Interest Rates Rising – the sequel

Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.
Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.

No doubt you’ve noticed about half the industry pundits cautioning that the US Federal Reserve is closer to ‘tightening’ monetary policy.  What this implies for us regular folk is that they will introduce monetary measures that will allow interest rates to rise.  We have enjoyed a very long period of inflation and interest rate stability following the financial crisis (a crisis almost forgotten by many).  Despite a recent slowdown in come economic indicators, efforts by governments around to world to jumpstart an economic recovery did bear some fruit.  The rebound in profitability, employment and growth has been particularly robust in the United States.  Both Europe and China are now making efforts to replicate this success by bolstering liquidity in their financial systems as the US did.

So what’s to worry about?  Savvy investors will have already noticed that interest rates in the world’s strongest economy have already begun to rise, even before the FED has taken any action.  This is what markets do – they anticipate rather than react.  Some forecasters predict that although interest rates are bound to trend upward eventually, there’s no need to panic just yet.  They suggest that there’s enough uncertainty (financial distress in Europe, fallout from falling energy prices, Russia’s military ambitions, slow growth in China) to postpone the threat of rising rates far into the future.

Yield Curves 2015-05-02_15-28-30

What they are ignoring is that the bond markets will anticipate the future, and indeed bond investors out there have already begun to create rising interest rates for longer term fixed-income securities.  The graph illustrates that U.S. yield curves have shifted upward.  The curve shows market yields for US Treasury bonds for various maturities back in February compared to rates more recently.  So what’s the issue?  If investors hang on to their bonds while rates are rising, the market value of those bonds declines.  This often comes as a surprise to people who own bonds to avoid risk.  But professional bond traders and portfolio managers are acutely aware of this phenomenon.  So they begin to sell their bonds (the longer term-to-maturity bonds pose the most risk of declining in value) in order to protect themselves against a future rise in the general level of interest rates.  More sellers than buyers of the bonds pushes down the market price of the bonds, which causes the yields on those same bonds to increase.

Many money managers (including me) have learned  that despite how dramatically the world seems to change, in many respects history does repeat itself.  For example, while writing my CFA exams back in the mid-1980’s, I was provided with sample exams for studying, but they were from the most recent years.  I figured it was unlikely that questions on these sample exams would be used again so soon, and managed to do some digging in order to find much older previous exams.  I reasoned there are only so many questions they could ask, and perhaps older exam questions might be recycled.  I was right! In fact several of the questions on the exam I finally wrote were exactly the same as the ones I’d studied from the old examination papers.

In my experience recent history is not useful at all when devising investment strategy or trying to anticipate the future, but often a consideration of historical events further back in time – especially if trends in important economic drivers are similar – can be very helpful indeed.

The consensus is that interest rates will rise eventually.  But it is human nature to stubbornly hang on to the status quo, and only reluctantly (and belatedly) make adjustments to change.  What if what’s in store for us looks like this:  Consistently increasing interest rates and inflation over the next decade?  This has happened many times before (see graph of rising 10-year Treasury bond yields from 1960-1970).

US Treasury Yields 1960 - 1970

Before you rant that things today are nothing like they were then (and I do agree for the most part) consider the following: Is the boy band One Direction so different today compared to The Monkeys then?  And wasn’t the Cold War simply Russia testing the fortitudes of Europe and America just like the country is doing today?  Weren’t nuclear capabilities (today it’s Iran and North Korea) always in the news?

Yes there have been quantum leaps in applied technology, brand new industry leaders in brand new industries.  China’s influence economically was a small fraction of what it is today.  So where is the commonality? The potential for rising interest rates coming out of a recession.  The US government began raising rates in 1959, which caused a recession that lasted about 10 months from 1960 – 1961.  From that point until 1969 the US economy did well despite rising interest rates and international crises.  But which asset classes did well in the environment?

Growth of $100 - 1960 to 1970

Could the disappointing 1st quarter economic data be hinting that we might also be entering a similar transitioning period?  Inflation is bad only for those unable to pass higher prices along to customers.  If the economy is strong and growing then real estate and stock markets provide better returns.  Since the cumulative rate of inflation between 1960 and 1970 was about 31%, investors essentially lost money in constant dollars (returns below the rate of price inflation) by being invested in the bond market.  They would have done better by simply rolling over short-term T-Bills.  An average house in the US cost about $12,700 in 1960 and by 1970 cost $23,450 – beating inflation handsomely.

Do I believe we will see a repeat of the 60’s in terms of financial developments?  Yes and no!  There will be important similarities – especially in terms of stock markets likely performing well enough and the poor prospects for the bond market. There will be differences too.  The outlook for real estate is clouded by the high level of indebtedness that has been encouraged by extremely depressed interest rates over the past few years.  Higher rates mean higher mortgage payments which might serve to put a lid on real estate pricing, or cause prices to fall significantly for a period of time before recovering.

Companies that have substantially financed their acquisition binges with low-cost debt will soon find that unless they can pass along inflation to their customers their profit margins will be squeezed.  Who will benefit?  Commodity producers have had to significantly reduce their indebtedness – commodity prices tend to stagnate when inflation is low, and even decline when economies are growing slowly.  In a global context, these companies have had a rough time of it.  It is quite possible that their fortunes are about to improve.  If Europe and China begin to enjoy a rebound then demand will grow and producers will have more pricing power – perhaps even enjoying price increases above the rate of inflation.

Do I believe any of this retrospection will prove useful?  I hope so.  The first signs that a different environment is emerging are usually evident pretty quickly.  If there were a zero chance of inflation creeping back then why are some key commodity prices showing signs of strength now?

recent aluminum price recent copper price data

If we begin to see inflationary pressures in the US before Europe and Asia, then the $US will depreciate relative to their currencies.  In other words, what might or might not be different this time is which countries benefit and which countries struggle. Globalization has indeed made the world economy much more difficult to come to grips with.  Nevertheless, there are some trends that seem to be recurring over the years.

There will be recessions and growth spurts.  In recessions and periods of slower growth, some formerly stronger industries and companies begin to lose steam as a paradigm shift takes place, but then other industries and companies gather momentum if the new reality is helping their cause.  This is why I’ve biased my own TFSA with commodity-biased mutual funds (resource industries, including energy) and a European tilt.  You guessed it – no bonds.

Any success I enjoyed while I was a money manager in terms of performance was because exercises like this one help me avoid following the mainstream (buying into things that have already done well) and identifying things that will do well.

 

 

 

 

 

 

 

Don’t get whipsawed by Risk Management!

Back in February of 2012, I recall a prominent CFO departing a global insurance company.  This particular individual was labelled “the highly regarded architect of a hedging strategy that proved key in rebuilding investor confidence in the wake of the financial crisis.”  The company had suffered financially during the prior market meltdown because of a huge exposure to equity-linked products;  pre-crisis the company had introduced investment products that guaranteed to return a substantial (if not all) amount of the investor’s initial investment.  The money was invested in the company’s funds which in turn invested in stock markets.  During the financial crisis, the value of these assets (stocks) held in the funds declined below the amount that was guaranteed spelling serious trouble for the company.  In response a stricter approach to risk management was adopted after-the-fact.

Sounds sensible doesn’t it?  But it just isn’t!  I’ve watched this pattern time and again over decades.  The fundamental flaw is a complete misunderstanding of what constitutes risk.

Risk is almost always equated to volatility.  For example, stocks move up and down rapidly with much magnitude so they are deemed more risky than bonds.  But are we really as averse to upside risk as downside risk?  Strangely people become more averse to volatility when they’ve suffered downside risk (and come to adore volatility when upside risk has rewarded them).  Because our internal model of risk is so much more complex than mathematics can reckon with, our efforts to ‘manage’ volatility can actually subject us to less volatility but more risk.  When we reduce risk (hedging strategies usually reduce volatility – both up and down) at the wrong times, we miss the chance to be rewarded by the kind of volatility we adore.  We are our own worst enemies.

The President and CEO of a completely different insurance company was quoted as saying this, also in February of 2012:

“We are maintaining our equity hedges as we remain very concerned about the economic outlook over the next few years. We continue to be soundly financed with year-end cash and marketable securities at the holding company of about $1 billion.”

 

This statement followed the company’s earnings release, having reported substantially increased losses from its investments – management had hedged the company’s equity position in 2010 (again, after-the-fact) and suffered investment losses in that year’s fourth-quarter because stock markets rose (instead of declining).  The actions designed to protect the company against volatility lost money.  Risk aversion after-the-fact caused the company to lose money and avoid potential returns from upside volatility.

Because the pain caused by the downside volatility suffered previously was still fairly recent, aversion remained at a high level causing the company to stick to its hedging strategy (in denial?) despite these huge losses, and it continued to lose money as the market continued to go higher and higher still.

The financial crisis is behind us and now that markets are hitting all-time highs, record amounts of dollars are scrambling to get some upside volatility action. Too late?  It’s hard to put a pin in it, but intuitively might one conclude that if managing risk (or ‘risk off’ as they say on business television) was a bad idea during and immediately after the financial crisis, then perhaps chasing volatility (‘risk on’) might not be such a good idea at present?

It might seem as if I was picking on insurance companies earlier, but many pension funds, other financial services companies, portfolio managers and everyday investors follow the same destructive pattern.  Adoring upside risk but loathing downside risk – always at the wrong times – has ruined careers and put a serious dent in the life-savings of families.  More experienced money managers (there are fewer of us nowadays) increase risk when others are most averse to the idea, and begin to manage risk (hedging, raising cash balances) during periods of ‘irrational exuberance.’  They’ve learned the hard way that it’s easier to keep all the hair on your head if you avoid circumstances that make you want to pull it all out.

Mal Spooner

Mutual Fund Mania – Choose wisely during RRSP season!

Usually the first vehicle of choice for new investors is a mutual fund. In days of yore, which in the investment industry is more than five years ago, investors usually bought equity funds but in more recent times balanced funds have grown more popular and even bond funds have attracted money.

Oftentimes, the first mutual fund experience is a disappointing one. There’s a reason for this. People intuitively want to be associated with success, so their first mutual fund will have these characteristics:

  • A great track record of top quartile performance over at least three to five years.
  • Billions of dollars invested in it, so it is “safe.”
  • Offered by an investment firm with a long and “distinguished” history.

Many years ago, there was much less data readily available and few statistical tools at one’s disposal, but I was curious and decided to examine a group of funds over time to see what their performance looked like. What I discovered is represented in the chart. There were no exceptions; every fund in my sample followed this same pattern.

It doesn’t take a mathematician to interpret a picture. If you invest in the fund when it’s a dog (ranks very poorly compared to other funds), the odds are great that given time it will be a top performer soon enough.

The problem is that most investors will pick a top performer. However, the top performer will soon become a dog, and the investor will be unhappy.

A great track record might actually guarantee poor performance.

When it comes to your money, intuition sucks. You “intuitively” steer towards something that “feels good.”

There is enough publicly available data nowadays to help you find a few funds that suit your tastes and examine their performance patterns. What suits your tastes may include funds that are easy to buy in and out of, those you have read about in the press, whose portfolio manager sounds smart on TV, or you may prefer socially responsible funds. When one of the funds that does occasionally perform very well has been in a slump over the past year or two, buy it. After the performance has improved over the course of a couple of years and you’re happy with the results, consider selling (or redeeming) it when the fund is in the top of the rankings (or wins an award) and buy a different fund that is in a temporary slump.

Being a curious sort, I once had the urge to see if award-winning funds followed the same pattern. After all, if someone wants a top-performing fund, wouldn’t they head straight for the ones that have just won awards for their outstanding performance?

I looked at the award-winning funds in any given year, and then checked their performance just one year later. Rather than examine every category (there are just too many nowadays) I stuck to basic Canadian equity, U.S. equity, small cap, international equity. Included were “thematic” funds popular at the time, such as ‘precious metals’ and the ‘dividend and income’ funds. Here are a couple of examples of what I usually found:

Results:

  • 100% of the winners were either 1st or 2nd quartile funds. The next year, 88% of these had fallen to 3rd or 4th quartile.
  • All the former 3rd quartile funds (dogs) rose to 1st quartile (stars) in the following year.

Winning an award (being a top performer) is not an indication of how that fund will rank in terms of its future performance, even in the following year. In fact, the odds are awfully good that your 1st or 2nd quartile pick will be below the median or worse one year later. Interesting! If there’s a lesson, I suppose it’s simply that funds should be bought because they meet your objectives, not because they’ve been performing well recently.

It’s not important to understand why this roller coaster occurs for mutual funds, it just does. Markets change, so, for example, when a growth fund invested primarily in technology stocks suffers, it’s no doubt because the upward trend in technology stocks, or their popularity among the herd, has either stopped or deteriorated. Apple is a prime example in the news right now.

Portfolio managers are just people working for people. I’ve witnessed the following scenario occur time and again:

  • Fund performance begins to soar.
  • Fund attracts lots of new money.
  • Marketing folks want more and more time from portfolio manager for meetings.
  • Money pours into the fund in droves.
  • Portfolio manager’s head swells (the “I’m a genius” syndrome).
  • Performance begins to deteriorate.
  • Money leaves the fund in droves.
  • Portfolio manager has to sell the fund’s best stocks (there are still buyers for these).
  • Performance sucks, and it takes two to three years for things to get back to normal.

Size really doesn’t matter…unless the fund is humongous.

A thinking person should be able to figure out that it doesn’t take a big fund or a big fund company to provide good performing funds. Think about it. Do you shop at the big box stores because the level of service is better? Is the quality of the merchandise better? No. You shop there because the economy of scale for the store allows them to buy products at a lower cost. They can order in bigger volumes and squeeze their suppliers. They then pass these savings to their customers.

Larger financial institutions enjoy similar economies of scale. Of course, the transactions and administration costs of the bank or insurance company are lower, and these benefits might come your way in the form of lower fees and expenses, but we’re not talking about buying lawnmowers. Rates of return on funds managed nimbly and intelligently can make those fees and expenses pale by comparison.

Bigger is safer possibly when you’re banking, but legitimate capital management companies are structured so that they never really touch your money. The custodial (where the money is physically held) and administrative (recordkeeping) functions are usually provided to these firms by big banks or huge financial institutions anyway—for safety and regulatory reasons and it makes the potential for fraud near impossible.

The reason why large financial services companies got into the fund management business was simply economics. They were providing banking, custodial, and administrative services to mutual fund and other asset management companies anyway, so why not also earn management fees by offering their own mutual funds and private wealth management services?

Take it from someone who knows from experience. Managing a massive quantity of money in one fund is much more difficult for a portfolio manager. You can only buy big companies. A portfolio manager will try to buy the best big companies, but since everyone else with big portfolios is doing the same thing, it’s not like you can outsmart them. It’s sort of like playing poker with jacks, queens, and kings being the only cards in the deck. If the three other players see three kings on the table, everyone knows you still have one in your hand.

Applying some discipline is important when directing your savings and will spare you much grief. For several years since the financial crisis, investors have swarmed into bond (see chart – it shows the net Sales of bond mutual funds) and balanced funds because of their strong relative performance and are considered to be less risky. Even today buying into income-oriented funds ‘feels good’ – everyone else is doing it, past performance is good and the fright we all experienced during the financial crisis still stings a bit.

Equity funds have been avoided for years – constantly redeemed – despite the fact the stock market returns have been outstanding since the crisis more or less ended (or at least stabilized). Now that the past returns are looking better, investors will be shifting money out of the bond funds (and perhaps balanced funds as well) and chasing the top performing equity funds.

This is an inferior strategy. If you examine the best ‘rated’ funds you will find they hold more dividend paying and income securities and will likely drop in the rankings very soon after you buy them.

With RRSP season comes a plethora of marketing campaigns and firms will be pushing us to buy their best performing funds (we are so quick to buy what ‘feels good’). Since you won’t see many advertisements for those not doing so well today, but are likely to do very well tomorrow, it would be wise to do a bit of homework before buying in. Good luck!

Mal Spooner