One aspect of Dynamic Asset Allocation, as I practice it, is that the investor has to take advantage of the opportunities created by market spasms regardless of any fixed percentages in their asset allocation plan. Time for a Paradigm Shift in Asset Allocation Theory: Need Dynamism, Better Assessment of All Forms of Risk, and Due Regard to Volatility Patterns I have spent a great deal of time discussing my movement into corporate bonds starting in October 2008. The spread between investment grade corporate debt and comparable treasuries widened to what I viewed then to be unprecedented levels. Part of that widening was due to the flight to safety, which drove treasury prices up in price and down in yield, but a great deal was due to panic selling of investment grade corporate bonds. In today's Baron's, there is a chart that vividly illustrates that spike in the spread. Barrons.com
Under Dynamic Asset Allocation, the events in the market can not be ignored as if they do not exist. A flexible response has to be tailored to each opportunity as it arises. So even if you are a young with a very high allocation to stocks, a movement in some other market can not be ignored as if it does not exist. The substantial fall in investment grade bond prices was an opportunity for the individual to increase their allocation to that asset class, regardless of age. It was probably more important for someone my age, but could not be ignored by anyone. Possibly, that shift into investment grade corporates could have been done by selling treasuries and buying comparable maturity corporate debt. I did it by re-deploying some cash raised earlier in the year with bond ETF sales and other sources, when those ETFs started to yield around 4%. BOND ETFs
The opportunity that I found was in a security that I call Trust Certificates. Trust Certificate Links in One Post When you buy one of those, you are buying what amounts to a beneficial interest in the assets of the Trust which consists of a bond from a single issuer. When I started this blog in October, an outgrowth of emails, I was already familiar with this type of security and I have them grouped together in one of my monitor portfolios at Yahoo Finance. Last October, during the meltdown in both the stock and corporate bond markets, it was not unusual to see a TC priced to yield in its interest payment 3 to 5% higher than the underlying bond. From my perspective, it was like buying something being heavily discounted by the market at an even larger discount. Just by way of example, one TC bought contained as its underlying bond a senior debt issue from AT & T maturing in 2031 (both the bond and the TCs containing that bond as their underlying security have desirable enhancement features in the event of a debt downgrade). In October 2008, I bought that TC at $12.5, 1/2 of its $25 par value, to yield 12% per year plus another 100% at maturity.JZE: MORE DETAIL I could have bought the bond in the bond market, but the TC gave me more yield and a bigger discount to par value. And, it is traded like a stock so individuals can decide how much or little they want to buy. I have bought as little as 50 shares of a TC and most of my orders for 5 $1,000 bonds in the bond market are just ignored as being to penny ante.
I raised this piece of history to make a point about static versus dynamic asset allocation. With my approach, I need to react to what the market is doing regardless of what my percentage allocation to stocks and bonds happens to be. In this particular example, I intend to keep most of what I bought during the 4th quarter of 2008, and some this year, for several years. Similarly, if the VIX Allocation Model flashes a green light on increasing stock exposure, I would hope to ride that wave for at least 3 or 4 years before making another meaningful shift.
Other opportunities have arisen during the 4th quarter of last year and this year in a class of securities that I call equity preferred issues. There are two major categories of these securities: fixed coupon and floating rate.
I recounted in numerous posts my trading activity in just one of these securities, INZ, a perpetual fixed rate preferred that is currently classified as paying qualified dividends, a factor important now to wealthy U.S. taxpayers. Of the 300 or so securities that I own, it has been the most volatile or close to it over the past 9 months. This provided an opportunity to manage risk by selling on the pops and buying the dips, until I reached the point of owning only shares purchased at below 7 in one account, and below 8 in another. ING Preferred Stocks: Links in one Post The buy of another ING preferred- ISF - was bought at $4.6 which will give me a perpetual yield until it is called at $25 of 34%. But, this is the rub on that one. It continued to fall to a low of $2.6 and the yield at that price was over 60% taxed at 15% to a U.S. taxpayer with cumulative features and even interest on any deferred dividend. So, go figure.
The floating rate preferred stocks became extremely desirable when their stock prices plummeted during the panic. Flexibility is the key, and seeing the opportunity is critical. Many of these securities pay the higher of a fixed amount or some percentage above a short term rate. One of the best equity preferred issues, in terms of just its guarantee and float provision, is a Met Life floater, METPrA. This one pays the greater of 4% or 1% over 3 Month Libor. METLIFE INC The float over Libor is a good one for these type of securities and provides in my view a degree of inflation protection. But, it was the guarantee that interested me when the price for the Met Life floater fell to $7 with a par value of $25. That made the guaranteed 4% worth something that was valuable, a deflation or low inflation hedge. A buy at $7 would juice the yield based on the minimum guarantee to 14.28% and buying at a discount to par value also juices the value of the float provision. I started talking about these securities from the start of this blog. METPRA is now at around $15. The opportunity has not entirely disappeared but it has diminished to the point where I am not a buyer or a seller, except I may sell the shares in an IRA and wait for an opportunity to buy them back in a taxable account.
The VIX Model is itself simple to apply, an elegant model, that has not yet blown up. I can look at the pattern of the VIX, apply the rule, and make an allocation decision without knowing anything about anything happening in the real world. I would not to do that of course. A thinking person has to decide ultimately whether the signals being given by the Model are valid and whether the Model itself is still valid. The Swing Trade SSO/SDS model, since modified, blew up in its then current form on 9/29/2008. LB and RB knew it on that day, and realized that it had to be reworked.
In the future, individuals reacting to this model or similar ones may themselves change its value. An example would be everyone selling on a Trigger Event, driving the VIX directly into Phase 2 of the Unstable VIX Pattern, which causes more selling and so on. A thinking person might say that the move out of the Stable VIX pattern to around 30 on the VIX, and the concomitant fall in the S & P 500 average, was more than enough to account for whatever caused in the Trigger Event in the real world. In that case, individual behavior reacting to the VIX move changes both the meaning and value of the signals flashed by the Model. A thinking being needs to account for that herd behavior.
Other examples of managing risk and taking advantage of opportunities as they arise involve a disfavored asset class called REIT cumulative preferred stocks. Embracing Volatility as A Risk Management Tool In the Sub-Asset Class of Equity Preferred Stock
In the prior post, I asked what would you do if stocks doubled in the next five years and the 10 year treasury rose from 3% to 8%, would you change the mix based on what the market was doing? I do not own any 10 year treasuries now. If I did I would sell all of them on Monday. That is just my personal opinion that there is a ton more risk in that security now than value, and my rational is explained in probably twenty or more posts.(the risk is not credit risk, but the risk of lost opportunity & a real risk of a negative real rate of return after taxes) In fact, I am hedging my corporate bonds with double shorts on the 10 and 20 year treasury, to try to hedge what I perceive to be, rightly or wrongly, an inflation risk down the road. A return of inflation, and it will return at some point, will wreck havoc on my fixed coupon long corporate bonds. But, if stocks have rallied for 3 or 4 years strongly, and a ten year treasury gradually falls in price and rises in yield to 8% during that same period, I can not ignore that the dynamics have changed, so then I would sell stock and buy treasuries. Nor, can I ignore that the risk metrics for stocks have changed when the VIX bursts out of the Stable Vix Pattern and forms the Unstable Vix Pattern. I have to recognize that with that increased and heightened level of volatility, stocks have increased their risk as an asset class, and an adjustment needs to be made in my allocation.
Some who read this may say why didn't the nerd by more of ISF when it was at $4.6. I could have bought 10000 shares, instead I bought 50. RB just said again, what a wimp. The answer is that I have survived and prospered by being cautious and conservative, always a little paranoid, as if someone in the market was purposely trying to squash me, always looking for that bogeyman around the corner. The ING Preferred issues were so volatile because of a perception that the cumulative preferred dividends might be deferred and concerns about ING's financial health. So, with enhanced opportunity, there is also enhanced risk.
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