Where to Hide From Volatility: 4 CEFs and an ETF

Includes: FAX, FCO, GLD, PCM, PTY
by: Daniel Moser

With all of the macroeconomic and political risks in the world today there are not that many no-brainer buys out there, if at all. As Alan Greenspan noted on CNBC about a week ago, there are some extreme pressures (both positive and negative) on the economy. In my view, there are enough significant head winds ahead of us that the Federal Reserve will remain quite accommodative on monetary policy. Sure they might raise interest rates up to 1%, but that really represents more of a "solidifying the foundations of global financial markets" more so than a significant shift into tighter monetary policy. Zero interest rate policy is dangerous but that does not dictate interest rates be raised into a restrictive level.

Equities are not in no-brainer buy territory AND because of all the downside risk potential, it seems prudent for investors to think about ways they can shift risk exposures to areas that are less volatile and less dependent on general equity markets. As it turns out, investors do not necessarily have to forgo earning a reasonable return while reducing risk.

The following is an example of how an investor might shift their asset allocation to risk exposures not so dependent on stock returns using a few closed end funds as well as an ETF.

Funds Included:

Aberdeen Asia-Pacific Income Fund (NYSEMKT:FAX) – is a closed-end, non-diversified management investment company. The fund's investment objective is to seek current income. The fund seeks to achieve its investment objective, through investment in Australian and Asian debt securities. The fund invests at least 80% of its net assets plus the amount of any borrowings in Asian debt securities, Australian debt securities and New Zealand debt securities. The fund may enter into repurchase agreements, and invest in credit-linked securities, which are unstructured, unleveraged pass-through vehicles to an underlying security denominated in a local currency. The fund uses derivatives to manage both currency and interest rate risk for global debt securities. The investment manager, adviser and sub-adviser of the fund are Aberdeen Asset Management Asia Limited, Aberdeen Asset Management Limited and Aberdeen Asset Management Investment Services Limited, respectively.

Some recent market commentary provided by the fund from May 2011 includes:

  • China and Taiwan hiked interest rates, while Singapore re-centered its currency band to allow greater currency appreciation.
  • Indonesian and Philippine bond markets were the best performers, thanks to better risk appetite and easing inflation concerns. Indian bond yields rose as the market priced in a 25- bps rate hike due to higher-than-expected March inflation.
  • The Australian yield curve flattened: Three-year yields rose sharply because of stronger domestic economic data, while 10-year yields declined slightly amid lower U.S. Treasury yields.
  • Credit spreads widened amid deteriorating debt problems in peripheral Europe, Standard & Poor’s downgrade of America’s long-term credit outlook, as well as the large volume of new issues. However, high-yield bonds, particularly those issued by Chinese property developers, performed well as valuations appeared attractive.
  • Asian currencies continued to strengthen against the U.S. dollar, led by the Korean won, and the Singapore and Taiwan dollars.

Aberdeen Global Income Fund (NYSEMKT:FCO)is a closed-end, non-diversified investment company. The fund’s principal investment objective is to provide high current income by investing primarily in debt securities. As a secondary investment objective, the fund seeks capital appreciation, but only when consistent with its principal investment objective. The fund’s investments are divided into three categories: developed markets, investment grade developing markets and sub-investment grade developing markets. The fund invests at least 80% of its net assets plus the amount of any borrowings for investment purposes, in debt securities. Aberdeen Asset Management Asia Limited (the investment manager) serves as investment manager to the fund, pursuant to a management agreement. Aberdeen Asset Management Limited (the investment adviser) serves as the investment adviser and Aberdeen Asset Management Investment Services Limited (the sub-adviser) serves as the sub-adviser.

Some recent market commentary provided by the fund from May 2011 includes:

  • Bond yields generally fell in most major global markets in April. U.S. Treasury yields fell by up to 30 basis points (bps) over the month as the Treasury market shrugged off Standard and Poor’s putting U.S. Government debt on negative credit watch.
  • In the UK, gilt yields increased in the early part of April only to fall back later in the month as expectations of tighter monetary policy by the Monetary Policy Committee faded.
  • Emerging market debt extended its gains in April, with the JPMorgan EMBI Global Diversified Index rising 1.36%, while the benchmark spread widened 4 bps to 281 bps over U.S. Treasuries.
  • The fund remains positioned with an overall 70%/30% asset mix in developed and emerging markets, respectively.
  • Looking ahead, we expect a bounce in second-quarter growth in the U.S., reflecting a more positive contribution from net trade, inventories and household spending on the back of positive developments in the labor market. Against this background, we believe that U.S. Treasury yields are likely to rise.

PCM Fund (NYSE:PCM)formerly PIMCO Commercial Mortgage Securities Trust, Inc., is a non-diversified, closed-end management investment company. The fund’s primary investment objective is to achieve high current income, with capital gains from the disposition of investments as a secondary objective. It invests in a portfolio consisting primarily of commercial mortgage-backed securities. These securities are fixed-income instruments representing an interest in mortgage loans on commercial real estate properties, such as office buildings, shopping malls, hotels, apartment buildings, nursing homes and industrial properties. It seeks to invest at least 65% of its total assets in commercial mortgage-backed securities, which may be represented by forwards or derivatives, such as options, futures contracts or swap agreements. It may invest in mortgage-related and other asset-backed securities. The fund’s investment manager and administrator is Pacific Investment Management Company LLC.

PIMCO Corporate Opportunity Fund (NYSE:PTY) – is a diversified, closed-end management investment company. Its investment objective is to seek total return through a combination of current income and capital appreciation in a diversified portfolio of United States dollar-denominated corporate debt obligations of varying maturities and other income producing securities. These include corporate bonds, debentures, notes and other similar types of corporate debt instruments. It focuses on corporate debt obligations rated in the lowest investment-grade category (Baa or BBB) and in the highest non-investment-grade category (Ba or BB). It invests in residual interest municipal bonds and residual interest tax exempt bonds (inverse floaters), whose interest rates bear an inverse relationship to the interest rate on another security or the value of an index. The fund’s investment manager is Allianz Global Investors fund Management LLC. Its sub-advisor is Pacific Investment Management Company LLC.

SPDR Gold Trust ETF (NYSEARCA:GLD) – is an investment trust. The investment objective of the trust is for the shares to reflect the performance of the price of gold bullion. The trust holds gold, and from time to time, issues SPDR Gold Shares (shares) in baskets, in exchange for deposits of gold and distributes gold in connection with redemptions of baskets. A basket equals a block of 100,000 Shares. The sponsor of the trust is World Gold Trust Services, LLC. BNY Mellon Asset Servicing, a division of The Bank of New York Mellon is the trustee of the Trust. HSBC Bank USA, N.A. serves as the custodian of the trust’s gold.

Is My Portfolio Diversified?

When investors are evaluating incorporating or removing any investment (stock, bonds, funds, etc.) to/from their portfolio it is crucial to remember the holy trinity of finance: risk, return, & correlation. With that in mind take a look at the correlation matrix of the investment funds being examined:

36 Month Rolling Correlation starting Dec 2009
fax fco pcm pty gld spy
fax 1.0000
fco 0.6839 1.0000
pcm 0.4671 0.2996 1.0000
pty 0.1307 0.3365 0.3374 1.0000
gld 0.1386 0.1401 -0.2539 -0.2694 1.0000
spy 0.5773 0.3610 0.5032 0.0660 -0.0312 1.0000

You will note that I have included the S&P 500 largely because I believe it is the go to risk asset that most investments are benchmarked against. The portfolio that was constructed for this analysis began in December 2009 so in order to avoid backward looking bias, I chose to only consider December 2009 through May 2011 to measure correlation.

Most investors focus far too much on returns, some investors focus on risk and returns, but far too little focus on the correlation between different investment opportunities. The correlation between different investments is exactly where the secret to diversification lies. Thus, in terms of correlation, the smaller the number between the row and the column in the matrix the better the diversification benefit.

These investment opportunities are, by in large, uncorrelated to one another and even more so uncorrelated to the S&P 500. The one primary exception is FAX vs. FCO. Those two funds are the most correlated to one another of any of the investments included in this analysis.

Portfolio construction process: I used a risk parity process to construct a portfolio of the 5 investment funds incorporated into this analysis. For those that do not know, risk parity is an investment approach designed to equalize the risk associated with various asset classes contained in an investment portfolio.

The weights were set in December 2009 using a 36 month look back period to establish the risk of each investment opportunity. The approximate derived weights were FAX: 22%, FCO: 21%, PCM: 18%, PTY: 13%, and GLD 24%.

(Click to enlarge)

On a cumulative basis, $100 invested in December 2009 and held through May 2011 would be worth roughly $134 compared to $120 if that same dollar was invested in the S&P 500.

(Click to enlarge)

So far in 2011, the numbers are impressive as well given the recent sell off in equities. Year to date, this portfolio has performed very well up 10.1% vs. +- unchanged for the S&P 500.

Why should investors consider this portfolio (or one of a similar type)? The volatility in this portfolio is less than half that of the S&P 500 (5.8% vs. 14.5% over the past 12 months annualized) and the risk exposures within the portfolio are far more diversified. This portfolio has a lot of non-dollar exposure, exposure to the mortgage market, exposure to inflation via gold, exposure to credit via corporate bonds as well as international bonds, etc. Overall this is a less risky way for investors to earn a reasonable rate of return until either equities enter no-brainer buy territory or macro risks are reduced. I think the case for a huge rally in the second half of the year is timid at best and as such I think shifting to yield/income oriented strategies that are not overly reliant on the general market or USG yields is a good way to shift your asset allocation – at least until there is some clarity on which path the fundamentals and the market are taking.

Good luck and thanks for reading.

Disclosure: I am long FAX, FCO, PTY, PCM.