Mutual Funds Confirm Closer Correlations
Third-quarter mutual fund performance confirmed a theme we discussed in last month’s AAII Journal: Asset class correlations have moved closer together. Every mutual fund category that we track for the Quarterly Mutual Fund Update had a positive return last quarter, except for contra stock market funds. (Contra funds are designed to move inversely to stock prices.) Furthermore, the price changes in domestic stocks, international stocks, emerging stocks, bonds and commodities were more in sync than they historically have been.
(As you may remember, correlation describes how close the total return of one asset, such as large-cap stocks, is to that of another, such as commodities. In a perfect world, you want investments that zig when your other holdings zag.)
Foreign stock, regional/country stock, emerging stock, and general and emerging international bond funds were among the top-performing categories, though mutual funds focused on U.S. stocks made money for their investors as well. Notably, there was no country concentration among the best-performing international stock funds for the period of July through September—an indication of how many countries saw their local market indexes rise.
Even precious metals funds rose, aided by gold’s ascent above $1,300 per ounce.
Though this is good news for your portfolio balance, it is important to realize that higher correlations mean higher risks. Over the long term, however, various asset classes should become less correlated. This is why one of your best defenses against uncertain market conditions continues to be diversification.
Source AAII’s Quarterly Mutual Fund Update, Third Quarter, October 2010.
Executives Stay Conservative, But Are Spending on Projects
Three surveys of corporate executives crossed our desk in early October. All of them signaled concern about the pace of the economic recovery. On the other hand, they also suggested a willingness to spend on capital improvement projects.
We’ll start with the bad news. Optimism about the U.S. economy fell among 53% of the finance executives polled in the third-quarter Duke University/CFO Magazine Global Business Outlook Survey. Pessimists in this survey outnumbered optimists by a four-to-one margin. The Business Roundtable’s third-quarter 2010 CEO Economic Outlook Survey Index fell 8.6 points to 86.0, its lowest reading since the fourth quarter of 2009. Optimism among North American respondents to the McKinsey Global Survey fell 16 percentage points from a year ago.
Nonetheless, companies do intend to spend money on capital improvement projects. Respondents to the CFO Magazine study expect capital spending to increase 7% over the next 12 months. Nearly half of the respondents to the Business Roundtable survey said they plan to spend more over the next six months, a six percentage point increase from the second quarter (49% versus 43%). Nearly two-thirds of those polled by McKinsey said they do not plan to postpone capital investments or mergers & acquisitions that could prove to be profitable.
As far as employment, none of the surveys suggested the job market will improve over the next 12 months. A lack of growth in both the economy and demand from customers were the primary reasons.
Surveys such as these are helpful for gauging the sentiment of corporate executives, but they should not be used as the primary reason for determining to invest in a certain stock or sector. Rather, they should be considered in the broader context of economic and industry data. Plus, the trends seen by a specific company may differ from what macro views suggest. Thus, be sure you understand a company’s business model and what particular factors may cause its sales and earnings to rise or fall.
Sources: “More Trouble Ahead?” by Julia Homer, CFO Magazine, October 2010; Business Roundtable; McKinsey Quarterly, September 2010, McKinsey & Company.
Bond Strategies for a Low-Yield Environment
We realize that many of you are displeased with current bond yields. At press time, the 10-year Treasury note was yielding 2.51%.
Though the low yields are problematic for income-seeking investors, keep in mind that bonds play three important roles in a portfolio. First, they provide a fixed stream of income. Second, bonds offer return of capital when held until maturity. (Corporate bonds are not completely without risk, so be sure to monitor the fiscal health of the issuer.) Finally, bonds have historically had low correlations with stocks. (When stock prices zig, bond prices often zag.) Thus, even in the current low-yield environment, bonds should not be ignored.
The obvious problem with bonds right now is that you can be stuck with securities that pay a low rate of interest. If inflation rises, the low yield could cause you to lose money on an inflation-adjusted basis. There is also the problem of reinvestment risk, meaning current bonds are paying a lower rate of interest than maturing bonds. This happens when a higher-yielding bond matures in a lower interest rate environment. You are effectively being penalized for maintaining your portfolio allocation to bonds.
There are strategies that can be used without exposing yourself to significantly greater credit risk (the risk of a bond issuer defaulting). The first is to ladder your bonds. This is financial-speak for buying bonds of varying maturities. Since you don’t know when interest rates will actually rise, you take the timing element out of your investing decisions. (This is akin to dollar cost averaging with stocks.) The second is to invest in overseas bonds. An international bond exchange-traded fund (ETF) or a mutual fund can help facilitate this. Though there is currency risk — the chance that the greenback will appreciate against a foreign currency, thereby decreasing the dollar value of international bonds and their interest payments—you’ll lessen your direct exposure to U.S. interest rates. Finally, you could buy Treasury Inflation-Protected Securities (TIPS) whose principal and interest payments adjust with inflation.
REITs, master limited partnerships (MLPs) and preferred stock can also supplement portfolio income. While many of these securities offer higher yields, they do not provide the portfolio allocation benefits of bonds. In addition, REITs, MLPs and preferred stocks must be sold to get your investment dollars back, whereas bonds pay a set amount of money (e.g., $1,000 per bond) at maturity, even if market conditions are worse than when you purchased the security.
Thus your goal should be to maintain a proper allocation to bonds and use other asset classes to increase your portfolio income, instead of simply avoiding bonds because of the current low yields and ongoing uncertainty about future interest rates.
Source: AAII Investor Update e-mail, www.aaii.com/email.