There is practically universal opinion that interest rates will rise in the future, and that bond portfolios will suffer painful losses when this happens. At Merriman, we think the financial news media has blown this story way out of proportion, with inflammatory headlines designed to capture attention. Narratives include “the coming bloodbath for bond holders” and “the imminent bursting of the 30-year bond bubble.”
Our Chief Investment Officer, Dennis Tilley, recently wrote an article detailing three reasons why we’re not worried about rising interest rates. Here’s a quick summary:
1. The Experts and Consensus Are Often Wrong
History provides countless examples of when experts and/or a super-consensus have been wrong about the future of stock and bond movements. This is why we don’t use market predictions to manage client portfolios.
2. A Portfolio Duration of Four to Five Years Is Optimal
The sweet spot duration for Merriman investors holding bonds is in the maturity range of four to five years. This intermediate duration provides a nice compromise of offering overall portfolio stability, market crisis/deflation/recession protection, a long-term real return above inflation and – perhaps most importantly – the ability to quickly adapt to a rising-rate environment. With this duration, we believe our clients don’t have to worry about rising interest rates. The article provides more detail and charts illustrating this point.
3. Rising Rates Signal an Improving Economy
Finally, rising interest rates are likely to coincide with an economy that is improving, which is generally good for stocks. Yes, temporarily, bonds will lose value due to rising yields. However, we expect only single digit losses from our bond portfolio, not the “bloodbath” that some pundits seem to think will happen.
If you’ve been tuned into financial news lately, you’ve no doubt heard about High-Frequency Trading (HFT). HFT is not new. In fact, it’s been around for over 20 years. Investopedia defines HFT as:
A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions.
So why is it news now? Last week, a 60 Minutes interview with Michael Lewis suggested that the stock market was “rigged” by high frequency traders. I want to provide my thoughts, as Merriman’s Chief Investment Officer and as a hedge fund manager, on how HFT is affecting Merriman client portfolios. While we will monitor developments over time, the bottom line is that we believe HFT has minimal impact on our client portfolios.
HFT firms are the new market markers in the stock market. Market makers, who’ve been active in markets ever since stock exchanges have existed, act to provide liquidity to stock trading by offering to buy stock at the bid price, and sell stock at a slightly higher ask price. While providing liquidity to the market, market makers have always strived to maximize their profits at the expense of institutional investors and the average person buying and selling stock in their brokerage account.
The transaction cost to investors can be viewed as an expense (paid to market makers) for providing liquidity, and has never and will never impact the fundamental value of the stock market. The cost only comes to bare when buying or selling a stock.
Two forces help protect us from market makers making excessive profits. The first force is the competition among market makers. As with any business, large profits attract competitors. Competition among market makers drives transaction costs lower as they fight amongst each other to provide this service. The battle among market makers is very similar to an ever increasing arms race, where whoever has the best technology wins. Over the last 10 years, computers have replaced the Wall Street traders and NYSE specialists – who in the old days were just as keen to profit from investors.
The second force limiting market maker profits are the countermeasures institutions use to trade large blocks for their clients. Attentive investors should be monitoring their trading and adjusting their investing/trading approach to minimize transaction costs. HFT is just the next story in the everlasting interaction between market makers and institutional investors. While the SEC and other government agencies will eventually catch on to illegal trading activities, the smartest investors generally take a buyer-beware approach to their trading.
In our MarketWise portfolios we take into account the sensitivity to trading costs when selecting investment managers. Dimensional Fund Advisors is obsessive in monitoring their trading costs and minimizing turnover. Their approach is to trade like a market maker by buying and selling stocks with limit orders and they are agnostic about what stocks they buy or sell (as long as a stock fits that fund’s investment approach). This trading approach is much less sensitive to HFT. Stock-picking active managers, and index funds, are typically demanders of liquidity when they trade stocks, which is much more susceptible to exploitation from market markers whether using HFT or via the old specialist system on the NYSE.
In our TrendWise portfolios, we also carefully track our ETF transaction costs to ensure that our approach is as cost -efficient as possible. And finally, individual investors, trading small quantities of stock in their own accounts, have benefited greatly from HFT as bid-ask spreads have narrowed significantly over the last decade or so.
If you have any additional questions about HFT or its impact on your portfolio, please don’t hesitate to speak directly with your advisor.
This is a quote from Charlie Munger, Warren Buffett’s right hand man, and a world-class investor in his own right.
It is one of my favorite quotes and has rung true throughout my investment career. In my experience, many financial professionals accept numbers too easily without fully understanding assumptions, sensitivity to inputs, and general rules of economics and competition.
We are always looking for ways to better design client investment portfolios. Every year, we are bombarded with new investment approaches, new products and new trading strategies to beat the market. Most new products can be tossed aside immediately, but a few require more detailed investigation. (more…)
Commodity prices are rising again, led by sugar, copper, corn, wheat, and silver. Demand from emerging countries is the typically-stated reason, with an assist given to the Federal Reserve recently announcing a second round of quantitative easing (a euphemism for printing money).
Whenever you read about soaring commodity prices, it’s usually too late to profit from the trend. Traders have already factored the latest news on supply, demand, weather, and trade policies into futures prices. This is the simple reason why we avoid a commodity allocation in our client portfolios.
There are actually a few more complicated and subtle reasons to exclude commodity funds. If you’re interested in those reasons, read this article: “Why We Still Don’t Favor Commodities.”
Since writing that article, commodity investors have only experienced gut-wrenching volatility and losses. Now the media is starting to notice and write about the fallacy of these funds – one of my favorite articles on the topic was published in Business Week. Read it here.
Do commodities have a rightful place in a broadly diversified portfolio? The obvious answer seems to be yes, they do. However, after a lot of careful study and thought we have concluded that the right answer is still no, they don’t.
Commodity prices across the board are at all time highs. Experts say the world is running out of natural resources and that production will not keep up with the rising demand from fast growing emerging economies.
From a portfolio point of view, commodities also have attractive characteristics. While commodity prices are quite volatile, they tend to zig and zag independently of stock and bond prices. Due to the uncorrelated price movements, adding a small amount of commodity exposure can actually lower overall portfolio risk for a given expected return.
There is also a small measure of portfolio insurance gained from commodity exposure. During a rare commodity-related crisis, such as the Arab oil embargo in 1973, a dramatic rise in commodity prices will help buffer the decline in both stocks and bonds. Commodity exposure can also provide some insurance against political risk, since many of the nations currently rich in natural resources also tend to be somewhat politically unstable.
For all of the reasons briefly described, we were keenly interested in adding commodities to our model portfolios. This was a hard problem with many subtleties and conflicting expert opinions to work through. Contrary to our expectations, after careful study, we recommend leaving commodities out of a diversified investment portfolio. (more…)
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