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Geoff Considine
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Geoff is the founder of Quantext. Geoff was an early contributor to SeekingAlpha and now writes regularly for Advisor Perspectives and Financial Planning. He has been working in asset management analytics and research for more than ten years. Before entering finance, Geoff was a research... More
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  • Treasury Yields De-Coupling From Other Bonds

    I just updated the tables of yield vs. risk on the Yield Frontier page. As part of an ongoing discussion of the frontier of yield vs. risk, I will first examine the bond asset classes--and they are very interesting. The results are shown below.

    What is most evident is that the different types of bonds (each represented by an ETF) show a consistent relationship between yield (vertical axis) and expected volatility (horizontal axis). The two exceptions to this relationship are intermediate and long-term Treasury bonds, which are providing very low yields as compared to their risk levels.

    These results tell an important story. The risk in bonds comes from two sources: inflation and default. Treasury bonds are assumed to have no default risk, so all of the risk is inflation risk. The various types of corporate and municipal bonds have varying balances of default risk vs. inflation risk. The very low yields on intermediate and long Treasury bonds tells us that investors are willing to accept less compensation (lower yield) for bearing inflation risk than for default risk. This decoupling has been partly driven by the U.S. government's purchasing of its own bonds as part of QE--the Fed is buying Treasury bonds to provide stimulus rather than in hopes of returns. Treasury bonds have essentially decoupled from other bond classes.

    High-yield corporate bonds and high-yield muni bonds have high yields relative to their risk levels, but these are part of a consistent tradeoff between yield and risk as compared to other fixed income classes. This is, in itself, somewhat intriguing given that there are reasons why high-yield bonds should behave somewhat differently than other higher-rated bonds classes. Many pension plans, insurance companies, and other institutional investors are prohibited from owning these asset classes because they are considered to be below investment grade.

    Nov 20 7:45 PM | Link | Comment!
  • Target Date Strategies Over The Last Five Years

    Target Date Strategies over the Last Five Years

    Originally published at

    The intent of target date strategies is to provide investors with fully-diversified portfolios that evolve appropriately as investors age. Target date funds have enjoyed enormous growth over recent years, not least because the Pension Protection Act of 2006 allows employers to direct retirement plan participants into these funds as the default investment option. Consultancy Casey Quirk projects that target date funds will hold almost half of all assets in 401(k) plans by 2020.

    Target Date Folios are an alternative to traditional target date funds, launched on the FolioInvesting platform in December of 2007. These portfolios now have more than five years of performance history. Prior to the design of the Folios, a detailed analysis of target date funds suggested that they could be considerably improved. The Folios were designed to provide investors with an enhanced target date solution. In this article, I will discuss the design and performance of the Folios and target date mutual funds over this tumultuous period. The risk and return characteristics of these funds and Folios provides insight into the effectiveness of different approaches to portfolio design and diversification.

    Risk Targets vs. Years to Retirement

    There are a number of considerations in designing a target date strategy. The first step is to estimate an appropriate risk level at each stage in a typical investor's life. Here, at the outset, there are substantial differences in the approaches employed for funds vs. the Folios. The most common fund approach starts with using the percentage of a portfolio that is allocated to equities as a proxy for risk. Using this approach, the designer of a target date fund determines a target percentage to equities for investors, as a function of the number of years until they retire (this is often referred to as the 'glidepath' of a fund). The most commonly identified problem with this approach is that different target date strategies may have dramatically different allocations to equities at each stage in an investor's life. The second problem, far less appreciated, is that using the allocation to equities as a proxy for risk can mask huge differences in the actual risks. Our analysis of target date mutual funds has clearly shown that there are substantial differences in risk levels even for funds with the same percentage allocated to equities. This should not be all that surprising. Some equity sectors have far more risk than others. Similarly, some bond classes are much riskier than others. Among target date funds designed for people who retired in 2010 with the same percentage allocation to equities, the trailing three-year risk levels varied by as much as 44%.

    The risk levels of different asset classes vary through time. The volatility of the S&P500 increased dramatically from 2007 to 2008, for example. Similarly, the relationships between different asset classes change over time. During periods of market stress, risky asset classes tend to move together, reducing the effectiveness of diversification as a risk mitigation tool, for example. For these reasons, the traditional glide path, which manages to an asset allocation goal, can expose investors to dramatic variations in risk level through time. The alternative is to manage to a risk goal, and varying the asset allocation through time to meet the appropriate risk level. This is the approach that we have taken with the Target Date Folios. Each year, the allocations are adjusted as needed to provide investors with a portfolio at the appropriate risk level rather than maintaining a policy asset allocation.

    Diversification Strategy

    The defining goal for target date strategies is to provide investors with well-diversified portfolios at an appropriate risk level. A diversified portfolio is one that combines asset classes with different types of risk, so that a decline in one asset class will tend to be at least partly offset by returns from other asset classes. While this idea sounds simple, the implementation of a diversified portfolio is quite complex and there are different schools of thought on how to build a well-diversified portfolio.

    The simplest approach to diversification is simply to own some of everything. By spreading your equity exposure across thousands of stocks, you limit your exposure to the risks of a decline in any single firm. The most common way to own a vast number of stocks is to buy an index fund, such as one that tracks the S&P500 or a global stock index. A similar approach can be taken with the bond portion of the portfolio. At the simplest implementation, a target date fund might hold just a few funds. Vanguard's target date funds are the best example of this approach. Vanguard s 2040 Target Date Fund (VFORX), for example, is comprised of a 63% allocation to the Vanguard Total Stock Market Index Fund (VTSMX), 27% to the Vanguard Total International Index Fund (VGTSX), and 10% to the Vanguard Total Bond Market Index Fund.

    This very simple strategy helps to keep costs low, but there may be some unintended consequences. While VTSMX holds more than 3,000 stocks, Apple (AAPL) comprised 3.95% of this fund at the end of September of 2012. Apple comprised such a large portion of the total stock index because of its enormous market capitalization. VTSMX holds stocks in proportion to their market cap. The more the price of a stock goes up, the larger the allocation to that stock. With 63% of VFORX allocated to VTSMX, and 3.95% of VTSMX invested in Apple, VFORX had 2.5% of its assets in Apple at the end of September of 2012.

    The second limitation to the very simplest asset allocation approach that holds just stocks and bonds is that research suggests that there are substantial diversification benefits to be had by investing beyond a total market stock index and bond index. Even through the bear market of 2008, there is evidence that diversification provided considerable value.

    If we move to more complex strategies than simply holding a few stock and bond index funds, what are the alternatives? First, we might replace the passive index-weighted exposure to different asset classes with actively-managed funds. The intent behind such an approach is that active managers will select investments that will, as a portfolio, out-perform the index-based allocations. The debate over the relative merit of active vs. passive investment selection is beyond the scope of this article. The second alternative, which is the approach used with the Target Date Folios, is to use a quantitative asset allocation model to create portfolios with the highest expected return per unit of risk. In this approach, a quantitative model projects risk and return for asset classes and sub-classes, as well as calculating the correlations between them. A quantitative model is used to determine the portfolio of assets that has the highest expected return for a target risk level. The goal of quantitative asset allocation is not to predict which stocks or sectors will out-perform, as would be the case with actively managed funds, but rather to combine asset classes in a way that maximizes expected return anticipating risk offsets between asset classes. This, in turn, tends to increase risk-adjusted return for the total portfolio. This process is often referred to as strategic asset allocation.

    There are a number of standard methods for performing quantitative strategic asset allocation. In the approach used for the Target Date Folios, we start with the universe of available ETFs. To be included in the analysis, an ETF must have at least four years of performance data. Without sufficient data, we are not confident that we can properly characterize the risk and return properties. Along with the risk constraint, we also specify limits on interest rate exposure. The portfolio allocations are determined using an optimization algorithm that maximizes expected return at each risk level.

    The Target Date Folios are re-analyzed once per year, and the asset allocations that result from the quantitative analysis vary somewhat from year to year. As noted previously, we specify risk goals rather than specific asset allocations and the model determines the portfolio with the highest return for a given risk level. In 2007, for example, the Target Date Folios had substantial allocations to inflation-protected bonds (OTC:TIPS). By 2012, the allocations to TIPS were much smaller and there were substantial allocations to municipal bonds. This shift in allocation was primarily due to the changes in the correlations between TIPS and equities. In 2007, TIPS had a very strong negative correlation to equities, which means that TIPS tended to offset risk from equities very effectively. By the end of 2012, this diversification benefit had been dramatically reduced, making TIPS less attractive.

    Five Years down the Road

    From their launch in December 2007 through December 2012, the Target Date Folios have out-performed a composite of the three largest target date fund families (that together hold about 75% of all assets invested in Target Date Funds) by 1% per year. This level of out-performance can have a huge impact over an investor's lifetime. As I have written previously, it is reasonable to project that this level of out-performance will result in 20% higher lifetime wealth accumulation over a working career. We cannot provide assurance that the out-performance will persist in the future, but the fact that the level of out-performance is consistent with what we originally projected could be obtained with additional diversification is encouraging. Our current projections suggest that this 'diversification alpha' persists. All projections are subject to a high level of uncertainty, of course.


    Target date solutions, all-in-one well-diversified investments, are an important innovation. Many, if not most, individual investors lack the expertise and time to build and manage a portfolio that is matched to their long-term needs. As the evolution from traditional pensions to self-directed plans continues, target date funds play an important role. We are seeing rapid adoption of target date funds, and this growth seems likely to continue.

    The value of target date funds notwithstanding, there are areas in which these funds need to be improved. Target Date Folios are designed to be the next generation of target date strategies. The primary benefits of the Folios as compared to mainstream funds are (1) improved risk management, and (2) better diversified asset allocations. In the five years since the Target Date Folios were launched, these non-traditional asset allocations have out-performed at a level consistent with projections.

    Jan 30 12:54 PM | Link | Comment!
  • Why Dividends Matter

    Ideas can become so entrenched that they are not questioned. One such idea is that investors should care only about total return (dividends plus price appreciation) rather than about the fraction of return delivered by dividends or price gains. This belief is pervasive in the financial services industry and I believe that very few people would argue with the proposition that the 'total return' paradigm is the standard of practice.

    The idea that investors should be indifferent as to whether their returns come from dividends or prices gains originates with the Modigliani-Miller Hypothesis. The basic idea, as far as dividends are concerned, is that companies it should be no more or less profitable to use your own retained earnings to fund future growth than it is to borrow money to fund future growth. As such, returning earnings to shareholders in the form of dividends should not matter to long-term profitability and, ultimately, to investor returns. The the MM Hypothesis depends on an assumption that capital markets are both rational and efficient. In this world view, there is no value- or small-cap effect. There is also no reason to invest in anything other than a market-cap weighted market index.

    If one believes in totally rational markets, in which the prices of every asset reflect all of the available information, it is perfectly reasonable to ignore dividends. The problem is that the real markets are demonstrably irrational. The existence of bubbles, for example, is a clear violation of efficient markets. There are many more examples, of course. A key idea that is ignored in so much of the rational markets literature is the uncertainty that people have when estimating future returns on different assets. Investors must explicitly or implicitly come up with expectations for future risk and return on the various investment alternatives available to them. How great is our uncertainty with regard to these estimates? How might our uncertainty with regard to our estimates of future return vary across different types of investments? This is where dividends differ from price appreciation. Our estimation of future returns from dividends is relatively more certain than our estimates of future price gains. I recently wrote a long article exploring this issue.

    The key issue that comes out of that analysis is that dividends matter if you care about being able to predict the consistency with which your portfolio generates returns. Clearly, this is a primary concern for people in or entering retirement. Even if you know with certainty that your portfolio will generate an average return of 8% per year, you may still end up depleting your portfolio entirely with only a 5% income draw if the portfolio has a bad run of returns at the start of retirement. If your portfolio has a dividend yield of 5% and expected price appreciation of 3%, for a total return of 8% per year, your situation is clearly different from a situation in which you have a dividend yield of 2% and are expecting price appreciation of 6%.

    David Blanchett, head of retirement research at Morningstar, published an important paper this summer that lays out some of the differences implicit in income-oriented portfolios and total return portfolios. This paper does not, however, deal with the issue of the differences in estimation risk for income-generating assets and non-income assets. In email communications, however, he has acknowledged the importance of this issue. His treatment assumes an investor preference for income vs. price appreciation via a new utility function, which is a mathematical description of how an investor balance risk and return.

    Receiving a dividend means that a company is paying cash to investors rather than investing this money in future growth opportunities. Investors are giving up future (uncertain) growth in preference for a payment today. This is similar to investors who sell call options against their holdings. Certainly your upside potential is limited while you still hold all the downside risk in both cases. In the worst case, in which a company defaults, neither dividends nor income from a covered call will substantially reduce your pain.

    I believe that the issue of dividends in equity returns is going to be enormously important as the U.S. ages and we transition from a population of investors who are fairly insensitive to the consistency of their returns to one in which investors have amplified sensitivity to variations in return from year to year. Once you start drawing income, consistency matters a great deal. This challenge is further magnified because bond yields are so low. While a portfolio entirely dominated by bonds was once a viable option for some fraction of the population, the percentage of people with sufficient assets to live entirely off of bond yield must surely be becoming vanishingly small.

    Dec 03 2:12 PM | Link | 1 Comment
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