Swedroe versus Ferri on Recommended Asset Classes

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Bradley » Fri Mar 22, 2013 8:40 pm

DaleMaley wrote:.......... Larry is a fan of the commodities asset class, and Rick is not. From Larry’s book, I found out he is also not a fan of high yield (junk) bonds ...................

I thought it might be interesting to contrast and compare the differences between Larry’s and Rick’s recommended asset classes for asset allocation.






Heads up, This thread started over 5 years ago


Now and then it is interesting to see how different points of view unfold over time. 10 years is not a long time in the investment world but it can shed some light on opinions/recommendations given years ago. Commodities is an asset class that has generated much discussion and even a “debate” at one time. If you were to compare Vanguard’s total market represented by VTI and Pimco’s commodity fund PCRIX over the past ten years the results would look like this.


1 year VTI..........+13.97%


3 year VTI.......... +5.21%


5 year VTI...........+9.57%


10 year VTI.........+1.21%




In 2008 VTI fell 36.98%


In 2008 PCRIX fell 43.33%




Let’s now look at High Yield. Below is shown the % amount that VWEAX outperformed PCRIX over the past ten years.



1 year VWEAX.....+11.51%

3 year VWEAX......+3.37%

5 year VWEAX......+12.59%

10 year VWEAX....+.50%




In 2008 VWEAX fell 21.19%

In 2008 PCRIX fell 43.33%
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby larryswedroe » Fri Mar 22, 2013 9:37 pm

Bradley
The comparisons are absurd as anyone with a basic understanding of portfolio theory and even basic finance would understand.

First the issue of high yield is high yield vs. what, certainly not commodities. As I have shown repeatedly, there have been more efficient ways to improve portfolio returns that moving from safe FI to high yield. Simply keeping with investment grade and tilting more to small and value would have improved results vs adding high yield.

Second, commodities should never be viewed in isolation, nor should any asset class. All that matters is how did the addition impact the return of the portfolio.And even there it would not be sufficient because adding Commodities allows you to take more term risk. CCF is added not for return but to reduce portfolio volatility, cut tail risks, which it has done.

Third, if you were even thinking correctly at all you would compare the return of the high yield in 2008 to the return of what the substitute was, say 5 year Treasury or Investment Grade at very least, and you would see massive underperformance. With CCF you would have compared that return to what it substituted for which would be equity allocation. So there the underperformance would have been minor. That would lead you to the correct answer, not comparing return of high yield to return of CCF which makes no sense whatsover.

It ain't what a man doesn't know that gets him in trouble, but what he thinks he knows for sure but ain't so.
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Re:

Postby Bradley » Fri Mar 22, 2013 10:57 pm

larryswedroe wrote:If we KNEW that the correlations of commodities would continue to be the same as historically and we also knew the diverisification return (as referred to by Erb and Harvey) would be the same then commodities should be 30% of a portfolio if you had room.

I recommend something like up to 10% of equity allocation only because we cannot be sure. And we also don't know if the roll return will be positive or negative or zero.

But it seems foolish to me to ignore the benefits of CCF because we are uncertain. That would be like ignoring the ERP because it is uncertain.


As to hi yield that is different. I cannot find any reason to own that.
Hope that is helpful



Larry,

The data I posted was simple and for illustrative purposes and not some white paper research. You may find the data absurd others may not. The first simply shows the difference in return between a total market fund and a commodity fund. Had I listened to your advice/post I may have taken funds out of a very productive fund (VTI) and allocated them to PCRIX. Thankfully I found Rick’s arguments much more convincing. I do not believe you would be so quick to criticize my post had your advice/post been shown to have been beneficial

Fact.

You were and have been an advocate for commodities Rick has not. Rick’s quote from earlier in this thread......”

“I have no issue with someone jumping on the commodities bandwagon and paying ten times the cost of the Vanguard US Total Stock Market ETF (VTI). Just understand that doing so means lowering the long-term portoflio return because it gives up a 6% in real stock market return for the 0% real return of commodities (before fees). Is this worth lowering portfolio risk a tiny bit? No.”



Rick also advocated VWEAX, many are happy we listened to him.

In both cases he was right. I do not believe, no matter how much you massage the data, you could come to any other conclusion assuming the goal is to “grow” your portfolio.


Go Duke!

Best,
Bradley
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby wolf433 » Fri Mar 22, 2013 11:50 pm

I don't know if or what Larry has changed in his recommendations since this post was started several years ago. I do believe Rick has eliminated all individual bonds and now uses only bond mutual funds. This may have been for philosophical reasons, but I think it was more for administrative purposes as it was just too difficult to manage so many individual bonds in hundreds of portfolios. In addition, he dropped both Padden and Bridgeway funds and made substitutions. Perhaps he can confirm this and explain why. I think it was that they just weren't doing the job for which they were selected and over time other funds came along that were both cheaper and better. This would be for the forum and not me as I watched it happen in my portfolio. Obviously, he has never believed in commodities or gold and has always used Hi Yield in his portfolios.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby rmelvey » Sat Mar 23, 2013 3:25 am

larryswedroe wrote:Bradley

Third, if you were even thinking correctly at all you would compare the return of the high yield in 2008 to the return of what the substitute was, say 5 year Treasury or Investment Grade at very least, and you would see massive underperformance. With CCF you would have compared that return to what it substituted for which would be equity allocation. So there the underperformance would have been minor. That would lead you to the correct answer, not comparing return of high yield to return of CCF which makes no sense whatsover.

It ain't what a man doesn't know that gets him in trouble, but what he thinks he knows for sure but ain't so.
Larry


Larry, that seems like an equally strange comparison to me. Wouldn't comparing the Sharpe ratio of HY to the Sharpe ratio of stocks be more informative? They have delivered a bet on the same macro outcome. Comparing HY credit to Treasuries makes no sense to me :o
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Roy » Sat Mar 23, 2013 7:22 am

rmelvey wrote:
larryswedroe wrote:Bradley

Third, if you were even thinking correctly at all you would compare the return of the high yield in 2008 to the return of what the substitute was, say 5 year Treasury or Investment Grade at very least, and you would see massive underperformance. With CCF you would have compared that return to what it substituted for which would be equity allocation. So there the underperformance would have been minor. That would lead you to the correct answer, not comparing return of high yield to return of CCF which makes no sense whatsover.

It ain't what a man doesn't know that gets him in trouble, but what he thinks he knows for sure but ain't so.
Larry


Larry, that seems like an equally strange comparison to me. Wouldn't comparing the Sharpe ratio of HY to the Sharpe ratio of stocks be more informative? They have delivered a bet on the same macro outcome. Comparing HY credit to Treasuries makes no sense to me :o


Larry made a valid comparison. They are both bond types. And for those who agree that portfolio stability is the prime objective of fixed income, Larry's point is clear. The Treasuries provided portfolio stability (when most needed) and the HY contributed to the collapse, especially for investors who had not accounted for the extra volatility of HY in their asset allocation.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby larryswedroe » Sat Mar 23, 2013 8:25 am

Bradley
The fact is you were trying to show that one fund/asset class was good and another bad. that was the reason for the post/comparison. The fact is the comparison was invalid, totally meaningless. The examples I gave showed why they are meaningless

Also note I have not recommended commodities. I have recommended investors CONSIDER commodities. And the higher the equity allocation and the longer the bond duration the more you should consider it. And also note I have repeatedly stated that when you own CCF you should do so only for "insurance" reasons, not for return reasons. And that means in general you should not hope for high returns from the CCF, as that would mean that the vast majority of your portfolio would likely be producing poor returns.

RMelvey
No that is not the right way to look at it because you are comparing apples to oranges. High yield is not the same as high quality in terms of an asset class. It is a hybrid security with equity like characteristics.
In addition the Sharpe ratio should be viewed in context of the portfolio, not the individual components. As I have shown adding high yield reduced the Sharpe Ratio of a portfolio. And even more importantly there are more efficient ways to improve Sharpe ratios--which is the right way to think about it---So instead of adding high yield, which adds risk, add tilt to small and value.
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Re:

Postby Bradley » Sat Mar 23, 2013 9:55 am

Larry,
Above you claim........"Also note I have not recommended commodities. I have recommended investors CONSIDER commodities. Well let's rerun the tape.



larryswedroe wrote:If we KNEW that the correlations of commodities would continue to be the same as historically and we also knew the diverisification return (as referred to by Erb and Harvey) would be the same then commodities should be 30% of a portfolio if you had room.

I recommend something like up to 10% of equity allocation only because we cannot be sure. And we also don't know if the roll return will be positive or negative or zero.

Hope that is helpful


Larry,

At least be honest. Through the years have have continually extolled your belief that commodities are good for a portfolio even participated in a debate. As the quote above from this very thread shows, you HAVE recommended commodities.

Best,
Bradley
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Rick Ferri » Sat Mar 23, 2013 10:10 am

Don't confuse philosophy with strategy. We're all Bogleheads, but that doesn't mean we should all hold the same portfolio. The difference between my strategy and Larry's is minor. I use a little high yield and no commodities because I believe HY has enough unique risk to warrant an investment and commodities add no real return benefit. Larry uses a little commodities and no high yield because he believes HY has too much equity-like risk and commodities will increase the risk-adjusted return of a portfolio. Over the past several years, high yield has performed extremely well and commodities have not. There's no telling what the next five years will look like.

To read more about our individule views on commodities, see this 2008 article The Great Commodities Debate.

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby larryswedroe » Sat Mar 23, 2013 10:21 am

Bradley
As always I was perfectly honest. I have always suggested that people consider adding commodities. I have also repeatedly stated that one should consider it in context of their other holdings--the more equity you hold, the more you should consider commodities and the longer your bond fund the more you should consider them, even adding that if adding commodities you should consider extending duration of bonds as well.
Note that for those investors that have very low stock allocations and relatively short bonds and TIPS, there is little need for commodities. On other hand those that have high equity allocations, with longer bond portfolio (the right mix IMO if high equity allocation) the more you should consider adding some commodities.

As to your quoting, you are taking it out of context--once you decide to own CCF in portfolio you should consider up to about 10% of stock allocation--but that too should be in context of how long your bond portfolio is. The longer the more commodities and vice versa

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Re:

Postby Bradley » Sat Mar 23, 2013 10:30 am

larryswedroe wrote:Rod
Let me just add this
If we KNEW that the correlations of commodities would continue to be the same as historically and we also knew the diverisification return (as referred to by Erb and Harvey) would be the same then commodities should be 30% of a portfolio if you had room.

I recommend something like up to 10% of equity allocation only because we cannot be sure. And we also don't know if the roll return will be positive or negative or zero.

But it seems foolish to me to ignore the benefits of CCF because we are uncertain. That would be like ignoring the ERP because it is uncertain.

Just my opinion.

I have no problem with people not wanting to use CCF, my problem is the reasons Rick offers and how he uses two sides of an issue differently depending on what he wants to argue.

As to hi yield that is different. I cannot find any reason to own that. And I doubt that investors who own junk have a clue that they really have an equity allocation and are likely holding assets in the wrong location.

BTW-we don't agree either on EM bonds, though I do agree that there you have at least some more unique risk--while only a tiny amount of unique risk in junk bonds. But still the data shows you are taking equity like risks (the lower the credit rating of the country the more equity like the risk) and you end up with the same location problem for individuals that institutional investors don't have. But at least here there are some offsetting benefits. I just personally don't see the net gain. Someone else might.

Hope that is helpful




Larry,

Above is the context. It seems clear to me you are recommending 10% allocation to commodities or 30% if you knew "that the correlations of commodities would continue to be the same as historically and we also knew the diverisification return (as referred to by Erb and Harvey) would be the same"

Anyways I'm having trouble with the Great Debate link Rick posted.


Hopefully the two below will work. The first is for part one and the second part 2.


http://www.hardassetsinvestor.com/inter ... art-i.html




http://seekingalpha.com/article/64656-t ... te-part-ii

Enjoy,
Bradley
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby larryswedroe » Sat Mar 23, 2013 1:44 pm

Bradley

Again, the discussion assumes that one has decided to include commodities. IF that is the case I recommended one consider 5-10%, not what the efficient frontier models were showing which was 30%.
There are many reasons to not include them, including investors not understanding CCF and how they work which would result in confusing strategy and outcome, not enough room in tax advantaged accounts to hold them, and having a low equity allocation and short bond duration. In that case I would see little need to own them, though one might consider including them if yield curve was steep so you could extend and hedge that risk by adding CCF.

As further demonstration of that I only recommend people consider it only about 30 percent of our clients have an allocation to CCF.

Here is what I wrote about CCF in my book on right allocation.It clearly demonstrates the above points.

Investors should consider an allocation to CCF of between 5 and 10 percent of their equity allocation.
Reasons to Increase Commodity Futures Exposure
The primary reason to add commodity futures to a portfolio is to reduce the overall volatility of that portfolio without the negative impact on returns produced by adding fixed income assets. This may seem counterintuitive because commodity futures themselves are very volatile, but historically, commodity futures have had negative correlation with most every other major asset class. Negatively correlated assets act like portfolio insurance. Including them reduces potential dispersion of returns — reducing the opportunity for greater than expected portfolio returns while lowering the risk of less than expected ones.
Candidates for Higher Commodity Allocations

• Risk averse investors. The more risk averse, the greater the allocation to commodities — but no more than 10 percent of the portfolio.
• Those in the withdrawal phase of their investment careers. Volatility negatively impacts the odds of a portfolio running out of money for any given withdrawal rate. Being negatively correlated with other portfolio assets, adding commodities reduces portfolio volatility, reducing the odds of a portfolio running out of money while simultaneously reducing the odds of leaving a large estate. Retirees and endowments are prime candidates for considering higher commodities allocations.
• Investors exposed to the risks of unexpected inflation. This includes both individuals on fixed income (fixed annuities or pensions) and those owning longer-term bonds.
• Investors needing greater return from their fixed income investments than short-term bonds can provide. In these circumstances it is better to take duration risk rather than credit risk. CCF can hedge the risks of longer-term bonds.
• Investors concerned about event risks that could negatively impact equities and nominal return bonds.
Adding commodities to a portfolio increases the odds of success in Monte Carlo simulations. Even a 3 to 5 percent allocation will generally improve the odds of success by about 2 percent. The offset is the allocation reduces the odds of achieving a very large estate. The allocation to commodities should be taken from the equity allocation. If taken from the fixed income allocation portfolio volatility will increase, defeating the main purpose of reducing such risk.
Application: An investor who has recently retired may want to reduce the volatility of his portfolio. Adding commodities has historically produced that result.

Reasons to Decrease Commodity Futures Exposure
Risk tolerant investors or investors needing a high return to reach their financial goals may not be willing to give up expected return in exchange for lowering portfolio volatility. Further, the addition of CCF increases tracking error risk. Perhaps most importantly, commodities should be considered only by those able to view the results of the whole portfolio, ignoring returns of the component parts. While to some degree this is true of all assets with low correlation, it is especially true in the case of CCF, which are highly volatile and have relatively low expected returns compared to the equities they displace in a portfolio. Due to the tax inefficiency of CCF, they should not be included in taxable accounts but in tax-deferred accounts. See Chapter 10 for more details on asset location.
Application: A young investor in the early stages of accumulation may not want to sacrifice expected return for lower volatility. He might choose to exclude commodities and accept higher volatility .
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby midareff » Sat Mar 23, 2013 1:57 pm

Thanks for spelling it out Larry. I don't know how you could make it plainer.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Bradley » Sat Mar 23, 2013 3:38 pm

larryswedroe wrote:Bradley

Even a 3 to 5 percent allocation will generally improve the odds of success by about 2 percent. The offset is the allocation reduces the odds of achieving a very large estate. ............
.......... A young investor in the early stages of accumulation may not want to sacrifice expected return for lower volatility. He might choose to exclude commodities and accept higher volatility .
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Larry,

Besides young investors, those who have children and little need to make withdrawals, those who can live comfortably on just interest and dividends, those who put growth above volatility, those who....................etc may be well served by foregoing CCF's in there portfolio. There are many roads to Rome.

Thank you for your measured response,
Bradley
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby rmelvey » Sat Mar 23, 2013 4:11 pm

larryswedroe wrote:Bradley
In addition the Sharpe ratio should be viewed in context of the portfolio, not the individual components. As I have shown adding high yield reduced the Sharpe Ratio of a portfolio. And even more importantly there are more efficient ways to improve Sharpe ratios--which is the right way to think about it---So instead of adding high yield, which adds risk, add tilt to small and value.


Okay that makes sense. Thanks!
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby nedsaid » Sun Mar 24, 2013 2:02 am

It would be useful to think of commodities as portfolio insurance rather than as a performance enhancer. This discussion reminds me of the debates over whether gold should be part of an investment portfolio. Commodities as an asset class have a zero real rate of return just like gold. But certainly in times of inflation and/or when people lose confidence in the dollar, people would be glad to have had them in their portfolios.

So if the dreaded high inflation/currency devaluation never happened then the effect of commodities or gold in a portfolio would be to detract from return. But these events do occur though rarely.

Having considered myself a younger investor for many years, I just felt that I could ride through extraordinary events and that eventually time and markets returning to normal would heal the damage. Now at age 53, I am wondering about buying insurance for my portfolio. It pays to keep an open mind and to continually learn.

My take on this is that after both gold and commodities have had such good runs, I would wait for lower and better prices before buying the insurance. I am just adverse to buying asset classes after years of hot performance.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby larryswedroe » Sun Mar 24, 2013 9:26 am

nedsaid
Re portfolio insurance. That's IMO exactly right. That's exactly the way I have explained why someone should consider it. CCF clearly hedge some of the risks of stocks and also the risks of nominal bonds. Any hedging vehicle/insurance by definition should not have a high expected return, but that doesn't mean you should not consider owning it---if that was the case no one would buy insurance of any kind as it always has a negative expected nominal, let alone real, return

Best wishes
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Rick Ferri » Sun Mar 24, 2013 9:46 am

It would be useful to think of commodities as portfolio insurance rather than as a performance enhancer.


Trying to hedge equity risk with commodities sure sounds good, it just doesn't work good.

The correlation argument for commodities is weak and unreliable. How soon people forget that commodity funds crashed harder than stock funds during the depths of the financial crisis. That's not portfolio insurance.

Commodities do not protect a portfolio in crisis and no amount of rewriting history is going to change this fact. They pay out on a coin flip. Sometimes they help hedge a bear market in stocks and sometimes make your returns worse.

You're also are giving up the real return from stocks to buy an allocation a higher-fee commodities product that has no expected real return on it's own. This guarantees a lower expected real return in a portfolio. Like insurance, you pay a price every year. Unlike insurance, there no guarantee it will work when you needed it.

Here is my recommendation; don't try expensive and gimmicky solutions to hedging stock risk. If you can't live with the volatility of stocks, then own less stocks. This the cheapest, most sensible and most reliable way to control equity risk.

Rick Ferri
Last edited by Rick Ferri on Sun Mar 24, 2013 11:10 am, edited 2 times in total.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Blues » Sun Mar 24, 2013 9:59 am

Rick Ferri wrote:Here is my recommendation; don't try expensive and gimmicky solutions to hedging stock risk. If you can't live with the volatility of stocks, then own less stocks. This the cheapest, most sensible and most reliable way to control equity risk.

Rick Ferri


Well said. :beer
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby bschultheis » Sun Mar 24, 2013 10:09 am

Rick Ferri wrote:Trying to hedge equity risk with commodities sure sounds good, it just doesn't work good. The correlation argument for commodities is week and unreliable. How soon people forget that commodity funds crashed harder than stock funds during the depths of the financial crisis. That's not portfolio insurance. Commodities do not protect a portfolio in crisis and no amount of rewriting history is going to change this fact. They pay out on a coin flip. Sometimes they help hedge a bear market in stocks and sometimes make your returns worse. You're also are giving up the real return from stocks to buy an allocation a higher-fee commodities product that has no expected real return on it's own. This guarantees a lower expected real return in a portfolio. Like insurance, you pay a price every year. Unlike insurance, there no guarantee it will work when you needed it. Here is my recommendation; don't try expensive and gimmicky solutions to hedging stock risk. If you can't live with the volatility of stocks, then own less stocks. This the cheapest, most sensible and most reliable way to control equity risk. Rick Ferri


Great, great post, Rick. I love it.

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby bertilak » Sun Mar 24, 2013 10:09 am

I would like to say I have learned a lot from both these guys.

Perhaps even their disagreements are a good thing. They make one think and feel more comfortable with whatever one gets from that thinking.

So, Rick and Larry -- thanks!
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Blues » Sun Mar 24, 2013 10:43 am

bertilak wrote:I would like to say I have learned a lot from both these guys.

Perhaps even their disagreements are a good thing. They make one think and feel more comfortable with whatever one gets from that thinking.

So, Rick and Larry -- thanks!


Totally agree. :beer

In the main they mostly agree on what I personally consider to be the "important stuff" which is why I hedge my bets by structuring my own portfolio in a manner which satisfies the core tenets of Bernstein, Swedroe, Ferri and Bogle as much as possible. Restful nights follow. 8-)
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby larryswedroe » Sun Mar 24, 2013 10:52 am

We've been through this before so I'll keep it brief.

Here's the problem with Rick's analysis. It makes the mistake of not looking at the whole, among other mistakes

First, what happened in 2008 was nothing new, as I pointed out in my books that came out before the crisis. You can see the data in the tables in my books. Commodities hedge SOME of the risks of stocks--that is true--but not all. But saying that is a reason not to consider owning them makes as much sense as saying you shouldn't buy fire insurance on your home because it doesn't protect you against floods. Commodities hedge supply shocks to stocks but not demand shocks. That's key to understanding how to employ them and whether to employ them. The two other big demand shocks we had prior to 08 were in 1981 and 2001. That's also why you take the commodities allocation from the stock side, not the bond side (because their risks can show up at the same time). Note that in 2008 while commodities had a very bad year (as you would expect) it wasn't much different than the return on a diversified global stock portfolio. So it actually did not hurt much if any. Want to hedge the demand shocks, look to the bond side.

Second, commodities hedge the risks of nominal bonds very well. There has not yet been a year when they had negative returns when longer bonds had negative returns as well. And there is no year when all three had negative returns. Thus if you add commodities you should also consider adding duration. Now if you did that in 2008 and took the CCF from the stock side you would have done better than if you did not own them at all. Thus that whole argument that 2008 proves CCF didn't work falls apart. (It's also why high yield should not be considered, it's risks show up at exactly the wrong time, and their correlation with stocks rises dramatically)

Tying it together, it's that demand shock that is the big risk to stocks and CCF, and that is when you need high quality FI to offset it, and why high yield should have no role in the portfolio IMO. While correlations drift as Rick correctly points out (after all they are just averages) what matters is when the correlations rise and fall. While CCF correlation with stocks rose in 2008 (as you would expect in demand shock) the correlation of stocks to LT Treasuries which is effectively zero over the long term, turned sharply negative!!!! Just at the right time.

The only right way to think of things is in the whole

Having said that I repeat, if you don't understand how CCF works, if you don't know your financial history, if you look at single years and confuse strategy and outcome, you should not own them. And if you have a low beta/high tilt portfolio with high quality FI, there is little need for it.

I hope this is helpful

Best wishes
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Rick Ferri » Sun Mar 24, 2013 11:14 am

Blues wrote:In the main they mostly agree on what I personally consider to be the "important stuff" which is why I hedge my bets by structuring my own portfolio in a manner which satisfies the core tenets of Bernstein, Swedroe, Ferri and Bogle as much as possible. Restful nights follow. 8-)


Absolutely. I'll repeat something I've have said many times; Boglehead philosophy is universal - strategy is personal. How you implement the philosophy is your choice. There is no right way or wrong way, there is only your way.

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby EDN » Sun Mar 24, 2013 2:39 pm

Just to add some diversity to the "advisor opinion" on the topic, I can tell you they are both wrong. You don't need and aren't likely to be better off using either strategy.

1. Start with the "asset class" decision--here you have stocks, bonds, real estate and inflation protected securities if you don't lump them in with bonds.
2. Next, consider the sources of expected return: within stocks, it's market cap and price. Within bonds, it's maturity and credit.
3. Diversify globally as much as you can (stocks and bonds at least, RE if you think that will help), keep allocations static and funds passive, and be done with it.

These niche strategies like CCFs, HY Bonds, Emerging Market Small Dividend stocks, not to mention all the hedged stuff, long-short, active tactical strategies, individual commodities, etc. they are all Wall Street creations designed to allow them to charge higher fees than they could get on traditional investments. And investors are the ones that suffer--buy high, pay high fees and get poor returns, then sell low and repeat the process. The investment managers make tons of money, investors underperform t-bills.

Eric
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby rmelvey » Sun Mar 24, 2013 2:54 pm

Saying that the only way to reduce stock risk is by holding less in stocks seems very wrong to me. It appears that Rick is saying that diversification between asset classes doesn't exist!

Equities are not, and have never been the optimal risky portfolio. There are huge benefits from diversification that can be made irrespective of how much risk you want to take. Adding long duration bonds and commodities to a stock portfolio provides huge diversification benefits that result in a much higher sharpe ratio. You could even lever up this portfolio to the same level of volatility as the stock market if you wanted.

Regardless, 100% equities is taking uncompensated risk in the capital markets. If you aren't taking advantage of diversification benefits that exist in other asset classes you are not getting your fair share of risk adjusted returns.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Rick Ferri » Sun Mar 24, 2013 3:45 pm

EDN,

High yield corporate bonds are not "Wall Street creations designed to allow them to charge higher fees." It's debt that's issued by companies to finance corporate operations. While many high yield bonds are issued by former investment grade companies in decline, the high yield market also provides financing for emerging companies seeking working capital expansion or to fund acquisitions.

HERE is a link to what high yield corporate bonds are.

rmelvey wrote:Saying that the only way to reduce stock risk is by holding less in stocks seems very wrong to me. It appears that Rick is saying that diversification between asset classes doesn't exist!.


I am confused by your post. What do you mean by saying diversification between two asset classes doesn't exist? Owning two asset classes is the definition of diversification. But let's go a step further and ask diversification into what? If you talking about bonds, then yes. If you're talking about commodity funds, then no. Stuffing money in a mattress is also diversification, but I wouldn't do that either.

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby EDN » Sun Mar 24, 2013 3:52 pm

rmelvey wrote:Saying that the only way to reduce stock risk is by holding less in stocks seems very wrong to me. It appears that Rick is saying that diversification between asset classes doesn't exist!

Equities are not, and have never been the optimal risky portfolio. There are huge benefits from diversification that can be made irrespective of how much risk you want to take. Adding long duration bonds and commodities to a stock portfolio provides huge diversification benefits that result in a much higher sharpe ratio. You could even lever up this portfolio to the same level of volatility as the stock market if you wanted.

Regardless, 100% equities is taking uncompensated risk in the capital markets. If you aren't taking advantage of diversification benefits that exist in other asset classes you are not getting your fair share of risk adjusted returns.


The only reason long-bonds look even remotely palatable in historical returns is due to an anamoulous and unrepeatable stretch of collapsing interest rates. A longer term perspective reveals long-bonds are a terrible investment. Globally, from 1900-2000, long-bonds beat bills (not 5YR bonds, but 1mo bills) by more than 1% in only 2 of 16 countries. In 3 countries, bills beat bonds. In the US, from 1926-1981, long-term bonds trailed 1mo bills. As for protecting risk of equities? Another view based on recency bias. Prior to 2000, there was no evidence LT did any better than short-term or cash when equities fell.

Stretching for yield by buying LT bonds is a bad enough idea, taking $ away from equities to buy CCFs just makes that decision exponentially worse.

Further, 100% stocks is fully diversified and carries NO uncompensated risk. Yes, adding bonds lowers risk and provides a diversification return, but it's still a lower return.

Adding alternatives and stretching for yield to try and defy basic laws of risk and return and is almost surely apt to turn out badly.

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Rick Ferri » Sun Mar 24, 2013 3:59 pm

High yield bonds are part of the total US bond market and should be included in a fully diversified US fixed income portfolio providing access is available at a low fee. That's not a "stretching for yield" strategy. Stretching for yield is when you don't own high yield, but you decide to buy them because investment grade bonds are not yielding high enough. That's an active timing strategy, not a passive strategy.

I agree that 100% stocks is fully diversified and carries no uncompensated risk. I disagree that adding bonds ALWAYS lowers risk ( there have been several periods when this was not true) and I disagree that adding bonds ALWAYS provides a lower return (bonds increase return during an equity bear market). Your observations about adding bonds has been true over the very long-term, but not in the short term.

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby rmelvey » Sun Mar 24, 2013 4:14 pm

Rick Ferri wrote:High yield bonds are part of the total US bond market and should be included in a fully diversified US fixed income portfolio providing access is available at a low fee. That's not a "stretching for yield" strategy. Stretching for yield is when you don't own high yield, but you decide to buy them because investment grade bonds are not yielding high enough. That's an active timing strategy, not a passive strategy.

I agree that 100% stocks is fully diversified and carries no uncompensated risk. I disagree that adding bonds ALWAYS lowers risk ( there have been several periods when this was not true) and I disagree that adding bonds ALWAYS provides a lower return (bonds increase return during an equity bear market). Your observations about adding bonds has been true over the very long-term, but not in the short term.

Rick Ferri


Rick,

I think our major point of disagreement is that you see stocks and bonds as operating within their own universes, whereas I see them as both part of the optimal risky portfolio. I think this confusion is the symptom of academics always computing beta with respect to the equity markets, which does everyone a terrible disservice! Beta should theoretically be computed with respect to the total risky asset markets (everything except T-Bills). Why? Because investors get compensated for taking systematic risk, risk that is associated with the global asset markets. Just doing it with respect to equities is a mere proxy, and it distorts the picture.

Adding bonds has historically resulted in a higher Sharpe ratio than all equities. Therefore, going 100% equities is taking an uncompensated risk. Just like putting all of your money into one stock sector is taking an uncompensated risk. You could have simply levered up the stock/bond portfolio to the level of equity volatility if you wanted a higher expected return. This is basic portfolio theory :happy
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby rmelvey » Sun Mar 24, 2013 4:30 pm

Furthermore, there is portion of the above ground stock of gold held by investors. Anyone who doesn't have some gold is tilting away from the market portfolio. Things become a lot more complicated and rewarding when you start thinking about beta with respect to the global investment portfolio instead of just US equities. It is quite possible that not holding gold is taking an uncompensated risk as well.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Rick Ferri » Sun Mar 24, 2013 5:31 pm

I think our major point of disagreement is that you see stocks and bonds as operating within their own universes, whereas I see them as both part of the optimal risky portfolio.


Haven't we learned yet that optimization doesn't work? Forget the concept of combining asset classes using past data to create the wonderful efficient frontier of the future. That's not possible. We can only know what the efficient frontier was in retrospect.

Accordingly, do not seek an "optimal" portfolio of separate risks. Diversify prudently among asset classes, but pick your asset classes this way:

1) Find those that have some unique risk that can be measured and explained (use correlation as a test)
2) Invest only in asset classes that have a known long-term real return
3) Use very low-cost and highly diversified liquid index fund or similar investments.

No magic to what I'm trying to do, or should I say have done very successfully. I buy cash-flow. I buy investments that have real returns on their own. I do not buy mathematical expectations about how an investment with no real return might work in a bear market to form alpha.

I don't want to eliminate real returning asset classes like high yield because an academic said that over the very short period studied (and always during falling interest rates) that there is no unique risk in high yield. And I am not giving up the real return of an asset class even partially to add a no-real return asset class like commodities because another academic study found that under ideal conditions in a bear market this investment might generate a portfolio benefit.

This whole nonsense about me "not seeing the portfolio in it's whole" is disingenuous. I've been doing this for 25 years and have been studying commodities for most of that time. I saw past the commodities trap 15 years ago and stopped using commodity funds in portfolios. It's an expensive story that sounds good, but doesn't work good.

MPT is theory. Sure, it's nice to get a portfolio benefit from adding something like commodities when it happens - but don't bet on a MPT benefit for retirement. Bet on a diversified set of investments that individually produce income and a real return in the long-term. There might be a little bit more volatility at times, but so what.

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby staythecourse » Sun Mar 24, 2013 9:29 pm

Rick Ferri wrote:MPT is theory. Sure, it's nice to get a portfolio benefit from adding something like commodities when it happens - but don't bet on a MPT benefit for retirement. Bet on a diversified set of investments that individually produce income and a real return in the long-term. There might be a little bit more volatility at times, but so what.


The more I read about investing the more I am coming to the same conclusion. I am starting to think MPT is only good for academic arguments. That may seem like heresy, but I woud agree the more different income streams one is has the true measure of diversification for the individual investor.

Good luck.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby nedsaid » Sun Mar 24, 2013 11:33 pm

I love the intelligent discussion on this forum and the spirited debate between respected financial advisors.

To Rick Ferri, I have never invested in commodities. I owned a few gold and silver coins and sold them in the late 1980's because I saw them as dead money. The proceeds went into an IRA account. I have never owned gold or silver or the stocks of their producers in my retirement accounts. I felt at the time that the cost of portfolio insurance wasn't worth the price. I felt that as a young investor (at the time), that I had the time to ride out market crisis. I felt as you do that if I wanted less risk that the solution was more bonds and less stock.

The truth is that portfolio construction mostly works but the component parts to guard against risks don't always work as designed. The one thing you didn't count on seems to be the very thing that happens. The broker I have worked with says that in times of financial crisis, that the only thing that goes up is correlation. Sometimes, no matter what you do everything goes down in price. It is just some things go down less than others.

To Larry Swedroe, I keep an open mind and force myself to consider new things. My progression as an investor went something like this. CDs at a Bank. Mutual Funds and Individual Stocks and Zero Coupon Bonds. Less individual stocks and more mutual funds. I discovered Index Funds. Then I discovered portfolio theory and asset allocation. Fortunately, I sold some stocks before the 2000 crash. Then I discovered "slice and dice". And then low cost EFTs. And then the Bogleheads. I would like to think that over time I became a better investor.

Though I have not invested in commodities directly, over the years I owned Oil Stocks, Timber Stocks, and even a mining stock at one time. So I have had involvement of companies that produce the stuff we all use. These turned out to be profitable investments and the dividends keep rolling in!! I still have stock of one of the major oil companies and a couple timber stocks. I am glad that I owned them. I would probably see a Natural Resource Fund as a better bet than a commodities fund because the companies themselves have cash flow, earnings, and real return over time.

The concept of portfolio insurance is something that I am willing to keep an open mind to.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby linenfort » Mon Mar 25, 2013 8:43 am

nedsaid wrote:The concept of portfolio insurance is something that I am willing to keep an open mind to.


Would it be safe to say that Rick's porfolio will probably return more if all goes well but that
Larry's Min Fat Tails would better survive an unexpected catastrophe, or is this an oversimplification?
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby staythecourse » Mon Mar 25, 2013 9:14 am

linenfort wrote:
nedsaid wrote:The concept of portfolio insurance is something that I am willing to keep an open mind to.


Would it be safe to say that Rick's porfolio will probably return more if all goes well but that
Larry's Min Fat Tails would better survive an unexpected catastrophe, or is this an oversimplification?


That depends on your definition of catastrophe. For me castrophe would be an overthrow of the U.S. government which would cause defaulting on bonds and make stock market exchange useless. That would make any of these portfolio's useless.

If you want to sum it up Mr. Ferri's portfolio should and will likely always out return Mr. Swedroe's portfolio as the assets it holds have a higher expected return in the long run, but with increased volatility. There is no free lunch with investing.

Mr. Swedroe's portfolio will do it's job and give returns with very little dispersion of returns.

I'm sure I can speak on both authors behalf and say both are likely to say one should be picking an asset allocation that fits your needs. Mr. Swedroe's is great for a 40 yr. who just sold a business for 10 mill., but not a 20 yr. old who has a blue collar job.

Good luck.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby linenfort » Mon Mar 25, 2013 9:41 am

staythecourse wrote:
linenfort wrote:
nedsaid wrote:The concept of portfolio insurance is something that I am willing to keep an open mind to.


Would it be safe to say that Rick's porfolio will probably return more if all goes well but that
Larry's Min Fat Tails would better survive an unexpected catastrophe, or is this an oversimplification?


That depends on your definition of catastrophe. For me castrophe would be an overthrow of the U.S. government which would cause defaulting on bonds and make stock market exchange useless. That would make any of these portfolio's useless.

...

Hahaha! I was thinking more along the lines of a stock market crash.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby staythecourse » Mon Mar 25, 2013 9:46 am

linenfort wrote:Hahaha! I was thinking more along the lines of a stock market crash


In a stock market crash Mr. Swedroe's would do best. In essense, any portfolio with reduced market risk (beta) would do well, i.e. decreased % allocated to stocks.

Good luck.
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Rick Ferri » Mon Mar 25, 2013 9:51 am

That depends on the asset class the reduced allocation to stocks went into and how that asset class performed in a bear market. Commodities performed worse than stocks during the last bear market.

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby larryswedroe » Mon Mar 25, 2013 9:53 am

staythecourse
I don't agree with the idea of higher expected return for the other approach

What I have shown is that you can get the same expected return using the high tilt/low beta approach AND have lower downside risk (though less upside potential). But the expected return is the same if designed right

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Rick Ferri » Mon Mar 25, 2013 10:06 am

Theoretically, Larry is correct. You can theoretically get the same expected return with slightly lower risk using a different mix including commodity index data baked into historic mathematical models. I used similar models 20 years ago when I included commodities in portfolios. They just didn't work as advertised. But, maybe the will work over the next 20-years. Who knows?

Or, you can skip the hope and buy only real returning asset classes that pay real cash-flow. It's all a matter of preference.

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby larryswedroe » Mon Mar 25, 2013 11:14 am

Rick my point above re the high tilt/ low beta strategy has nothing to do with whether you include commodities or not. The fact is that if you add more tilt you need less equities to get the same expected return. That approach, which also increases diversification ACROSS RISK FACTORS has led to lower dispersion of returns.

Now let's look at 2008 and get the full picture.

PCRIX lost 43.4 percent. Now it's true you would have had a lower loss if you invested solely in the S&P 500 which lost 37 percent. But let's look at some other asset classes one might have included in their stock portfolio

EAFE -43.4 (exactly the same)
International small -47.1
International value -45.1
International small value -42.5
EM -53.2
US SV -44.5
US LV -53.1

It's certainly not clear that adding commodities in the worst type of environment for them would have cost you anything. And of course if one added bit of duration to the bond side if included CCF then that portion would have done even better (especially if you avoided HY (:-))

But to repeat, all I have suggested is that investors consider adding them. And if you have a low beta/high tilt portfolio and own TIPS or ST bonds, not much reason to buy the insurance since you don't have much exposure.

Now of course you can also look at some other periods when you had supply shocks, not demand shocks and you would see a different outcome.

Best wishes
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Oversimplification ?

Postby Taylor Larimore » Mon Mar 25, 2013 11:20 am

linenfort:
Would it be safe to say that Rick's porfolio will probably return more if all goes well but that
Larry's Min Fat Tails would better survive an unexpected catastrophe, or is this an oversimplification?


It's an "oversimplification." No one can predict the future.

Best wishes.
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Re: Oversimplification ?

Postby Blues » Mon Mar 25, 2013 11:23 am

Taylor Larimore wrote:It's an "oversimplification." No one can predict the future.

Best wishes.
Taylor


Sez you...

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(I thought the thread could use a little lightening up. And now back to our regularly scheduled programming...)
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Taylor Larimore » Mon Mar 25, 2013 11:26 am

Blues:

Thank you for a good laugh!

Best wishes.
Taylor
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby Rick Ferri » Mon Mar 25, 2013 11:54 am

It's an interesting 5-year old conversation, but it does show that we have so little to disagree on that it boils down to either owning 5% in commodities or 5% in high yield bonds. In the long-term, I don't think it's going matter much either way.

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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby midareff » Mon Mar 25, 2013 12:19 pm

Is that Johnny?
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby bertilak » Mon Mar 25, 2013 12:40 pm

Rick Ferri wrote:It's an interested 5-year old conversation, but it does show that we have so little to disagree on that it boils down to either owning 5% in commodities or 5% in high yield bonds. In the long-term, I don't think it's going matter much either way.

Rick Ferri


Some say commodities
Some say HY bonds
Some say TIPS
Some say REITs
Some say I-bonds
Some say CD ladders
Some say small cap
Some even say mid-cap
Some say value
Some say gold
Some say silver
Some say emerging markets
Some say canned goods and ammunition

At 5% each I'm over 50% in tilts and hedges!

So I listened to those who say "none of the above" and put it all in a low-cost balanced fund!

Well, OK, I kept my 5% REITs. When I walk into a Simon mall I like to know I own a piece of it! I'll pick up litter and put it in the can. :D
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Re: Swedroe versus Ferri on Recommended Asset Classes

Postby larryswedroe » Mon Mar 25, 2013 12:47 pm

Taylor
I would disagree, while it's true we cannot know the future, what is true is that it's difficult to envision a scenario where a high tilt/low beta portfolio would underperform a TSM type portfolio with the same expected return in a bear market (it's easy to envision that in a bull market--that is in fact the trade off). The beta risk is much greater than the size or value risk relative to the beta risk. So while small and value will likely underperform in demand shock type markets like 2008, they won't underperform by so much that it will offset the lower beta and the fact that you have a significantly higher exposure to high quality bonds that go up in that environment. That's why the tail risk has historically been cut. I don't see any reason to expect anything different. Of course that means both tails get cut, the bad left tail and the good right tail.

Best wishes
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Predicting the future.

Postby Taylor Larimore » Mon Mar 25, 2013 1:09 pm

Taylor wrote:
No one can predict the future.

Larry wrote:
Taylor, I would disagree

I thought you like to say: "My crystal ball is cloudy." :wink:

Best wishes.
Taylor
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