returns of these funds lag market returns.

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Has The Realized Equity Premium Been Shrinking?

westloop — Mon, 23 Jun 2014 15:20:00 +0000

Tying up our two-part series on premiums, today we’ll explore the equity premium.

Claude Erb has done a series of papers in which he examines the various premiums – size, value, momentum, and beta – and found that there’s a demonstrable trend in each case of the premiums shrinking in terms of realized returns. His April 2014 paper, “The Incredible Shrinking Realized Equity Risk Premium,” focused specifically on the equity risk premium.

To create a trend line Erb used a three-step process:

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