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The WSJ columnist Jason Zweig reported on the data on money flows during January and notes the following, all of which point to the investor tendency to chase returns and panic-sell at the lows.

Overall Equity Allocation

Zweig notes:

Since the end of 2008, when the financial crisis was near its worst, investors have taken $105 billion more out of U.S. stock mutual funds and exchange-traded funds than they put in….Last year, investors ditched a net $34 billion in funds holding the biggest U.S. growth stocks, like those in the Standard & Poor's 500 index.

The consequences of the market timing: quite a bit of missed opportunity -- SP 500 since Dec. 1, 2008, +73%. Since Jan 1, 2011, +10%. While there may be better ways to passively invest than simply buying the S+P 500, market timing is not a very successful alternative strategy.

What would the rebalancer have done over the same period? Rebalancers incorporate into their strategy a target allocation in which they rebalance by selling outperformers and buying laggards in order to get back to the target allocation. Using the simplistic example of a 50/50 allocation between the S&P 500 (NYSEARCA:SPY) and the Aggregate Bond Index (NYSEARCA:AGG), and total portfolio of $200,000 such an investor would have seen his stocks rise to $101,900 and his bonds rise to $107,700 in 2011. Unlike the bulk of investors who sold stocks, he would have been buying stocks in the process of rebalancing. Similarly. at the end of 2008 at the end of a one year decline of 37% in the S&P 500 and a gain of 7.9% in bonds rebalancing would have dictated significant purchases of stocks.

Sector Chasing

Investors also tend to try to sector pick even as some have given up on stock picking. Their key criteria is often past performance. In the current low yield environment it seems another criteria has moved into the equity area: yield chasing. With the current conventional wisdom pushing for dividend stocks it shouldn't be a surprise that such stocks have benefited from price momentum, leading to high valuation, likely leading to future underperformance.

Last year for the first time in decades utility stocks (NYSEARCA:XLU) were the top performing sector. Such stocks were long a focus of dividend investors looking for cash flow and low risk and willing to sacrifice some long term returns.

With the rush of investors looking at stocks based on dividend yields, the money flows pushed utility stocks up 11% in 2011 vs. 2% for the S&P 500. And what do the January ETF flow numbers show? $8 billion in new cash into utilities YTD.

Comparing performance YTD may not be the best measure of long-term performance (SPY +9.1%, XLU -2.5%). But several factors do not make the outlook particularly positive for outperformance from the utility sector again in 2012:

  • Potential for those performance chasers to sell aggressively based on recent performance.
  • Change in valuations due to the price run-up: XLU is trading at a forward P/E ratio above that of the S&P 500 and a current p/e about equal to the S+P 500 despite lower return on equity and earnings growth.
  • Yield differential vs. total return. Many investors may insist they look only at dividend flows and not total return. But others may note that the 2% annual yield advantage for XLU vs. SPY has already been more than wiped out by the 6.5% total return disadvantage in only 2 months.

In the Bond Sector: Yield Chasing

The article notes that the flows into bond funds show a significant amount of yield chasing both among individual and institutional investors:

The bond funds taking in new money are hardly low-risk, either. In January, corporate and high-yield, or "junk," bond funds took in $23 billion, and emerging-markets bond funds raked in $2 billion. That's 77% of the total taken in by all taxable bond funds.

These types of bonds substantially out-yield Treasuries -- but, compared to U.S. government bonds, they run a higher risk of doing poorly when U.S. stocks suffer.

... With interest rates near record lows, most private pension plans are urgently seeking to buy long-term corporate bonds.

Spread Watching vs. Yield Chasing

In my articles on bond allocations I have pointed out the importance of monitoring yield spreads among credit quality and maturity. Based on the low current rates on Treasury bonds, I have recommended looking at other investments with risk characteristics close to those of Treasuries.

Picking Up Yield Without High Credit Risk

One core holding is the Vanguard GNMA fund (check my instablog), which offers credit risk close to that of US Treasuries but higher yield.

High Yield Bonds

I also have observed that high yield bonds merit a place in bond allocations but that in "watching the spreads" is crucial.Current yields are close to their long term average. Investors should also remember that high yield bonds do not behave like a true fixed income asset. High-yield bonds behave like a hybrid of equities and bonds.

An Interesting Observation For income investors

The correlation between (NYSEARCA:HYG)and SPY is +.75 meaning they move in tandem. Interestingly, that is almost identical to that of the SDY dividend aristocrats ETF.

HYG is yielding 7.32% and (NYSEARCA:SDY) yields 3.1%. Yet both have the same correlation to the overall stock market. The volatility of SDY is almost twice that of HYG. I'll leave it to the income oriented investors to evaluate the relative benefits of high yield bonds vs. dividend stocks.

Spread Watching and High Yield Bonds

Do high yield bonds make sense as an allocation in a portfolio? My answer would be yes provided the investor doesn't view them as 1:1 substitute for higher quality bonds. They should be viewed as an asset class with their risk as somewhere between that of stocks and bonds.

I noted in my article on high yield bonds, based on current market conditions that spreads vs. Treasury bonds are around the mean of long term differentials. There is no reason for a very large allocation to high yield despite the temptation to yield chase.

Yield Chasing by Extending Maturities

The Wall Street Journal notes that institutional investors have been looking for yield pickup by holding corporate bonds and extending maturities in place of their traditional Treasury bond holdings. Doubtless individual investors have been doing the same.

With interest rates near record lows, most private pension plans are urgently seeking to buy long-term corporate bonds, says Anthony Gould, an executive at J.P. Morgan Asset Management who advises corporate pension plans on long-term strategy.

Spread Watching on the Yield Curve

Research has shown that there is little long term gain in returns by extending maturities beyond 5-7 years. There is a yield pickup under most periods between shorter and longer term rates (positive sloping yield curve). But there is also more risk of adverse price movements due to changes in interest rates. The "sweet spot" in terms of risk and return is in the range of intermediate term bonds.

Looking at yields on corporate bond ETFs (NASDAQ:VCIT) (intermediate term) has a yield of 3.3 and (NASDAQ:VCLT) (long term) of 4.78. A "yield chaser" might be inclined to move all his corporate bond holdings to the longer term bonds to pick up the extra 1.4%.

A more balanced view would be to overweight holdings to the intermediate term. The price volatility of VCLT is twice that of VCIT and the longer duration of VCLT makes it twice as sensitive to movements in interest rates. Although long term rates may not be moving up significantly for the foreseeable future the risk remains and too high a weighting of long term corporate bonds is definitely a risky move.

Behavioral Finance and Portfolio Strategy

Data have shown over again that investors fall into the trap of recency and performance-chasing. They focus on recent performance when making investments. In the current low-interest-rate environment, this has become both performance-chasing and yield-chasing. Investors are well advised to take a second look before following the crowd.

Source: How To Avoid Chasing Performance And Yield