Emerging Markets Bonds May Protect Purchasing Power of U.S. Investors

At Pilot Capital one of our concerns going forward is the value of the U.S. Dollar relative to its peers (Yen, Euro, and Pound) and to the currencies of developing markets. We believe that, over the next several years, the dollar will continue to be weak because of the still-large (although shrinking) U.S. trade deficit, our very large (and growing) national debt, and the anemic U.S. economic growth that we foresee. This has profound implications for the financial well being of our clients, whose wealth is denominated in U.S. dollars. Remember that we all operate in a global economy (we buy lots of stuff from folks in other countries and we depend on them to buy things from us). Any decline in the dollar versus the currencies of our trading partners lowers your purchasing power relative to the folks we are buying from and selling to, an uncomfortable situation. This makes it important that we look for a hedge against a chronically declining dollar. It would also be helpful if we were being paid to hold this hedge.

When looking for what currencies would represent a good hedge against a declining dollar, we rejected the other developed market currencies as many are in the same situation as the dollar. In fact, there is the strong possibility that developed market currencies will “lock” over the next few years and essentially move together eliminating any diversification advantage.
Many emerging markets countries, on the other hand, run trade surpluses, are less indebted to the rest of the world, and are likely to grow faster than the U.S. and the rest of the developed world in the foreseeable future. The most visible examples of this are Brazil, India and China. In addition, emerging-markets currencies offer higher yields, which attract the capital flows that support their currencies. Longer term, as the balance of the global economy shifts, it may become increasingly in emerging-market countries’ self-interest to allow their currencies to appreciate versus the dollar (currently many peg their currencies to the dollar) in order to improve the purchasing power of their consumers. Taking into account all these factors, we believe that a basket of emerging-markets currencies is the best way to protect our balanced portfolios from a decline in the U.S. dollar. The best way to achieve this goal is to own a diversified portfolio of good quality bonds denominated in (interest payments are made in) a variety of these currencies. If global economic recovery continues and the dollar continues to weaken we would profit in three ways.

· First, we are being paid our interest in the local currencies. For this income to be returned to us it must be converted to dollars. If the dollar cheapens versus the local currencies we can buy more dollars (hence preserving our spending power).

· Second, rates are much higher in developing countries than in the U.S. and the yield curve much steeper (a bigger difference between short and long term rates) this gives a good, active manager an opportunity to use interest rate risk strategies to add value.

· Third, we believe that the perception of risk in these markets will decline over the next few years and there may be more demand for debt from these countries allowing for capital gains.

When looking for an investment vehicle to position this hedge we favor active managers and not indexed funds (note that this effectively eliminates ETF’s). An active manager is able to take full advantage of the steeper yield curves available in emerging bond markets as well assess currency weightings in the portfolio to maximize currency translations versus the dollar.

Jobs Data a Rally Killer?

The stock market reacted violently to yesterday’s jobs data. As usual I would be very cautious about making any moves based on a single data point. In this forum I like to help my readers find information that’s important. Also I try not to reinvent the wheel (who has time for that anyway) and, where appropriate, to defer to better writers. In just that spirit I direct you to Bob Johnson, the Associate Director of Economic Analysis at Morningstar who yesterday put up an excellent post on why you should not read too much into yesterday’s jobs data. http://advisor.morningstar.com/articles/blogentry.asp?id=16776 Enjoy and have a safe and pleasant holiday weekend.

This week I’m delegating my blogging chores to a “guest blogger”. This link will take you to EconBlog, which is written by a promising young financial writer who is interning in our office this summer. For a look at emerging markets and the risks and return potential there, click on http://econblogsoc.blogspot.com/2009/06/emerging-markets-worth-look.html.

Keep Watching Libor

Of all the economic news posted lately the most encouraging was that the three-month U.S. Dollar Libor, seen as a key gauge of the effectiveness of the Federal Reserve's monetary policy, fell to 0.63688% yesterday, the lowest rate since the British Bankers Association began publishing Libor data in 1986. Click this link for the Wall Street Journal Article http://online.wsj.com/article/BT-CO-20090603-704345.html?mod=dist_smartbrief . Very early in the financial crisis the three month Dollar Libor rate peaked at 4.81875% on Oct. 10, 2008, indicating a near shutdown of interbank lending. LIBOR is important for a host of reasons. The most important is that it is the rate that banks around the world charge each other to borrow U.S. Dollars. It is generally regarded as a measure of the level of confidence that bankers have in each other’s institutions. It is also vital to the health of the balance sheets of individual families as it is a key standard for setting interest rates on all kinds of variable rate loans such as floating rate mortgages and home equity loans. Many commercial and municipal loans with variable rates are also based on Libor. Obviously lower rates on these loans help individuals and businesses meet their debt obligations and are a key piece of working our way out of a very nasty economic situation. We said very early on that Libor was going to be a key indicator of our progress. Myriad problems remain in the global economy, but real progress is very visible. We are encouraged, and so are the financial markets.

On the downside, we are concerned that the recent rise in oil prices could nip our nascent recovery in the bud. Keep in mind that the drop in gasoline prices from over $4 a gallon to less that $2 was a de facto tax cut for the U.S. consumer. The recent rise to $2.50 is not a killer but bears watching. In general, gasoline in the U.S. over $3 a gallon is a problem for consumers. This is a two edged sword for Pilot Capital though, as our managed portfolios at PCM tend to have an overweight to energy. We continue to like the sector. Our long term secular outlook for a great many people looking to use fewer resources remains intact.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investor’s should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.

Change in Name and Focus

Please note that I am changing the name of my blog from” Mutual Fund Watch” to “The Old Perfessor’s Investment Blog”. I am finding the number of investment topics that I want to share with you going far beyond just mutual funds. I’ll still write about mutual funds, but the wider scope allows me to comment on so much more at a time when I feel it’s sorely needed.

Thanks for Reading!

Greg Staub, Ph.D., CFA

Old Perfessor’s Investment Blog

I have been a professional investor for over 20 years. To say that a great deal has changed in that time is a spectacular understatement. When I first started helping others to invest, there were about 1,500 publicly traded mutual funds. Today, the Morningstar data base lists 26,842 mutual funds and ETF’s. We live in an age of virtually unlimited, inexpensive access to massive amounts of information about just about anything. Perhaps my greatest disappointment has been that despite the profusion of data that investors now have available, it seems that individual investor’s decision making is worse than ever.

From an investor’s point of view, the world has become a much more complex and dangerous place. The basic problem, as I see it is that the vast majority of individual investors no longer see investing as the ownership of assets that can build wealth or deliver steady income. Rather, investing has become more like a giant gambling casino complete with get rich quick schemes and “systems” delivered to us 24/7 on cable TV. Very few people seem capable of looking at the information available to them, taking a step back and asking, does this make any sense in light of what’ s possible and what’s probable.

My goal with the “Old Perfessor’s” blog is to find information that will allow you to invest the right way and filter out the massive amounts of financial pornography that’s flooding the media in all its myriad formats. I’m going tell you what’s important and what it means to you. Also it’s my opportunity, from time to time, to have a little intellectual fun with the purveyors of the aforementioned material.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investor’s should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.

Target Date Funds Create Controversy

In a March 26th letter to the Senate Special Committee on Aging, the Department of Labor announced that it was beginning an immediate review of Target Date Funds (TDF). TDF’s have become a popular option in 401(k) and other defined contributions plans as they offer to simplify investor’s decision making. These offerings are typically “funds of funds” meaning that they are managed using other mutual funds, usually from the fund family sponsoring the TDF. For example, Vanguard target date funds are managed using Vanguard funds as the underlying investment vehicles. They are managed to become more conservative (less stocks, more fixed income) as the holder approaches retirement. This relieves investors from having to make timing decisions regarding their portfolio.

While I agree with the concept of TDF’s, I have often been critical of the execution. My criticism has centered on three key issues. The first and most critical is that there is no mechanism to match the investment allocation of a TDF to an individual investors risk tolerance. In other words, even though you and I may be planning on retiring around roughly the same time, we may not have the same tolerance for risk in our retirement investments. When investing in retirement date portfolios we are forced to accept what someone else dictates as an appropriate asset allocation and risk level for someone retiring within a certain date range. Which brings us to the second issue, opinions differ greatly on the appropriate risk level for any given time horizon. Hence there is an incredible amount of variation in the amount of equity (stock) risk between funds with the same target retirement portfolios run by different management groups. During our research for clients we have seen TDF’s from different vendors with the same target date differ in equity content by as much as 30%. The third problem is the fact that most individual investors really have very little idea of what they are buying when investing in target date funds or what’s in them. They simply fail to do the appropriate research.

Given the above issues, it’s not surprising that when an extremely trying market cycle occurs that a significant number of investors in target date funds are going to be disappointed in their results. I thought it would be helpful to share the protocol that I use to evaluate whether to recommend that clients use the target date funds available in their 401(k) plans.

1. Determine the clients risk tolerance
2. Develop an asset allocation based on risk tolerance
3. Develop a portfolio using the non target date funds available in the plan. Note that I have run across plans that are so poorly designed that it is not possible to design a properly diversified portfolio.
4. If TDF’s are available in the plan, identify the fund whose asset allocation most closely matches the one developed from the client’s risk tolerance not the one whose target retirement date most closely matches the clients.
5. Compare the past performance of the TDF with the performance of the portfolio assembled from the non-target date funds in the plan.
6. If the TDF has consistently outperformed the portfolio put together using the non-target date funds or it is not possible to put together a decent portfolio using the non-target date funds then you should use the TDF. Note that past performance is no indication of future performance; it is however along with common sense, all we have to base decisions on.
7. If we identify a TDF that looks like it might be an effective investment tool for that client, then we look at the underlying fund investments and check for diversification and management quality. One other issue with TDF’s is that some fund families have used them to gather assets for in house funds that have performed poorly and have difficulty attracting assets on their own.

This is the only protocol that properly evaluates all of the options available to a 401(k) plan participant. The bad news is that it represents a fair amount of work, more that most 401(k) participants are willing to do. The above protocol takes me about 4-5 hours and I have been doing research like this for over 20 years. Further, I know of very few plan vendors that supply plan participants with the research tools to follow the above protocol to make a rational and informed decision about the use of a target date fund, while my practice spends a great deal of money annually on independent research so we can make effective, unbiased decisions for our clients.

One of my pet peeves is people who write lengthy criticisms but offer no solutions. So if you are a participant in a 401(k) plan that offers target date options or you already own one, here’s what you should do.:

1. Make the commitment to thoroughly understand the options in your plan. Use the protocol I have outlined above to evaluate the use of target date options in your plan.
2. If you are unwilling or unable to make the commitment, seek out an independent, fee-only financial planner in your area and hire them to evaluate your plan and make recommendations. A good place to start your search is The Paladin Registry, an independent evaluator of planners www.paladinregistry.com .

For what it’s worth, here are some suggestions for the Department of Labor and The Senate Special Committee on Aging as they look into participant complaints regarding target date funds:

1. Require a disclaimer on information of all forms accompanying target date funds that warns participants that the risk inherent in investing in a TDF may have no relation whatsoever with their own tolerance for risk.
2. Set standards for information that should be made available to plan participants so that they can make informed decisions. This information should be readily accessible and streamlined so that plan participants do not need advanced degrees in economics, law or finance to use or understand the material.
3. Recognize, finally that not all plan participants want to, or are able to, make their own investment decisions and allow plan sponsors (employers) to be able to offer the services of independent, unbiased fee-only investment advisors without the fear of lawsuits provided that those giving advice have the proper credentials and training.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investor’s should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.

Time To Consider Some Inflation Insurance?

As I have written before, I firmly the believe that the actions being taken by the U.S. Federal Reserve and most other major central banks around the world, while costly and politically unpopular in many circles, are both necessary and correct. We are in the midst of a major global recession caused by an intense deleveraging movement by businesses and consumers. Financial markets have experienced a massive flight to quality. There are very few historical parallels to this situation, but history clearly indicates that to keep the current situation from deteriorating into a prolonged and deeper recession and potentially a deflationary spiral, central banks need to act as a counterweight to the deterioration in both credit and liquidity by re-inflating the financial system. Here in the U.S. the Fed is literally throwing everything, including the proverbial “kitchen sink”, into the effort to repair the system and restore economic stability.

My biggest concern is not that the Fed’s action will not work; they will eventually produce the desired results, but rather the consequences and future cost of the “fix”. One of my bigger concerns is future inflation. You may ask how I can be concerned with inflation when the global economy appears to be walking a very thin line between disinflation and deflation. Providing liquidity basically means printing money. This action has the potential to be extremely inflationary. In the short run it is not, because it counterbalances a decrease in the money supply due to the aforementioned deleveraging and flight to quality. Eventually, however, the effect of all that liquidity will produce the desired result (people start spending again) and then the Fed must withdrawal liquidity to avoid inflation (too much money chasing too few goods and services). There are two problems with this. First, central banks tend to err on the side of caution, meaning rather than nip off a developing recovery the Fed will keep then excess liquidity out there longer. The second is that politically, it is more difficult to withdraw liquidity and rain on the recovery party.

My working hypothesis is that liquidity actions by global central banks begin to take hold late in 2009 and the recession bottoms during that time. Inflation then, may rear its ugly head by mid to late 2010. I believe it is prudent to begin to seek opportunities to reposition some assets as “inflation insurance”. Assets that I am considering include real estate, commodities, infrastructure investments and Treasury Inflation Protected Securities (TIPS).

Right now TIPS appear to offer a decent entry point. For a discussion of what TIPS are and how they work to protect your spending power, please see my article on TIPS recently posted on Pilot Capital’s website http://www.pilotcapitalmanagement.com/files/TIPS%20Article%201-9-09.pdf. As of this writing, The Vanguard Inflation Protected Securities Fund (VIPSX) offers a yield of 3.02% without any inflation adjustments. The comparable treasury fund, Vanguard’s Intermediate Term Treasury Fund (VFITX) yields 2.02%. TIPS are commonly valued in terms of the Break Even Inflation Rate (BIR). Normally the BIR would be on the order of 3%, in other words inflation would have to be at least 3% to have the TIPS perform equal to the comparable treasury. Right now the BIR is -1%. This means that the market is expecting consumer prices to drop 1% a year for the next 7-10 years. I view this as possible, but not probable as, since 1933, there have been only three years when the CPI growth rate was negative. The way I look at it, we can buy a U.S. Treasury bond with absolute inflation protection for 1% more yield than one with no inflation protection. In other words the U.S Treasury is buying our inflation insurance. Sounds like a deal!

A couple of caveats however, are in order. Note that TIPS work much better in tax advantaged portfolios such as IRA’s as the inflation adjustments to TIPs represent a taxable event and lower the after tax return in taxable accounts. Interestingly, this is an asset where the ETF alternative is not cheaper. Both the IShares Barclays TIPS Fund (TIP) and VIPSX charge an identical 0.25%. In addition, there is currently a disconnect between the net asset value (NAV) of the ETF, and its actual price. The ask premium over the NAV at the date of this writing is about 3.5%. Paying this premium would more than negate the advantage over the comparable treasury. Even with the trading advantages of the ETF, I prefer the mutual fund in this case.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investor’s should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.