'Fear Trade' Favorites Less Appealing Than Higher-Yielding ETFs

by: Gary Gordon

There will be times when investors succeed in spite of what they are doing, not because of what they are doing. For example, on a year-over-year basis, plowing money into treasury bond funds has been exceptionally profitable. And the longer the duration, the better the results.

Year-Over-Year Treasury Bond Profitability
Approx %
Vanguard Extended Duration Treasury (NYSEARCA:EDV) 56.0%
iShares 20 Year Treasury Bond Fund (NYSEARCA:TLT) 34.0%
iShares 10-20 Year Treasury (NYSEARCA:TLH) 20.6%
PowerShares Laddered Treasury 1-30 (NASDAQ:PLW) 19.5%
iShares 7-10 Year Treasury (NYSEARCA:IEF) 13.9%
iShares 3-7 Year Treasury (NYSEARCA:IEI) 5.7%
Vanguard Total Stock Market (NYSEARCA:VTI) 4.5%

The performance discrepancy between stocks and treasury bonds may be even more startling over three years where the iShares 20-Year Treasury (TLT) beat Vanguard Total Stock Market (VTI) 55% to 50%. Over five years with the 2008 stock market collapse? No wonder so many retail investors refuse to believe in stocks anymore.

401k plans and brokerage statements condition us to think in terms of rolling dates - like 1, 3 and 5 years. In fact, not only do we sheepishly think about them, we tend to act on them.

Indeed, people have pulled money from stock funds every single month for three consecutive years (since mid-2009). With investors receiving statements showing that every single stock fund presented double-digit negative returns for 1- and 3-years ... with the same statements showing that treasury bond funds offered ”double-digit” positive returns ... why wouldn’t the 2009 decision-maker gravitate toward the money-winning alternative?

In 2012, retail investors are continuing to stick with treasuries because this asset class has made money over 1, 3 and 5 years. What’s more, bonds have always enjoyed the perception of being less risky.

Still, what if longer-maturity treasury bonds lose significant money for investors over one year? With its standard deviation of 16, what if TLT loses -20% for its current buyers over the next 12 months? Will Fed stimulus and foreign buyers be able to prop up treasury bond prices once more or will there be an exodus from oversubscribed government IOUs?

The answer, of course, is unknowable. Yet the bond bulls who continue to swear by the “treasury trade” are counting on circumstances that don’t necessarily even exist.

For instance, ”recessionistas” who talk endlessly about a deflationary spiral dismiss the actual inflationary data. Specifically, in spite of household deleveraging, the Consumer Price Index (NYSEARCA:CPI) in the U.S. demonstrated 2.25% annualized inflation over the last five years. That’s not Japanese-style deflation of 0%. In fact, actual inflation may be significantly understated since it doesn’t account for things like college education or healthcare.

So if inflation averages 2.25% over the next decade (it is probably more like 3%), and one owns a 10-year treasury of 1.5%, he/she will be losing purchasing power. And for those who expect to make money not from the yield but from price appreciation instead, there is precious little room for interest rates to go lower.

IEF may have been able to gain 8% when 10-year yields dropped from 2.75% to 1.75%. Will IEF really gain another 8% by seeing 10-year yields fall to 0.75%? Over what time frame? And by extension, isn’t it equally plausible that the 10-year could rise from 0.75% to 1.75%, then 2.75% shortly thereafter? How much would an investor in IEF lose then?

The truth on why treasury bonds continue to win is painfully simple. Money has flown from tech stocks to real estate to commodities to treasuries. In each case, the latest investors to the party experienced monstrously painful losses.

I expect treasuries to hold up as long as the fear over Europe’s debt looms as large as it does. Nevertheless, I’d rather incorporate higher-yielding assets with some opportunity for capital appreciation into my client portfolios. Investments like PowerShares Fundamental High Yield (NYSEARCA:PHB), iShares Intermediate Investment Grade Corporate (NYSEARCA:CIU), iShares Mortgage REITs (BATS:REM) as well as Vanguard High Dividend Yield (NYSEARCA:VYM) are particularly appealing.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.