Letters to the Editor
To the Editors:
I enjoyed the exchange between Rick Spillane and James Cloonan discussing the use of fixed-income investments in reducing portfolio risk [“Letters to the Editor” in the February 2007 AAII Journal]. I’m skeptical of bonds, believing that the return penalty far exceeds the value of their perceived safety or diversification benefit. I’m convinced that the enthusiasm of managers and advisors for bonds in a portfolio has more to do with protecting themselves from criticism than with maximizing return for their clients. I’m quite pleased to see James Cloonan’s comments supporting the idea that a well-constructed portfolio can indeed be all-equity and still maintain a low-risk profile. Of course, if everyone shifts from bonds to equity, presumably returns on the former will climb at the expense of the latter.
But I have a follow-up question for Dr. Cloonan: Do high-yield funds fill a useful function here? Looking over recent history (say, the last 10 years) it seems that the volatility of the high-yield funds isn’t much greater than their A-rated counterparts, but their returns are as much as 1% higher. As to long-term performance, I’m not sure we have good historical data because of the Milken anomaly of the 1980s. Or, is recent experience the anomaly? Is the behavior of high yields correlated more with equity or with fixed-income investments? (Or do they combine the worst aspects of both?) I have seen high-yield exposures in the 5% to 10% range recommended, but my question is: Can they reasonably be used as the entire fixed-income component, say in the 20% to 40% range?
James Cloonan Responds:
I want to point out that diversification within equities and real estate can only reduce risk to a certain level. For investors who need even lower risk, a low-risk component in the portfolio will be necessary. I prefer short-term Treasuries for this purpose rather than long-term bonds because you need fewer dollars to get the same risk reduction.
Your other topic, high-yield bonds or bond funds, is too complex for a short answer and is a completely different area of investment. The immediate yield is evident but the default risk is very difficult to analyze. The usual equity measure, volatility, is not meaningful when complete default is a possibility. I believe that the market often misjudges bond risk and thereby offers opportunity for investors who can analyze it more effectively, but it is a difficult chore. The spread between high-yield and investment-grade bonds varies with the economy since in good times default is less likely in a portfolio. For most of us, if we wish to take on more risk for higher bond returns, the best approach is to go with a bond fund where management has shown the ability to handle default risk over time. I would go that route only for long-term investments because there are short-term cyclical events that can increase risk for short-term investors.
To the Editors,
I have a few comments regarding the article “‘Enhanced’ Index Funds: Can They Beat the Market?” by John C. Bogle [May 2007 AAII Journal].
According to an article by Robert Arnott that appeared in the Financial Analysts Journal in 2005, there is a flaw in capitalization-weighted indexes—overvalued stocks are overweighted and undervalued stocks are underweighted. The result is a “drag” on the return of cap-weighted indexes. Randomizing this flaw using fundamental metrics—such as earnings, dividends, book value or cash flow—rather than cap weighting improves returns by about 2% annually. This is backtested from 1962 through 2004 and documented in the article.
Not everyone is as negative on fundamental indexation as Mr. Bogle, who says that it is merely an investment strategy masquerading as an index.
Charles Schwab says that fundamental indexing is “the most important innovation in passive investing since indexing was popularized in the 1970s.” On April 2, 2007, Schwab initiated three fundamental-weighted index funds.
Jeremy Siegel, Ph.D., author of “The Future for Investors,” says that, “fundamentally-weighted indexing is the next wave of indexing, and that these indexes have the potential to change the way we think about constructing investors’ portfolios.” He is an advisor to WisdomTree Investments, which has initiated quite a number of fundamental-weighted index funds based on dividends.
Mr. Bogle said that the “long-term margins” of this indexing method “are not large.” A 2% annual improvement would double the total return for a passive investor over 35 years. This is significant. In the interest of education of AAII members please consider Mr. Arnott’s view of fundamental-weighted indexes.
Also, I suspect that before long Vanguard will start offering fundamental-weighted index f
For another view on fundamental indexes, see the sidebar on page 12 of William Reichenstein’s article in this issue.