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The Results are in for my January CNBC Experiment: It Proves Nothing and Everything. What?

07 Friday Feb 2014

Posted by wmosconi in asset allocation, beta, bonds, business, Consumer Finance, currency, Education, EM, emerging markets, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial planning, foreign currency, forex, fx, Individual Investing, interest rates, investing, investments, math, NailedIt, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stock prices, stocks, Suitability, volatility, Yellen

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bonds, business, cnbc, currency, education, EM, emerging markets, finance, financial planning, forex, fx, individual investing, interest rate risk, interest rates, investing, personal finance, rising interest rates, stocks, thought experiment, volatility

Sometimes the most important lessons in the individual investing sphere are complicated and simple at the same time.  At the very beginning of January, I recommended a little experiment that related to the financial market coverage on CNBC.  The specific details of this “thought experiment” can be found in the original blog post from January 1st:

https://latticeworkwealth.com/2014/01/14/happy-new-year-beginning-thoughts-and-information-for-international-viewers-2/

The brief version of the exercise related to watching Monday and Friday coverage of the current events in the global financial markets during the month.  The simple exercise was to watch CNBC’s Squwak Box every Monday during the course of the month.  The second part was to watch the last hour of the Closing Bell segment.  What was the logic?  The Monday show is a three-hour program, and there are many current issues considered and opinions from various market participants (e.g. traders, money managers, economists, investment strategists, research analysts, etc.).  Monday is critical due to the fact that the market participants cannot trade on Saturday and Sunday.  You might think of it as “forced” time to think and/or reflect about how current events are affecting investment opportunities and risks.  Friday’s reflections from the same market participants is focused more on trying to explain the “vagaries and vicissitudes” (i.e. volatility of the stock market and changing opinions) of the markets ups and downs over the course of the week.  Furthermore, many commentators and guests try to explain why the predictions on Monday did not or did match up with the ideas expressed at the beginning of the week.

The overall point of this experiment was to “drive home” the fact that trying to time the market or predict its direction over the short term is extremely challenging and can seem hopeless.  Toward the end of December, the general investment thesis for the majority of money managers was that the stock market was poised to have a very positive January due to the fact that the financial markets did not really dive after the Federal Reserve announced the reduction of the tapering program, commonly referred to as QE (quantitative easing).  Additionally, the main belief was that bonds were one of the least attractive investments to own.  Most people assumed that the 10-year US Treasury Note was headed up to the 3.0% level.  Things seemed pretty simple and not too many headwinds in the near future.  So what happened during January?

The main event that most people remember was the currency difficulties of a number of emerging market countries.  The financial media focused a lot on the Turkish lira (TRY) and the Argentine peso (ARS).  Turkey had political problems, and Argentina has a huge problem as it relates to political leadership (or the absence thereof) and dwindling currency reserves.  There were other currencies that experienced trouble as well like the South African rand (ZAR).  The other important development was that the Japanese yen (JPY) reversed its direction and strengthen versus the US dollar (USD).  Oddly enough, the Argentine Merval stock index was one of the best performers over the course of the month.  No one saw this coming to such an extent.  You might term this an exogenous event as anything that occurs outside of your current model to build a portfolio or invest in individual stocks/bonds.  It is largely unknown and hard to predict.  (As an aside, this is NOT the same thing as a “black swan”.  That term is overused and conflated with many other things.  Refer to Dr. Nassim Taleb for a further definition of the termed that he famously coined years ago).  These events tend to be unknowns and have a greater impact because the general level of the perception of risk changes almost instantly and affect market sentiment and momentum.  Market participants need to alter their models rather quickly in order to account for the occurrence of these events.

The other big event was the movement of the yield on the 10-year US Treasury note.  Instead of following a general path of rising, the interest rate actually fell.  The yield on this instrument drifted down roughly 40 basis points (0.4%) from the 3.0% level.  What most people fail to realize is that interest rates go down if economic data turns out to be worse than expected normally (e.g. December jobs of 70,000 and the lowest labor force participation rate since the 1980s), but, more importantly, there is a “flight to quality” phenomenon that occurs over and over again.  There tends to be a bit of a “mini panic” when unexpected and impactful events occur.  If all else fails, institutional investors like hedge fund managers tend to buy US Treasury bills, notes, and bonds for safety.  The additional demand causes bond prices to go up and, by definition, yields will go down.

The combination of bad economic data and dealing with the currency woes in the emerging markets causes many short-term traders and speculators to buy these risk-free assets and figure out how to trade later.  It is sort of an example of reflexivity.  The bottom line for individual investors is that many sold bonds and purchased dividend stocks instead.  The exact opposite happened:  bond yields went down and dividend stocks sold off.  The worst short-term investing strategy was to search for yield in the stock market rather than the bond market due to rising interest rates.  For more information you can refer to one of my former posts on how to look at the various risk factors associated with bonds.  Trust me, there is a lot more to bonds than simply interest rate risk.  Here is the link to a former blog post that addresses this very issue:

https://latticeworkwealth.com/2014/01/02/a-bond-is-a-bond-is-a-bond-right-should-you-sell-bonds-to-buy-stocks/

There were many other smaller events that happened over the course of the month that affected the general volatility experience in the financial markets.  At the end of the day, even the “experts” had a monumental task trying to explain all the macroeconomic events, currency movements, and interest rate implications throughout January.  If the task was so difficult for them, it is normally advisable for individual investors to not follow the market daily and get caught up in temporary “greed and fear” of traders and speculators.  Investment ideas and predications can change from day to day and even minute to minute in the short term.  It is much more important for individual investors to develop a long-term financial plan that will allow them to reach future financial goals.  You then blend that with your risk tolerance.  For example, how likely would you have been to sell the positions in your portfolio given the volatility experienced during the course of January?  An outlook of five years is normally a great start for that plan.  If you look out into the future with a longer timeframe like an annual basis in terms of adjusting the components of your asset allocation, you are less likely to constantly trade the securities in your personal portfolio.  The frenetic pace of traders/speculators and the volatility of the stock and bonds markets makes it seem that you MUST do something, anything!

If you would like to learn a bit more about behavioral finance, you can refer to this blog post from last year (note context of examples referred to is from August 2013 when the piece was published):

https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/

One of the most important things to learn in investing is how to control your emotions.  It is easy to map out your investment strategy and risk tolerance on paper.  Many asset managers who have experienced a multitude of secular bull and bear markets refer to this phenomenon as your EQ versus your IQ.  Thus, when actual “money” is involved, volatility and uncertainty in the financial markets brings forth challenges that even the best money managers have a hard time keeping up their nerve.  The other takeaway is that people’s investment recommendations can change on a dime.  Market participants can be very hopeful on one day and think the sky is falling the next day.  Trying to time the market is so difficult that you end up developing a portfolio allocation for your investments that assumes that general events with transpire.  All the planning in the world cannot account for all possibilities of geopolitical and global events that might really cause the market to go down more than normal in a short time period.

The whole point of this “thought experiment” was to encourage you to take a long-term view of investing in the financial markets.  It is a lot less stressful, less complicated, and tends to lead to better overall investment returns (i.e. you do not “sell low and buy high” as much because everyone tells you to).  For more information on stepping back and thinking about the long term, I have included a final blog post.  You always need to remember that your financial professional (or yourself if you manage your own investments) who advises you about investment decisions is forever impacted by the start of their investment career.  They tend to be biased and make investment recommendations based upon how things used to be when they started in the business.  It is very hard to separate your “biases” from the present day.  Here is the link:

https://latticeworkwealth.com/2013/08/18/before-you-take-any-investment-advice-consider-the-source/

Well, I hope you learned a few things by participating in my experiment and maybe even had a little bit of fun.  Please feel free to leave a comment or send me an email directly at latticeworkwealth@gmail.com with more specific feedback and/or questions.  Sometimes you can learn a great deal just by being an observer of financial market volatility.  What is the nothing part of this learning journey?  The moral of the story is that everyday guests appearing on CNBC or other commentators will let you know that the stock market with either go up, go down, or stay unchanged.  Obviously everyone knows that simple concept to begin with.  Thus, it is hard to choose who to listen too because of so many divergent opinions.  Lastly, you should realize that this same experiment would have worked with the other business networks and large financial news publications like the Wall Street Journal, Financial Times, Barron’s.

Not all Index Mutual Funds and ETFs are Created Equal: Part 1 of 2

28 Tuesday Jan 2014

Posted by wmosconi in asset allocation, beta, bonds, business, Education, emerging markets, finance, financial planning, Individual Investing, investing, investments, personal finance, portfolio, risk, stock prices, stocks, Suitability, volatility

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asset allocation, Bogle, bonds, EM, emerging markets, ETF, ETFs, finance, index mutual funds, passive investing, personal finance, stocks, volatility

I am definitely a big advocate of passive investing in either index mutual funds or exchange traded funds (ETFs).  However, the proliferation of products over the last 10 years or so has made things quite a bit more complicated than the old days of John Bogle introducing the first large offerings of index mutual funds at Vanguard over 30 years ago.  I figured it would be worthwhile to address a few topics in this regard.

There are two issues that are central to my discussion that individual investors need to be aware of.  The first issue is that the underlying stock or bond holdings of these offerings can be very different even if the names sound exactly the same.  The second issue is that many of the new registrations for ETFs or recently issued securities are more akin to what is termed enhanced indexing or “smart” beta.  These types of choices are not active mutual funds or ETFs in the traditional sense.  Moreover, they are not passive either.  These newer products will slice and dice a universe of securities or use “proprietary” methods to actually beat the index.  Now by definition an index investor knows that he or she will underperform the index when costs are taken into account.  Any “passive” product that claims that the advisor can beat the index is therefore more akin to an active approach.  There are many different terms to describe.  I will postpone the discussion of that salient topic in the second part of this post though.

There is a great example in recent days of why this is important.   An ETF is the best way to analyze the issue because they must be transparent daily.  The holdings of any ETF are publicly available to see each day.  Additionally, each ETF will hold all the components of a particular index.  Therein lies the extremely vital piece that most individual investors are unaware of.  There happen to be multiple indexes that attempt to capture the stock and/or bond investment performance of a particular piece of the financial markets.  The definition of that universe is what matters to investors.  A timely example is the stock performance of emerging markets which has been incredibly volatile of late.  However, not all ETFs follow the same definition of what an emerging market country is.

The two main emerging market ETFs are offered by Vanguard and BlackRock.  The Vanguard offering is through their VIPER series and is called the Vanguard FTSE Emerging Markets ETF (Ticker Symbol:  VWO).  The BlackRock offering is through their iShares series and is called the iShares MSCI Emerging Markets ETF (Ticker Symbol:  EEM).  Most individual investors (and some financial professionals) think of these ETFs as being the same.  However, they are actually quite different.  Why?  Well, the difference in the names kind of gives the answer away.  The Vanguard ETF is tied to the FTSE Emerging Markets Stock Index, while the BlackRock ETF is tied to the MSCI Emerging Markets Stock Index.  Both of these ETFs invest in all the components of stocks in those two respective universes.  The definition of emerging markets by these two index providers is quite different.

The main difference between the two is how they classify stocks traded in South Korea.  MSCI considers South Korea to still be an emerging market and 15.8% (as of January 27, 2014) of the ETF is allocated to that country.  FTSE considers South Korea to be mature enough to be thought of as a developed economy and no longer should be viewed in the same light as other countries in the emerging markets.  They have reached a level of sophistication in terms of the economy, banking system, and breadth in trading of the stocks there.  Thus, Vanguard does not allocate any money to South Korea.  There are some other slight differences in countries within the two indexes but the aforementioned percentage is definitely significant.  If you are ever confused why the total returns of the VWO and EEM ETFs do not equal even after taking into account investment fees, that is the primary reason why.  Over the course of an entire year, the difference in the total return can be striking depending on the performance of the KOSPI (South Korea’s main stock index).

Investing in the Vanguard version instead of the BlackRock version can be more risky since the relatively more mature stock market of South Korea is not included.  As I have mentioned in the past, I do not advocate the purchase of any particular stock, bond, index mutual fund, or ETF.  With that being said though, it is important to know the differences between two similarly sounding offerings.  If you want to have exposure to the emerging markets, you should not simply look at investment fees.  The expense ratio on the VWO is 0.18% and the 0.67% for the EEM.  Most people would say that the VWO is better because the fees are lower.  However, you are not comparing apples to apples due to the South Korea inclusion issue.

The main takeaway here is to read the prospectus for any index mutual fund or ETF.  Or, at the very least, you should pay careful attention to the fact sheet provided for either.  You should look at what index the index mutual fund or ETF advisor is using.  You can go to the link of that index provider to see what is included (in terms of individual stocks or bonds or countries, etc.), so you are aware of what you are buying.  It is much easier to avoid a purchase of a particular security than to have to sell after an unexpected loss because you purchased the “wrong” thing based upon your risk tolerance and financial goals, and how that particular asset was going to complement your overall portfolio allocation.

I have included links to the major index providers for ease of reference.  There are many others, but these are the major players in the passive investing world.  They are as follows:

1)       Standard & Poor’s – http://us.spindices.com/

 

2)       Russell Investments – http://www.russell.com/indexes/americas/default.page

 

3)      MSCI – http://www.msci.com/products/indices/

 

4)      FTSE – http://www.ftse.com/Indices/

 

5)      Barclays – https://ecommerce.barcap.com/indices/index.dxml

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