Ben Graham on Bonds

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
User avatar
Topic Author
Robert T
Posts: 2803
Joined: Tue Feb 27, 2007 8:40 pm
Location: 1, 0.2, 0.4, 0.5
Contact:

Ben Graham on Bonds

Post by Robert T »

.
Here are some extracts from “The Intelligent Investor” by Ben Graham.
  • “We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with the consequent inverse range of between 75% and 25% in bonds.”

    “To the extent that the investor’s funds are place in high-grade bonds of relatively short-maturity – say, of seven years or less – he will not be affected significantly by changes in market prices and need not take them into account.”

    “Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default.”
Obviously preferences differ across investors, but personally I find this to be reasonable advice. Seems similar to what I do with my 25% bond allocation to the highest quality bonds with about a 5 yr duration.

FWIW the worst performing Vanguard fund YTD to Oct. 8, 2008 is the Emerging Market fund which is down 49.6%, the best performing Vanguard fund YTD is the Vanguard Intermediate Treasury fund which is up 5.8%. I own shares of both. My bond allocation seem to be playing its downside protection function relatively well...

Robert
.
User avatar
Kenster1
Posts: 3225
Joined: Wed Feb 28, 2007 9:50 pm

Post by Kenster1 »

Thanks Robert for that info.

I would like to add the related quote by David Swensen in his "Unconventional Success" book:

"Treasury Bonds provide a unique form of portfolio diversification, serving as a hedge against financial accidents and unanticipated deflation."
SURGEON GENERAL'S WARNING: Any overconfidence in your investing ability, willingness and need to take risk may be hazardous to your health.
fundtalk
Posts: 334
Joined: Tue Jun 05, 2007 3:52 pm

Post by fundtalk »

Robert, do you split your fixed income between intermediate treasuries and TIPS (as Swensen recommends) ?

That is what I do ( thanks to the fantastic guidance from Swensen and Swedroe) and it has worked very well.

I've been tempted to change to short term treasuries/ TIPS while adjusting the allocation based on real rates as Larry discusses in his bond book. But, I'm a little worried if I do that it will bring out some bad behavioral traits on my part. That being said, it is hard to ignore real rates getting close to 3%.
User avatar
Topic Author
Robert T
Posts: 2803
Joined: Tue Feb 27, 2007 8:40 pm
Location: 1, 0.2, 0.4, 0.5
Contact:

Post by Robert T »

.
fundtalk,
Robert, do you split your fixed income between intermediate treasuries and TIPS (as Swensen recommends) ?
Yes, have done so since start of 2003.
I've been tempted to change to short term treasuries/ TIPS while adjusting the allocation based on real rates as Larry discusses in his bond book. But, I'm a little worried if I do that it will bring out some bad behavioral traits on my part. That being said, it is hard to ignore real rates getting close to 3%.
First, on nominal vs. real. I agree its hard to ignore real rates close to 3%. My simple view is if my expected (needed) return from bonds is 5% nominal or 2% real and I can lock in real rates above this level, then why not do so with a higher share of fixed income. The trade-off IMO is lower downside protection (marked-to-market) against locking in needed real returns (bought at issue and held to maturity). With TIPS at 3% the real return benefits IMO out-weight the downside protection of nominal bond so don’t mind holding a higher share of fixed income in TIPS.

Second, on shifting maturities/duration (as used by some of the DFA funds). IMO, Fama’s research results underlying this method are not as robust (good research, just weak results IMO) as some of his other research result (such as that in the Common Risk Factors in the Returns on Stocks and Bonds). For example from the article on Update of the Research Underlying Dimensional's Bond Strategies Fama concludes “The implication of regression slopes close to 1.0 in Table 1 is that the wanderings of forward-spot spreads on average show up one-for-one as wanderings in term premiums. This is the basis of Dimensional's variable maturity strategies, and it is the source of their value added over fixed maturity strategies.” Now if we look closely at Table 1, the explanatory power of the models is very low. i.e. the variation in forward spreads explain between 2% and 13% of the variation in term premiums (much weaker than the 95% explanatory power of the FF equity factors). As a result, I’m less inclined to shift between short and intermediate term (based on these results). Having said that, for someone who doesn’t like TERM risk a ST Treasury/TIPS strategy will do just fine.

Robert
.
mksanjay
Posts: 162
Joined: Wed Jul 09, 2008 10:55 am

Re: Ben Graham on Bonds

Post by mksanjay »

Robert T wrote:.
Here are some extracts from “The Intelligent Investor” by Ben Graham.
  • “We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with the consequent inverse range of between 75% and 25% in bonds.”

    “To the extent that the investor’s funds are place in high-grade bonds of relatively short-maturity – say, of seven years or less – he will not be affected significantly by changes in market prices and need not take them into account.”

    “Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default.”
Obviously preferences differ across investors, but personally I find this to be reasonable advice. Seems similar to what I do with my 25% bond allocation to the highest quality bonds with about a 5 yr duration.

FWIW the worst performing Vanguard fund YTD to Oct. 8, 2008 is the Emerging Market fund which is down 49.6%, the best performing Vanguard fund YTD is the Vanguard Intermediate Treasury fund which is up 5.8%. I own shares of both. My bond allocation seem to be playing its downside protection function relatively well...

Robert
.
Hi all,

what funds do you use to add bond allocations to your portfolio. Individual treasuries, Vanguard Intermediate-term Bond Fund or a pure Vanguard TIPS fund(VIPSX?).

Thanks in advance.

Sanjay.
User avatar
stratton
Posts: 11085
Joined: Sun Mar 04, 2007 4:05 pm
Location: Puget Sound

Post by stratton »

You can capture most of the benefits of Larry's shifting TIPS maturity by rebalancing. I prefer to retain some investment in TIPS at all times so I don't get caught out. In opposition to that Larry does shift to the traditional pre-TIPS inflation fighting method using short term bonds.

If TIPS have a huge NAV increase like we did sell some and move it to cash. This might add up to 10% of your TIPS account so its probably no more than 2% of your asset allocation. Also remember to allow for the TIPS coupon payout if you have individual TIPS bonds.

When the TIPS yield curve gets steep sell shorter term TIPS and move to longer ones. You'll probably need to buy individual longer TIPS bonds to implement this.

Paul
bookshot
Posts: 392
Joined: Mon Sep 01, 2008 9:25 pm

Post by bookshot »

Why does everyone ignore CDs? They are about as safe as Treasuries and usually yield far more. Instead of using funds, how much work does it take to ladder CDs, along with Treasuries depending on rates, via a low cost broker? Save the fixed income funds for access to munis, GNMA/GSEs, and ST corporate bonds.
dumbmoney
Posts: 2419
Joined: Sun Mar 16, 2008 8:58 pm

Post by dumbmoney »

Robert T wrote:.
With TIPS at 3% the real return benefits IMO out-weight the downside protection of nominal bond so don’t mind holding a higher share of fixed income in TIPS.
Why not increase the term of the nominal bonds as you decrease the %?
I am pleased to report that the invisible forces of destruction have been unmasked, marking a turning point chapter when the fraudulent and speculative winds are cast into the inferno of extinction.
SmallHi
Posts: 1718
Joined: Wed Feb 21, 2007 5:11 pm

Post by SmallHi »

I agree with Robert's thoughts, and great advice from Graham. I don't think an individual investor should bother shifting between short/long bonds anymore than they should shift between stocks/bonds in a manner other than called for in their IPS. I prefer short term bonds (certainly term is not without its risks -- despite its apparent hedging qualities), but thats just me. If someone wants to ride a bit more TERM, tickets are no doubt available.

DFA does it, and thats fine. It seems to work well, even in light of the one-way interest rate market we've seen in the last few decades, as Fama mentions:
But for 1953-1985 average term premiums decrease with maturity, and the average premiums for four-year and five-year bonds are negative. For 1986-2002 average forward-spot spreads increase more strongly with maturity, from 0.67% for two-year bonds to 1.26% for five-year bonds. Average term premiums increase even more sharply, from 1.05% for two-year bonds to 2.77% for five-year bonds.
Over an entire interest rate cycle, it is DFA's/Fama's opinion that a ST variable maturity portfolio will have returns competitive with a LT indexed/laddered portfolio without much of the volatility and interest rate risk. But not on each side of that cycle. I think the best thing we can say about the approach in the last 20 years is its <using DFA 5YR Global> about matched, net of fees (which were in the 0.4% range 10+ years ago), the returns of the Lehman Credit/Gov't Intermediate Index (1-10YR) with less interest rate and default risk, while outpacing the Lehman Credit/Gov't Short Index (1-5YR), and 1-5YR Hedged World Bond Index -- both with similar maturity limits:

Code: Select all

1/91-9/08

DFA 5YR Global = +6.3%
Lehman 1-10 YR US Gov't/Credit = +6.3%
Citigroup 1-5YR World Bond Index (Hedged) = +6.0%
Lehman 1-5 YR US Gov't/Credit = +5.6%
DFA obviously runs other fixed income funds (One Year, Two Year, Five Year Gov't, and Short Term Muni), some of which have had different results. Fama, to his credit, is pretty honest about it:
To some extent, the fine performance of the funds over the last twenty years is luck. The overall path of interest rates during the live period is down; and, as outlined above, this creates unexpectedly high returns for longer-term bonds. Since the term structure of forward rates is mostly upward sloping during the period, Dimensional's bond portfolios were long most of the time, so they profited from the unexpected decline in rates.


For Int'd Gov't portfolios, Vanguard is about the best in the business, but DFA and iShares all offer excellent options.

sh
User avatar
Topic Author
Robert T
Posts: 2803
Joined: Tue Feb 27, 2007 8:40 pm
Location: 1, 0.2, 0.4, 0.5
Contact:

Post by Robert T »

.
Sh,

I agree, its difficult to assess the relative value added of a DFA variable maturity strategy.

Of the benchmarks you listed, the most relevant one IMO is probably the Citigroup World Government Bond Index 1-5yr (hedged).

As you highlight, there’s a 0.3% difference since the DFA fund inception. Is this due to the corporate bond content of the DFA fund relative to the Citigroup index, or due to the variable maturity approach? Hard to say IMO. A similar question could be posed for the last 1 yr return to end Sept. 2008. Over this period the DFA global 5yr fixed income fund return was 1.67%, while the Citigroup World Gov. Bond index return was 4.88%. Is this difference due to the variable maturity approach (i.e. differences in duration) or due to corporate bond exposure? According to the Annual Report the DFA global 5yr fixed income had 31% in US corporates, 35% in foreign corporates, 31% in foreign government bonds, and 3% in ‘supranational’ bonds.

The variabile maturity approach is interesting and corresponds to Fama's earlier work, but IMO its hard to assess value added (as there is lack of a corresponding benchmark that doesn't use this approach). Finally, given the low explanatory power of Fama's earlier models on this, I wouldn't be surprised if the value add is small, if any (or random). Could be wrong.

Robert
.
SmallHi
Posts: 1718
Joined: Wed Feb 21, 2007 5:11 pm

Post by SmallHi »

Robert T wrote:.
Sh,

I agree, its difficult to assess the relative value added of a DFA variable maturity strategy.

Of the benchmarks you listed, the most relevant one IMO is probably the Citigroup World Government Bond Index 1-5yr (hedged).

As you highlight, there’s a 0.3% difference since the DFA fund inception. Is this due to the corporate bond content of the DFA fund relative to the Citigroup index, or due to the variable maturity approach? Hard to say IMO. A similar question could be posed for the last 1 yr return to end Sept. 2008. Over this period the DFA global 5yr fixed income fund return was 1.67%, while the Citigroup World Gov. Bond index return was 4.88%. Is this difference due to the variable maturity approach (i.e. differences in duration) or due to corporate bond exposure? According to the Annual Report the DFA global 5yr fixed income had 31% in US corporates, 35% in foreign corporates, 31% in foreign government bonds, and 3% in ‘supranational’ bonds.

The variabile maturity approach is interesting and corresponds to Fama's earlier work, but IMO its hard to assess value added (as there is lack of a corresponding benchmark that doesn't use this approach). Finally, given the low explanatory power of Fama's earlier models on this, I wouldn't be surprised if the value add is small, if any (or random). Could be wrong.

Robert
.
Actually, I don't think the World Bond Index is the most appropriate -- for the reason you state. DFGBX can buy AAA rated corporate bonds if it is part of the plan. Hedging foreign gov't or corporate bonds back to dollars puts the holdings on par (adjusted for credit risk) with a US only portfolio. I think ST Bond Index is the best credit/duration matched bogey*.

And, to the extent that DFGBX held any corporate bonds during this stretch, it may have been a net negative. The Lehman 1-5YR Treasury Index compounded at +5.9% over this period, vs. only 5.6% for 1-5YR Credit/Gov't. There was no credit premium over this period, if the US market was indicative of the world market. So that probably took away from the returns, as did the expenses that were probably 0.35% on average for the last 19 years (about 0.28% today). According to a Bernstein article in 1999, they stood at 0.41% at that point.

Finally, almost all short term dislocations between DFGBX and laddered indexes is due to duration mismatches. For much of the time between 2007 and 2/2008, DFGBX had a portfolio duration of about 1 year or so. Maybe some of the underperformance was its corporate exposure. I believe, as of 3/31 and looking on the website for recent holdings, its about 50% Gov't bonds, 50% AAA/AA corporate bonds.

Sometimes it works, other times it looks out of step. A great example is 1993 to 1999, when the Lehman Short Term Bond Index was +5.5% annually, while DFGBX was +7.6%. While US risk free rates were relatively high (and yield curves not very sloped), many overseas curves were very steep, providing better diversification and return potential as DFGBX no doubt owned plenty of hedged, overseas 4 and 5 year bonds.
Again, probably not the credit risk, as ST Treasury beat ST Bond Index over this period by almost 0.2% annually.

Of course more recently paints another picture of relative performance -- this time negative.

Thats all I got. To summarize: 5 years seems about right. Whether you want to make that your average duration or maximum maturity is a matter of personal opinion. The later has certainly worked better in recent memory.

sh

*don't think DFA is trying to set the world on fire with bonds. Since 1991, DFGBX would have outpaced the Vanguard ST Bond Index (the Leh Index net of 0.1% fee) by about 0.8%. Close to their goal of adding 1% to 2% most across asset classes.
User avatar
Topic Author
Robert T
Posts: 2803
Joined: Tue Feb 27, 2007 8:40 pm
Location: 1, 0.2, 0.4, 0.5
Contact:

Post by Robert T »

.
Sh,

Thanks for your thoughts...
Actually, I don't think the World Bond Index is the most appropriate -- for the reason you state. DFGBX can buy AAA rated corporate bonds if it is part of the plan. Hedging foreign gov't or corporate bonds back to dollars puts the holdings on par (adjusted for credit risk) with a US only portfolio.
Using LB 1-5 Government/Credit as the benchmark still doesn’t seem to point to value added with a shifting maturity approach. And don't think this is necessarily a better benchmark than a World Bond benchmark. Here are the returns I get which I will analyze in a bit more detail below.

Code: Select all

Return (%)
     
            DFA 5yr     LB 1-5yr    LB 1-5yr     
          Global FI    Gov/Credit    Gov.
1991         12.77       13.17      12.94
1992          6.48        6.83       6.71
1993         11.53        7.10       6.88
1994         -4.35       -0.71      -0.77
1995         15.99       12.88      12.66
1996         10.83        4.67       4.60
1997          8.31        7.13       7.11
1998          8.36        7.63       7.65
1999          3.71        2.09       1.96
2000          6.66        8.91       9.09
2001          5.93        9.03       8.64
2002         10.39        8.12       7.69
2003          2.97        3.35       2.16
2004          2.89        1.85       1.54
2005          1.72        1.44       1.48
2006          3.89        4.22       4.02
2007          5.22        7.27       7.82
	 		 
Annualized 
Return        6.56        6.11       5.94
SD            4.86        3.86       3.90

The Lehman 1-5YR Treasury Index compounded at +5.9% over this period, vs. only 5.6% for 1-5YR Credit/Gov't. There was no credit premium over this period, if the US market was indicative of the world market. So that probably took away from the returns, as did the expenses that were probably 0.35% on average for the last 19 years (about 0.28% today). According to a Bernstein article in 1999, they stood at 0.41% at that point.
Following the above table, I get a small credit premium from 1991-2007. The LB 1-5 Gov/Credit annualized return was 6.11% while the LB1-5 Gov. annualized return was 5.94%.
Finally, almost all short term dislocations between DFGBX and laddered indexes is due to duration mismatches. For much of the time between 2007 and 2/2008, DFGBX had a portfolio duration of about 1 year or so. Maybe some of the underperformance was its corporate exposure. I believe, as of 3/31 and looking on the website for recent holdings, its about 50% Gov't bonds, 50% AAA/AA corporate bonds.
Following the above table the largest mismatch in returns was 1996 (which accounted for the majority of the outperformance over the full period). Here are the returns from different term exposure in 1996.
  • US Tbill...........5.21%
    1-3 Gov. yr.....5.08%
    1-5 Gov yr......4.60%
    5 yr................2.10%
Compare this with the 10.83% return of the DFA 5 yr Global fixed income fund for that year. If the fund’s term exposure is contrained to 5 yrs or less, the 5% excess return couldn’t be from varying maturities. That leaves credit and foreign exposure. In 1996 there was a positive credit premium (from the above table), but for AA and above this seemed fairly small. From this I conclude that the 1996 difference in return was not due to shifting maturity or US equivalent credit risk, which leaves foreign exposure. If it was due to foreign exposure, then a world bond index may be more relevant.

Again, its difficult to isolate the added value from a shifting maturities approach, and after the above analysis, my ‘value added’ conclusions are the same as in my previous post.

IMO the expectation for the DFA 5yr Global FI fund should be to provide associated returns from exposure to a globally diversified high quality bond portfolio with an average duration of 2-3yrs. Nothing more (which BTW is good in itself). Don’t get me wrong, I want it to outperform as I own share of it through the WV529, but will not be disappointed if it doesn’t (based on the power of Fama’s earlier models on this, which also seems to be reflected in the above analysis). I stand to be corrected. Time will tell.

Robert
.
SmallHi
Posts: 1718
Joined: Wed Feb 21, 2007 5:11 pm

Global Bonds

Post by SmallHi »

Robert,
Using LB 1-5 Government/Credit as the benchmark still doesn’t seem to point to value added with a shifting maturity approach. And don't think this is necessarily a better benchmark than a World Bond benchmark. Here are the returns I get which I will analyze in a bit more detail below.
The World Bond Index is all gov't issues, normally the DFA fund is in the 40% to 60% gov't bond range (and anywhere from 0% to 100%). I think its more important to match funds based on their term and credit qualities, but its not a big deal. DFGBX has a slightly higher correlation to the world bond index than a domestic short term bond index, so statisticially speaking, I guess Citi 1-5YR Gov't Bond Index is the best bogey.
Following the above table, I get a small credit premium from 1991-2007. The LB 1-5 Gov/Credit annualized return was 6.11% while the LB1-5 Gov. annualized return was 5.94%.
My numbers above were a bit more up to date, through 9/30/08, which as we know makes a difference this year, as credit is getting killed.
If the fund’s term exposure is contrained to 5 yrs or less, the 5% excess return couldn’t be from varying maturities. That leaves credit and foreign exposure. In 1996 there was a positive credit premium (from the above table), but for AA and above this seemed fairly small. From this I conclude that the 1996 difference in return was not due to shifting maturity or US equivalent credit risk, which leaves foreign exposure. If it was due to foreign exposure, then a world bond index may be more relevant.
This is accurate, just make sure you (mainly I mean other readers) aren't assuming when you say "foreign" you mean its due to foreign currency exposure. Its due to the exposure of foreign yield curves (which offered higher expected returns at the time) that were fully hedged back to dollars. I am not sure about the credit risk premium, over 70% of the fund was in gov't bonds and supranationals that year.

I believe what happened in 1996 was a display of the variable maturity approach in action. A quick history:

a) For the first 6 months of the year, the fund was relatively short term, matching the return of the 1-5YR Global Index (2.5% for both vs. 1.7% for the 1-30YR Index).

b) For the next 12 months (through 6/97), the fund was fully extended at 5 years or so, basically matching the returns of the 1-30YR Global Index (+12.7% for DFGBX vs. +8.5% for the 1-5YR Global Index and +7.4% for the 1-3YR Global Index)

Sometimes, the fund turns on a dime when yield curves change drastically.
Again, its difficult to isolate the added value from a shifting maturities approach, and after the above analysis, my ‘value added’ conclusions are the same as in my previous post.


Thats fine, its not the easiest analysis for sure. From 91-07, DFGBX was only able to add about 0.5% annually above the Citi 1-5YR Gov't Index (hedged), which to some may seem statistically insignificant or random. Can't argue much with that.

However, if we realize the fund had expenses, then we are looking at closer to 0.9% gross outperformance (just to study the long term benefits <if any> of the variable maturity approach). Also, 0.5% net outperformance might not seem like much, however when we consider the Vanguard Short Term Bond Index has underperformed its index by 0.25% annually for the last 10 years, we realize outpacing a bond index is not usually a small task. I believe you pointed out at one point the Vanguard ST Investment Grade fund is closer to 0.5% a year behind its index in the last decade. Since 1991, Vanguard ST Treasury is about 0.2% behind the 1-5YR Treasury Index.
IMO the expectation for the DFA 5yr Global FI fund should be to provide associated returns from exposure to a globally diversified high quality bond portfolio with an average duration of 2-3yrs.


If this were the expectation, at least historically, you would have been pleasantly surprised. With a TERM premium of +4.92% from 91-07, a CREDIT premium of (1.0%), and DFGBX's term exposure of 0.3 and credit exposure of 0.1, you'd expect a return of around +5.4% (or +1.4% abov 1 month t-bills). Instead, net of fees, DFGBX compounded at +6.6%. Although the r^2 over this period is only about 0.60, it does register a stastically signifcant alpha of 0.09% per month.

Actually, over this period, even though it is a short term fund, it basically matched the Ibbotson 5YR Treasury Index -- an intermediate term portfolio. I guess the goal is, if you can come closer to intermediate fund's returns during a period of falling rates, and then closer to an ultra short fund during a period of rising rates...you are going to see attractive results over the full cycle.

My opinion--its a fine fund, and I do believe the diversification across bond markets is a benefit over time. Sometimes there appears to be "gifts" in the way of steeper foreign yield curves. And if most term premiums come from upward slopes, diversifing across 5 to 10 or more at a time seems to spread the risk somewhat--although, as we have seen in the last year, flat curves don't always indicate the lack of a future term premium.

You have of course fared much better in the last 6 years with Int'd Treasuries/TIPS however, so I doubt you are sweating this small stuff.
Don’t get me wrong, I want it to outperform as I own share of it through the WV529
I don't, I am just trying to pump you up! :lol:

later,

sh
User avatar
Topic Author
Robert T
Posts: 2803
Joined: Tue Feb 27, 2007 8:40 pm
Location: 1, 0.2, 0.4, 0.5
Contact:

Post by Robert T »

.
Sh,

Few more, perhaps final thoughts…..
I believe what happened in 1996 was a display of the variable maturity approach in action. A quick history:

a) For the first 6 months of the year, the fund was relatively short term, matching the return of the 1-5YR Global Index (2.5% for both vs. 1.7% for the 1-30YR Index).

b) For the next 12 months (through 6/97), the fund was fully extended at 5 years or so, basically matching the returns of the 1-30YR Global Index (+12.7% for DFGBX vs. +8.5% for the 1-5YR Global Index and +7.4% for the 1-3YR Global Index)
Perhaps partly, but still seem to be a large share unexplained…

1996 returns

................................1st 6 mths..........2nd 6 mths
US Tbill.......................2.52%…........……2.62%
1-3 Gov. yr.................1.43%………........3.61%
1-5 Gov yr...................0.77%…….....….3.79 %
5 yr...........................-2.15%……......…..4.34%

DFA 5 yr Global ………..2.49%……..........8.12%

For 1996, from the above returns, the best return in the first 6 mths (2.52) added to the best return in second 6 mths (4.34%) comes to about 7%. My understanding was that the DFA 5 yr Global Fund has a maturity cap of 5 yrs (from Prospectus “It is the policy of the Portfolio that the weighted average length of maturity of investments not exceed five years”). So there still appears to be significant ‘non’ varying maturity related returns (from the above table comparison). There was a small credit premium in the second 6 mths of 1996 (LB 1-5 Gov returns were 3.79%, compared with the 3.87% returns for the LB 1-5 Gov./Credit returns). But this doesn’t seem to explain the close to 4% difference (10.8 for the DFA 5yr Global FI vs. the 7% for similar varying maturity fixed income). Interestingly the Payden Global Fixed Income return for the second 6 mths of 1996 was 6.41% (closer to the 8.12% for the DFA fund), which seems to suggest foreign (hedged) exposure may explain part (perhaps even more) of the difference. Again, the above analysis doesn't seem to suggest that most of the difference/value added (the largest of the 1991-2007 period) was due to varying maturity. Perhaps DFA have a more exacting analysis of this...but the above results are not too convincing.

Robert

PS: Using US bond factors in the FF two factor regression on a global bond fund complicates interpretation IMO, as would using US equity factors in a FF three factor regression on a global stock fund. Therefore difficult to draw strong conclusions (as the R^2 suggests)…
You have of course fared much better in the last 6 years with Int'd Treasuries/TIPS however, so I doubt you are sweating this small stuff.
Yes, just trying to check the claims of significant superiority of the DFA variable maturity approach... :)
.
SmallHi
Posts: 1718
Joined: Wed Feb 21, 2007 5:11 pm

Post by SmallHi »

Robert,

First...a couple of broad thoughts -- because I am not sure we are on the same page.

There are a few aspects to the "variable maturity" approach in DFAs 5YR Global fund <its not as simple as "shifting rates">:

1) evaluate 10 or more different global yield curves (europe, aussie, jap, UK, canada, US, etc) for the steepest slopes (Fama/DFA assume term premiums are most reliable when yield curves are upwardly sloped). This could result in 100% US <2003>, or 0% US <1997>. This will be variable.

2) Within each yield curve, evaluate the buy and sell decisions based on current prices (buy a 5 year bond with the intension of selling it in one year and buying another 5 year bond...or buy a 3 year and hold it two years...etc). This too will be variable.

3) Within each yield curve, evalate the spreads (and slopes) of corporate vs. gov't bonds, and opt for credit risk when yield spread is sufficient to justify the risk (coupon premium of 3% or more, or whatever the rule is). Finally, this also is variable.

...so, to that extent, I believe all 3 ("the variable maturity approach) contributed positively in some way to DFGBXs significant return in 1996 (and has detracted from returns recently as it was "too short" last year).

As I pointed out using the hedged global bond indexes of 1-3 (ultra short), 1-5 (short), and 1-30 (medium/long with TERM of 0.5 -- or similar to when DFGBX has reached "maxium extension"), the shifting maturities of the fund from short to long midway through 1996 turned out to be very precient with hindsight...and using those indexes, its clear to see where most of the returns came from. No need to use the US indexes as the US curve was shaped differently and did not change as foreign curves did.

Also, remember that the bond indexes keep constant exposures to the various bond markets, where DFGBX can isolate 2 or 3 contries where yield curves are particularly steep and avoid others that must stay in the index. In 1996, the fund only invested in about 5 bond markets, vs. the 10 or more in the index. Not every overseas yield curve was upwardly sloped -- thats likely where the extra return enhancement came from.
For 1996, from the above returns, the best return in the first 6 mths (2.52) added to the best return in second 6 mths (4.34%) comes to about 7%. My understanding was that the DFA 5 yr Global Fund has a maturity cap of 5 yrs (from Prospectus “It is the policy of the Portfolio that the weighted average length of maturity of investments not exceed five years”). So there still appears to be significant ‘non’ varying maturity related returns (from the above table comparison). There was a small credit premium in the second 6 mths of 1996 (LB 1-5 Gov returns were 3.79%, compared with the 3.87% returns for the LB 1-5 Gov./Credit returns). But this doesn’t seem to explain the close to 4% difference (10.8 for the DFA 5yr Global FI vs. the 7% for similar varying maturity fixed income). Interestingly the Payden Global Fixed Income return for the second 6 mths of 1996 was 6.41% (closer to the 8.12% for the DFA fund), which seems to suggest foreign (hedged) exposure may explain part (perhaps even more) of the difference. Again, the above analysis doesn't seem to suggest that most of the difference/value added (the largest of the 1991-2007 period) was due to varying maturity. Perhaps DFA have a more exacting analysis of this...but the above results are not too convincing.
Again, I have tried to be more specific about the sources of returns. When the fund was over 90% in foreign markets (but always fully hedges back to US dollars -- which eliminates currency risk and only exposes one to interest rate risk across bond markets), I am not sure the behavior of US markets mattered much at all over this period -- it was primarily the regional specific variable maturity decisions. Thats why I said above that I could see why Citi 1-5 YR World Bond Index maybe the best bogey. (even though ST Bond Index has closer credit charateristics to DFGBX)
PS: Using US bond factors in the FF two factor regression on a global bond fund complicates interpretation IMO, as would using US equity factors in a FF three factor regression on a global stock fund. Therefore difficult to draw strong conclusions (as the R^2 suggests)…
I don't think the stock factors : bond factors are completely fair. For one, most Int'l stocks are unhedged. Furthermore, globally hedged bond markets are more highly correlated that global equity risk factors.

The 60% isn't perfect, or the 95% we'd hope for or get with the 3F model, but we can certainly speak intelligently about more than half of the returns we are witnessing. With the shifting global maturities, shifting global markets, and shifting credit decisions, the strategy is obviously too robust and strategic for a simple 2 factor model. Local term and credit premiums across 10 different markets would likely be necessary -- a 20 factor fixed income model I guess.

Just as I believe global size, value, and equity premiums should be the same over time, I also think global term and credit risks should also be similar....just won't track closely every year. But from a risk/adjusted basis, I think ST Bond Index (not Global Gov't Index) is the appropriate bogey -- even with modest tracking error.
Yes, just trying to check the claims of significant superiority of the DFA variable maturity approach...


Well, 0.5% annual outperformance net of fees over global bond benchmarks, when most bond indexes trail theirs by 0.25% or more is a pretty good start. In reality, if the variable maturity strategy works as it should (and is intended) over an entire interest rate cycle, we could see returns higher than ST, Int, or LT bonds.

Just image the period of 64-07. If a fund captured the "1-5YR return" from 64-81, and then closer to the "5YR return" from 82-07 <"variable*>, that would be a higher total return than short/medium/or long static portfolios without the significant volatility or inflation risk:

Code: Select all

1964-2007

1YR = +6.7%
*Variable = +7.7%
5YR = +7.4%
20YR = +7.5%
Depending on your expectations I guess, it seems to be working. Just my view.

Thats all for me, thanks for the Graham quote, I had been looking for something like that from him.

sh
Post Reply