1. Emerging Market Bonds and Currencies as a Sub-Asset Class: Recently I bought some shares in a new ETF offering by Wisdomtree that will attempt to match the movement of a basket of emerging market currencies. Bought 50 Currency ETF for Emerging Markets-CEW/ Bought GYC: Synthetic Floating Rate Bond Wisdomtree provides a chart of the correlation of emerging market currencies with other asset classes. The correlations were all positive with the correlation to U.S. stocks at .68% and to international stocks at .8%. This would suggest that this ETF would add diversity but would not be a hedge for those other asset classes. here is a lower positive correlation with alternative asset classes such as gold and commodities. CEW-570.pdf In that PDF, there is another chart that shows that adding a 10% allocation to emerging market currencies to a balanced portfolio of stocks and bonds, which I would never consider doing, would increase returns and lower volatility, always a desirable objective from my viewpoint. That is always my objective, to outperform the S & P 500 with less volatility, though I would add the goal of outperforming that stock index while realizing over twice as much current income than 100% exposure to that index would produce in dividends.
This is a link to a chart showing the correlation of an ETF for emerging market bonds and the S & P 500. Features That chart shows a low positive correlation over an extended period which suggests that emerging market bonds can offer diversity to a holder of U.S. stocks, with some potential of equity like returns. There does appear to be a high positive correlation when stocks started their meltdown in 2008, which would indicate to me that emerging market debt may need to be eliminated or substantially trimmed when the VIX Allocation Model flashes red for U.S. stocks. You do not want an asset class that has a very high positive correlation with U.S. stocks in a stock bear market. This is just another reason why so many static allocations fail-an unwillingness to adjust to the market in their mechanical glide paths to mediocrity.
The need to eliminate a sub-asset class at times would also be true for emerging market stocks. Those stocks are not only positively correlated with the U.S. stock market, but have a very high beta. This article shows that when the S & P moves 1%, an emerging market ETF would amplify that move to 1.83%. Seeking Alpha See also, Do Emerging Market ETFs Help You Diversify? | ETF Trends This is the kind of data that would justify my decision to dump emerging market stocks prior to 2008. A target fund would just keep that kind of asset in the allocation irrespective of market conditions and signals. I would also generally expect all stocks to fall in a bear market led by the U.S. The emerging market stocks most likely would only serve to amplify the down move in U.S. stocks, and would be counter-productive as an asset class in those circumstances. Another article has a chart showing, for example, a high positive correlation between emerging market stocks and the S & P 500 during the 2000 to 2002 bear market. Seeking Alpha
2. The Many Failures of Mechanical Glide Paths in Target Funds:
I just briefly discussed my general observations about the failures of Target Funds over the past decade as an asset allocation model. The Failure of Target Funds for Retirement:
I do not even view this point to be debatable.
The MSN Money web site is one of the best for analyzing mutual funds. This is a link to the performance data for the Fidelity 2020 fund. FFFDX - Fund returns - MSN Money Over the past 10 years, the annualized return is shown as .94%. That return is listed as #1 in the category. This is the link for the same date on the Fidelity 2010 fund. FFFCX - Fund returns - MSN Money
So, what is the problem? In a nutshell, a workable asset allocation can not be based on a static glide path model. The problem with such a static approach is discussed by me in the many posts linked in my main Gateway Post on Dynamic Asset Allocation. Time for a Paradigm Shift in Asset Allocation Theory: Need Dynamism, Better Assessment of All Forms of Risk, and Due Regard to Volatility Patterns
To summarize, some adjustments need to be made in asset allocation based solely on an assessment of volatility of an asset class. As shown in my Vix Asset Allocation Model, it would have been foolish to maintain the same allocation to stocks after the first Trigger Event in August 2007. VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern When volatility becomes more elevated out of a long term stable pattern, the risk has increased substantially for stocks as an asset class. Along with that increased risk, there is a substantial likelihood of lower prices. This would require some shift out of a fixed stock allocation required by some brain dead glide path model to an asset class likely to show negative correlation with stocks. This would need to be done regardless of a person's age. Since all stocks would likely have strong positive correlation in a bear market, this would require a lightening up in all stock classes, not just U.S. stocks, but all international stock classes and sub-classes, particularly emerging market stocks that will likely swing harder in the same downward direction. So one of the major failures of these glide path funds is a unwillingness to make adjustments tied to increased risks signaled by a movement into elevated volatility ranges.
The books that I am have listed on my profile page are just the ones that I am reading now. In one of them, written by David Swenson who runs Yale's endowment, he spends a great deal of time discussing the many failures of mutual funds. I did not need much convincing. Most of us are already aware that the stock mutual funds as a class underperform dumb index funds. And that is another problem with these target funds.
Recently, however, one of the more serious problems is the failure of the bond components of these funds to match the dumb index from Vanguard for the total bond market. In a really serious bear market for stocks, this is a time for bond funds to shine, to prove their worth as an asset class with a low positive correlation with stocks or a much needed negative correlation during a stock bear market. Some bond funds, like the Loomis Sayles retail bond fund, showed a very unhelpful positive correlation with stocks in 2008 falling 22.1% according to the MSN data. LSBRX - Fund returns - MSN Money
The Fidelity Strategic Real Return fund, a component of Fidelity's target funds, was one of the funds used by Fidelity in the bond allocation. This is the MSN link to the component funds of Fidelity's 2010 fund. FFFCX - Fund Top 25 holdings, Fund top twenty-five holdings - MSN Money The Strategic Return fund was down 23.4% in 2008 according to the MSN data. FSRRX - Fund returns - MSN Money That fund made up 6.88% of the Fidelity Freedom 2010 target fund. The Fidelity Short Term bond fund made up 4.97% and it fell in 2008 too. FSHBX - Fund returns - MSN Money The dumb index fund, the Vanguard Total Bond Market, was up over 5% in 2008. VBMFX - Fund returns - MSN Money
Another critical failure is the inability to recognize prolonged periods where major asset classes fail. The S & P 500 is now back to where it was in May 1997 as shown in this chart. S&P 500 INDEX,RTH Index Chart - Yahoo! Finance This is not the first time stocks went nowhere for 10 to 15 years. This is a similar chart for the S & P from early 1965 to the summer of 1982, S&P 500 INDEX,RTH Index Chart - Yahoo! Finance If you had a target fund during those years, what would you expect. When the professors and pundits start talking about how well something may work since 1871 or over 60 yearsTo Professor Siegel: Time for a Re-Think, I would just suggest that 15 years is an awful long period of time in an individual's life for any asset allocation model to fail.
At least back in the 60s and 70s, dividends would have provided some overall upward movement in the stock allocation. I found this chart this morning showing the rates of returns for stocks, t bills and treasury bonds: Historical Returns This chart starts in 1928. I am going to look at it more closely later today but it appears that all three of these asset classes are started at a constant 100 value in 1928. This is the kind of chart Professor Siegel would use to show the long term value of stocks. Since I am a stock jock, I agree with him on that point, as long as you look at very, very long periods of time.
What I wanted to highlight now is the period staring in 1965 and compare the lowly T Bill with the Treasury Bond:
T Bill 1965 $179.28 T Bill 1981 $512.73
T Bond 1965 $ 274.49 T Bond 1981 $484.91
To me this illustrates the failure of the bond asset class over a 16 year period. This did set up the bond class for a period where in retrospect it would outperform stocks. (page 3: Barrons.com)
Duality of Long Term Risks/Stocks Under $5: Per Se Lottery Tickets
Buy of 50 CUZPRB in Regular IRA/Bonds vs. Stocks: 1968 to 2009/ABBOTT/UBS & Tax Evasion by the Rich/NRA: AK47s for Everybody
Duality of Long Term Risks/Stocks Under $5: Per Se Lottery Tickets
Buy of 50 CUZPRB in Regular IRA/Bonds vs. Stocks: 1968 to 2009/ABBOTT/UBS & Tax Evasion by the Rich/NRA: AK47s for Everybody
When you start to have failures in a major asset class lasting 15 years, or have bonds and stocks going basically nowhere for 15 years, that may be find in academia or with a professor, or a person who says just give it some more time and it will come around. In the real world, where human beings have limited life spans and real situational risks, 15 years is a long time. Just ask that retiree who has had to go back to work because their portfolio has just been smashed, or someone who will have to postpone retirement for five or more years for the same reason. Or someone who had their college fund decimated at the time a kid is about ready to start college. Or countless other situational risks. I would submit that all of those risks need to be managed including the very important risk of volatility of asset classes particularly as it relates to situational risks. While proponents of the glide path target funds may look good again for a few years, when a bull cycle starts again in stocks, I would just remind people to come back and look at what has happened in the past twelve years or in earlier periods. Is that target fund going to make the same mistake again down the road?
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