Transition for Portfolio Two

Portfolio Two is transitioning to ETF’s and CD’s.  This is aligned with the “basic plan” that I refer to here.  The portfolio has $28,781 (all in cash) as of December, 2015.

At a high level our investments will consist of:

  • $10,000 in the lowest risk interest rate products (Federally insured CD’s bought through a brokerage, go here if you want to learn more)
  • $9000 low-cost ETF tracking the US stock market
  • $4500 low-cost ETF tracking the non-US stock market, unhedged
  • $4500 low-cost ETF tracking the non-US stock market, hedged

CD Investment:

In the old days you used to need to call a broker to buy a CD or physically visit a bank.  Now you can buy CD’s online through your brokerage account.  To avoid more complicated tax issues with gains and losses I am sticking to “new issue” CD’s which are always issued at par (100 cents on the dollar).  When you are buying existing CD’s (the secondary market) they have gains or losses implied as they do not sell for 100 cents on the dollar and this causes additional tax issues that aren’t significant but I want to keep this simple and at this purchase level it is easier just to buy new issues.  For each CD there is a minimum bid quantity – for the highest yielding 2-3 year CD selected below, the minimum bid quantity is 10 at $1000 or $10,000.

Goldman Sachs bank USA CD 1.55% due 7/6/2018 paid out semi annual (audited by PWC).  Thus it is a CD that will pay back the $10,000 in 2 1/2 years from now.  Here is the link to a page that shows which external firm audits each entity.

The CD is semi-annual so it pays 1.55% * 10,000 / 2 = $78 every 6 months, or $155 / year.

There are no expenses (on buy, sell) and no fees with this holding.  By contrast a money market fund pays about 0.2% (or $20) after fees.

If we need cash we can sell this in the secondary market and there will be a small gain or loss depending on how interest rates have moved since the purchase date, and likely a bit of slippage in the buy / sell.  If for some reason the bank goes bankrupt (highly unlikely since this is Goldman Sachs) the government will pay back our $10,000 and accrued interest through the last date.  This did happen to me back in the 2008-9 time frame when a number of banks were taken over by FDIC as they became insolvent and deposits were guaranteed.


We will put half the remaining in US stocks and half in foreign stocks.  The US stock will be in the Vanguard ETF VTI.   Vanguard is audited by PWC.

VTI has a yield of 1.91% (dividends).  We will invest $9000 in this fund.  It has an expense ratio of 0.05%.

We will put half the remaining in an overseas stock fund.  We will put $4500 in VEU which is the Vanguard all-world index except the USA.  It is not hedged.  The yield is 2.96% and fees are 0.14%.

Will put the other $4500 remaining in a hedged overseas stock fund.  We will put put $4500 in HEFA which is an overseas ETF that is owned by Blackrock (iShares).  It has a yield of 2.35% and fees of 0.36%.

Blackjack (iShares) is audited by Deloitte and Touche.

Recent Stock Moves

Rise of the China Stock Market

When you are judging the success of your portfolio against benchmarks, which conceptually is a simple exercise, the question soon arises:

1) who are you comparing yourself against?

2) what currency is your benchmark denominated in?

Whether you want to invest there or not, China has had a major rally, and the Chinese Yuan is stable against the US dollar (in the range of 6 Yuan / dollar and 6.4 Yuan / Dollar over the last 3 years) as opposed to other currencies like the Euro and the Japanese Yen which have cratered in dollar terms.

The incredible rise in stocks in Chinese stock prices has mostly gone “under the radar” of US media.  Recently they connected the stocks in Hong Kong with stocks on mainland China and not only have prices risen substantially, the same stock trades for different prices in each location.  Per this WSJ article

Shares of Chinese companies listed in Hong Kong look like a steal compared with shares of the same companies that are listed in Shanghai. Such stocks on average trade at a 32.89% discount in the former British colony, according to the Hang Seng China AH Premium Index.

Typically, under a concept called “arbitrage”, the price of equivalent items in different markets are narrowed when investors take steps to capture the “easy money” of buying that same good cheaper in a different place.  A very simple example is that you can’t have gasoline selling for $4 in one state and $3 in an adjacent state; everyone just crosses the border to buy the cheaper gas until the price differential narrows.  Gaps of a couple of percentage even across exchanges is enough for investors to jump in and take advantage; a 32% differential is extreme.

This rally isn’t due to a perception that the economy in China is getting better; in fact it seems to be getting worse.  The rally has been enhanced by structural moves that allow more investors into the market (largely retail mainland investors) and lets them buy stock on margin, as well.  Per this WSJ article:

Margin lending has more than tripled in the past year to a record 1.7 trillion yuan ($274.6 billion)…The practice isn’t unique to China, where margin debt equals 3.2% of total market capitalization, compared with 2.3% in the U.S. But when compared with the value of stock that is freely traded, making it accessible to ordinary investors, the percentage for China rises because state entities own more than half of the market.  Research by Macquarie Securities Group shows China’s margin-debt ratio at 8.2% of the free float. That easily exceeds the peak of 6% reached in the late 1990s in Taiwan, the second-highest level globally in recent years.

Thus if you didn’t have a proportionate share of your portfolio invested in Chinese stocks, you were a “relative” loser, although there are many reasons to believe that this rally isn’t sustainable.  This goes back to the original question of how benchmarks are defined.

Individual Stock Moves

In one of the portfolios I follow there have been significant and immediate moves in several of our stocks.  These stocks were related to China or the the technology industry.

Linked In (LKND) recently had an earnings call and their stock price plunged by over 20% in one day.  The cause of the drop wasn’t the earnings themselves (they beat expectations), it was their “forward guidance”.  For stocks with a high price / earnings multiple like Linked In, the market needs to have continued rapid growth to justify the high stock price today.  In fact, Linked In currently doesn’t book profits, primarily due to their high amounts of stock based compensation (stock given to executives in lieu of cash).  Linked In’s guidance talked about currency headwinds (meaning that if they brought in the same revenues overseas it would “count less” towards net income because of the rise in the US dollar) and also some one time acquisition costs from recent companies they’ve purchased.

Amazon (AMZN) had their last earnings call where they continued to show no profits on a GAAP basis and yet their stock rose 6.8% due to other factors that analysts apparently found compelling.  Note that a 6.8% gain for a company the size of Amazon is a large increase in market capitalization (over $10 billion) in a single day.

China Life Insurance ADR (LFC) has almost doubled from around $40 / share to $80 / share as part of the overall China rally discussed above.  While a seemingly sound stock this performance gain is not tied to any fundamentals in how the company operates; this growth is tied to the giant overall rally.

Wynn Resorts (WYNN) dropped more than 10% in a single day after earnings were released.  Wynn has a property in Macau (China’s only location with legal gambling) and it has been hit hard with a recent crackdown on high-roller gamblers by China’s communist leaders.  Note that the scale of gambling in China dwarfs Las Vegas by any measure (total market, amount bet per player, etc…) and thus properties in China have been proportionally more lucrative than their US equivalent.  It is not known whether this will be a long term reduction of high rolling gamblers or a short term hit; that depends on inscrutable Chinese government polices.  Left to their own devices, it is highly likely that Chinese would continue to gamble at record rates.  Wynn also has long running board issues and governance issues as well.  At risk is their dividend, which “income investors” price highly in an era of virtually zero yield on debt (without taking on significant risk).

Westpac (ADR) – the Australian bank slightly missed earnings and their stock went down almost 5%, but then recovered a bit and was down 3%.  The CEO said that flat earnings won’t be tolerated in a later interview.  Unlike those companies with little or no GAAP profits (Amazon, LinkedIn), a company like Westpac won’t usually fall as much with a minor earnings miss because it has a lower P/E ratio and incredible future profit growth isn’t already “baked in” to the stock price.

Seeing large moves in single stocks can be viewed as a sign of a bull market in its last stages.  Since we invest for the long term we don’t pull in and out of the market based on short term moves but it is definitely something to consider; stocks with limited earnings and high P/E ratios or tied to giant rallies like is occurring in China today should be on some sort of watch.

Cross posted at Chicago Boyz

The Liquidation of Markets

Every weekend I read Barry Ritholtz’s recommended reading and there are a lot of gems in there. Recently he posted this Credit Suisse graphic about markets at the turn of the 20th century by market share and compared it with 2014 on the topic of global equity investing.


In his article he mentioned the fallacy one might fall into as a UK equity investor in 1899… why bother investing in the USA when the UK market is so much larger? And then this line of thought ends up missing the huge growth in US market share over the next century.

However, the real issue here isn’t the relative change in market share by the different countries; it is the fact that almost all of these markets were entirely extinguished at one time or another by political, economic or military events that wiped out the investors.
Continue reading “The Liquidation of Markets”

Investing – Basic Plan

If you want to invest on your own, there are some basic ways to approach it.  Here is a simple model that you might want to consider using.

The goals of this approach are as follows

  • Build a simple, consistent approach that does not require a lot of re-balancing
  • Minimize fees and expenses

The money you want to invest can be split into any grouping depending on your risk tolerance.  For the sake of this discussion, let’s assume that you want to split evenly before the 4 categories that are listed below.  If you were putting in $100,000, you might put $25,000 into each of the 4 categories below.

  1. 2 year new issue brokerage CD’s (bought at par, or 100 cents / dollar, no gain loss)
  2. 5 year new issue brokerage CD’s (bought at par, or 100 cents / dollar, no gain loss)
  3. Vanguard ETF total US stock market (ticker VTI)
  4. Vanguard ETF total world stock market except US (ticker VEU)

I wrote a lot of articles about buying CD’s from a brokerage.  Some highlights include 1) you get better rates than you get through your bank (for instance I saw 2 year CD’s at my bank at 0.7% and was able to get 1.2% through my brokerage) 2) the CD’s are guaranteed against loss – worst case you get your principal and accrued interest back (many of my CD’s were tied to banks that failed in 2008-9, so I tested this theory) 3) when you buy the CD’s up front through your brokerage account you pay no expenses except for any per-trade charge your brokerage like eTrade or Vanguard or Schwab might add to the trade (i.e. no annual fee).

What are the CD’s accomplishing?  They are your “safe money” in the portfolio.  You effectively can’t lose money if you hold them to maturity.  If you have to see early before they expire (i.e. you need the money to buy a house) your brokerage account can put them up for sale and you will have a small gain or loss depending on how interest rates have moved since the time you bought your CD.

There are other ways to do this (buying bonds, treasuries), but they are more complicated, and don’t offer significantly better returns than this.  On the other hand, you may note that some bond funds have had big gains, but these are mainly bets on interest rates and on the riskiness of portfolio items and this is fine but you need to know what you are getting into.  The CD’s should work fine for most investors.

Also note that many bond funds have fees in the 0.5% range (although some are more, and many are far less).  At this point, the fees will eat up your entire return!  We need to plan as if the low interest environment (ZIRP) that we are in will go out indefinitely, which means low returns and watching expenses is paramount unless you want to take on more risk in terms of your investments.

As far as the ETF’s, it is easy to buy them through your brokerage account, you just figure out how much you want to buy (say $25,000) and determine the current price (about $107 / share) which is 230 or so shares.  Put in an order, which might be free or might cost you up to $25 (depending on your brokerage), and voila – you are done.

Both VTI and VEU have rock bottom expense rates – VTI is at 0.05% / year (meaning $25,000 costs you $12.50 / year) and VEU is at 0.15% / year (meaning $25,000 costs you $37.50 / year).  Note that a typical financial advisor plus fees on ETF and mutual funds might cost 1.5% / year, which would mean $25,000 would cost you $375 / year.  Of course they also give you expert advice, so that is the flip side of that transaction.

How do you manage money using this model and re-balance?  Easy.  Likely semi-annually you will receive interest on your CD’s – this is about 1.5% on average between both of them – so you’d have 1.5% times $50,000 = $750 / year in interest.  That doesn’t sound like much, but that’s pretty much the best you can do nowadays.

For your stocks – you will receive the dividend yield every year as cash in your account – VEU yields about 3.5% and VTI yields 1.75%, so on average you’d probably get about 2.6% / year in dividends or $50,000 * 2.6% = $1300 in cash.

The interest income on CD’s is taxed at the highest marginal rate for you (likely 28% or higher) but the dividends will be taxed at a lower rate of about 15%.

Rebalancing?  You shouldn’t need to.  Just leave the assets where they are.  The 2 year CD’s will come due and you can buy new 2 year CD’s, and later the 5 year CD’s will come due.  Unless you need to buy a house or something I would just leave the ETF’s there forever – they are a bet on the stock markets in the US and around the world.

As your assets earn cash they will be deposited back in your cash brokerage account.  Take that cash, plus new cash you’ve saved up, and then pick one of the 4 categories depending on your risk tolerance, and invest more.

That’s it.  This is a super low cost plan that requires little re balancing and gives you a balanced portfolio.

Stock Market Performance and Our Stocks in the News

Over the 11+ years that we’ve been setting up these trust funds, tools for monitoring stock performance have improved greatly.  Today I use Google Finance to keep portfolios online for each of the six trust funds, and I update them for buys and sells and available cash.  When we first started these portfolios, it was the dawn of the Internet age (remember those commercials for e-trade), and we usually waited to receive our paper statements.

On the other hand, you don’t want to move into a mode of constant reshuffling of the portfolios.  Watching frequently is strongly correlated with frequent trading – you see and react to short term market movements, and you “kick yourself” when you don’t act on short term hunches.

For these portfolios there is a secondary consideration that I want the portfolio beneficiaries, who will ultimately receive 100% of the value of these stocks, to be as large a part of the decision making process on purchases and sales as possible.  This is a key purpose of these trust funds – to teach the beneficiaries about money and to show the real and substantial long term gains that can occur from systematic investing in a thoughtful way over a long period of time.  For purchases we are able to accomplish this by making it an annual process, tied with the annual back-to-school ritual.  For sales, I am attempting to make this more of a joint decision making process by setting “stop loss” levels up front and communicating these levels rather than selling when I think something is 1) overvalued 2) headed for a big loss.  I still have to move unilaterally on an occasional sale when I want to move relatively quickly, however, but I try to minimize those activities.

With all this said, I do watch the markets relatively closely (usually for a few minutes each night I scan the google finance portfolios for the six trust funds and see if alerts pop up for any of the stocks).

While it is easy to say that “the market has rallied this year and gone up by x%” and then to compare this return vs. your stocks, in reality every stock has its own story based on nationality (about 1/2 of our stocks are non-US), its industry, and then finally there is the large “joint” component of economic moves by the Federal Reserve starting with ZIRP and then moving into “Quantitative Easing”.  These events greatly influence all stock pricing, which can be seen clearly when the entire portfolio moves up and down in unison based on news (or perceived consensus on behavior) from the Feds.

Another entire path is how the international markets are faring – the Chinese economy is built on capital expansion, both in real estate and in manufacturing, and they have their own version of high leverage in various trust products and local debt and banking relationships that are starting to flash major warning signals.  When you listen to the news on economics 90% of it is about the US and our policies, when we represent maybe 20% of the world wide economy and we are heavily influenced by what happens elsewhere.  Of high interest to stock investors is the fact that Chinese markets have been in a slump for years, as they anticipated high growth before the growth became reality and then Chinese investors have since moved on to the (perceived) “easier gains” of local real estate.

Thus with all of this background behind us, here are some of the stories that I’m watching…

Australian banks seem to be the most expensive in the world, and are booming due to a real estate and highly valued currency.  We own Westpac, and this is something to watch.  Note also that when evaluating a high dividend stock (they currently yield almost 6%), it is important to look beyond just the stock value to see the total return.

Yahoo! is a 2013 pick and has done very well recently, up over 40% since we selected it in late Q3 2013.  The new CEO (Marissa Mayer) recently fired her hand-picked head of advertising who had a $60M pay package and their advertising revenue isn’t growing.  However, this doesn’t matter much since almost all of the value of this stock is in its China (Alibaba) stake and Japan stake – the US operations are mostly irrelevant (or a possible upside) to the stocks’ total valuation, per this article.

Shell (we own the “B” shares because they are out of the UK and don’t have the dividend withholding that we would have if we owned the “A” shares out of the Netherlands) recently issued earnings guidance that was touted as “Shell shock” about bad quarterly results.  The stock went down and now we are watching to see what happens next.

Beyond Shell we have a large exposure to the oil industry, including Statoil (Norway), SASOL (South Africa), CNOOC in China (we sold CEO recently when it hit our stop loss), Exxon, and also Anadarko (natural gas).  Thus we need to monitor these companies, to some extent, but we mainly buy and hold them because this is an essential part of the world economy and they pay strong dividends (mostly).

We continue to monitor these stocks and will close down our stop-losses pretty soon and create new stop-losses going out into 2014 for a few months.  We want to keep some down side coverage going both for stocks that have had a great run but also for stocks that might be headed for a fall.  Our stop loss strategy is summarized in this post.

Portfolio Six Updated November 2013

Portfolio Six is two years old and is our newest portfolio.  The beneficiary contributed $1000 and the trustee $2000 for a total of $3000.  The current value is $3287 for a gain of $287 or 9.6%, which works out to 6.2% / year over the life of the portfolio.  Go here for details or go to the links on the right side of this page.

The portfolio has 3 ADR’s (foreign stocks) and one US stock.  Since there are only four stocks changes in the value of any one stock will impact the total portfolio value.  We will continue to add to this portfolio in the years to come.

Portfolio Five Updated November 2013

Portfolios Four and Five were both set up four years ago. The beneficiary contributed $2500, the trustee contributed $5000 for a total of $7500. The current value is $9,116 for a gain of $1616, which is 21%, or 6.6% / year over the life of the portfolio. Check results here or in the links on the right side of the page.

Recently two outstanding items in the portfolio were cleared up when we gave up on the metals company Alcoa, which is well run but faces ferocious state-supported Chinese firms willing to work at a loss.  We also sold Riverbed when it bounced up a bit as a raider considered a stake in the company.

The remaining stocks are either brand new (too soon to judge) or doing well.  We will watch Siemens which is near a 5 year high and not ride it all the way back down.  The current portfolio has 9 stocks, with 7 of the 9 being foreign ADR’s (the two recent sales were US companies).

Portfolio Four Updated November 2013

Portfolios Four and Five are both four years old.  The beneficiary contributed $2500 and the trustee contributed $5000 for a total of $7500.  The value is $9284, for a gain of $1784 or a 24% gain, which is 7.2% / year.  The portfolio can be viewed here or in the links on the right.

There are ten stocks in the portfolio, with 4 overseas stocks and 6 US stocks.  The portfolio is getting to the point where changes in one stock won’t significantly impact the total value overall.

The portfolio is doing well, with Nucor on a stop loss to not go below the original purchase price (it was underwater for several years) and for Oracle because it is near a multi-year high and facing cloud competition.  The positions are generally doing well, with Westpac (Australian bank) and Wal-Mart the best performers.


Portfolio Three Updated November 2013

Portfolio Three is our third longest lived portfolio, at six years. The beneficiary contributed $3500, the trustee contributed $7000, for a total of $10,500. The current value is $12,673 for a gain of $2948 or 28%, which is 6.2% / year over the life of the portfolio. See details here or download the spreadsheet on the right.

There are 10 stocks in the portfolio, of which 6 are US and 4 overseas, although since WYNN has most of its’ value from China holdings, you could say that it has a 50/50 ratio.  The portfolio is almost to the point where the swing in a single stock won’t disproportionately change the total portfolio value and it is reasonably diversified.

Splunk has been a big winner, with a gain of over $1000 in less than a year.  Other winners include Siemens which is near a five-year high as well as Wal-Mart which is steadily growing with a solid and rising dividend.

We are watching WYNN and Urban Outfitters which had been way under water until the recent run-up; we are using stop loss orders that we will renew to ensure they don’t go back underwater.  Cliffs also has a stop loss because it originally started tanking after we bought it but turned around immediately.  We recently sold Bancolumbia as it neared a 20% loss (excluding dividends).

Portfolio Two Updated November 2013

Portfolio Two is our second longest lived portfolio, at nine years. The beneficiary contributed $5500 and the trustee $11,000 for a total of $16,500. The current value is $23,245, for a gain of $6745 or 41%, which works out to annual performance of 5.6% / year over the life of the portfolio. There are 18 stocks in the portfolio, of which 9 are US and 9 are overseas. As we noted with Portfolio One, a rough guide is that when you have beyond ten or so “different” stocks you have a diversified portfolio. Most of the stocks are around $1100 / each, with a few around $2000. You can see the detailed portfolio here or at the list on the right.

The portfolio recently has had a couple of big winners with Facebook and Splunk. These two combined for about 1/3 of the total gain in the portfolio. Many of the stocks are near all time or 5 year highs, including Oracle, China Petroleum, Siemens, Diageo, Exxon-Mobil, Toyota and NIDEC. These stocks had been hit hard just a couple of years’ ago and we will watch them closely to make sure they don’t fall back too far.

Oracle, WYNN and Urban Outfitters currently have stop loss orders in that we will need to review in early December. We are going to keep them on Urban Outfitters and WYNN because we don’t want to fall below original purchase prices and Oracle we will review along with many of the other stocks that have soared over the last couple of years.

Portfolio One Updated November 2013

Portfolio One is our longest lived portfolio. It began right after 9/11 and thus has been through twelve years. The beneficiary has invested $6,000 and the trustee has invested $13,500, for a total of $19,500. The current value in $33,161 for a gain of $13,661 or 70% in total, which works out to approximately 8% / year. You can see the detail behind this portfolio here or at the link on the right side of the page.

In rough terms if you have a more than 10 or so stocks you have a diversified portfolio (assuming of course that the stocks represent different sectors, market cap, and even countries) and there are 20 stocks in this portfolio, with an average value of around $1600 or so, and I would say that this portfolio is pretty diversified. About half the stocks are non-US (and the US stock Philip Morris is all overseas) and thus the benchmark would be about half the S&P 500 and half an international index of developed countries not including the US.

On the downside, we are watching Urban Outfitters which moved above our purchase price (finally) and which we are not riding back down. There is a stop loss order in for this that we will continue to renew (it only goes out for 90 days at a time).

We also are looking at stocks which may have reached their apex or might be on the verge of being over valued. The current stage of the bull market seems frothy and since we are long term investors we aren’t inclined to immediately sell but we may put in some stop loss orders to prevent some stocks that have risen a great deal from coming down too far. We are less inclined to sell a stock with a high dividend because it will continue to pay out than a stock which has risen a great deal but has no dividend. For now there won’t be any stop orders placed but we will watch stocks like EBAY and Taiwan Semiconductor which have had a great run for us.

As far as stocks we sold in the past, Amazon continues on its tear because it stands alone as a stock that has no profits for investors yet continues to soar and sports an enormous market capitalization. I have literally no answer for this phenomenon.

Microsoft, which we sold a few years ago, increased from the sale price of $25 in 2010 to $37 today. A lot of this gain is because their lunk-headed CEO Ballmer is finally leaving… since he retained his stock the day he announced his departure, the stock soared, and he made himself an extra billion dollars just for firing himself. Now that is surreal.

In general this portfolio is doing well and hope to keep it rolling another twelve years!

US Markets vs. The Rest of the World

Although the US stock market has pulled back a bit as of late, we are up over 10% in the year to date. The rest of the world with the exception of the US, however, is actually down about 1% or so. The Vanguard ETF VEU is a decent, simple proxy for the rest of the non-US market (although any single measure is flawed). I started using an average of the US markets and the VUE to compare against the trust funds documented in this blog (see funds 1-5 plus newly started 6 in links to the right) because it is a more applicable mix since 30-50% of the assets are in non US stocks (ADR’s).

There are two main components for the foreign markets right now

1) their currency against the US dollar
2) their market index performance

The US dollar has strengthened against many of the foreign currencies, which means that US assets are worth more and foreign assets are worth correspondingly less. We recently looked at the impact of this on the Japanese markets, where strong growth in local currency (the Yen) didn’t translate to increases in value of stocks to US citizens (unless you bought from an ETF or mutual fund that hedged the dollar / yen exposure to stay neutral, which most of them do not).

Many of the foreign indexes have declined, and European stocks in general have not recovered from the 2007-8 crash to the same extent as the US market did. A simple rule is that anything (in the US) bought in 2006-7 near the peak was way overpriced and anyone who bought during the trough in 2008 when the markets were in their nadir did very well. This rule generally applied overseas as well but some markets didn’t come back as strongly.

Every country is unique as is their impact on the markets. There have been riots and other acts of instability in emerging markets. However, it seems that the moves of the US to perhaps reduce “quantitative easing” by the Fed (QE1-3…) that are spooking the foreign markets, since a rise in the value of the US dollar and interest rates is thought to have a major impact on the relative attractiveness of these foreign markets. Today the world benefits from low interest rates and it is anticipated that at some point these low interest rates will rise and it will have various (mostly negative) impacts on countries and currencies around the world.

Investing is very complex and this blog highly recommends that you do your own research. The point of this post is that in order to judge performance you need some applicable benchmarks and if over 30% of your portfolio is in non-US assets you can’t judge against a US benchmark. You also need to understand not only the performance of the overseas markets but also the performance of their currency vs. the US dollar.

The Role of Bonds in a Portfolio and Foreign Bonds

A while back I was talking with a friend of mine in the money management industry. I asked him if any of his high net worth clients bought non-US bonds in their accounts (the securities are held in the name of the client, but the advisor helps with selections) and he said one of them picked up a big position in Australian bonds. How did he do? I asked. The answer:

His bond positions increased significantly in value

Why is this? And what was the client trying to accomplish?

The client was likely looking for an increase in the value of the Australian currency against the US dollar, and buying bonds as a proxy for this bet. Bonds have the advantage of paying off interest as well as providing diversification from the US dollar, but in the case of this Australian debt, the percentage of the return that came from the increase of the Australian dollar vs. the US dollar provided most of the gain. The Australian dollar was as low as 63 cents per USD in late 2008 / early 2009 and is now at over $1.03 per USD as of mid 2012. That is a 95% gain! Any interest income or changes in creditworthiness (short of seismic market events like the Greek default) don’t move the return like this.

His client wasn’t the only one. At about that same time I talked to another professional who also said that the commodity producing countries were going to have stronger currencies relative to the US dollar, and was making his equity picks accordingly. If you bought an Australian ADR on an Australian exchange in 2008/9, in US dollar terms it would also be up an additional 95% (give or take some) in US currency when compared on a similar apples to apples basis, before taking into account the performance of the underlying stocks. Google Finance offers a simple graphing tool to see the performance of various currencies against one another over multiple time periods – the US dollar vs. Australian dollar is here.

Let’s look at BHP (Broken Hill Proprietary), the massive mining conglomerate out of Australia. On the ASX (Australian stock exchange) you can see that the price was about $25 in late 2008-9 when the Australian currency was at its nadir and the price today on the ASX is around $32, a gain of about 28%. However, the price of BHP as an ADR listed on the US stock exchange (which is exactly the same instrument, denominated in US dollars) was drastically different – it went from around $35 to $65, a gain of 86%. The difference in the change of the currency contributed to over 2/3 of the total gain during this period.

A different example is Bankocolumbia. Here is a graph of the Columbian Peso (COP) vs. the USD per Google Finance for the year to date through mid 2012. The Columbian peso is up almost 10% vs. the US dollar during this time. The ADR for Bancolombia S.A. (CIB) is up about 9% during the year (listed in the US on the NYSE). Bankocolumbia listed on the Columbian exchange (and obviously denominated in Columbian dollars) can be found on Reuters (Google apparently doesn’t include the Columbian exchange in its price history) and the price has been roughly flat during the year to date ended June 2012 at a price of around 27,000 CP.

Based on these examples if you know 1) the performance of the stock on its “home” exchange 2) the performance of the currency vs. the US dollar 3) the performance of its ADR on a US exchange, you can see the portion of the return that is “currency based” and the portion of the return that is “stock based”.

While sophisticated investors have known about the impact of currency changes on portfolios for decades, given the relatively rapid (in years, not decades) shifts in relative currencies that is occurring today, it is important that smaller investors start to understand the impact of these currency changes on their investments.

The most important part of the view is what you DON’T see on your (relatively worthless) brokerage statement – the “absolute” return of your dollar denominated assets relative to what they would be if they were denominated in other currencies. By this (theoretical) example, if you held assets in US dollars, and you could have had those same assets held in Japanese Yen over the same period, you lost 35% of your value over the last 5 years due to the decline of the US dollar vs. the Japanese yen. Until a turnaround in 2012, the US dollar had been declining against virtually every other major currency in the world, and reducing returns in the US in absolute terms, as a result, whether we noted it or not in our statements.

Thus the conclusion (this is obvious, sorry) is that the relative return of stock instruments is substantially impacted by currency returns, and thus if you are selecting an ADR of a foreign country you are betting on 1) the future price of the stock vs. today’s price 2) an increase or decrease in that country’s currency vs. the US dollar, with increases in that country’s currency vs. the dollar “boosting” your return here in that stock in the US. This can be seen clearly by the three components listed above. Since stock investors are (generally) trying to earn a long term return above inflation and inclined to take some risks, these risks are reasonable given the “mission” of stock investing and thus is in line with investor motives (depending on their risk profile).

For instance, why are people discussing the relative merit of a split of stocks vs. bonds vs. cash? When I sign into my brokerage online what jumps up instantly is a split of my instruments and a split of what is stock vs. bonds. This is due to the fact that there is a basic premise that “stocks are risky money” and “bonds are safe money”, thus investors should split their dollars between these two pools of money in order to provide for upside risk (stocks) and avoid downside risks (bonds).

A recent New York Times article titled “The Search for Calm In Bond Markets” discusses this impact among other issues in the article.

A 2011 study by the Vanguard group showed that currency fluctuations, not market moves, account for a vast majority of the overall volatility in foreign bonds.

Thus what are you trying to accomplish with bonds in the first place? Is it preservation of capital and “keeping up” with inflation, which is the implied theme in most investing literature? If this is the case, then investing in foreign bonds generally violates this “purpose” of investing in debt.

However, another “implied” conceit underlying the typical bond / stock discussion is that depreciation or decline in the value of the “base” currency (the US dollar, for this discussion) doesn’t really matter, when in fact it matters greatly, especially over time. The net value lost to US citizens caused by the US government’s zero interest rate policy (ZIRP) which contributes to the currency’s decline, along with other elements, is very significant and over 30% depending on how you measure us against other economies and currencies.

To jump around a bit more, CIB (the Columbian bank) is now issuing debt for Western (US investors), denominated in US dollars! While debt doesn’t always directly impact a stock price, moves in a currency now could significantly impact the company depending on whether or not that debt is hedged against the dollar (and if it is hedged, the cost of those hedges must be considered in addition to the interest rate on the debt from the perspective of a stock holder, since it isn’t free). Recently I wrote about the vast riskiness of these plays, given that currencies can move significantly and the issuer must be prepared for these moves. CIB issued $1 Billion in bonds denominated in US dollars with a 10 year maturity payable annually at an interest rate of about 6%. Western investors who are hungry for yield apparently snapped up the bonds, and this went virtually unnoticed in the popular press. Given the (stale) perception of Columbia as a drug haven tied to virtual civil war, it is pretty amazing that they are now able to borrow $1 Billion US dollars at 6% over a period of 10 years and it isn’t news anymore. I hope whomever bought those bonds understands the risks, and the fact that 1) this is Columbia, not a state down the street 2) the bonds are denominated in US dollars and CIB needs to be prepared for swings in relative values of currencies, which have moved over 25% on a given year 3) 6% is a rate that would have been unheard of even 5 years ago.

If I was advising someone getting into the finance industry today I’d say that bonds is where the action is, not stocks. Bonds range from some of the most risky instruments on the low or high end and encompass all sorts of risks and opportunities. To someone just looking at bonds as a safe asset class, you are missing the mark.

Difficult (short-term) Time for Stocks

The markets have been selling off lately. Since these portfolios are a mix of US and non-US companies there aren’t “simple” indexes that I can use to compare them. But in general, the US markets which by various measures had been up in the 10-20% range are mostly back down to where they were in the beginning of the year and European and Asian markets are about the same or mostly worse.

These portfolios are meant to be long equity-only vehicles for young individuals with a very long time horizon in front of them (50+ years). They are “part” of a total portfolio and meant for a specific purpose; no one should just put all their wealth into a long-only stock fund.

Thus based on these elements I am loathe to do specific buys and sells based on total market conditions, because you are often selling off one stock for another stock with similar characteristics. Our markets today have very high “correlation”, meaning that almost all of the stocks tend to go up or down on a single day, especially when big market events occur. Correlation has been increasing over the years, meaning that even if you have a diversified fund (a rule of thumb is that you have 10 or more instruments that aren’t similar to one another) that doesn’t necessarily “save” you if they all move together.

The nature of the stock markets have been changing in the eleven years since I started this effort with Portfolio One, right around 9/11. There are many trends, but here are the key ones in my opinion:

  • Rise in international markets – international markets have always been important, even to US-centric investors, but today they are even more critical.  A stock market is fundamentally about “growth”, and most of the real growth is occurring off US shores.  Thus to not invest internationally, even with all their structural differences from the US market and other risks, is to miss out on the future
  • Reduction in IPO’s – the number of companies listed on exchanges has fallen as the number of IPO’s hasn’t kept pace with companies being acquired either by other companies or “going private”.  Also the IPO’s are later (see FB) meaning that a lot of the “upside” is gone when they launch, or there often is no upside at all if they are being sold out of a private equity fund (they already captured that)
  • Focus on Dividends – some of the dividend focus is due to favorable tax treatment (the limits on double taxation of dividends) and their 15% rate rather than as ordinary income and some is due to the gradual dawning on more investors that a substantial part of the total return is due to dividends and not just share price appreciation (unrealized)
  • Increased government intervention – in order to understand markets today you need to anticipate government moves to a greater degree than in the past.  Our large banks might never have survived the 2008 crisis without government intervention, and today they exist.  Will the government let them survive the next crisis, or will equity holders be wiped out like their were for Fannie Mae and Freddie Mac or Lehman?  Now you need to anticipate government reaction
  • Increasing Currency gyrations – for many years we had currency stability but we may be entering an era of less stability, especially in the key currencies the dollar, Euro, pound, yuan, etc…  This has many effects on competitiveness and immediate valuations
  • Low interest rates – a low interest rate policy has many effects on the market.  It depresses interest earnings (which impacts some equities) but also makes equities more attractive relative to debt instruments, especially when the chance of default rises.
  • The rise of Chinese stocks – while the US market went (mostly) moribund a whole host of Chinese companies came onto US exchanges or were accessible to US investors.  A lot of the “froth” and potential “boiler room” activities went into those stocks instead of US stocks

Here at Trust Funds for Kids we try to look at the long time horizon and make decisions accordingly.  This doesn’t mean that short term gyrations aren’t painful, as well.

Researching Foreign Bond Funds (ETF’s)

Recently I have been evaluating my total portfolio in terms of US dollar exposure.  Traditional (primitive) metrics of portfolio evaluation picked concepts like

  1. Splitting your portfolio between cash / bonds / stocks / real estate
  2. Splitting your stock portion between US and foreign stocks
  3. Breaking down your stock exposure into industry sectors like technology, finance, consumer products, etc…
  4. Adding a category for commodities, generally broken down between the precious metals (particularly gold, which had a huge run up) and everything else (oil, grains, metals, etc….)
  5. Reviewing your investments in terms of yield whether it is measured in interest return (bonds, REITS) or dividends (stocks)
  6. Categorizing your investments by “tax efficiency”, which favors municipal bonds (which are exempt from Federal and often state taxes) and currently dividends (taxed at a 15% rate) but punishes normal interest which is taxed as ordinary income
  7. Splitting your personal portfolio into “retirement” funds which generally are invested without paying taxes, grow (hopefully) over the years with reinvested dividends and interest, but are taxed when you retire and start taking withdrawals, from “non-retirement” funds which are subject to current taxation on dividends and interest but whose “basis” or original investment value have already been taxed.  A third category is Roth investment vehicles which are taxed now but the gain or loss above the current value is not taxed when you take out funds upon retirement

These concepts are all useful ways to review how your money is being allocated across all these sectors of investing.  There is no “one” right way to allocate your portfolio or to even assess how your portfolio is currently deployed.

On the topic of bonds, to me they traditionally represented 1) primarily a vehicle to earn interest, with the rate of interest dependent upon the riskiness of the bond 2) a (relatively) secure means of investing meaning that you expect to get your principal back (i.e. if you invest $50,000 at 2% which unfortunately would be a great rate now you pretty much are focusing on earning $1000 / year in interest and ultimately getting back your $50,000 when the bond matures).

However, the general perception that the bond world is “safe” doesn’t jibe with events that have occurred over the last decade or so.  These events include:

  • The massive budget deficits being run by the major world democratic powers in the US and Europe both at the Federal and regional / local levels, which are unsustainable as we found out in Greece and are likely to find out in many other places to come
  • The decline of over 30% in the US dollar against other currencies over the last few years, caused by many factors but primarily our low interest rates and a semi-deliberate policy of devaluation
  • My personal local exposure to government entities in Illinois at the state and local level (Illinois has the worst state credit rating in the US, and Cook county and the city of Chicago are famously corrupt) which leads me to expect the worst from the municipal bond market

These factors caused me to begin researching foreign bond funds.  My goal was to find foreign bond funds that are

  1. From countries with a reasonable prospect of being stable and paid back (i.e. not Greece or countries with no track record)
  2. Denominated in a currency that is not US dollar based that is likely to be around in the future (i.e. Canadian or Australian dollar, the Asian currencies, etc…)
  3. Put into a fund that doesn‘t HEDGE vs the US dollar – many overseas bond funds hedge against the US dollar so although you get foreign investment exposure in terms of returns and risks, you still are based on the US dollars gains and losses over time.  This is new because until recently most of the funds I can find tended to hedge currency exposure
  4. Have a low cost of ownership; preferably as an ETF which doesn’t (generally) incur capital gains and losses on a given year; these changes are “baked” into the share price which fluctuates over time and then you can choose when and how to incur the gain or loss by selling shares rather than being forced to book the gains or losses each year depending on fund activity

I briefly considered buying individual foreign bonds but this required a lot more work and understanding than I was prepared to do.  This may be something I’d consider in the future but since I don’t want to be consumed in research and exposed to unknown IRS forms and risks (since we do our own taxes and direct our own investment) for now I was looking at something less complex.

While it may seem that a lot of individuals are thinking the same things as me (the above thoughts are pretty obvious) sometimes you have to “wait around” for the industry to come to the same conclusions.  I bought the first dividend-focused ETF (DVY) when it came out and was waiting for a while to find it (and I heard about an early cash-back credit card and was an early adopter of this, as well).

PIMCO recently seemed to have what I was looking for when they released three new ETF’s.  The ETF’s are for Australia, Canada and Germany.  Here is a link to the PIMCO web site describing these three investment opportunities.

 PIMCO recently introduced three country index exchange traded funds (ETFs) focused on enabling investors to capitalize on the investment opportunities in Australia, Canada and Germany. PIMCO believes these three countries have balance sheets and debt dynamics that are well positioned in the global economy, considering the potential for slower growth and ongoing deleveraging, and offer important diversification of currency exposures for U.S. investors.

This description from their web site has what I am looking for:

  • Countries whose debt load appears sustainable or well managed
  • Non US currency exposure THAT IS NOT HEDGED
  • In ETF form to limit annual capital gains and losses but allow you as the investor to choose the time for “harvesting” your gains and losses
  • A reasonable level of total expenses, which are incredibly important for interest bearing instruments at a time of low interest rates (they are 0.5% for the Australian bond fund, which is still on the high end for me)
  • A reasonable level of asset size is desired so that the ETF doesn’t behave erratically or face the possibility of closure (sometimes ETF’s are closed and money is given back to investors).  It helps that PIMCO is huge and if they are likely to move into a sector like foreign bond ETF’s they wouldn’t seem likely to just shut down a fund if it grows more slowly than anticipated
  • Australia in particular offers yield (investment return) much higher than US bonds; they currently are above 4% when you’d be lucky to get 2% in US equivalent Federal debt right now.  This of course is factored into the currency level vs. dollar (it is high now) so in some “grand equilibrium” scheme they may or may not be in balance; but in the short to medium term it is fair to say that Australian debt “yields” more than US equivalent debt

In my investing I generally try not to anticipate specific events but rather to have a broader and more diversified spread on investments.  From a currency side, you have the Australian dollar, the Canadian dollar, and the Euro.  The Australian and Canadian dollars have had a huge run-up against the US dollar, which would make someone “chasing return” salivate, and the Euro faces downward pressure for many reasons most notably the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and their expanding financial difficulties and deficits.  However, the game ahead is very long, and anyone that can reliably predict the trend of currencies against the US dollar wouldn’t be writing a blog like this or even commenting on it, they’d be in a giant private jet flying to their giant private island because that is an exceedingly difficult or possibly impossible thing to do.  And even if the Euro goes kaput, a German focused fund would convert into the new German currency, which would be predicted to be among the best currencies of the broken-up Europe.

I will look at these three funds in detail and likely buy ETF’s in them which will 1) be in the bond class 2) hold a reasonable prospect of continued repayment 3) provide non US dollar diversity.

Cross posted at LITGM