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Surprise Report © July 2013 Page 1
Welcome back! In this mid-‐year report we review all of our Surprise Portfolio investments and make some important, positive changes in the portfolio. This report will explain exactly why we’ve made the portfolio changes and how they align with our investment concepts and our expected economic scenario. While the portfolio structure has not changed, we did change an asset class and switched a few assets in the other classes. We also further developed our software so that we can assign different weights to the asset classes and generate plots more quickly so that we can shift the balance of presentation from tables to plots. The portfolio continues to be composed of three sub-‐portfolios -‐-‐ fixed income, equity income, and hard assets (including commodities, resources, real estate, and infrastructure). Each sub-‐portfolio, SIP-‐A, SIP-‐B, SIP-‐C, consists of four asset classes that are represented by symbols such as CBND for corporate bonds. Each asset class contains one or two assets that provide sufficient diversification.
Portfolio benchmarks are the US stock and US bond markets. The price and return data is denoted SPX (S&P 500 total return, cash index) and TBI (total bond index) respectively.1 The mutual funds, VFINX
1 Our SPX is not a futures index or typical ex-‐dividend cash index. The bond index is the Barclays’ (formerly Lehman) total, aggregate, or composite bond index. Our symbol SPX is an industry standard but TBI is not.
Portfolio
Sub-‐Portfolios
ABND IBND CBND FBND CSEQ DVEQ MVEQ GLEQ GOLD INFR ENER REIT Asset Classes
AGG IPE VCIT PCY XLP HDV USMV KXI SGOL MLPI BPT HCN AssetsMVO NHI
SIP-‐A SIP-‐B SIP-‐C
SIP
The Surprise Report ©
Featuring the
Surprise Investment Portfolio ©
Surprise Report © July 2013 Page 2
and VBMFX are used for longer back tests, while the newer ETFs, SPY and LAG are used for shorter back-‐tests.
Portfolio Objectives
Over the last 18 months, we frequently presented and discussed the Portfolio’s specific objectives and targets. In the November and December issues of this Report, we noted how the Surprise Portfolio is similar in concept to the permanent portfolio developed by Harry Browne and the all-‐weather portfolio developed by Ray Dalio and Bridgewater. While the Surprise Portfolio was not explicitly built on permanent, all-‐weather concepts, in retrospect, these concepts influenced our investment philosophy at a time when we had lost interest in computer based, momentum trading and began to focus exclusively on our core, long term SIP portfolio.
Again, the Surprise Portfolio is a simple, low cost, low maintenance portfolio with the primary objective of significantly outperforming the stock market over two or more business cycles and with much less risk measured by volatility and beta, as well as depth of drawdown.
Here are a few of the relevant highlights from the November and December 2012 Surprise Reports:
Harry Browne believed that investors only need four assets to take advantage of the various investing scenarios or economic environments:
• Stocks for periods of prosperity • Bonds for periods of prosperity and deflation • Gold for periods of inflation • Cash for periods of tight money
Browne thought the perfect portfolio should be rebalanced to 25% in each asset any time an asset exceeds a 35% weighting or falls below a 15% weighting. Thus in a back-‐test of his portfolio the weights – not just the cumulative results – are dependent on the start date. In December we back-‐tested the permanent portfolio from 1990 and found that it would have been rebalanced seven times with, on average, three years between rebalances. Here’s the table we presented using VFINX for ‘stocks’ (for the longest back-‐test of total return):
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Interestingly, Browne’s portfolio would have been rebalanced in 2006 and July 2011 due to the high price of gold; in March 2000 due to gains in stocks; and in July 2002 and November 2008 due to stock losses! Not bad for scheme that was created in the early 1970s. If you like this scheme, we believe the best assets for this portfolio currently are VTSMX, SGOL, VUSTX, and MINT.2
Here’s a graph of Browne’s permanent portfolio from 1971 through 2011 from the Crawlingroad website.
2 We used VFINX in our back test analysis since it has a much longer price record than VTSMX – the Vanguard Total Stock Market mutual fund.
Date Asset Reason Years2/27/909/1/95 GOLD Hit min 5.57/3/97 VFINX Hit max 1.83/23/00 VFINX Hit max 2.77/10/02 VFINX Hit min 2.35/2/06 GOLD Hit max 3.811/20/08 VFINX Hit min 2.67/27/11 GOLD Hit max 2.7
Average 3.1
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This portfolio performance would be completely acceptable given its simplicity and low cost, but we think we can do much better. When interpreting the graph, note that the rebalances create much of the value in the permanent portfolio – and it takes time for the rebalancing scheme to evolve (if you initiated this portfolio at the beginning of the year with 25% allocations, the results would not match those of the portfolio initiated in 1990).
Recently, the AAIA Journal published an article about Browne’s investment concepts, The Permanent Portfolio: Using Allocation to Build and Protect Wealth. The authors made some important points.
“Simple, safe and stable: These are the three tenets of the Permanent Portfolio, a strategy invented by the late Harry Browne to help investors grow and protect their life savings no matter what was going on in the markets.
“Over the last 40 years, the strategy has returned 9.5% compound annual growth. The worst loss, a drop of 5%, occurred in 1981. In 2008’s financial crisis, the portfolio was down only around 2% for the year. We think that’s pretty impressive for a strategy that appears so startlingly simple on the face of it.
“Ironically, the primary risk to the portfolio is the investor himself (as it usually is). Three of the four assets are very volatile when you look at them individually (stocks, bonds and gold). It can be hard to watch a big drop in stocks, even though your bonds may have gone up and offset the decline in stock prices. Likewise, a sudden drop in gold can cause some people to get upset, even though the stock allocation may have increased enough to negate the losses. Furthermore, it is the hard-‐to-‐shake feeling you can predict the future and adjust the allocation based on your gut feeling that can cause lots of problems.
“This is why we encourage investors never to look at assets in isolation. Only total portfolio value matters. If an asset has fallen by 20% in a year, but the total portfolio value has risen by 8%, does the decline in one asset really matter? No, it doesn’t. And since you can’t predict what asset will do best ahead of time, the constant exposure to all of them ensures you’ll always own a winner no matter what is going on. Further, the Permanent Portfolio only works as a package. If you tinker with the assets or do not own them at all times, you can seriously compromise the safety the Permanent Portfolio is intended to offer.”
But the permanent portfolio is less effective when stocks and bonds fall at the same time.3 This is why the issue of a fundamental change in the bond market is so important. In the next Surprise Report we’ll try to bring Browne’s permanent portfolio up to date and see if the combination of stock increases and gold decreases have triggered a rebalance. If there is enough interest, we may develop a web page to show current allocations based on this back-‐test from 1990.4 We will then develop a similar rebalance scheme for the Surprise Portfolio.
3 We think this ‘market scenario’ – which is not a rational economic scenario -‐ is due to Fed tinkering. 4 A 1990 start date was driven by total return mutual funds being available for stocks and bonds.
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We also looked at the all-‐weather portfolio concepts last November and December. An article in Seeking Alpha entitled ‘Bridgewater's All Weather Portfolio vs. Harry Browne's Permanent Portfolio’ described the four ‘economic environments’ identified by Ray Dalio’s investment management company, Bridgewater. These economic environments are conceptually similar to those of Harry Browne.
Note that a risk parity method is implicit since the assets appropriate to each scenario are allocated to contribute 25% of the portfolio risk (volatility) -‐ unlike Browne’s scheme of allocating 25% of the capital to each scenario. Because long-‐term asset volatility is quite stable, rebalances would be infrequent.
The author of the Seeking Alpha article – not Bridgewater – believes that the following portfolio represents the asset classes and allocations in the table above.5 We think these asset selections look pretty good, with the exception of GLD to represent commodities. There are a number of broad commodity ETFs, but they are built on futures contracts, which may have been the author’s concern. The following table was copied directly from the article.
It’s the risk parity allocation method that drives the high allocation to bonds. Of course it’s the 30 year bond bull market that’s driven their moderate return with low risk.
5 Bridgewater manages a $70B hedge fund called the All-‐Weather Fund. Link to the Bridgewater white paper “The All Weather Story”
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The Surprise Portfolio uses the same asset classes, but much different allocations and with one additional asset class that has been our top performer over the last couple of years – high yield assets.
In summary, the SIP differs from the Seeking Alpha author’s implementation of an all-‐weather portfolio, specifically the SIP includes
• A greater equity allocation to equities and with a focus on ‘value’ • A lesser allocation to emerging market bonds • A slightly greater allocation to commodities but balanced between gold and oil • A greater allocation to corporate bonds • A lesser allocation to nominal bonds • A lesser allocation to TIPS • An allocation to infrastructure and REITs – asset based securities with relatively high yields
The $70B Bridgewater All-‐Weather fund has not performed well this year. Over the last several months stocks and bonds have declined, which is an outcome not covered by the all-‐weather economic scenarios.
“The Bridgewater All Weather Fund is down roughly 6 percent through this month and down 8 percent for the year, said two people familiar with the fund's performance. The All Weather Fund is one of two big portfolios managed by Bridgewater and uses a so-‐called ‘risk parity’ strategy that is supposed to make money for investors if bonds or stocks sell off, though not simultaneously.
“Different types of assets do well in each of these [four] scenarios and the all-‐weather portfolio
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contemplates spreading its risk evenly.
“But money managers familiar with the strategy said it does not perform when both stock and bond prices tumble, as global markets have experienced in recent weeks.
“Last year, the All Weather fund rose 14.7 percent, according to a year-‐end investor note. Despite recent losses, the fund has still delivered a return of 34 percent over the last three years, according to the sources familiar with performance numbers.
"Ray Dalio and Bridgewater are very smart investors. The model -‐ the All Weather Fund -‐-‐ is beautiful long-‐term," said Mark Yusko … “It doesn't mean you can't lose money. All assets are in corrective mode right now.”
Another recent article entitled, “Bridgewater’s All Weather Fund Includes Rain: WSJ” notes:
“The All Weather fund has gained 8.5% annually since it was launched in 1996. Last year, the fund returned 14% net of fees, close to the overall stock market’s gains. All Weather was down 20% in 2008, beating the overall market. The fund charges fees that are below the 2% management fees and 20% performance fees collected by most hedge funds, part of its appeal with pension funds and others.”
The Surprise Portfolio asset reevaluation featured in this report are based on 3 year back-‐tests, so we decided to back-‐test these unofficial permanent and all-‐weather portfolios without rebalancing, our long term benchmark portfolio, BMP, a typical 60/40 US stock/ bond portfolio, and the Surprise Portfolio.6 The table below shows the 3 year gains and the return rate to risk ratios for each.
Not surprisingly the portfolio with the largest stock allocation won – after all, the stock market has been in a strong cyclical bull over the last 3 years. You see that the 60/40 portfolio had the highest gain at 39%, but the SIP was close behind at 34%. The All-‐Weather portfolio does have a risk management objective and you see that its return rate to risk ratio is slightly better than the 60/ 40 portfolio despite a lower return rate. (It is more than 40% bonds.)
But the SIP had by far the highest return rate to risk ratio – which is our principal asset selection criteria – despite those volatile SIP-‐C assets which we believe are necessary to long term portfolio performance. So the SIP outperformed these implementations of the permanent and all-‐weather portfolios, our original portfolio and benchmark, BMP, and the Permanent Portfolio mutual fund, PRPFX.
6 The BMP consists of equal allocation to PTTRX, OAKBX, PRPFX.
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In the quotes above we saw that the Bridgewater All-‐Weather Fund gained 34% -‐ same as the SIP at 34.1%. We don’t know if that is net of fees, but we guess that the Bridgewater fund investors had much higher taxes due to portfolio turnover. The Bridgewater fund did beat the Seeking Alpha writer’s implementation. In addition, the Permanent Portfolio mutual fund, PRPFX, had a 3 year gain totaling 16% -‐ less than half the SIP 3 year gain.
The Reuter’s quote above states that the $70B Bridgewater fund achieved an 8.5% annual compounded rate of return since its inception in 1996. Coincidently, the SIP dates back to June 1996 and has achieved an 8.93% annual compounded yield!
So we are very satisfied with our Surprise Portfolio results relative to our objectives.
The Economic Scenario
Some of our asset changes were influenced by a possible shift of ‘economic scenario.’ Most of you know that we face a number of important questions about our current economic environment:
• Have we transitioned from an equity secular bear (but cyclical bull) market to a secular bull market?
• Have we transitioned from a bond secular bull market to a secular bear market? • Are we really in a deflationary period that warrants this Fed’s policy response of avoiding a debt
deflation? (See October 2012 Surprise Report on the economic reasoning behind Bernanke’s concern about a debt deflation.)
• How long will or can the Fed continue to buy most of the issued treasury and mortgage bonds? • Are global equity markets and currencies so weak that they should be avoided?
o The export oriented countries seem to be in a competitive currency devaluation maybe kicked off by Japan
• Is the real economy growing or is it just the financial economy spilling over?
We first checked inflation (or at least CPI-‐U prices) and plotted the 12 trailing month trailing (annualized) rates over the preceding year. We see that the price index has trended down over the last two years, which indicates disinflation, so there is no inflationary pressure on commodity prices or interest rates.7
7 We discussed last October why Bernanke suspects and fears deflation.
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The CPI-‐U price data is found at the BLS site. To see another view of inflation, here’s a plot from John Williams’ site that compares CPI-‐U inflation to inflation as it was calculated by the BLS in 1990 – labeled SGS Alternate.8 That rate is currently about 4.25%, which is higher than the 30 year T bond rate. In this case we have the scenario of financial repression as described by Reinhardt and Rogoff and discussed in the Surprise Report in February 2012. This is a process by which governments have historically dealt with excess debt.
Are we at the end of the 30 year bond bull market? Bill Gross believes that it has ‘likely’ ended. Here’s his tweet that announced the change from secular
bull to secular bear.
8 The C-‐CPI is the ‘chain weighted’ CPI that likely further understates inflation, but is the measure used by Bernanke for his 2% inflation target.
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Let’s check the bond price history and see if it’s topping. The best total bond price indicator that we know is the Vanguard Total Bond Market mutual fund, VBMFX, that dates back 23 years to June 1990. The annual compounded rate of return on the composite US bond market has been 6.3%. This total (aggregate or composite) fund gained 329% over the 23 years. Note that the bond fund’s daily rate of return was slightly negatively correlated with stocks (-‐.11) which is important to developing a diversified portfolio that does well through each economic scenario over multiple business cycles.
The graph below indicates that the current downturn in bonds appears more significant than at any other time over the 23 years – although maybe comparable to 1994 or 2008, but in those years interest rates were at higher levels – so there was the potential for higher bond prices.
We wanted to see more than 23 years of total bond prices, but we don’t know of an older bond, total return index, so we downloaded the 30 year Treasury yield history from Yahoo Finance (^TYX) back to
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1977. The 30 year rate peaked at 15.20% in August 1981 and thus the nearly 32 year bond bull market began.9
Maybe the 2.47% yield in July 2012 was the low yield? Maybe the 2.87% yield on April 29 confirmed the bond market top? The yield is now back up to 3.5% -‐ a significant jump from the recent low. But a break to the upside isn’t yet confirmed – the downward trend remains in place until it breaks above ~4% as seen in the chart below. But yields could bounce along the bottom driven by Fed purchases. Who besides the Fed or other central bank would buy a 30 year bond at 2.47%? On the other hand maybe we should be examining a graph of long term Japanese government bonds? The Japanese (JGB) 30 year treasury may have found a low yield of 1.2% on April 5th and has been below 2.5% for more than 5 years !10
9 The 30 year Treasury bond was introduced in 1973. The Yahoo price follows the bond’s futures contract. 10 Chart from Bloomberg
Surprise Report © July 2013 Page 12
Source: Quandl
We then searched for an even longer yield history for long-‐term US Treasury bonds – we wanted even more historical perspective – past the 1973 introduction of 30 year Treasuries. On the Quandl site we found a monthly yield history for 10+ year time to maturity for US Treasuries that records yields from 1925 – an 87 ½ year record.
We found that the lowest yield prior to 2012 was in January 1941 at 1.98%. Interestingly the annual CPI-‐U ‘inflation rate’ in January 1941 was 1.44% -‐ it’s currently 1.36% so essentially the same ‘inflationary’ environment. This data set showed a resent low yield of 1.53% on July 31, 2012 – an all-‐time low yield.
Note that yields generally rose over the 40 ½ year period from January 1941 to September 1981 when the 10+ year yield hit 15.32% (slightly higher than the Yahoo Finance 30 year peak yield.)
The graph shows the January 1941 bottom of 1.98% as a red line and shows the average yield over 87 ½ years as a green line at 5.1%.
One might conclude from staring at the graph that the secular bear began in April 1954 when the yield hit a low of 2.29% (again in a very low inflationary environment) -‐ in that case the bear market lasted 27 ½ years to August 1981.11
How about the US stock market trend? Recall that we use Yahoo Finance symbols as follows
• SPY or VFINX for the S&P 500 inclusive of dividends and inflation (CPI-‐U) depending on the length of the back-‐test
• ^GSPC for the S&P500 exclusive of dividends and inclusive of inflation
11 The bond market from January 1941 to April 1954 was a sideways market and not really part of the long-‐term bull market.
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• xxxx-‐D any asset, xxxx, exclusive of inflation (the price series for xxxx is deflated by CPI-‐U)
The graph below shows that begins at the October 2007 peak, we see that the S&P500 has likely moved to new highs, by 3 of the 4 measures, however an equity market correction may still lie ahead. If this rally fails, we may conclude that the index exclusive of dividends and inflation may be the best index for technical analysis.
We were interested in running this back-‐test from the inception of the VFINX fund in March 1987 to observe the ‘value’ due to dividends and inflation. 12 Note that starting this back-‐test at different dates will lead to different values.
12 The common S&P500 price series that records the index values which are lowered when dividends are paid, but that’s not a true record of stock market returns.
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First note the difference with the inclusion of dividends – compare VFINX (blue line) to ^GSPC (green line.) Obviously the difference in value is dependent on the start date. Now compare the difference due to inflation – compare VFINX (blue line) to VFINX-‐D (red line.) Over 26 ¼ years, inflation raised the S&P500 by more than double, while dividends raised the S&P500 total return by almost double. Note the spread between the VFINX (dark blue line) and the ^GSPC-‐D (light blue line) – that spread is the value from dividends and inflation, which is most of the gain! So over the long term, dividends and inflation resistant assets are absolutely essential. Note this insight was we review out SIP-‐B and SIP-‐C sub-‐portfolios below.
Also note the 1987 crash. While it was the largest percent crash over a few days, it sure wasn’t the largest point crash!
Here’s the table of statistics for VFINX since March 1987. The VFINX, inclusive of inflation and dividends, has had an annual compounded rate of return of 8.5% per year and a return to risk ratio of .55.
But many investors believe that while we may be in a new secular bull market in equities, its been artificially driven. Here’s the graph of Robert Shiller’s PE ratio also called the ‘cyclically adjusted price earnings ratio.’ Remember that Shiller published his book called Irrational Exuberance in March 2000 just before that downturn. Here’s a plot of the Shiller PE ratio from Quandl.
What can we conclude? The market PE ratio is now higher than in 1987, but lower than in the 2004 to 2008 period, and much lower than in the 1998 to 2000 period. So we cannot conclude that the stock market is overvalued.
We also hear about a stock sector rotation so we back-‐tested the SPDR equity sector funds to the beginning of the year. Four sector funds outperformed the SPDR S&P 500 fund, SPY. The outperforming sectors were consumer goods – staples and discretionaries, healthcare, and financials. So any rotation would be from those sectors into technology and materials and
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maybe energy and industrials. While interesting, we have no opinion since the consumer staples sector is the only one that in which we make a specific allocation.
How about the ECRI leading economic indicator? It may be flattening out, but there’s no clear indication of a downturn.
Source: Quandl
How about the University of Michigan Consumer Sentiment Index? Its in an uptrend.
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Source: Advisor Perspectives
And how about the US dollar? Is it relatively strong or weak? Here’s a plot of the DXY index represented by the ICE continuous, front month futures contract. We see that the dollar is in an uptrend and we all understand the fundamental driver for the trend -‐ to borrow a phrase from Bill Gross -‐ the US is the ‘cleanest dirty shirt.’ We also see that the dollar has been much stronger for most of the last two decades. But keep in mind that this dollar strength is a measure against other currencies especially the euro and yen that represent 70% of the DXY currency basket.
Source: Quandl
Here’s a zoom in on the last two years. You see that the most recent dollar low occurred in May 2011.
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It’s interesting looking back on that long term dollar chart. I remember stuffing my suitcases with ‘stuff’ even from duty free shops while on frequent business trips to Europe in the early to mid 1980’s. Then note the fall of the dollar driven by the Plaza Accord (1985) that contributed to the 1987 stock market crash. I also considered buying a condo in Paris where I was living during 2000 and 2001. Exchanging dollars to buy a euro priced condo would have been a great deal.
SIP-‐A Analysis
Now we begin our SIP portfolio asset analysis with SIP-‐A. The sub-‐portfolio has certainly performed poorly over the last couple of months due to rising interest rates and a strengthening dollar. If these are cyclical trends, then ‘no worries’ – we don’t trade cyclical trends, but if these trends are secular then we must reduce risks in our fixed income portfolio – and that is our decision. We now believe there’s more downside risk than upside gain in US or foreign bonds.
Our two recent underachieving assets are the treasury inflation protected bond fund, IPE, and the emerging market sovereign bond fund, PCY. However these were two of our best performers during 2011 and 2012. Here’s a price chart of our 4 bond funds during 2013. We believe that the possible change in trend needs to be addressed. If rates have changed secular trend, then we must select different assets. An asset being down for a year or so is acceptable, but not down for 30 years. However, check the graph at the top of page 12 again – note that rates bounced along the bottom from 1941 to 1954 … 13½ years while the Dow Jones Industrial Average (excluding dividends rose by a factor of 2.7 ! The Japanese 10 year government bond yield has been less than 2% since 1999!
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Fixed income plays an important role in our portfolio since low credit risk bond returns are uncorrelated with equity market returns and thus reduce portfolio risk.13 However, we don’t want to hold assets that will more likely decline than gain over multi-‐year or multi-‐decade periods, however we could see a decade long bottom bounce.
So in the SIP-‐A sub-‐portfolio what are our options for investing in our 4 asset classes? We could
• Switch to an inverse bond fund • Shorten the duration of a bond fund • Replace a current bond asset class with say a convertible bond asset class to take advantage of
the strong stock market • Buy an actively managed bond fund • Drop our foreign bond fund • Go to near cash such as an ultra-‐short bond fund or a floating rate fund
Actually we will take a number of these alternatives. The reasoning is addressed by asset class.
We’ll start with our total US bond market class, ABND, which has held the AGG fund. This fund is down 2.5% for the year, which is not too bad for an asset in a diversified portfolio of 12 asset classes – we don’t expect all asset classes to gain each year, but we don’t want assets that are in a secular bear market either despite the warning on warning at the top of page 4.14
Our final choices were to either go with Bill Gross’s actively managed ‘total return’ bond ETF, BOND, or switch to a shorter duration ‘total’ bond fund like BSV or ISTB. Here’s our analysis of BOND, which was
13 Note in the table on page 7 most clearly in the 60/40 portfolio that stock and bond return risks offset and are not just added. 14 Even if a manager could time the market successfully, we doubt that they could also pick a diversified portfolio of 12 asset classes that all gain over some investment period.
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introduced in March 2012. We first considered whether Gross had under or out-‐performed the total bond market e.g., AGG. Here’s the plot. So despite Gross’s widely reported bad May-‐June, Gross’s bond market outperformance since inception is notable.
We had not previously considered BOND due to its lack of long-‐term performance data during our last two rebalances, but now the fund has more than a year track record (which is still shorter than ideal.) We were then curious as to its performance relative to Gross’s ‘total return’ mutual fund, PTTRX, which had been one of our core holding for many years. It is interesting that the PIMCO total return bond ETF has outperformed the Pimco total return mutual fund.
We then considered whether PTTRX, which was introduced in 1996, had outperformed our long term US total bond market benchmark, VBMFX, which was introduced in 1990. The plot of the back-‐test from 1996 shows the PTTRX was the stronger performer.
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So we decided to swap out AGG for BOND with the goal that the Bond King could manage this bond market for us.
However we did check AGG’s shorter duration sister fund, ISTB, which was introduced in October 2012 – a good time to start a bond performance comparison. Our goal was to illustrate the difference in performance between short and intermediate duration bond funds that have similar management and credit risk. So since October you see that the declines in ISTB are much less, but the potential upside is much less also. ISTB’S duration is 2.7 years, while AGG’s is 5.2 years.
The next decision is in the CBND (corporate bond) asset class where we have the investment grade Vanguard Intermediate Term Corporate fund, VCIT. We were first interested in the return and risk
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performance of the Vanguard short (VCSH), intermediate (VCIT), and long duration (VCLT) funds from their inception in November 2009.
The higher returns, higher drawdowns, and higher volatilities with the longer durations are clear. Here’s the table of results associated with the graph above.
After some consideration we decided remain long corporate bonds, but to shorten the duration by splitting the allocation between VCSH and VCIT.
We similarly decided to shorten the duration in our inflation protected bond asset class and not to short TIPs or go to cash – just reduce the risk. We compared our current fund, IPE, to two leading short duration TIP funds -‐ STIP from iShares and VTIP from Vanguard. The newest fund, VTIP was introduced last October, so we ran the back-‐test from October through the end of June.
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The results are as expected. We chose VTIP since it likely has a little less duration indicated by its performance above and we like the Vanguard funds generally since the management fees are always amongst the lowest and the management amongst the highest quality. Again the risk management approach here is to give up potential big gains (if interest rates fall substantially) at the cost of avoiding large losses (if interest rates rise.) We did not split the allocation since we find less upside value in treasury debt (TIPs) than we do in corporate debt.
Our last SIP-‐A class, FBND, has been interest rate and exchange rate challenged over the last few months. However PCY was a solid performer in 2011 when it was up 8.4% and in 2012 when it was up 21.9%. We don’t mind some cycles of under-‐performance, but if we are facing secular (long-‐term) head winds in interest and exchange rates then we want to make a change.
First we checked the performance of our current fund, PCY, against the total bond market fund, AGG. The good news is that holding PCY from the time of our initial purchase in May 2011 still had slightly higher gains than holding the index fund AGG. But the decline that started in May is a concern. We don’t want to take the risk of further declines despite PCY’s nice current yield of 4.79%. The value of our FBND asset class is that it generally has higher yield and currency and economic diversification.
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In order to preserve the fidelity of our FBND class we considered the short-‐term international treasury (sovereign) bond fund, ISHG, but the yield is less than 1%. We also considered currency hedged foreign bond funds, but found nothing suitable.
We also considered currency funds. We had looked forward to the introduction of a Singapore dollar fund – which was finally introduced earlier this year, FXSG. Note in the graph below that the Singapore dollar had strengthened fairly steadily against the US dollar for years.15 But the chart indicates that this is not the time to buy and we’re all familiar with concerns about China’s economy.
Source: Quandl
Our preference is to find a fund consistent with each asset class, but in the case of FBND we just couldn’t find one. So we’ve decided to just go to cash. So we explored the options of ultra-‐short US bonds, such as in the Pimco MINT ETF, a US floating rate note ETF e.g., FLOT, FLRN, FLTR and a bank loan
15 Singapore has been called the ‘Switzerland of Asia’ due to its strong banking industry and currency management. Singapore is also a ‘gateway to China.’
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ETF e.g., BKLN In order to make a choice we plotted their total return performance over the last 1½ years.
The BKLN looks interesting due the gains and the lack of correlation with fixed income, so we looked at the entire BKLN price history from March 2011, which includes that credit market drama in August 2011 when S&P downgraded US Treasury debt.
BKLN and FLTR experienced too much downside, so we decided to split the asset class allocation between the two lower volatility funds MINT and FLOT with the understanding that this asset class is a little better than holding cash.
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Finally we plotted MINT and FLOT versus our bond market benchmark, AGG. It’s interesting to see that over a two year run, AGG nearly fell to the same total return as our new ‘near cash’ assets.
So here’s the summary detail of our SIP-‐A holdings. The yield on this sub-‐portfolio has dropped considerably; in fact it’s now more of a cash portfolio – as in the permanent portfolio concept. We look forward to the time that we can make the reverse move.
Sub Port Asset
Class Asset Div Yield Yahoo Morning
star Data Sheet Asset Name
SIP-‐A
Fixed Income
ABND BOND 2.06% Link Link Link PIMCO Total Return IBND VTIP 0.00% Link Link Link Vanguard Sht Term TIP CBND VCSH 2.07% Link Link Link Vanguard Sht Term Corp Bond VCIT 3.29% Link Link Link Vanguard Int Term Corp Bond
FBND MINT 1.00% Link Link Link
PIMCO Enhanced Sht Term Maturity
FLOT 0.95% Link Link Link iShares Floating Rate Note
SIP-‐B Analysis
Surprise Report © July 2013 Page 26
The SIP-‐B portfolio has been a strong performer over the last year although with its value orientation, but it did slightly underperform the S&P 500. Of course this is the expected outcome during a cyclical bull equity market – note that the SPY was up 20½ % over the last 12 months as shown in the table.
Here’s the plot of our SIP-‐B asset prices. The prices all moved fairly correlated which is indicated in the table (column Corr) and had a good run from mid-‐November through mid-‐May. The global consumer staples fund, KXI, out-‐performed over that period until the May-‐ June market correction when it fell below the US consumer staples fund, XLP. Nonetheless we’ve decided to no longer have a separate category for foreign equity funds; we’ll henceforth include global and international funds when we select assets in each asset class -‐ consumer staples, low volatility, and high dividends.16
We start the SIP-‐B analysis by comparing our consumer staples fund to its competitors to assure our selves that we’re getting the most return for the risk taken – and the moderate risk with a consumer staples fund certainly a target. Here’s a plot of one of the older consumer staples funds, ICLEX, which was launched in May 1997. Its outperformance relative to the market over several cycles illustrates our selection of this asset class.
16 ‘Global’ funds include US assets, whereas ‘international’ funds do not.
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The Vanguard Consumer Staples mutual fund, VCSAX, was introduced in February 2004. It similarly has outperformed the market – most notable are the more shallow drawdowns.
We had earlier included the Vanguard Consumer Staples ETF, VDC, which we compared over 3 years to our current fund XLP and our foreign GLEQ fund – also a consumer staples fund – KXI.17 In our back-‐testing we are generally looking for the fund that had the best return rate to risk ratio among funds that meet our fundamental view. We of course also prefer higher dividends. The performance of VDC and
17 We always begin such a search by looking at all the funds by category and type at ETFdb.com (ETF data base) and sorting on the 3 year performance.
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XLP were nearly identical (red and blue lines below), but VDC was slightly greater.18 So we’ll switch XLP for VDC in our Surprise Portfolio, but there’s no need for current XLP investors to switch especially since XLP has a 1/4 % yield advantage.
We next tested our high-‐dividend equity asset class that we denote as DVEQ. Following our typical procedure, we start by checking ETFdb.com and include international funds. We back-‐tested a number of funds over the 2¼ years that our current fund HDV has traded.19 And again sorting on return rate to risk ratio, we see that HDV remains on top. HDV had the largest 2¼ year gains at 40.3% and the highest return to risk ratio at 1.25. We wish that it had the highest dividend yield, but we’ll stay with HDV.
We generally don’t invest in sector funds – other than consumer staples -‐ since we’re interested in return and risk -‐ not sector, but we were interested in which sectors our funds invest. The HDV fund’s highest allocations are to consumer staples (defensive), healthcare, utilities, and telecom – all of which would be interesting sectors for us. So through HDV we’ve invested in the higher dividend firms in these sectors.
18 Note again that our plots are dividend inclusive, whereas most plots that you see including those from Yahoo Finance use closing price, so that when a stock or ETF pays a dividend and the price drops -‐ that value is no longer included in the price. So we don’t think that’s the correct comparison for long term investors. 19 The HDV strategy is to match the Morningstar Dividend Yield Focus Index.
Surprise Report © July 2013 Page 29
Source: Yahoo Finance
Our next SIP-‐B asset class is the low or minimum volatility asset class denoted MVEQ. Our current asset is USMV; we had previously held SPLV. We back-‐tested these two funds as well as several others including international funds over the time from the inception of USMV in October 2011.
First we plotted USMV against SPY to get a visual on what lower volatility looks like. USMV is 83% correlated with SPY and had a 10.4% standard deviation of simple daily return rates compared to 14.7% for the SPY. Due to the lower volatility risk, USMV had a higher return to (volatility) risk ratio. The table with the numerical data follows the graph.
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The USMV and SPLV risk and return results are almost identical despite following different indices – the USMV follows a Morgan Stanley index while SPLV follows Standard and Poor’s index. We also tested global, EAFE (Europe, Australia, Far East), and emerging market funds, but these ranked lower than SPLV and USMV.
In the portfolio we’ll go with SPLV since it achieved the same performance but has a ½ % greater dividend. However, as in our CSEQ asset class, we do not recommend making this switch on current positions since the transaction costs including capital gains tax will outweigh the expected performance advantage.
So what sectors are represented in the SPLV fund? Utilities and consumer staples (defensive) comprise 54% of the fund.
Source: Yahoo Finance
Our last SIP-‐B asset class has focused on global or international equities. The objective was sub-‐portfolio diversification, but many of the firms in our first three classes are global firms despite being US based and we saw that global and international funds did not outperform in any of the other three equity asset classes. So henceforth we’ll evaluate global and international funds in all four asset classes and redefine this 4th class.
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There are a number of ways to add relatively low risk equity value by including funds that select on dividend growth, earning growth and yield, free cash flow ratios, wide moat strategies, hedge e.g., long short, and share buy-‐back strategies. After considerable analysis, we decided to go with an asset class exemplified by two ETFs that select equities based on ‘shareholder yield’ and ‘share buy-‐back.’
The Cambria shareholder yield fund, SYLD, was just introduced in May but has gotten a great deal of media attention. Cambria describes the fund as follows:20
“The Cambria Shareholder Yield ETF is an actively managed fund that employs the manager's quantitative algorithm to select U.S. listed companies that show strong characteristics in returning free cash flow to their shareholders. Specifically, SYLD invests in 100 stocks with market caps greater than $200 million that rank among the highest in (a) paying cash dividends, (b) engaging in net share repurchases, and (c) paying down debt on their balance sheets.
“Free cash flow has long been emphasized by investors as a key predictor of a company’s strength. Companies that pay cash dividends, one indication of strong free cash flow, have historically outperformed the broader market. Focusing strictly on dividend payments, however, misses two key indicators of strong free cash flow: net share repurchases and net debt pay-‐down. The manager believes that a focus on all three factors – dividend payments, net share repurchases and net debt pay-‐down, a trio collectively known as shareholder yield – produces a portfolio of companies that offer strong free cash flow characteristics.
“According to data compiled by Robert Shiller, over the past 70 years, companies have continued to pay a lower and lower percentage of their earnings in cash dividends. Due to tax treatment and regulatory changes in the 1980s, U.S. companies have shifted their payout mix to include more share buybacks, and according to research conducted by Jeremy Schwartz, seven out of the ten S&P 500 sectors in 2011 offered a higher yield resulting from share repurchases than resulting from cash dividend payments.”
In finance courses globally, students are taught that the financial value of a company is the present value of its future free cash flows. And at least ideally, all free cash flow should be paid out to equity and bond holders – the company’s investors, thus the value of the company is its value to its investors. So free cash flow is certainly “a key predictor of a company’s strength” -‐-‐ it’s the very definition of a company’s value! In an upcoming Surprise Report we’ll explain free cash flow in detail.
The other fund with a similar strategy is the Trim Tabs Float Shrink fund, TTFS. This fund has traded since October 2011 – much longer that SYLD however its daily trading volume and capitalization are low. The AdvisorShares site describes the fund as follows:
“The portfolio manager invests in companies that finance float shrink via free cash flow relative to peers rather than debt issuance. The portfolio manager looks for three main characteristics in its stock picks: shareholder-‐friendliness (measured by float shrink), profitability (measured by free cash flow relative to other securities) and solid balance sheet (measured by leverage ratio).”
These descriptions are very similar since ‘float shrink’ is due to ‘share buyback.’ The TTFS site provides
20 We’ve placed their description the Cambria font J
Surprise Report © July 2013 Page 32
some of the numbers that TrimTab tracks. The free cash flow yield of the fund is 7.90%, which sounds pretty good although we don’t have the comparable for alternative investments. But this does mean that 7.90% of revenue is or could be returned to investors through debt repayment, share buybacks, and dividends, which we see are rather small at ¼ %. So TTFS is investing in companies that have healthy free cash flow and return most of it through share buy-‐backs. Note that this does eliminate firms that are well known for increasing the number of shares (their ‘float’) through employee incentive stock options – this dilutes earnings and free cash flow per share for the benefit of management bonus. TTFS has invested in firms that have an average market cap of $15B which is in the mid to large cap – but not mega cap -‐ range. The average market cap of S&P500 equities is about $30 billion.
We back tested TTFS against our other SIP-‐B assets, HDV, SPLV, VDC, and the asset that is to be replaced, KXI, from TTFS inception in October 2011. TTFS was the top gainer – in fact outgained the SPY! The down side is that the fund is somewhat more volatile than the SPY. It also has a much lower dividend than our other SIP-‐B funds. Yahoo TTFS’s showing its dividend yield at less than 1%, but the tradeoff again is returning funds to shareholders through buybacks and not dividends, thus the opportunity is long-‐term capital gains and not current dividend income. Another TTFS advantage is that it is less correlated with the total equity market, thus does provide the diversification – non-‐correlation (.56) that KXI had not provided (.88.)
We checked Yahoo Finance for the sector allocations to better understand the non-‐correlation of TTFS. The largest sector allocations are different from the other three SIP-‐B assets – consumer cyclical (discretionary), technology, and financial services. So collectively the SIP-‐B funds do offer excellent sector diversification.
Surprise Report © July 2013 Page 33
Source: Yahoo Finance
We compared the SIP-‐B funds and SIP-‐B candidates, TTFS and SYLD, from May, which is of course really too brief to gain much understanding, but it was a volatile and thus an interesting period for equities. The graph below shows that TTFS and SYLD outperformed the other SIP-‐B funds over this volatile period. So we expect that these funds will exhibit shallower drawdowns in bear cycles, but strong gains over a number of business cycles.
We like both of these fund’s objectives even though we are a little concerned about the low trading volume of TTFS, the lack of track record of SYLD, and the small capitalization of both. So we’ve decided to take a half position in each. After SYLD has had at least year-‐long track record, we’ll pick one for the portfolio.
Surprise Report © July 2013 Page 34
Here’s a summary of the updated SIP-‐B equity sub-‐portfolio. We don’t yet know the SYLD dividend yield but it’s certainly greater than 0%. We realize that dividends from stocks and bond have been squeezed to very low levels. This does cause concern.
Sub Port Asset
Class Asset Div Yield Yahoo Morning star
Data Sheet Asset Name
SIP-‐B Equity Income
CSEQ VDC 2.57% Link Link Link Vanguard Consumer Staples DVEQ HDV 3.22% Link Link Link iShares High Dividend Equity MVEQ SPLV 1.75% Link Link Link PowerShares S&P Low Vol
SHEQ TTFS 0.54% Link Link Link Trim Tabs Float Shrink SYLD 0.00% Link Link Link Cambria Shareholder Yield
SIP-‐C Analysis
Now we turn to our asset oriented sub-‐portfolio SIP-‐C and start by showing our 3 year back-‐test on the current SIP-‐C assets. The returns for our infrastructure fund, MLPI, the healthcare REITs, HCN and NHI, and the energy trusts, MVO and BPT, have been excellent. Unfortunately, due to the recent action in gold, our SGOL holding had a slightly negative return. But due to our diversified sub-‐portfolio, overall performance was excellent. Here’s the table of results for the current 6 assets.
The following graph is the price plot of the 6 assets. It shows quite a spread of price trajectories! Diversification in this sub -‐portfolio is really important. The plot illustrates that large gains come with the cost of large risks – both volatility and drawdown.
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Note that the healthcare REITs were the top performers with about 20% annual compounded rates of return over 3 years (the geometric mean return rate column – third from the right.) We know that REITS have done well due to low mortgage rates and that the healthcare sector has been the top US industry sector. (Check page 15 for sector performance in 2013.) We were curious as to how our two healthcare REITs faired against leading healthcare and broad REIT funds such as those from Vanguard, VNQ and VHT. The plot is below.
Until the interest rate driven May-‐June market dive, the healthcare REITs had outperformed the healthcare and REIT funds by a wide margin. Their fall was likely due to relative overvaluation and their higher yields. But after three years the healthcare REITs are still up more than 80%. The Vanguard healthcare fund, VHT, had a total gain of nearly 80%. (3rd column from right.) We conclude that the healthcare focus did add value to our REIT asset class, since the Vanguard broad REIT fund was up ‘only’ 63% -‐ almost the same as SPY at 64%.
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We are pleased with the results in this asset class, yet want to insure that we have the top assets so compared the results to a few other top healthcare REITS over 3 years.
Indeed HCN and NHI are at the top of the list sorted on return to risk ratio. We considered OHI for inclusion since it was the top gainer and has the highest dividend yield, but also has the highest volatility and thus potentially the deepest drawdown, so we won’t change our current assets.
Our infrastructure asset (a master limited partnership), MLPI, had an excellent return and return rate to risk ratio. There are 2 other MLPs that have traded for at least 3 years – AMJ and MLPN. Here’s the three-‐year price chart – again including the pay-‐outs which are significant (~4 ½%) for this asset class.
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The performance of each asset is nearly the same. The case could be made for switching to MLPN due to a slightly higher 3 year gain at 76.1% and its higher yield at 4.61%. We’ll stick with MLPI due to its slightly higher return rate to risk ratio. (AMJ and MLPI track the same Alerian MLP index, whereas MLPN tracks the Credit Suisse MLP index.)
Now on to our energy royalty trust class that so tried our patience last year. We see from the table on page 33 that MVO and BPT have been up 54% and 38% respectively, but since January 2013 they are up 40% and 49% respectively. Our former holding royalty trust SBR is up 35% year to date. Recall last summer we switched from SBR to BPT and included MVO last fall. The switch was motivated by the higher returns of the crude oil royalty trusts relative to the natural gas royalty trusts.21
We ran a 3 year back-‐test and included SBR and another royalty trust, Permian Basin Trust, PBT. MVO and BPT remain the clear top choices. MVO and BPT had the highest returns, the highest yields, and are almost entirely crude oil.
Finally we turn to our gold asset class for which we’ve discussed our interest in a number of Surprise Reports over the last year and a half. Of course in hind sight we would have preferred to sell at the top, but we believe that we’re near the bottom now since the gold price is near its cost of production in much of the world – but gold has and can sell below the price of production – there’s a lot of gold above ground that could be re-‐priced and it’s not perishable or consumed unlike say corn or oil.
How did gold perform since say the introduction of the gold ETF, GLD, in November 2004 and its peak in August 2011?
21 SBR’s revenue is 65% from crude oil while MVO is 98% crude oil and BPT is 100% crude oil. The balance of SBR’s and MVO’s production is natural gas.
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Over this time GLD had a 21% annual compound rate of return. It outperformed equities by ~4x. Sometimes you hear the phrase “a blow off top” – that’s sure the case with gold as it went ‘parabolic’ in July – August 2011. But now look back at page 2. The Harry Browne rebalancing scheme would have provided significant value over this time. The rebalances would have moved some gold to stocks in mid-‐2006 (preceding a stock run up,) more gold to stocks in late 2008 after much of the stock decline, and even more gold to stocks in late July 2011 as gold was going parabolic.
Certainly the gold price had quite a run up over the last twelve years and was due for a correction, but this decline is more than a correction. We believe there are quite a few reasons other than supply and demand for physical gold and that this sell-‐off has or will overshoot to the downside.
So we’re going to stick with gold since we do want an allocation to monetary assets outside of the US banking system. So we have made no changes at all to our SIP-‐C sub-‐portfolio! Here’s the summary.
Sub Port Asset
Class Asset Div Yield Yahoo Morning
star Data Sheet Asset Name
SIP-‐C
Hard Assets
GOLD SGOL 0.00% Link Link Link ETFS Physical Swiss Gold Shares
ENER BPT 10.00% Link Link Link BP Prudhoe Bay Royalty Trust MVO 11.10% Link Link Link MV Oil Trust
INFR MLPI 4.39% Link Link Link
UBS Alerian MLP (Energy) Infrastr
REIT HCN 4.60% Link Link Link Health Care REIT NHI 4.90% Link Link Link National Health Investors
Surprise Report © July 2013 Page 39
The Updated Portfolio
We’ve switched some assets, kept most in place, and changed one of our asset classes – switched GLEQ to SHEQ. Here’s the new portfolio structure and assets.
For previous portfolio updates, we rebalanced each asset class to 1/12 (one-‐twelfth) or 8.33% of the portfolio, but at this time we won’t rebalance -‐ we’ll shift funds from deleted assets to new assets. We don’t yet want to move profits from equities, real estate, oil, and infrastructure to gold and bonds relative to our rebalance last November. The allocations are as follows:
Signing Out
We know that this report is already too long, but we covered many very important topics!
Next month we’ll address our Fidelity retirement portfolio. It also requires some reallocation.
Thanks for reading!
Disclaimer
The Surprise Investment Report is published as an information service for subscribers. It includes opinions as to buying, selling and holding various exchange traded securities. However, the authors are not brokers or investment advisers, and they do not provide investment advice or recommendations directed to any particular subscriber or in view of the particular circumstances of any particular person.
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The authors make no representations or warranties about the accuracy or completeness of the information presented including the information that is sourced at third-‐party websites.
The authors assume no responsibility or liability for your trading and investing results. And as everyone knows -‐ past investment results are not necessarily indicative of future investment results – and that’s because markets and economies are complex systems!
Licensing Note
The lead photo was licensed from Gordon Wolford on 10 January 2012.