Monday, May 30, 2016

The Ultimate Diversifier?

Joe Davis of Vanguard wrote a very interesting comment, By this measure, bonds have never been more valuable:
Global bond yields hover near all-time lows. In the United States, a 10-year Treasury note yields less than 2%. In Europe and Japan, the bond markets have tumbled through the looking glass into a world of negative interest rates. About 40% of European government bonds yield less than 0%. In Japan, the figure is 70%.

The prospect of low to negative returns on government bonds has raised doubts about their value. Why hold an asset that yields almost nothing (or less than nothing)? Why take on any price volatility if you can stash cash in a safe?

The doubts are understandable. Return is the most salient feature of any asset class, and it’s hard to get happy about 0%. In an asset allocation framework, however, return has different dimensions. And by one critical measure in mean-variance optimization, which weighs both return and risk, high-quality government bonds have never been more valuable.

Portfolio specs

Building a multi-asset-class portfolio appropriate to a given goal and risk preference depends, primarily, on the following three characteristics of each asset:
  • its expected return
  • the expected volatility of those returns
  • the correlation of the asset’s return with those of other assets (i.e., its covariance)
The low yields of U.S. Treasury bonds imply that their expected returns are exceedingly modest. We expect the volatility of government bonds to remain consistent with recent trends. But government bonds’ correlation with stocks suggests that their diversification power has never been stronger. And under some simple assumptions, this higher diversification value offsets the lower expected returns on government bonds. Period.

The chart below displays the correlation between monthly percentage changes in the price of the S&P 500 Index and changes in the yield of the 10-year U.S. Treasury note. The blue line displays correlations over rolling five-year periods. The data come courtesy of Nobel laureate Robert Shiller (click on image below).

Since 1871—yes, almost back to the American Civil War—the correlation between changes in stock prices and changes in bond yields has averaged 0%. Over the past five years, the correlation has averaged –0.6%, the lowest in U.S. history.

In portfolio construction, assets with a strongly negative correlation to other portfolio assets are the Holy Grail. They rally when other assets retreat. This relationship was especially visible at the start of 2016. The U.S. dollar is the world’s reserve currency, making U.S. Treasuries the destination of choice in a flight to quality. And when global stock prices tumbled earlier this year, intermediate-term Treasury bonds rallied.


Data: Shiller, correlation between monthly percentage changes in S&P 500 and inverse monthly difference in 10-year yields.

What explains the unusually negative correlations? The correlation between stocks and bonds changes through time. It has tended to rise in periods of higher-than-expected inflation, as in the stagflationary late 1970s and early 1980s, when both stocks and bonds retreated. Stock-bond correlations in the United States have tended to fall in periods of slow growth and deflationary fears, the environment that has prevailed over the past few years. Our outlook suggests that such conditions are likely to persist in the years ahead.

A reassessment

My colleague Fran Kinniry has called high-quality bonds the Rodney Dangerfield of investments. Like the late comedian, they get no respect. And as yields have crept lower, their status has declined. But that drop in status is undeserved. Successful portfolio construction is not just about return. It’s also about diversification. And at the moment, the data indicate that no asset boasts more potent diversification power—and more potential to protect a portfolio in a stock market downturn—than U.S. Treasury bonds.

Notes:

Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.

All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
I've been meaning to write a comment on the ultimate diversifier for a long time. Why do I call US governments bonds the ultimate diversfier? Because even though some strategist claim deflation is dead, I see it very much alive everywhere outside the United States and that is a very bullish for US government bonds.

How should people think about bonds? A few very brief points:
  • Bond yields move inversely with bond prices. As fears of inflation pick up, yields on US government notes (10, 20, 30 year government bonds) will rise and their price will fall.
  • The longer term bond prices swing much more than shorter term ones because there is a lot more uncertainty the further out you go into the term structure. The Fed's decision on rates impacts short term bonds, inflation expectations are what matter most for long term bonds.
  • If you believe the global recovery is gaining steam and that inflation expectations are picking up everywhere, then you should be hedging inflation risk by buying Treasury Inflation Protection Securities (TIP).  
  • Conversely, if you believe that deflation headwinds are picking up all over the world, you should be buying nominal US government notes (TLT) to hedge against deflation and deleveraging, not to mention a possible market crash
  • If you want more bang for your bond buck in a deflationary world, you can buy zero coupon bonds like the PIMCO 25+ Year Zero Coupon US Trs ETF (ZROZ) or the Vanguard Extended Duration Treasury ETF (EDV) but you need to understand what zero coupon bonds are, the difference between them and regular bonds and the risks associated with these investments
  • If you think everything is just fine and we're in a period of low inflation and modest growth, then you can take more risk and follow high rollers flocking to the 'HYG Hotel' in record numbers. High yield bonds (HYG or JNK) are basically a call on the economy; when it does well, they do well and offer a very nice yield too. They act a lot like high dividend stocks (DVY or VYM) and are very sensitive to changes on interest rates or fears of a market jolt (in a Risk Off environment, they get clobbered hard, just like stocks).
Now that I got those brief points out of the way, I want to come back to bonds as the ultimate diversifier in a deflationary world.  On Friday, I discussed hedge funds' day of reckoning and went over structural factors that are impacting the performance of most hedge funds.

One thing I keep noting is all these billions chasing alpha, investing in hedge funds and private equity funds, are inadvertently ensuring that future returns will be mediocre or modest at best.

Importantly, if you calculate the aggregate net IRR after all fees of hedge funds and private equity funds as assets under management mushroomed, you'll see the performance has declined quite drastically.

Of course, some funds are doing much better than others but even elite funds can't magically create returns in a world where ultra low rates or negative rates are here to stay (unless they crank up the risk and expose themselves to blow-up risk).

This is why most Canadian pensions are investing in real estate and infrastructure to capture steady returns over a very long period but in doing so, they're driving the valuations of these assets up and taking on ever more illiquidity risk.

This is why when Ontario Teachers' CEO Ron Mock went over their 2015 results, he specifically noted  that "privates kicked in last year but a few years back, it was bonds that kicked in." Ron emphasized a total portfolio approach and he understands the important role of bonds in a pension portfolio.

It's all about maximizing your risk-adjusted rate-of-return. Bonds protect against downside risk like no other asset class when it hits the fan. And this is why Ron Mock and HOOPP's CEO Jim Keohane keep emphasizing the importance of path dependency for pensions which are trying to reach fully funded status like their plans have achieved.

If you are a chronically underfunded pension plan taking ever more risk in hedge funds and private equity funds, stocks and corporate bonds, you can make money but if you suffer another drawdown like in 2008, you're basically toast (just like an individual who loses 50% in a stock and has to make 100% to get back to to even).

Again, go back to read my comment on building on CPPIB's success where I discuss the total portfolio approach and recommend books like like William Bernstein's The Four Pillars of Investing and The Intelligent Asset Allocator. Smart portfolio construction, diversification and rebalancing are the key to long term investment success.

Lastly, it is Memorial Day, US markets are closed and I wasn't going to write anything but I wanted to bring your attention to an article by CNBC's Gina Gusovsky,
LinkedIn and other tech companies investing in military veterans:
The unemployment rate for veterans who served on active duty since September 2001 hovers at around 5.8 percent, which is higher than the national average of 5 percent. And even when employed, about half of veterans leave their first jobs after the military within a year of transitioning home and 65 percent within two years, according to a survey on job retention among veterans.

These statistics are encouraging veterans and advocates to focus on a smoother transition from military to civilian life. Medal of Honor recipient and retired Army Captain Florent Groberg has partnered with LinkedIn to encourage more hiring managers to pay attention to the skills that veterans have to offer.

"Our veterans program is about how many vets we can empower to find employment," Groberg said.

Currently, the technology sector is a big part of this mission, both in the networking platform and ultimate work placement.

Groberg told CNBC that the program will assist around 100,000 veterans this year with free premium subscriptions to LinkedIn.

"What I learned after many failures is that networking is the solution."

Promoting veteran candidates within the technology industry specifically was the focus of a recent hearing on Capitol Hill, which included representatives from Microsoft, Amazon and Uber testifying about their respective companies' opportunities for veterans.

Ohio Congressman Brad Wenstrup, Republican and Chairman of the Subcommittee on Economic Opportunity, Committee on Veterans' Affairs, said that he was highlighting the tech industry specifically because the "flexibility these jobs offer, as well as the skills needed to be successful in these careers, make veterans an obvious fit for these positions and trades."

Bernard Bergan, technical account manager at Microsoft and a veteran himself, told the committee that "it is past time for industry, government and nonprofit leaders to give back to our veterans."

Microsoft's goal is to train and find IT careers for 5,000 service members over the next five years, Bergan said.

Amazon pledged to hire 25,000 veterans in the next five years, and Uber said the company had already fulfilled its goal of employing 50,000 veterans.

The need for veteran candidates extends far beyond the tech sector, though, and that is something that America's largest nonprofit health-care system, Ascension, acknowledged as well.

Ascension CEO Anthony Tersigni told CNBC that the company currently has 2,000 employees who are veterans. "Right now in many parts of the country the veterans are most vulnerable," Tersigni said. "We understand that veterans have different needs than some of our other patients, and we want to have a better understanding of them and so we want to engage those veteran organizations and the veterans themselves."

Groberg said that regardless of the industry or sector, finding better employment opportunities for veterans and retaining them in these jobs will only occur by helping veterans build a professional identity, a professional network and professional skills in a civilian career.

Florent Groberg has already met with companies, including IBM, Google, HP and JPMorgan Chase, to help them better understand how to best serve veterans in their time of transition.

"I go in there, and I talk to them about what we can bring to corporate America as service members, because the skills that allowed us to be successful in the military are transferable to corporate America," Groberg said.

The survey on job retention among veterans, conducted by Syracuse University's Institute for Veterans and Military Families and VetAdvisor, found that respondents employed in their preferred career field reported longer average job tenure.

"I think we can be successful in any sector if given the right opportunities and the right mentors."
My grandfather after whom I was named left Crete when he was 17 to go work in the United States. He fought with the US Army in World War I and then returned to Crete to settle down and have a family. After he died, my grandmother in Crete continued receiving a decent  pension from the US Army which covered her basic needs. I remember her telling me how proud he was of his service, how thankful she was for that pension and how good the United States was to her and my grandfather.

Taking care of US veterans, many of whom are disabled and/ or suffer from mental illness, should be priority number one for any US government and Corporate America. Period. It's nice to hail soldiers as heroes when they go off to fight for their country but it's more important to treat them like heroes when they come back by creating employment programs that specifically target them.

When it comes to diversity in the workplace, I'm a stickler for concrete action and solid programs which target women, visible and ethnic minorities, the disabled, veterans and any group which has a much harder time finding suitable employment in this cutthroat world focused on "profits at all cost," ignoring the human and social responsibilities companies have to protect the rights of disadvantaged groups.

If you are a CEO of a bank or major corporation, a public pension fund or some huge hedge fund and private equity fund, always ask yourself: "Are we doing enough to diversify our workforce?". I guarantee you the answer is "no" and that there is a lot more work ahead (a good starting point is to look at what the Royal Bank is doing in terms of diversity and inclusion but even it can do a lot more at all levels of its organization...others are much, much worse).

Below, CNBC's Dina Gusovsky reports on how the jobless rate for military veterans and their struggles in return to civilian jobs have created a critical mission.

Last year, Blackstone CEO Steve Schwarzman talked to CNNMoney's Cristina Alesci about how hiring veterans has been good for the firm and veterans alike. Listen to his comments.

Third, ABC's Bob Woodruff reports on the remarkable story of the unbreakable bond between Navy SEALs and their combat interpreter Nguyen Hoang Minh. I love this story, it epitomizes the best in humanity and gives me hope that there are still many decent people out there doing the right thing.

Lastly, Sebastian Junger has seen war up close, and he knows the impact that battlefield trauma has on soldiers. But he suggests there's another major cause of pain for veterans when they come home: the experience of leaving the tribal closeness of the military and returning to an alienating and bitterly divided modern society. Watch his powerful Ted Talk below, it is truly excellent. 




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