Nola Kulig
Kulig Financial Advisors
Longmeadow, MA, 01116 USA
413-565-2839
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Be Ready for Performance Claims

November 22nd, 2013

Investors, be alert for the fact that things will look very different for fund performance once we close 2013. By December of this year, five-year calculations of fund performance will drop off the impact of 2008. We should expect that trailing fund results will suddenly look quite a bit better than they have for some time. There is nothing nefarious or illegal about the performance you will see, but remember to put those ads in context. Five years does not necessarily encompass a full market cycle.

Here Come the Hedgies!

November 22nd, 2013

If you have not already read this in the press, be forewarned that the SEC lifted an 80-year-old ban and will now allow hedge fund to solicit funds not only from sophisticated investors, but from any who meet a minimum standard of $1 million in net worth or annual income of $200,000.

There is a lot of concern in the industry (myself included) that these complex products will be sold aggressively to investors who don’t really understand the risks. Coupled with the high fees they charge, they should be irresistible to any red-blooded salesperson with a pulse. Given the war chests of some firms, we will also likely be seeing advertising. So why should we be cautious about investing in them?

Years ago I was encouraged to run a fund of these hedge funds, as my background includes a successful run in selecting investment managers. I did research on these funds as a class, and the following factors dissuaded me from attempting to introduce this type of product:

  • While hedge funds claim to be their own asset class, they really can only invest in existing markets. They can leverage (invest with borrowed money) and short securities (bet on them going down), but when you look at historical returns, they are surprisingly correlated with traditional asset classes. So the diversification benefit can be overstated.
  • They charge horrendously high fees.
  • They have hot and cold performance streaks that are unpredictable, just like traditional mutual funds. In other words, human nature and fallibility prevail. If performance consistency is an issue, and you don’t have an extremely large staff to stay on top of this universe of managers, you really don’t have any business investing here.
  • Transparency is a problem. While this is improving, with more funds becoming more forthcoming (especially those in mutual fund form), many remain opaque about what they are really doing with your money.
  • Hot money jumps out of these funds quickly. The investor base of many funds can be very fickle, which is not surprising when you consider the high fees. You don’t want to be the last investor out and be left holding the bag. This is especially important for funds that invest in illiquid securities. In 2008, many investors wanted out of their hedge funds, and they were prevented from exiting because of “gates” the funds put up preventing liquidations.
  • In aggregate, the record of hedge funds has been mixed; while they claim to have low correlations to the traditional markets, this meant that in 2008, you might have lost 20% of your money instead of close to 40%, and they did not rebound as strongly thereafter. If you expected a somewhat lower volatility approach, you were satisfied with those results, but if you were expecting absolute returns regardless of market environment, you were disappointed. P.S. A traditional portfolio did as well or better, depending on your asset allocation, and at much lower cost.

Please also know that while I continue to search for alternative investments with low correlation to traditional asset classes, they need to be available in a form that is transparent and as low cost as possible. They are specialized asset classes, many in ETF (exchange traded fund) or mutual fund format, rather than a hedge fund.

Third Quarter and Year-to-Date Markets Review

November 22nd, 2013

The stock markets were resilient through the first three quarters of the year, despite multiple headwinds: the possibility of rising interest rates, challenges for Europe and emerging markets, renewed conflict in Washington, and some concern about corporate profits.

As noted earlier in the year, despite some increased volatility, if an investor’s portfolio was balanced between asset classes, he/she wasn’t hurt too badly. The following summarize some observations on the markets in the third quarter:

  • Cash was still “trash” (offering negative returns after taxes and inflation), bonds leveled out and gained a bit, and US stocks were still strong. Non-US developed stock markets were also strong, and emerging markets bounced back after some terrible performance earlier this year.
  • Performance was strong across a number of economic sectors, but investors continued to avoid yield sectors like utilities, which actually trailed broad bond indexes.
  • Frequently commodities and emerging markets move together, since both depend on growth in Asia, particularly China. There was some optimism that China’s growth may have bottomed and was in fact turning around, leading to better emerging markets performance. Emerging markets were also helped by the Federal Reserve’s statements that they were not pulling back on quantitative easing, which the markets finally believed.
  • The optimism on emerging markets did not carry over to commodities. Commodities in general, including gold, continued to struggle, although they are positive for the year. Analysts have been focusing on whether China has already stockpiled enough commodities despite possibly turning the corner on economic growth.
  • Gold managed a positive return this quarter. The yellow metal has been hit hard throughout the year by many factors, not the least of which was greater competition from interest-bearing assets as rates rose in the spring/summer. (Since gold pays no dividend or interest, the cost of holding it is low as long as rates remain near zero.) Some analysts have continued to raise questions about the amount of dumping of gold exchange traded funds, and there has been some finger-pointing at hedge funds as culprits. Other sources of demand for gold, such as central banks, remain strong. Gold coin demand has also remained strong, with some selling as soon as they are issued. (Postscript: central bank demand has since declined, although coin demand remains strong.)

Market Returns

Market

Index

Month

Q3 2013

YTD
9-30-2013

Year Ending
9-30-2013

Stocks          
Large Cap S&P 500 Index

   3.1%

   5.2%

  19.8%

  19.3%

Midcap S&P Midcap

5.2

7.5

23.2

27.7

Small Cap S&P Small Cap

6.2

10.7

28.7

31.5

Non-US Developed Mkts. MSCI EAFE

7.4

11.6

16.1

23.8

Emerging Markets MSCI Emerging Mkts.

6.5

5.8

-4.4

1.0

US Bonds Barclays US Aggregate

0.5

0.0

-8.0

-6.9

REITs S&P US REIT

3.1

-3.1

3.1

5.7

MLPs Alerian MLP

2.3

-0.7

21.2

17.0

Gold Dow Jones-UBS Gold Sub index Total Return

-5.0

8.3

-21.2

-25.6

Commodities Dow Jones-UBS Commodity Index TR

-2.6

2.1

-8.6

-14.4

Sources: AJO Partners, Factset, Dow Jones Indexes

There were a few interesting outcomes for the year-to-date results:

  • As has been the case earlier in the year, asset classes diverged in performance, so that diversification continues to be a benefit. This is in contrast to much of what we have experienced since the financial crisis in 2008, and it is occurring despite synchronous loose money policies implemented by the world’s largest central banks.
  • Although Real Estate Investment Trusts (REITs are dependent on low-rate financing, the declines were rather moderate compared to the rhetoric in the press and to what one might have expected with concerns about the potential for change in Federal Reserve policy. They have booked a small gain for the year.
  • A sector which investors have been purchasing for yield, the energy-related MLP sector, held up well and actually rose in value despite bond rate increases.

The observation on portfolio diversification bears repeating, especially since monetary stimulus has meant that in recent years, many asset classes have risen in tandem. If your portfolio is diversified, something will likely always be underperforming. If you are a client of mine, or a regular reader of this newsletter, you have heard this from me before. But it always bears repeating.

Since we have covered what happens to stocks and bonds in rising rate environments earlier this year, if you haven’t already read them, we’d refer you to those issues of Kulig Financial Perspectives to become comfortable with your portfolio. If you did not receive those newsletters, please head to my blog at http://www.kuligfinancial.com/blog/. Subscribers receive my letters first, so they are posted here in a slightly different format with a delay.

Portfolio Implications

We addressed this earlier in the year, since market action was fairly dramatic. If you have not already done so, the markets have provided opportunities to rebalance your portfolio if it is already diversified, or to create a diversified structure if you have been waiting for an opportunity.

Importantly, the following comments are not intended to be speculative investment recommendations. Instead, these are tweaks one could make to a diversified portfolio that has been designed to fit your financial situation, risk tolerance, and most importantly, your risk capacity (risk that you can afford to take). Those who are clients at Kulig Financial will be familiar with all of those terms and concepts.

The following are just some of the areas an investor can consider. Many of them are in the bond sectors, but there are also some in other markets:

  • For the first time in quite a while, we are seeing positive real yields on Treasury Inflation Protected Securities (TIPs). The stated yield on TIPs is called the real yield (meaning a yield net of inflation), while the principal is adjusted for inflation over the life of the bond. For quite some time, investors have been concerned about inflationary prospects due to loose money policies by the Federal Reserve, and TIPs became so popular as a way to hedge against inflation that yields actually went negative. In other words, investors were willing to pay the government to get the inflation coverage. With concerns about potential tightening measures, rates have risen across all bonds, and we now have positive, although small, real yields.
  • Municipal bonds and emerging markets bonds were beaten down, so these markets may also represent opportunities to rebalance.
  • Emerging markets stocks remain at low prices relative to developed markets. Some analysts are finding this an intriguing area. Economic growth has disappointed year to date, although it remains at higher levels than in developed markets (which have also seen downward revisions to expectations). More recently the economic growth has been exceeding investor expectations, which tends to help these markets. Analysts have also noted that by some estimates the S&P 500 trades at levels roughly 45% more expensive than emerging markets. Of course, the fact that a market becomes relatively cheap says nothing about when it may rise in value. All you really know is that you have reduced the risk of overpaying.
  • Gold continues to intrigue more analysts at these levels. They note that the macroeconomic concerns that make gold attractive (namely loose money policies which could eventually manifest in hyperinflation) remain in place. Gold is also an asset class (like stocks) that is volatile on a stand-alone basis, but very diversifying for a portfolio. Small weightings result in lower overall portfolio volatility. They remain concerned by the exchange traded fund price action compared to the lack of supply in some physical gold markets. For this reason, it may be prudent to change your some of your holdings to physical gold, although this presents challenges of physical storage.

In summary, with US stocks having had such strong results over the last year (and looking further back, ever since 2009), if you haven’t reviewed your portfolio’s allocations across different asset classes, it is time to do so. You may find your portfolio is over allocated to stocks (unless you have avoided them since 2008, as some have).

We have discussed reallocating to bonds in previous issues of Kulig Financial Perspectives as stocks have risen this year. We would stand by those comments and reiterate them here for new readers (others can skip this section since you have heard this before).

Many ask whether it is even worthwhile purchasing bonds at today’s low rates. It is admittedly a difficult time to think about making new purchases, but we have to look at the role they play in a portfolio. Normally we look to them as income instruments, and it is difficult to do so now. But the other role they play is as portfolio stabilizers. No matter how poorly bonds may do, their worst historical returns have never been as volatile as stocks.

If you are concerned that bonds are expensive, there are several things you might consider in order to “play defense” and help preserve your capital (note: these strategies paid off in June’s rocky bond markets):

  • Keep maturities short. The longer the maturity, the more negative the price impact if rates rise.
  • Stick with higher quality bonds. If you reach for yield, you are likely to end up holding junk bonds or other lower quality securities. Many investors bought these earlier in the year and got hammered in the recent downturn for bonds. When these markets decline, they can exhibit stock-like volatility. That usually isn’t what investors are looking for in their bond portfolios.
  • Be careful with closed-end funds. Some purchase these securities for their higher yields, but many of them are leveraged, meaning they invest with borrowed money. Leverage works great so long as the fund’s investments keep rising; but if they decline (as bonds have recently if interest rates rise), then leverage works in reverse and you lose money. Think about highly indebted borrowers in the housing market in 2008, and you get the picture. It can happen with any asset class. Avoiding leverage is difficult with closed-end funds since most use it, but only purchase non-leveraged ones if you can. At a minimum, know what your fund does with leverage and assess whether you can deal with the risk that may introduce.
  • Be careful with bond indexes in today’s environment. I am usually a fan of index investing, but in today’s world passive bond funds could be vulnerable. Many analysts think that the Treasury and government agency markets are some of the most overvalued. These sectors currently comprise large percentages of traditional bond indexes. For example, Vanguard’s Total Bond Market Index has a bit over 68% US government and agency securities, making it very nearly a government bond fund. Even if you have a positive view on these types of bonds, you’ll want to integrate other strategies into your bond portfolio for broader diversification.

So where will rates go from here? The truth is that nobody really knows. Many knowledgeable veteran bond investors think the markets overreacted to Fed commentary, especially looking at the slow growth and continued unemployment in the US, not to mention that Europe looks worse and remains a drag on the global economy. Some, like Bill Gross at Pimco, are becoming increasingly convinced that we may remain in a low rate environment for many years to come (others have remained steadfast in that belief throughout the financial crisis and beyond). But even if they are wrong, as we noted in the June issue of Perspectives, it is possible to play defense with bonds, rather than desert them entirely.

So what is the message from all this? It is boring to hear this yet again, but stay diversified in your portfolios and make sure the risks you are assuming fit your situation.

Investment advisor representative of an investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Kulig Financial Advisors may offer investment advisory services in the state of Massachusetts and other jurisdictions where exempted.