Overwhelmingly, financial advisers steer their clients to funds. Generally, this works out very well for them, and often not so well for the clients. Funds of all kinds, whether stock or bond, tend to have layers upon layers of fees. The more "sophisticated" (i.e. complicated) the strategy, the higher the fees. Often as not, some of these fees make their way back to the adviser who suggested them in the first place. Well, you philosophize, you get what you pay for, right?
With stock funds, I think the answer is "WRONG"! You tend to get a lot less than you paid for, as the track record of stock fund professionals is, by and large, abysmal. They rarely keep up with the indexes they supposedly track, they hop in and out of whatever looks hot, they dress up the portfolio at quarter's end so that it looks like everyone else's tired results, they give and take kickbacks left and right, and draw huge salaries along the way. All of this comes out of YOUR pocket. ETFs, the really big ones, and those that track really big indexes, do much better. They have much less turnover, are therefore tax-efficient, and have very low expense ratios. They are absolutely the way to go, if you want exposure to stocks. However, advisers rarely steer you to them.
Well, then, how about bond funds? Actively managed bond funds have most of the warts that deface their stock counterparts. Fees, fees, fees, churn, churn, churn! Yes, they may get better purchase and sales prices and manage risk a bit more artfully than you can, but the elevated fees wipe those advantages away. How about bond ETFs? Well, they're fairly new, and many of them are synthetic products. You're not really buying a portfolio of bonds, you're buying a debt obligation of a third party. I see heartbreak looming.
But, surely a low-fee bond fund (say Vanguard) is a good choice? If you really don't want to do the work, then OK. But you lose all sorts of control. When you buy a portfolio of bonds, you can decide exactly what you want to buy, and how long you want to keep it. You can ladder religiously (each year further out gets the same dollar allocation), or you can move maturities in any direction you like. I, for example, have skewed heavily to the long end. Above all, you can lock in a position. If those 7.75% Union Carbide bonds of 2096 look good, you can load up, and your grandchildren will collect the money until THEY are old. What better way for them to remember you fondly?
With a bond fund, this lock feature is not possible. Sure, you can start out with a long-bond fund and a nice high yield. Sure as clockwork, though, newbies will flock in as yields start to fall. The fund will soon be buying lower-yielding bonds to put their money to work. The fund will bear the costs of investing this new money, which means that you share those costs, and they can be substantial. Should rates rise later, you will also share the costs of redemption, which might be very high indeed. Losses incurred selling the dogs will be shared by you, even if those dogs weren't in the fund when you joined the party. The bottom line is that a bond purchase reflects your investing values at one point only, the time you buy in.
There is one scenario where the ability to control duration has serious positive consequences. Typically, upon inheritance, the deceased's assets are "stepped up" in value. That means that the tax basis for the recipient is the value at death, not the original value. So, if a bond has increased steeply in value (remember I urge you to try to buy bonds at a discount to par), the tax basis for your heir is the more recent value. Upon maturity therefore, the tax bill will be substantially lower, perhaps even non-existent. While this can work even more spectacularly in the case of appreciated stocks, the implications for bond investors are also significant.
Tuesday, June 12, 2012
Monday, June 4, 2012
The End of the World!
Do I have your attention? I have enjoyed the observation, whose author I cannot pin down, that "the end of the world occurs only rarely." I think there is a lot of juice in this fruity apercu.
First, in the most mundane way, the end of the world is coming without any doubt. Something, the apocalypse for the religiously minded, global warming for the scientifically alarmed, and the inevitable solar nova for the scientifically dispassionate, will bring things to an absolute end.
I can think of nothing more pointless, though, than planning for it. When society as we know it comes tumbling down, no bunker, no stockpile of twinkies and assault rifles, and no stack of krugerrands will shield you from the barbarians. Somebody with bigger guns and a meaner disposition will take it all away, and you will probably pass your scanty remaining days as a miserable minion.
In a more sensible way, though, the end of the world has occurred a number of times in a number of places. Both world wars tore holes in the existing social fabric, destroying lives, homes and livelihoods in the process. This occurs with chilling regularity in less-developed places around the world as we speak. America has been blessed, having experienced only two world-ends. The first was the Civil War, which fell unevenly upon Americans. It was an economic and social tidal wave for the South, and actually a net plus for the North. (Please don't get me wrong; those who fought on both sides experienced enormous suffering.) The second end of the world for America was the great Depression, from 1929 to the beginning of the Second World War. This event impoverished a majority of the population, and destroyed confidence in a better future for a solid generation.
So, why am I trying my hand at both history and philosophy? Simply this: the end of the world DOES, blessedly, occur only rarely. And planning for it is an exercise in futility. Don't waste your time. Instead, I think a rational person should assume that things will ultimately work out, and make plans based upon that assumption. This has direct relevance for recent events (2008-2009) and right now (the Euro crisis). Perhaps you have forgotten how black things looked when Bear Stears and Lehman Brothers went belly-up and AIG's multi-trillion dollar bets went sour. I haven't though.
I was scared to my very marrow, but ultimately followed this simple line of thought: If the US government cannot deal with this crisis, then all bets are off. I have no way of anticipating what will happen next, and no sensible way to shield myself from the collapse of our financial and social system. So, the only reasonable thing to do is assume that the US government will find a way to prevent that collapse. It was frantically signaling its intention to do just that, by handing TARP funds to America's largest banks, and arranging forced mergers left and right. It took over AIG, GM and Chrysler for that exact same reason.
From this simplification, a number of steps became obvious to me. Financial instruments of nearly every kind were terrific buys. Stocks were frantically cheap, but bonds offered once-in-a-lifetime opportunities. Citicorp and Bank of America bonds were sporting yields of 15% and more, while the best banks in America (JP Morgan, Morgan Stanley and Goldman Sachs) were all around 10%. Either the end of the world was at hand, or I was staring at the best deals of my life. As I've explained repeatedly, the purchases I made then worked out splendidly.
So what, you reply, that's old news. EXCEPT, there is a new "end of the world" lurking: Europe, the Euro, Greece, Spain, Italy, Portugal, etc. The collapse of Greece will lead to ... well, maybe very bad things indeed. A string of bank defaults might spread to Italy, Portugal and Spain. The European Union might collapse, along with the Euro. Since everybody in Europe has his/her wealth in Euros, what will happen to that wealth? Honestly, I have no idea at all. It sounds suspiciously like the end of the world to me.
There are parallels to 2008-09. Some very large banks with very diversified operations, are now selling at a discount to their assets. Their bonds have been marked down steeply, as bondholders (a notoriously skittish group) seek the safety of German bunds and American (!) treasuries. What do do, what to do? Again, I apply Occam's razor: since the end of the world serves nobody, it will, somehow, be avoided. There will be a lot of noise, a lot of terror, and ultimately a lot of money to be made by those who can control their fears.
I think the Germans, their northern neighbors, and France will eventually find a way to keep things going. The largest European banks, too big to fail, will receive a functional guarantee of survival from the folks that matter. When and how will this occur? Damned if I know. It's probably too soon to take aggressive advantage. Buying big chunks of bank bonds now might lead you to stomach-churning, if temporary, paper losses.
The problem, though, is that the bargains will melt away once people think that it's safe. To quote myself about the issue of timing: if taking action is painful, then it's probably the right thing to do. So, I would nibble. I mentioned a couple of banks in an earlier post, both with yields near 8%. I'm pretty sure those yields will go higher. But guess what, 8% is not a bad return, assuming the company survives. If you can buy more later, at better prices, then fine.
First, in the most mundane way, the end of the world is coming without any doubt. Something, the apocalypse for the religiously minded, global warming for the scientifically alarmed, and the inevitable solar nova for the scientifically dispassionate, will bring things to an absolute end.
I can think of nothing more pointless, though, than planning for it. When society as we know it comes tumbling down, no bunker, no stockpile of twinkies and assault rifles, and no stack of krugerrands will shield you from the barbarians. Somebody with bigger guns and a meaner disposition will take it all away, and you will probably pass your scanty remaining days as a miserable minion.
In a more sensible way, though, the end of the world has occurred a number of times in a number of places. Both world wars tore holes in the existing social fabric, destroying lives, homes and livelihoods in the process. This occurs with chilling regularity in less-developed places around the world as we speak. America has been blessed, having experienced only two world-ends. The first was the Civil War, which fell unevenly upon Americans. It was an economic and social tidal wave for the South, and actually a net plus for the North. (Please don't get me wrong; those who fought on both sides experienced enormous suffering.) The second end of the world for America was the great Depression, from 1929 to the beginning of the Second World War. This event impoverished a majority of the population, and destroyed confidence in a better future for a solid generation.
So, why am I trying my hand at both history and philosophy? Simply this: the end of the world DOES, blessedly, occur only rarely. And planning for it is an exercise in futility. Don't waste your time. Instead, I think a rational person should assume that things will ultimately work out, and make plans based upon that assumption. This has direct relevance for recent events (2008-2009) and right now (the Euro crisis). Perhaps you have forgotten how black things looked when Bear Stears and Lehman Brothers went belly-up and AIG's multi-trillion dollar bets went sour. I haven't though.
I was scared to my very marrow, but ultimately followed this simple line of thought: If the US government cannot deal with this crisis, then all bets are off. I have no way of anticipating what will happen next, and no sensible way to shield myself from the collapse of our financial and social system. So, the only reasonable thing to do is assume that the US government will find a way to prevent that collapse. It was frantically signaling its intention to do just that, by handing TARP funds to America's largest banks, and arranging forced mergers left and right. It took over AIG, GM and Chrysler for that exact same reason.
From this simplification, a number of steps became obvious to me. Financial instruments of nearly every kind were terrific buys. Stocks were frantically cheap, but bonds offered once-in-a-lifetime opportunities. Citicorp and Bank of America bonds were sporting yields of 15% and more, while the best banks in America (JP Morgan, Morgan Stanley and Goldman Sachs) were all around 10%. Either the end of the world was at hand, or I was staring at the best deals of my life. As I've explained repeatedly, the purchases I made then worked out splendidly.
So what, you reply, that's old news. EXCEPT, there is a new "end of the world" lurking: Europe, the Euro, Greece, Spain, Italy, Portugal, etc. The collapse of Greece will lead to ... well, maybe very bad things indeed. A string of bank defaults might spread to Italy, Portugal and Spain. The European Union might collapse, along with the Euro. Since everybody in Europe has his/her wealth in Euros, what will happen to that wealth? Honestly, I have no idea at all. It sounds suspiciously like the end of the world to me.
There are parallels to 2008-09. Some very large banks with very diversified operations, are now selling at a discount to their assets. Their bonds have been marked down steeply, as bondholders (a notoriously skittish group) seek the safety of German bunds and American (!) treasuries. What do do, what to do? Again, I apply Occam's razor: since the end of the world serves nobody, it will, somehow, be avoided. There will be a lot of noise, a lot of terror, and ultimately a lot of money to be made by those who can control their fears.
I think the Germans, their northern neighbors, and France will eventually find a way to keep things going. The largest European banks, too big to fail, will receive a functional guarantee of survival from the folks that matter. When and how will this occur? Damned if I know. It's probably too soon to take aggressive advantage. Buying big chunks of bank bonds now might lead you to stomach-churning, if temporary, paper losses.
The problem, though, is that the bargains will melt away once people think that it's safe. To quote myself about the issue of timing: if taking action is painful, then it's probably the right thing to do. So, I would nibble. I mentioned a couple of banks in an earlier post, both with yields near 8%. I'm pretty sure those yields will go higher. But guess what, 8% is not a bad return, assuming the company survives. If you can buy more later, at better prices, then fine.
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