Thursday, July 28, 2011

Sovereign Debt and the Equity Investor

By Weston Wellington

Last week we came across an "Economic and Policy Watch" update prepared by a major investment bank that reviewed recent government proposals to address the nation's funding crisis. Titled "It Just Gets Worse," the report chided policymakers for actions that "look like a poor cover for loose money, rising inflation, and fiscal problems," and warned that "government financing needs are corrupting monetary policy." As a result of these ill-advised tactics, the bank had turned "more negative" on the outlook for financial stability and saw "little hope of improvement in the inflation/currency mix."

Amidst the barrage of news coverage from dozens of sources probing the US debt/default/downgrade issue, such a conclusion might seem unremarkable. We found it of interest because the focus of the report was not the US Treasury but the government of Indonesia, and it appeared over a decade ago, on July 16, 2001.

Indonesia's sovereign debt rating at that time placed it firmly in the "junk" (non-investment grade) category: B3 from Moody's and single-B from Standard & Poor's. Although Moody's upgraded Indonesia to a B2 rating in 2003 and to Ba1 in early 2011, at no time over the past decade was Indonesia deemed to merit an investment grade rating.

What has been the experience of equity investors in Indonesia since this report was published? The Jakarta Composite Index closed at 415.09 on January 16, 2001, while the Dow Jones Industrial Average finished that day at 10,652.66. On Wednesday, the Jakarta Composite closed at 4,087.09 and the Dow at 12,592.80. If the Dow Jones Average had kept pace with Indonesian stocks over the past decade, it would be over 104,000 today.

Investors in Indonesia have had their share of ups and downs over the years, and markets fell even harder than the US during the financial crisis, with a peak-to-trough loss of nearly 60%. But the recovery was sharper as well: The Jakarta Composite recouped all of its losses by April 2010, and the all-time high on July 22 this year was 45% above the high-water mark of early 2008.

For the ten-year period ending June 30, 2011, total return as computed by MSCI was 29% per year in local currency and 33% in US dollar terms. At no point throughout this period did Indonesia have an investment grade rating for its sovereign debt, and outside observers continue to find fault with the country's troublesome level of corruption, primitive infrastructure, and unpredictable regulatory apparatus.

We are not suggesting that investors should dismiss the effects of a US government credit downgrade. US Treasury securities are so widely held around the world that any potentially destabilizing event is worrisome. Nor are we suggesting that investors focus solely on countries with low credit ratings. Just as a broadly diversified portfolio includes companies with high and low credit quality, investing in countries with both high and low ratings is equally sensible.

Some might say the strong performance of Indonesian stocks over the past decade was at least partly attributable to the nation's improving credit profile, even if it remained at a relatively low level. The US, in contrast, appears to be deteriorating. Our point is that a low credit rating in and of itself is not necessarily a death sentence for equity investors. Citizens of triple-A countries behave much like those living in single-B territory—they eat, drink, shop, get stuck in traffic jams, chatter on mobile phones, and check their Facebook pages. (Indonesia claims the second-largest number of members in the world.) Companies doing business in either location generate cash flows, and investors do their best to evaluate what those cash flows are worth. A triple-A sovereign debt rating is no guarantee of superior equity market returns, and a "junk" rating is no assurance of failure. A diversified strategy will have exposure to both.

Research assistance by Victoria Choi.

Ray Farris, "It Just Gets Worse," ING Barings Economic and Policy Watch, January 16, 2001.

"Global Credit Research," Moody's Investors Service, March 2004.

"Missing BRIC in the Wall," Economist, July 21, 2011.

Securities data provided by Bloomberg.

Yahoo! Finance, (accessed July 25, 2011).

Debt Ceiling: Potential Implications

By Larry Swedroe

To date, we have had lots of rhetoric but no real progress on meaningful deficit reduction. Yet, the August 2 deadline looms. If you’re like most investors, you’re concerned about the potential implications of reaching that deadline without a resolution. Let’s look at some of the potential fallout if such a situation were to occur. (Of course, keep in mind that my crystal ball remains cloudy as always. And thanks to my friends at Appleton Partners for sharing their thoughts with me on this subject.)

The government has two big payments due in the first part of August:

  • It owes about $32 billion in Social Security and other payments on August 3.
  • It owes about $31.5 billion in debt service and redemption on August 15.

I doubt that the Treasury would suspend any debt payments, because the long-term cost of a default would be too high. But it’s seems certain the government would need to defer payment on other debts and subsidies.

One of the most important implications of a failure to reach agreement on extending the debt ceiling and/or failing to put in place credible deficit reduction programs is that the ratings agencies would likely downgrade Treasury debt. They’ve already warned about this prospect. If that happened, Treasury bills would no longer be the benchmark “riskless” asset. In addition, there are several other bonds that would likely suffer reviews and downgrades:

  • Government-sponsored entity or such related debt
  • Prerefunded bonds backed by Treasuries
  • Bonds relying heavily on capital market access, such as variable-rate demand notes and commercial paper

However, there doesn’t seem to be any reason to believe this would harm the credit ratings of AAA-rated corporate bond issuers, nor the AAA ratings of any state issuers in the municipal market. Each situation would be evaluated on its own unique characteristics and exposure to the Federal government (direct or indirect). Those not as reliant on the Federal government will likely keep their rating.

There are some other implications to consider. The most important one is that there would likely be a disruption in the liquidity of the markets (both stock and bond). While it would likely be brief, it would also likely create great volatility, and markets could easily “seize up,” with liquidity disappearing. As I stated in my post on July 18, forewarned is forearmed.

While we’ve always preached the merits of maintaining very strict credit standards, maintaining those standards (and not stretching for yield, which can be tempting in a low-rate environment) is more important than ever. In addition, it’s also more important than ever to be sure to have sufficient liquidity in highly liquid assets (such as bank accounts).

Tuesday, July 19, 2011

Debt Ceiling: Why You Shouldn't Rush to Change Your Portfolio

By Larry Swedroe

As you might expect, I’ve received lots of calls and e-mails asking what to do about the impending crisis surrounding the debt ceiling. So I thought I’d share my thoughts.

As I noted in my post on the Greek crisis, the first and most important point is that if you have a well-developed investment plan, it will have anticipated crises (which by definition aren’t predictable or we would avoid them) and incorporated the virtual certainty that they’ll occur.

In other words, we live in a world of uncertainty. As Napoleon Bonaparte stated, “Most battles are won or lost [in the preparation stage] long before the first shot is fired.” That means we shouldn’t take more risk than we have the ability, willingness or need to take. Having a plan that anticipates severe bear markets gives you the greatest chance of staying disciplined and avoiding panic selling. Without a plan, you’re much more likely to allow your stomach to make investment decisions, and stomachs don’t make for good advisors.

Returning to the debt limit problem, it certainly is true that this crisis creates the potential for another financial “meltdown,” especially when we consider that there’s a similar crisis on the other side of the Atlantic — a crisis in Greece that has the potential to rapidly spread to Ireland, Portugal, Spain and even Italy. These crises taken together — or even separately — contain the seeds for another “seizing up” of capital markets as occurred when Lehman failed.

Though my crystal ball is always cloudy, if that were to occur, it’s seems likely the valuations of all risky assets (stocks and bonds) would fall rapidly, and the more risky and less liquid the asset, the faster and steeper the fall. And since this time the crisis would encompass what U.S. investors consider the riskless asset (Treasury debt), it’s hard to even imagine what could happen. And investors hate uncertainty.

The risks are clearly great if we don’t get an agreement. The problem is that we don’t know what will happen. The crisis could be resolved, or we could see a default. We could also see defaults in Greece and other defaults might follow (or at least markets would likely worry about that happening), and we might also see the end of the Euro, and who knows what else.

I think it’s interesting to note that the stock market has risen in the past month despite these problems. On June 15, the S&P 500 Index closed at 1,265, despite:

  • The failure to resolve the US debt ceiling problem
  • No resolution on the Greek crisis
  • Weakening economic data
  • Rising unemployment
  • The end of QE2 (which some gurus were predicting would lead to major problems for the bond and stock market alike)

On July 14, the S&P 500 closed at 1,308, up more than 3 percent. And despite Moody’s warning of a downgrade of Treasury debt, the 10-year Treasury rate was unchanged at 2.98 percent. I seriously doubt anyone would have predicted that outcome. Certainly bond guru Bill Gross didn’t forecast this. He sold Treasuries back in March, and did so with a lot of fanfare. Yet just recently he started buying back Treasuries, at much higher prices.

So that brings us to what should YOU do about the situation. I can tell you what we are doing as advisors. We aren’t making any adjustments to client portfolios in response to the debt ceiling debate. The market is well aware of the fact that the debt ceiling discussions are ongoing and U.S. Treasury rates are still very low, indicating the market believes the debt ceiling will be increased and that financial market disruptions are unlikely. We believe that efforts to try to move in or out of the stock or bond markets in anticipation of what will happen aren’t productive.

Even if the worst case scenario materialized and the U.S. debt ceiling isn’t raised, it’s seems likely that it would be raised quickly if there were any subsequent disruptions in the financial markets. Also keep in mind that this is a political technicality more than anything and not an issue with the capacity of the U.S. government to pay its debts.

If you won’t follow our advice, just ask yourself what Warren Buffett is doing these days. Is he selling?

With that said, we have minimized exposure to European banks and governments. We moved money out of money market funds that had significant exposures to these credits and into what we believe are safer assets. That is a move you should consider, as it’s a classic example of Pascal’s Wager (the consequences of being wrong are really bad compared to the benefits if you’re right and no losses occur).

The bottom line is this: If your stomach is growling and you’re losing sleep worrying about the outcome, you likely either don’t have a well-developed plan or you were overconfident about your ability to deal with bad economic times. If the former is the case, then you should immediately develop a plan. If it’s the latter, you should probably rewrite your plan and permanently lower you equity allocation, because this likely won’t be the last crisis you’ll have to deal with.

Read more:

Wednesday, July 13, 2011

Discipline: Your Secret Weapon

By Jim Parker

Working with markets, understanding risk and return, diversifying and portfolio structure—we've heard the lessons of sound investing over and over. But so often the most important factor between success and failure is ourselves.

The recent rocky period in financial markets has brought to the surface some familiar emotions for many, including a strong urge to try to time the market. The temptation, as always, is to sell into falling markets and buy into rising ones.

What's more, the most seemingly "well-informed" people—the kind who religiously read the financial press and watch business television—are the ones who feel most compelled to try and finesse their exit and entry points.

This suspicion that "sophisticated" investors are the most prone to try and outwit the market was given validity recently by a study, carried out by London-based Ledbury Research, of more than 2,000 affluent people around the world.1

The survey found 40 per cent of those questioned admitted to practising market timing rather than pursuing a buy-and-hold strategy. Yet the market timers were more than three times more likely to believe they traded too much.

"On the face of it, you might think that those who were trading more actively would be more experienced, sophisticated and able to control themselves," the authors said. "But that seems not to be the case—trading becomes addictive."

This perspective has been reinforced recently by one of the world's most respected policymakers and astute observers of markets—Ian Macfarlane, the former governor of the Reserve Bank of Australia and now a director of ANZ Banking Group.

In a speech in Sydney2, Macfarlane made the point that the worst investors tend to be those who follow markets and the financial media fanatically, extrapolating from short-term movements big picture narratives that fit their predispositions.

"Most people experience loss aversion," he said. "They experience more unhappiness from losing $100 than they gain in happiness from acquiring $100. So the more often they are made aware of a loss, the unhappier they become."

Because of this combination of hyper-activity, lack of self-control and loss-aversion, investors end up making bad investment decisions, Macfarlane noted.

These behavioural issues and how they impact on investors are well documented by financial theorists. Commonly cited traits include lack of diversification, excessive trading, an obstinate reluctance to sell losers and buying on past performance.3

Mostly, these traits stem from over-confidence. Just as we all tend to think we are above-average in terms of driving ability, we also tend to over-rate our capacity for beating the market. What's more, this ego-driven behaviour has been shown to be more prevalent in men than in women.

A study quoted in The Wall Street Journal4 showed women are less afflicted than men by over-confidence and are more likely to attribute success in investment to factors outside themselves – like luck or fate. As a result, they are more inclined to exercise self-discipline and to avoid trying to time the market.

The virtues of investment discipline and the folly of 'alpha'-chasing are highlighted year after year in the survey of investor behaviour by research group Dalbar. The latest edition showed in the 20 years to the end of December 2010, the average US stock investor received annualised returns of just 3.8 per cent, well below the 9.1 per cent delivered by the market index, the S&P 500.5

What often stops investors getting returns that are there for the taking are their very own actions—lack of diversification, compulsive trading, buying high, selling low, going by hunches and responding to media and market noise.

So how do we get our egos and emotions out of the investment process? One answer is to distance ourselves from the daily noise by appointing a financial advisor to help stop us doing things against our own long-term interests.

An advisor begins with the understanding that there are things we can't control (like the ups and downs in the markets) and things we can. Some of the things we can control including ensuring our investments are properly diversified—both within and across asset classes—ensuring our portfolios are regularly rebalanced to meet our long-term requirements, keeping costs to a minimum and being mindful of taxes.

Most of all, an advisor helps us all by encouraging the exercise of discipline—the secret weapon in building long-term wealth.

1. 'Risk and Rules: The Role of Control in Financial Decision Making', Barclays Wealth, June 2011

2. 'Far Too Much Economic News for Our Own Good', Ross Gittins, Sydney Morning Herald, June 13, 2011

3. Barberis, Nicholas and Thaler, Richard, 'A Survey of Behavioral Finance', University of Chicago

4. 'For Mother's Day, Give Her the Reins to the Portfolio', Wall Street Journal, May 9, 2009

5. '2011 QAIB', Dalbar Inc, March 2011

Thursday, July 7, 2011

Legg- Mason Does it Add Value?

By Larry Swedroe

We continue to look at the ability of the leading mutual fund families to add value. Some of the fund companies we’ve recently examined include Northern Trust, Oakmark, Fidelity and American.

Today, we look at Legg Mason, which was the 11th largest asset manager in the world at the end of 2010 with $672 billion under management. Legg Mason Capital Management’s chairman and chief investment officer is Bill Miller, the legendary manager of the Legg Mason Value Trust (LMVTX). Miller accomplished something even Peter Lynch had never done by outperforming the S&P 500 Index for 15 straight years. Money magazine named Miller “The Greatest Money Manager of the 1990s.”

To see if its family of funds has added value, we compared their performances to similar passively managed funds. Using the Morningstar classifications, there are six equity asset classes for which Dimensional Fund Advisors has similar funds.

The table below presents the results for the 10-year period ending April March 2011. Returns were rounded to the nearest tenth, so averages may not match.

Legg Mason’s funds managed to underperform in all six asset classes, with the underperformance ranging from 0.9 percent to as much as 3.6 percent. An equally weighted by asset class portfolio of Legg Mason funds underperformed the equally weighted passive portfolio by 2.4 percent. As my Right Financial Plan co-author Kevin Grogan noted, “If this were a fight, it would be stopped.”

While at least some investors are aware of the difficulty that active managers have in generating alpha, many aren’t aware that research shows that the funds that do manage to outperform tend to do so by relatively small amounts, while those that underperform tend to do so by larger amounts. This is especially true for taxable accounts. Thus, the risk-adjusted odds against outperformance are very high. The evidence on Legg Mason’s performance is consistent with the historical evidence.

The question I have is: Why does Legg Mason still manage almost $700 billion in assets? In a triumph of hope, hype, marketing and a belief in the past performance of active managers as a predictor of future performance, investors have been leaving billions of dollars a year on the table in their quest for the Holy Grail.

What explains this behavior? Are investors impervious to poor performance? Are they willfully blind to results? Is the truth so painful that the mind doesn’t want to face it, so the fantasy survives? Or is it that investors have a very difficult time admitting the errors of their ways? Thus, they cling to the hope that Legg Mason’s performance will turn around.

Wes Wellington, vice president at Dimensional Fund Advisors, offered this explanation: “Miller is clearly very smart, very well-read and is catnip to journalists who seek out money managers with a knack for thinking outside the box and expressing it thoughtfully. It’s hard to imagine anyone being unimpressed by his intellect and the breadth of his reading list. As a result, for the overwhelming majority of investors, it’s all but impossible to accept the notion that someone of such erudition can’t outperform a simple market index, and even a sustained period of underperformance is chalked up to bad luck that will be corrected in the next cycle.”